I tend to think in its application, it is more of a marginal concept than an ave
ID: 2613710 • Letter: I
Question
I tend to think in its application, it is more of a marginal concept than an average concept. Okay, we now have a great new product opportunity ahead of us. We'll need to raise $500,000 in capital to launch the product though. We want to make sure that the product will result in a favorable return to the company's shareholders. We predict that with the $500,000 investment, it should return 11%.
What cost of capital calculation would you use to compare to the 11% in this scenario: (1) the company's historical cost of capital, using the historical weights of the capital components (i.e., debt, preferred stock and common stock), or (2) the marginal cost of capital (i.e., the weights of the capital components we expect to require to fund the $500,000)
Does it matter which cost of capital we use? Why or why not?
Explanation / Answer
The marginal cost of capital will provide the true picture of the funding cost specific to the particular product launch. In case of historical cost of capital, the funding cost would be diluted due to various different kinds of fund sourcing at various stages. Also, it would be difficult to compare the required rate of return of the present project to the historical return because the historical cost of capital might be lower than the marginal cost of capital which will then lead to a wrong decision. If the marginal cost of capital is lower than the rate of return of the project then it is a safe bet.