Q. Explain Marginal cost of capital?
The calculation of cost of capital focused when the firms total financing and its paten of financing is given and remains constant. However in practice the investment proposal may require funds to be raised from new internal external sources and thus, increasing the total funds also.
The cost of capital of the additional funds is called the marginal cost of capital. If the additional financing uses more than one source, say a combination of debt and preference share capital, then the WACC of the new financing is called the Weighted Marginal Cost of Capital (WMCC).
The WMCC for any firm depends upon several factors and therefore the calculation of WMCC is a typical exercise. The following variables may affect the marginal cost of capital of a specific source and thereby may affect the WMCC as follows:
1) The investors may perceive an increase in business risk of the firm.
2) The financial risk of the firm may also change as a result of change in composition of the capital structure.
3) The increase in business and financial risk may increase the marginal cost of capital.