The use of marginal weights involves weighting the specific costs by the proportion of each type of fund to the total funds to be raised. The marginal weights represent the percentage share of different financing sources the firm intends to raise/employ. The basis of assigning relative weights is, therefore, new/additional/incremental issue of funds and, hence, marginal weights.
In using marginal weights, we are concerned with the actual amounts of each type of financing used in raising additional funds to finance new projects by the company. In fact, the use of marginal weights is more attuned to the actual process of financing projects. Another merit of marginal weights is that their use also reflects the fact that the firm docs not have a great deal of control over the amount of financing obtained through retained earnings or other sources which are influenced by several factors, such as, temper of the market, investors preference and so on.
What is the relative suitability of marginal weights to compute the overall cost of capital? The composite cost of capital is computed. It would be recalled, to be used as an investment criterion. The capital budgeting decision is concerned with the selection of new investment proposals. As already the cost of capital, conceptually speaking, which is relevant is the cost of the new capital to be roused to finance the current capital expenditure decision, that is, marginal cost. It is, therefore, argued that the weights must correspond to the proportions of financing inputs the firm intends to employ, that is, the combined cost of capital should be calculated by marginal weights. If marginal weights are not used, the implication is that new capital is proportions other than those used to calculate this cost. As a result, the real overall cost will be different from that calculated and used selection decision. There is bias in the exercise. If the real cost is more than the calculated one, certain investment will be accepted that will have the effect of leaving the investor worse off than before bee potential profitability has been overestimated. On the other hand, if the real cost is less measured cost, projects that could increase the shareholders wealth would be rejected. Fixed problem of choosing between book-value weights and market value weights does not case of marginal weights.
However, the marginal weighting system suffers from serious limitations. One major critical of the use of marginal weights is that this approach does not consider the long-term the firm’s current financing. Since capital decisions are long-term investments firms, attention should be given to the long-term implications of any financing cheaper sources of funds to finance a given project may place the firm in a position we expensive equity financing will have to be wasted to finance a future project. For example may be able to sell debt at an after-tax cost of 9 per cent. If the best investment currently available returns of 10 per cent and the weighted average cost of capital marginal weights is used as a decision criterion, the project will be accepted. If next year must raise equity at a cost of 16 per cent, it will have to reject a project, returning as. Thus, the fact that today’s financing affects tomorrow’s cost is not considered marginal weights? In other words, the interrelationship among the various methods of firm is ignored if marginal weights are used to calculate the cost of capital.