Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

The Marginal Cost of Capital

The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.


LEARNING OBJECTIVE

  • Describe how the cost of capital influences a company's capital budget

KEY POINTS

    • The marginal cost of capital is calculated as being the cost of the last dollar of capital raised.
    • When raising extra capital, firms will try to stick to desired capital structure, but once sources are depleted they will have to issue more equity. Since this tends to be higher than other sources of financing, we see an increase in marginal cost of capital as capital levels increase.
    • Since an investment in capital is logically only a good decision if the return on the capital is greater than its cost, and a negative return is generally undesirable, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into raising more capital.

TERMS

  • capital gains yield

    compound rate of return of increases in a stock's price

  • marginal tax rate

    the percent paid out to the government of the last dollar (or applicable currency) earned

  • Marginal Cost of Capital

    The cost of the last dollar of capital raised or the minimum acceptable rate of return or hurdle rate.

The marginal cost of capital is calculated as being the cost of the last dollar of capital raised. Generally we see that as more capital is raised, the marginal cost of capital rises . This happens due to the fact that marginal cost of capital generally is the weighted average of the cost of raising the last dollar of capital. Usually, we see that in raising extra capital, firms will try to stick to desired capital structure. Usually once sources are depleted they will have to issue more equity. Since the cost of issuing extra equity seems to be higher than other costs of financing, we see an increase in marginal cost of capital as the amounts of capital raised grow higher.

The Marginal Cost of Capital is the cost of the last dollar of capital raised. It is an important consideration the firm must take into account when making corporate decisions.

The marginal cost of capital can also be discussed as the minimum acceptable rate of return or hurdle rate. The investment in capital is logically only a good decision if the return on the capital is greater than its cost. Also, a negative return is generally undesirable. As a result, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into raising more capital. If it is determined that the dollars invested in raising this extra capital could be allocated toward a greater or safer return if used differently, according to the firm, then they will be directed elsewhere. For this we must look into marginal returns of capital, which can be described as the gains or returns to be had by raising that last dollar of capital.