What is the Incremental Cost of Capital?

The incremental cost of capital is the weighted-average cost of new debt and equity issuances during a reporting period. When the incremental cost of capital begins to rise, it indicates that investors feel the entity has an excessively risky capital structure that is weighted too far in the direction of debt. When investors feel that a firm’s incremental cost of capital is clearly too high, they will tend to avoid purchasing its debt, or will only do so at a significant discount. At some point, acquiring too much debt will result in a rapid boost in the incremental cost of capital, which sends a message to management that the capital markets will require the firm to raise more equity funding. The incremental cost of capital can also change due to general market conditions, which has nothing to do with a firm’s capital structure.

When to Use the Incremental Cost of Capital

The incremental cost of capital concept is commonly used in capital budgeting decisions, where the return on an investment is compared to the incremental cost of capital to see if it makes sense to acquire more funding in order to pay for a new capital project. The incremental cost of capital is used instead of the average cost of capital, since the incremental cost more accurately reflects the actual cost of the funds that will be used to pay for an investment.