Question

What is historical or embedded and what is marginal cost in terms of capital budgeting?

Answer 1

Historical cost:

A historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. The historical-cost method is used for assets in the United States under generally accepted accounting principles (GAAP).

Historical cost means acquisition price. For example, the businessman paid Rs.7,00,000 to purchase the machine, its acquisition price including installation charges is Rs.8,00,000. The historical cost of machine would be Rs.7,00,000.

Marginal Cost:

Incremental cost of capital is a capital budgeting term that refers to the average cost a company incurs to issue one additional unit of debt or equity. The incremental cost of capital varies according to how many additional units of debt or equity a company wishes to issue. Being able to accurately calculate the cost of capital and the incremental effects of issuing more equity or debt can help businesses reduce their overall financing costs.

Marginal cost of capital is the weighted average cost of the last Rupee of new capital raised by a company. It is the composite rate of return required by shareholders and debt-holders for financing new investments of the company. It is different from the average cost of capital which is based on the cost of equity and debt already issued.

According to the Terminology of Cost Accountancy, Marginal Cost is the amount at any given volume of output by which aggregate costs are .hanged if the volume of output is increased or decreased by one unit. Same principle is being followed in cost of capital.

That is, marginal cost of capital may be defined as the cost of obtaining another rupee of new capital. Generally, a firm raises a certain amount of fund for fixed capital investment. But marginal cost of capital revels the cost of additional amount of capital which is raised by a firm for current and/ or fixed capital investment.

When the firm procures additional capital from one particular source only, i.e., not from the different sources, in given proportions, the marginal cost in that case, is known as specific or explicit cost of capital. In other words, marginal cost of capital may be more or may be less than the average cost of capital of a firm.

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