Reviewed by Oct 05, 2020| Updated on
The increase in financing costs for a lending institution as a result of adding one more dollar of new funding is known as the marginal cost of funds. It is the incremental cost or differentiated cost and is considered important for making decisions on the capital structure.
The marginal cost of funds is used by the financial managers while selecting the capital sources, to isolate the sources of financing methods, which adds the smallest amount to total funding costs incrementally.
The marginal cost of funds should not be confused with the average cost of funds. The latter is calculated by computing a weighted average of all sources of finance and their respective cost of funds.
Investors think of the marginal cost of funds as the funds borrowed from someone else. However, it is important to view it from a different perspective where the money is borrowed from oneself or from the company's assets. The marginal cost of funds can be described as the opportunity cost of not investing the existing funds anywhere else and receiving interest on it.
Consider that Company A decides to build a new factory at the cost of Rs.1.5 crore. The marginal cost of funds, in this case, would translate to the rate of interest Company A could have earned if the sum were to be invested rather than spending on the factory construction.
Similar to the marginal cost of funds, there is a concept called the marginal efficiency of capital. It measures the annual percentage yield earned by the additional unit of capital. The concept refers to the market rate of interest at which it begins to pay off to undertake capital investment.