What it means
Most people first meet the weighted average cost of capital, which blends the cost of all the debt and equity currently on the balance sheet. That average is a historical figure, and it can be badly misleading once market conditions have moved since the funding was raised.
The incremental cost of capital asks a forward-looking question instead: what will the next dollar cost? The two numbers can differ sharply.
A company that borrowed at 4% three years ago may face 8% today, so a project judged against the old average would look attractive while actually destroying value. Using the incremental figure as the hurdle rate keeps investment decisions honest.
It is calculated in the same way as a weighted average, but with the weights and rates of the new money only. If a firm plans to fund a $10 million expansion with 60% debt and 40% equity, the incremental cost is the after-tax cost of that new debt and the required return on that new equity, weighted 60 and 40.
Interest is taken after tax because it reduces taxable profit, while dividends do not. The cost rises in steps rather than smoothly.
Cheap sources run out in order: internal cash first, then the existing credit facility, then a more expensive tranche of debt, then new equity, and each step lifts the marginal rate. The points where the rate jumps are called break points, and plotting them produces the marginal cost of capital schedule.
The main caution is not to treat the incremental cost as project-specific risk pricing. It reflects the cost of the firm's next funding, not the risk of the particular project, so a materially riskier venture still needs a premium on top.
Many companies get this wrong by applying one company-wide rate to every proposal on the list.
In practice
Real-world examples.
Example
A distribution business is choosing between two warehouse projects returning 7% and 9%. Its published weighted average cost of capital is 6.5%, so both look viable. Once the treasurer prices the actual funding at 8.2%, only the second project survives.
Example
A fast-growing retailer exhausts its cheap revolving facility and must issue a bond two percentage points higher to fund the next twenty stores. The incremental cost of capital jumps at that point, and head office raises the internal hurdle rate for new store approvals accordingly.
Example
A private company weighing a $5 million acquisition finds that its bank will lend only $2 million on reasonable terms, with the rest coming from a new equity investor demanding 18%. The blended incremental cost turns a deal that looked accretive into one that barely covers its own funding.
Formula
Calculation
Incremental cost of capital = (Wd x Kd x (1 - t)) + (We x Ke)
Wd and We are the proportions of new debt and new equity, Kd is the interest rate on the new debt, t is the corporate tax rate, and Ke is the required return on the new equity.
A manufacturer plans to raise $10 million: $6 million of new bank debt at 7% and $4 million of new equity on which investors require 12%. The corporate tax rate is 25%.
After-tax cost of the new debt = 7% x (1 - 0.25) = 7% x 0.75 = 5.25%
Debt component = 0.60 x 5.25% = 3.15%
Equity component = 0.40 x 12% = 4.80%
Incremental cost of capital = 3.15% + 4.80% = 7.95%
The firm's existing weighted average cost of capital is 6.4%, so any project funded by this raise has to clear 7.95%, not 6.4%, before it adds value.Case study
Seen in the real world.
Coldbrook Foods is an illustrative and entirely fictional chilled food producer that had been approving capital projects against a hurdle rate of 6% for six years. The rate came from a weighted average calculated when its long-term debt was fixed at 3.5%, and nobody had revisited it since.
When the company sought $18 million for a new production line, its bank quoted 8.5% and the family shareholders wanted 14% on the equity they were being asked to inject. The incremental cost worked out at just under 10%, and three projects already approved under the old hurdle were returning about 7%.
The illustrative lesson is that a stale cost of capital is not a harmless piece of administration. Coldbrook had spent three years investing in projects that returned less than the money cost, and the damage only became visible when new funding forced a recalculation.
Watch out
Common mistakes.
- Using the historical weighted average cost of capital as the hurdle rate for new projects after market rates have moved.
- Forgetting the tax relief on interest, which makes debt cheaper after tax and changes the weighted result.
- Treating retained earnings as free money, when shareholders could have received that cash and it therefore carries the cost of equity.
Questions
People also ask.
Why does the incremental cost of capital rise as a firm raises more money?
Cheaper sources are used first, and each further tranche of debt or equity carries more risk for the provider, who prices accordingly.
Should every project be tested against the same incremental cost?
No, the incremental cost reflects funding rather than project risk, so unusually risky proposals need a premium added on top.
Is the incremental cost of capital the same as the marginal cost of capital?
In everyday use the terms are treated as interchangeable, though marginal cost of capital more often refers to the whole schedule of rates across funding levels.
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