by A.W. Berry

Created on: December 07, 2009   Last Updated: March 01, 2011

As the names imply, both Weighted Average Cost of Capital (WACC) and Marginal Cost of Capital measure cost of capital. Capital is any money used to finance a business and/or its operations and can include a number of sources and methods. These sources may include traditional debt or equity financing or owner financing. Other forms of financing include grants, gains on investment capital, retained earnings, accrual financing contracts and forward payment agreements on capital.

Marginal cost of capital

Different types of capital are used in different amounts and for different costs. It is the costs of capital that is marginal and may involve or include a basic interest rate cost structure. For example, if Company A acquires a loan for $100K at an interest rate of 7% for one year, compounded annually, that capital will cost $7K. A simple average cost of capital may not accurately represent the true cost of capital for a company. For example, if Company A is financed by 1) $100K of debt at 7%, 2) $50K of equity at 12% and 3) $75K of owner financing at 0%, the average cost of capital would be 7% + 12% + 0% divided by 3=%19/3=6.33%. However this cost is not accurate because it does not take into account the different amounts of money at the different rates. In order to amend this discrepancy in calculation, the weighted average cost of capital is used.

Weighted average cost of capital

Weighted average cost of capital multiplies the amount of capital by the percent rate of cost for that capital as a proportional percentage of total capital and then averages 2 or more costs that are calculated in the same way. This can be further understood by dividing the previous sentence into two concepts 1) average amount of total capital and 2) percentage cost of capital type. Using the above example concept 1 is illustrated below:

Concept 1: Average Amount of Total Capital

If 3 types of capital are used; one at 44.44% of total capital, two at 22.22% of capital, and 3 at 33.33% of total capital the three added together add up to 99.99% of total capital. These 3 percentages are the proportions by which each rate of capital cost must be multiplied by in order to obtain the weighted average cost of capital.

Concept 2: Percentage Cost of Capital

The percentage cost of capital takes the marginal cost of capital and multiplies that by the proportional cost of capital. To continue illustrating with the above example, Company A uses $7K at 7% of debt at 44.44% of total capital that equals

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