Tuesday, July 1, 2014

Corporate Finance - Marginal Cost of Capital

The marginal cost of capital  is the cost of the last dollar of capital raised, essentially the cost of another unit of capital raised, As more capital is being raised, the marginal cost of capital rises,
as we compute weighted average cost of capital as follows: 

WACC = (wd)(kd)(1-t), + (wps)(kps) + (wce)(kce),
WACC = (0.4)(0.07)(1-0.4), + (0.05)(0.021), + (0.55)(0.12) ,
WACC = 0.084, or 8.4%

We originally determined the WACC for  to be 8.4%.  cost of capital will remain unchanged as new preferred stock, debt, & retained earnings are issued until the company's retained earnings are depleted. 

Example: Marginal Cost of Capital
Once retained earnings are depleted, one person decides to access the capital markets to raise new equity.  Assume the company's stock is selling for $40/-, its expected ROE is 10%, next year's dividend is $2.00/- and the company expects to pay out 30% of its earnings, Additionally, assume the company has a flotation cost of 5%. Cost of new equity (kc) is thus 12.3%, 

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