In economics, marginal cost of capital refers to the added cost associated with securing one additional unit of capital investment. It is typically expressed as a percentage, similar to an annual percentage rate or rate of return. In simple terms, marginal cost of capital (MCC) is equal to the cost of financing one more dollar of capital investment. Generally speaking, the more money a firm tries to borrow, the higher the interest rate on these funds, thus the higher the marginal cost of capital. MCC should not be confused with marginal cost of production, which refers to the added cost of producing one more unit of product.
Businesses have three basic options for financing new capital, such as equipment or factories. These include reinvesting retained earnings, borrowing from investors using stock certificates, or borrowing from banks and taking on debt. Most companies who wish to invest in new capital will start by investing retained earnings, as this form of financing does not have any associated costs.
After retained earnings have been depleted, the company must compare the marginal cost of capital to the expected rate of return from this new capital investment to determine how much to borrow, or how much stock to issue. If the expected rate of return of borrowing more money is greater than the MCC, the firm will take on the debt. If the MCC is higher than the expected rate of return, then the firm will likely not take on the new debt.
To understand why marginal cost of capital increases as firms try to borrow more, or find more investors, consider the simple law of supply and demand. The more stock holders a company has, the greater the supply of stock available. With so many existing investors, firms will have trouble finding a supply of suitable investors to buy their stock. To attract more investors to buy this additional stock, the company will have to pay a higher price to investors, resulting in a higher MCC.
It can be very easy to confuse marginal cost of capital with total cost. To understand the difference, consider a company that wishes to borrow $100,000 US Dollars (USD) to invest in new equipment. A bank offers to make this loan at an annual percentage rate, or total capital cost of 12 percent. If the company wishes to borrow $110,000 USD, the bank will charge 15 percent interest on the additional $10,000 USD to cover the added risk of the larger loan. This means that the MCC is 15 percent on the extra capital, while the total cost of capital is between 12 and 15 percent.