The marginal cost of capital is the cost that a company incurs by raising each additional dollar. This weighted value combines the marginal costs for issuing preferred stock, common stock and debt, which are the three different methods of raising capital. Shares cost the company through the expense of paying dividends. Debt costs the company through the expense of paying interest, though the company can deduct part of this expense from its tax liability.
Decide the proportion of capital you want to raise from each source. For example, a company may choose to raise its 20 percent of its capital from preferred stock, 30 percent of its capital from common stock and 50 percent of its capital from debt. In this case, a new dollar will need 20 cents from preferred stock, 30 cents from common stock and 50 cents from debt.
Divide the dividend that the company has promised for each preferred share by the preferred stock price. For example, suppose that the company issues new preferred stock at $40 per share, promising a $5 dividend per share. Divide $5 by $40, giving 0.125.
Multiply the factor from the previous step by the number of cents you must receive from preferred stock. With this example, multiply 0.125 by 20, giving 2.5 cents.
Divide the common shares' initial dividends by their share price. For example, suppose that the company issues new common stock at $50 per share, offering an initial $4.50 dividend per share. Divide $4.50 by $50, giving 0.09.
Add to this value the common stock dividends' predicted growth rate. For example, if you predict the dividends will grow by 6 percent each year, add 0.09 to 0.06, giving 0.15.
Multiply the factor from the previous step by the number of cents you must receive from common stock. With this example, multiply 0.15 by 30, giving 4.5 cents.
Subtract the company's marginal tax rate from 1. For example, if the company's profits face a 35 percent marginal tax rate, subtract 0.35 from 1, giving 0.65.
Multiply this value by the yield on the debt that the company issues. For example, if the company issues debt with a yield of 5 percent, multiply 0.05 by 0.65, giving 0.0325.
Multiply the factor from the previous step by the number of cents you must receive from debt. With this example, multiply 0.0325 by 50, giving 1.625 cents.
Add the costs from Steps 3, 6 and 9. Adding 2.5, 4.5 and 1.625 gives 8.625. This is the marginal cost of capital, measured in cents. Divide it by 100 to give $0.08625, the cost in dollars.
- James Madison University: The Cost of Capital
- Contemporary Financial Management; R. Charles Moyer, et al.