Incremental Cost of Capital
Candlefocus EditorIn order to calculate the incremental cost of capital, the respective costs of each component of the capital structure should first be determined. This means estimating the cost of debt (after taking into account tax considerations and any debt covenants) and the cost of equity, which is usually estimated by estimating the company’s Weighted Average Cost of Capital (WACC). The cost of capital, then, is the sum of all of the component parts, with debt and equity weighted according to their relative proportions in the capital structure.
The incremental cost of capital is determined by how the addition of more debt or equity will affect the overall cost of capital. This can be assessed by understanding the cost of each component of capital as well as the effect of any additional debt or equity on the company’s leverage. For example, if a company adds debt to its capital structure, this will increase the company’s leverage and lower its overall cost of capital. On the other hand, if more equity is added then there will be more shares outstanding and this will dilute the existing shareholders’ equity and reduce the value of their shares.
Incremental cost of capital is a key factor that is taken into account by investors when assessing a company’s performance and whether or not a particular project is a good idea. If the incremental cost of capital rises, this can be a sign that the company is leveraging itself too much, thus making it a riskier investment. On the other hand, a falling incremental cost of capital is generally seen as positive, as it suggests that the company is managing its capital structure in an efficient manner that is unlikely to negatively impact its borrowing costs.
Incremental cost of capital is an important variable to consider for both investors and companies alike. If corporations are able to assess the incremental cost of capital accurately, they are more likely to make informed decisions about their capital structure and the impact of any projects they consider investing in. Therefore, understanding how to accurately estimate the incremental cost of capital is integral to having a successful business.