Investing Basics

What is Weighted Average Cost of Capital Wacc and Marginal Cost of Capital



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As the names imply, both Weighted Average Cost of Capital (WACC) and Marginal Cost of Capital measure cost of capital. Capital is any money used to finance a business and/or its operations and can include a number of sources and methods. These sources may include traditional debt or equity financing or owner financing. Other forms of financing include grants, gains on investment capital, retained earnings, accrual financing contracts and forward payment agreements on capital.

Marginal cost of capital

Different types of capital are used in different amounts and for different costs. It is the costs of capital that is marginal and may involve or include a basic interest rate cost structure. For example, if Company A acquires a loan for $100K at an interest rate of 7% for one year, compounded annually, that capital will cost $7K. A simple average cost of capital may not accurately represent the true cost of capital for a company. For example, if Company A is financed by 1) $100K of debt at 7%, 2) $50K of equity at 12% and 3) $75K of owner financing at 0%, the average cost of capital would be 7% + 12% + 0% divided by 3=%19/3=6.33%. However this cost is not accurate because it does not take into account the different amounts of money at the different rates. In order to amend this discrepancy in calculation, the weighted average cost of capital is used.

Weighted average cost of capital

Weighted average cost of capital multiplies the amount of capital by the percent rate of cost for that capital as a proportional percentage of total capital and then averages 2 or more costs that are calculated in the same way. This can be further understood by dividing the previous sentence into two concepts 1) average amount of total capital and 2) percentage cost of capital type. Using the above example concept 1 is illustrated below:

Concept 1: Average Amount of Total Capital

If 3 types of capital are used; one at 44.44% of total capital, two at 22.22% of capital, and 3 at 33.33% of total capital the three added together add up to 99.99% of total capital. These 3 percentages are the proportions by which each rate of capital cost must be multiplied by in order to obtain the weighted average cost of capital.

Concept 2: Percentage Cost of Capital

The percentage cost of capital takes the marginal cost of capital and multiplies that by the proportional cost of capital. To continue illustrating with the above example, Company A uses $7K at 7% of debt at 44.44% of total capital that equals a proportional rate of 3.11%. Using the same reasoning for the $50K of equity at 12% and $75K of owner financing at 0%, WACC becomes 3.11% + 2.66% + 0%=5.77%/3=1.9233%. So the weighted average cost of capital is 1.9233% and is a more accurate representation of Company A's cost.

Summary

Marginal cost of capital and weighted average cost of capital a cost values that help a company manage its capital budgeting and asset management operations. Without knowing cost of capital, a company is less able to determine what rate of return projects and investments are required in order to break even, or surpass initial cost to acquire a profit margin. Marginal Cost of Capital may involve less calculation than WACC, however marginal cost may be calculated by incorporating tax rates, overhead, insurance or any other cost associated with acquiring the particular capital.

Marginal cost of capital can be included in the weighted average cost of capital calculation because each type of capital when weighted itself has marginal cost. Thus, marginal cost of capital and weighted average cost of capital are not necessarily mutually exclusive. Moreover, weighted average cost of capital generally cannot be a component of marginal cost of capital whereas the inverse is true for marginal cost of capital. Marginal cost of capital and WACC are important cost variables used in finance, accounting, project management, strategic management in addition to non-corporate analysis of the company such as in auditing, investment analysis, tax regulation and external financing.

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