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The marginal cost of capital could be defined as the cost of raising an additional unit of capital which is defined in terms of currency. The financial manager always makes it sure that capital is raised for a substantial amount. Since the capital is always raised in substantial amount, in practice the marginal cost is referred to the cost incurred by the business in raising extra funds which could be used in order to attain the long term financial goals of the business.
Marginal cost is derived through average cost.
The procedure of computation and calculation of marginal cost is pretty simple. The marginal cost is simply derived when the average cost is computed by using the marginal weights. Marginal weights are thus the indicators of the proportion of the funds which the firm wants to employ. The biggest benefit in this concept is the fact that there is no problem is choosing the weights between book value weights and marginal value weights.
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While the marginal cost is computed, the calculation is carried out in a much more composite manner.
For the process of calculation of weighted marginal cost of capital, the intended financing proportions should be applied as weights to marginal component costs. (Horne, Wachowicz, 2008) A business organization raises the funds in ratios or proportions. If any business follows the same procedure and practice for over large number of periods, there will hardly be any difference between average cost of capital and marginal cost of capital. The components costs could remain constant up to certain level of funds raised and then it could then start increasing with the amount of funds raised.
It is common phenomena that whenever the cost of components start increasing, the overall average cost of the capital will increase.
The difference being the fact that marginal cost will increase at a faster rate. Weighted Marginal Cost of Capital Schedule: It could be simply defined as a graph which shows the relationship between weighted average cost of per unit of capital with that of the new funds raised in the organization. The relationship could be defined as: WMCC Schedule: Weighted Average Cost per unit: New Funds raised (Total Amount)
As it is already been discussed, weighted average cost of capital is the minimum rate of return allowed when the organization is meeting the financial obligations like payment of interest, debt and dividend in some cases. In other words, WACC could be defined as the tool which averages the return from various sources of capital. Assumptions of the schedule: While constructing the WMCC schedule, it is assumed that the optimal structure of the capital for the business organization is fixed.
Another assumption is the fact that the company does not have any intention of moving from the current optimal capital structure. As long as the capital costs remain constant, the schedule is pretty smooth as the WAC and MC of capital are equal. When more expensive forms of capital are used, the variation between the marginal cost and averge cost of capital starts to increase. The points at which the MCC jumps from the smooth straight line are known as break points.
In most of the cases it gives accurate decisions and the information derived from this schedules is a common tool in the financial decision making. Whenever the equity component of capital is introduced, the schedule will not be able to present the complete picture. When new equity is introduced in the organization, it results in diluting the control of management over the affairs of the company. But this fact is ignored in the schedule. This simply draws a relationship. (Brigham, Ehrhardt, 2007).
Financial Goals of the Business. (2020, Jun 02). Retrieved from https://studymoose.com/financial-goals-of-the-business-essay
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