Question

Explain the definitions and differences between the weighted average cost of capital and the marginal cost of capital.   What business decisions are impacted by the marginal cost of capital and why is the marginal cost of capital calculated for this purpose?

Answer 1

Weighted average cost of capital(WACC) is the weighted average of debt and equity used in the capital structure of a firm. The WACC is normally used for valuation purposes if the investment undertaken by the firm is of average risk.

The Marginal cost of capital on the other hand is the weighted average of the last dollar of capital raised by the company. This is used as a parameter by the equity and debt holders to demand the rate of return from the company raising the capital. The marginal cost of capital differs from the WACC as the company which is already high on capital raises more and more capital thus the capital providers demanding higher required returns, The projects would be accepted only if the expected returns is higher than the required returns(marginal cost of capital).

The marginal cost of capital is typically employed for a firm where is capital is scarce and the firm increasingly uses capital to finance expansion raising the costs of capital.