Intro to Finance: Cost of Capital - Marginal vs. Historical, Cost of Capital

What This Is

The marginal cost of capital (MCC) and historical cost of capital (HCC) are two distinct concepts used in finance to evaluate a company's capital structure and investment decisions. The MCC represents the cost of capital for a new investment, while the HCC is the average cost of capital for the company's existing capital structure. Understanding the difference between MCC and HCC is crucial for making informed investment decisions and evaluating a company's capital structure.

For example, consider Apple Inc., which has a market capitalization of $2 trillion and a debt-to-equity ratio of 0.2. If Apple wants to invest in a new project with a required return of 12%, the MCC would be 12%, while the HCC would be a weighted average of the company's existing debt and equity costs.

Key Formulas & Symbols

• MCC = (E/V) × Re + (D/V) × Rd where MCC = marginal cost of capital, E = market value of equity, V = total market value, Re = required return on equity, D = market value of debt, Rd = required return on debt.
• HCC = (E/V) × Re + (D/V) × Rd where HCC = historical cost of capital, E = book value of equity, V = total market value, Re = required return on equity, D = book value of debt, Rd = required return on debt.
• WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc) where WACC = weighted average cost of capital, E = market value of equity, V = total market value, Re = required return on equity, D = market value of debt, Rd = required return on debt, Tc = corporate tax rate.
• TCO = (E/V) × Re + (D/V) × Rd × (1 - Tc) + (P/V) × Rf where TCO = total cost of capital, E = market value of equity, V = total market value, Re = required return on equity, D = market value of debt, Rd = required return on debt, Tc = corporate tax rate, P = preferred stock, Rf = required return on preferred stock.
• TCO = WACC + (P/V) × Rf where TCO = total cost of capital, WACC = weighted average cost of capital, P = preferred stock, Rf = required return on preferred stock.
• MCC > HCC when the company's capital structure is changing, and the MCC represents the cost of capital for a new investment.
• MCC = HCC when the company's capital structure is stable, and the MCC represents the average cost of capital for the company's existing capital structure.

Step-by-Step Calculation

1. Calculate the market value of equity and debt for the company.
2. Determine the required return on equity and debt using the CAPM or other methods.
3. Calculate the MCC using the formula MCC = (E/V) × Re + (D/V) × Rd.
4. Calculate the HCC using the formula HCC = (E/V) × Re + (D/V) × Rd.
5. Calculate the WACC using the formula WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc).
6. Calculate the TCO using the formula TCO = WACC + (P/V) × Rf.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value instead of book value to reflect the current market price of the company's equity and debt.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate of return on an investment, while NPV is the present value of an investment's cash flows. Use IRR to evaluate the attractiveness of an investment and NPV to evaluate the investment's value.
• Mistake: Not considering the corporate tax rate when calculating WACC.
• Correction: Include the corporate tax rate in the WACC formula to reflect the tax benefits of debt financing.

Exam / CFA Tips

• Tip: When calculating WACC, use market value instead of book value for equity and debt.
• Tip: When evaluating an investment, use IRR to determine the rate of return and NPV to determine the investment's value.
• Tip: When calculating TCO, include the corporate tax rate and the required return on preferred stock.

Quick Practice Problem

Apple Inc. has a market capitalization of $2 trillion and a debt-to-equity ratio of 0.2. If Apple wants to invest in a new project with a required return of 12%, what is the MCC?

Answer: 12% Explanation: The MCC is the required return on the new investment, which is 12%.

Last-Minute Cram Sheet

• The MCC represents the cost of capital for a new investment, while the HCC represents the average cost of capital for the company's existing capital structure.
• The WACC is a weighted average of the company's equity and debt costs, including the corporate tax rate.
• The TCO is the total cost of capital, including the WACC and the required return on preferred stock.
• The MCC and HCC are not the same, and the MCC is not always equal to the HCC.
• The CAPM is used to determine the required return on equity and debt.
• The book value of equity and debt is not the same as the market value of equity and debt.
• The IRR is the rate of return on an investment, while the NPV is the present value of an investment's cash flows.
• The corporate tax rate is included in the WACC formula to reflect the tax benefits of debt financing.