Incremental Cost of Capital: What It Is and How It Works
What it is
Incremental cost of capital is the average cost a company will incur to raise one additional unit of financing, whether through debt or equity. It reflects the marginal effect of new issuances on the company’s overall cost of funds and can differ from the company’s current average cost.
Why it matters
- It helps determine the true hurdle rate for new projects: companies should accept projects whose returns exceed the incremental cost of the capital used to fund them.
- It signals changes in financial risk: rising incremental costs often indicate higher perceived risk or heavier leverage.
- It guides financing strategy: knowing the incremental cost helps choose between issuing debt or equity and timing market access.
How it works
- Each additional issuance of debt or equity can change a company’s risk profile and hence the required returns demanded by investors.
- As debt increases, lenders may demand higher interest rates (coupons) to compensate for added credit risk. Similarly, issuing equity can alter shareholder expectations and cause dilution concerns.
- The incremental cost is the weighted average cost of the new sources of capital raised during a period — essentially the marginal or composite cost of the funding being added.
Calculating incremental cost (conceptual)
- Determine the cost of the new sources:
- Cost of new debt (after tax) ≈ Rd × (1 − Tc), where Rd is the interest rate on new debt and Tc is the tax rate.
- Cost of new equity can be estimated with models such as CAPM: Re = Rf + β(Rm − Rf), or via expected dividend/earnings growth.
- Weight each new source by its proportion in the incremental financing mix to get the weighted average incremental cost.
- Note: This incremental rate can differ from the firm’s existing WACC because new capital may have different costs than existing capital.
Example (simplified):
– If a company raises 70% debt at an after-tax cost of 4% and 30% equity at a cost of 10%, the incremental cost ≈ 0.70×4% + 0.30×10% = 5.8%.
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Relation to WACC (composite cost of capital)
- WACC (weighted average cost of capital) measures the average cost of all capital on the balance sheet, weighting each component by market value.
- Incremental cost is focused on marginal financing — the cost of the next dollars raised — and may be higher or lower than WACC depending on market conditions and the company’s credit standing.
- Both are used in capital budgeting, but for evaluating a new project, the incremental cost often provides a more accurate hurdle rate.
Impacts on investors and stock price
- A rising incremental cost of capital signals increased financing risk and can reduce investor confidence.
- If debt becomes costly, companies may shift to issuing equity, which can lead to share dilution and further downward pressure on stock price.
- Investors monitor changes in incremental cost as an indicator of capital structure stress or shifts in growth and financing strategy.
Practical use in decision-making
- Use the incremental cost to evaluate project acceptance: accept projects with expected returns above the incremental cost associated with funding them.
- Reassess financing mix when incremental costs change — a sudden rise may justify deleveraging or delaying new debt issuance.
- Consider both short-term funding needs and long-term capital structure implications when choosing debt versus equity.
Key takeaways
- Incremental cost of capital measures the marginal cost of raising additional debt and equity.
- It can differ from a company’s current average cost and often increases as more capital is raised.
- It is a critical input for capital budgeting and for assessing financial risk and optimal financing strategy.
Conclusion
Understanding incremental cost of capital allows managers and investors to make better-informed financing and investment decisions. It complements measures like WACC by focusing on the marginal cost of new funds and the real-world effects of raising additional capital.