Incremental Cost of Capital
Definition of 'Incremental Cost of Capital'
The ICOC is calculated by adding the company's weighted average cost of capital (WACC) to the risk premium for the new project. The WACC is a weighted average of the company's cost of debt, the cost of preferred stock, and the cost of equity. The risk premium is a measure of the additional risk associated with the new project.
The ICOC is an important concept in capital budgeting because it helps companies to make decisions about which projects to invest in. Projects with an ICOC that is lower than the WACC are considered to be financially viable, while projects with an ICOC that is higher than the WACC are considered to be not viable.
The ICOC can be used to compare different projects and to rank them in order of their financial attractiveness. It can also be used to evaluate the potential return on investment for a particular project.
The ICOC is a dynamic concept, and it can change over time as the company's financial situation changes. The WACC can change as the company's cost of debt, cost of preferred stock, and cost of equity change. The risk premium can also change as the company's risk profile changes.
It is important to remember that the ICOC is only a guide, and it should not be used as the sole basis for making investment decisions. Other factors, such as the strategic fit of the project and the company's overall financial situation, should also be considered.
The incremental cost of capital is a valuable tool for capital budgeting, but it is important to understand its limitations. By using the ICOC, companies can make more informed decisions about which projects to invest in.
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