In this article we will discuss about the opportunity and marginal cost of capital, with the help of suitable diagrams.
Opportunity Cost of Capital:
When an organization faces shortage of capital and it has to invest capital in more than one project, then the company will meet the problem by rationing the capital to projects whose returns are estimated to be more. The firm might decide to estimate the opportunity cost of capital in other projects.
Western Ltd. has got two project proposals A and B on hand with limited resources to take up one out of it. The estimated return on capital employed of two projects are 15% and 18% respectively.
The opportunity cost of capital for taking up Project A is 18%, since if the funds are invested in Project B, the company will get 18% return on invested funds. Hence, expected return on Project B is the opportunity cost of capital for Project A.
Another approach to opportunity cost of capital concept is that the expected rate of return that equates to the market interest rate for investments of a similar risk profile. While discounting the risky cash flows at different rates, the companies will take into consideration different risk premium for different types of investments depending on the nature of investment. This is usually in the form of premium on what is considered the basic company cost of capital.
The opportunity cost of funds can be analyzed from the following two angles:
Opportunity Cost of Equity Funds:
If a company cannot earn sufficient profits, shareholders will be dissatisfied. The company will not be able to raise funds from new issue of shares, because investors will not be attracted.
Existing shareholders who wish to sell their shares will find that buyers, who can invest in whatever securities they choose, will offer a comparatively low price, and the market price of the shares will be depressed. Since investors have a wide range of shares available to them there is a market opportunity cost of equity funds.
Opportunity Cost of Debt Funds:
Financial management is concerned with obtaining funds for investment, and investing those funds profitability as to maximize the value of the firm. It is not enough to invest at a profit, it is necessary to invest so that the profits are sufficient to pay lenders a satisfactory amount of interest.
If a company cannot pay interest at the market rate demanded by lenders, the lenders will prefer to invest elsewhere on the capital market, where they can get this rate. There is a market opportunity cost of debt funds which a company must expect to pay for new finance.
Marginal Cost of Capital:
Firms calculate cost of capital in order to determine a discount rate to use for evaluating proposed capital expenditure projects. The cost of capital is measured and compared with the expected benefits from the proposed projects. The marginal cost of funds is the cost of the next increments of capital raised by the firm.
The costs of additional individual components of finance like shares, debentures, term loans etc. should be ascertained to determine its weighted marginal cost of capital. The new capital projects should be accepted if they have a positive net present value calculated after discounting the revenue and cost streams at marginal cost of capital to the firm.
Emphasis is being placed on marginal cost of capital, for it is used as a cutoff point for new investments. The concept of marginal cost of capital is based on economic theory that a firm should undertake a project whose marginal revenues are in excess of its marginal costs. When the capital investment decisions are taken in consonance of this principle, shareholder’s wealth is maximized.
The weighted average cost of capital (WACC) of the firm is not relevant for making new (marginal) resource allocation decisions. All the projects that have an internal rate of return greater than its marginal cost of capital would be accepted.
Only when the returns of a particular project is in excess of its marginal cost of capital, can add to the total value of the firm. The marginal cost of capital of additional finances of a new project will reflect the changes in the total weighted average cost of capital structure, after the introduction of new capital into the existing capital structure.
Investment Appraisal and WACC:
The cost of capital is a market determined rate of interest, and is the discount rate or required rate of return which is used for discounting cashflows in investment appraisal calculations. The overall investment of a firm, in different projects can be invested, so long as its internal rate of return is above its WACC.
Figure 26.1 illustrates that the firm can invest in projects A, B, C and D because their returns exceed the firm’s cost of capital. The firm’s value is maximized by selection of project A, B, C and D. Projects E and F should be rejected, otherwise the value of the firm will be diminished.
Marginal Cost of Capital and WACC:
The relationship between marginal cost of capital (MCC) and weighted average cost of capital (WACC) is explained in figure 26.2.
While MCC is less than WACC, the WACC will fall. When MCC raise above WACC, the WACC will also show an increase, but the rate of increase is lesser than the rate of increase of MCC.