Accounting

Difference between Marginal Cost of Capital (MCC) and Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) is the average cost of all the capital a firm has already raised, weighted by the proportion of each source in the total capital structure. It is a historical/average measure and is used to evaluate the overall cost of financing the existing capital base.

$WACC = W_d K_d(1-t) + W_p K_p + W_e K_e$

where $W_d, W_p, W_e$ are weights of debt, preference and equity; $K_d, K_p, K_e$ are their respective costs; and $t$ is the tax rate.

Marginal Cost of Capital (MCC) is the cost of raising one additional rupee of new capital. It is the cost of the next unit of financing and is relevant for incremental investment decisions. It is computed as the weighted average cost of the new (marginal) funds raised, not of the total capital already employed.

$MCC = \frac{\text{Total cost of new financing}}{\text{Total amount of new financing raised}}$

Key differences:

In short, WACC is the "average" cost while MCC is the "incremental" cost. A firm should accept a project only if its return exceeds the MCC of the funds used to finance it, and the point where the MCC curve intersects the investment opportunity schedule gives the optimal capital budget.

Major ratios used in analyzing the financial statements of a financial institution

Financial institutions (banks, finance companies, microfinances) are analyzed mainly for safety, liquidity, profitability and efficiency, so the ratios used differ somewhat from those of trading/manufacturing firms. The major ratios are:

1. Capital Adequacy Ratios

• Capital Adequacy Ratio (CAR) = (Tier I + Tier II Capital) / Risk-Weighted Assets × 100
• Core Capital Ratio = Tier I Capital / Risk-Weighted Assets × 100
• Reason: Banks operate on high leverage with depositors' money. CAR measures the cushion available to absorb unexpected losses. NRB requires CAR of 11% (and 8.5% core capital) for commercial banks, so this ratio directly reflects regulatory compliance and solvency.

2. Liquidity Ratios

• Cash and Bank Balance to Total Deposit Ratio
• Liquid Assets to Total Deposits / Total Assets
• Credit to Deposit (CD) Ratio = Total Loans / Total Deposits × 100
• Reason: Banks must meet daily deposit withdrawals and loan demands. A very high CD ratio means over-lending and liquidity risk; a very low ratio means idle funds and lost income. NRB prescribes a CD ratio of about 90%, so this ratio shows both liquidity and lending capacity.

3. Asset Quality Ratios

• Non-Performing Loan (NPL) Ratio = NPL / Total Loans × 100
• Loan Loss Provision to NPL Ratio
• Reason: Loans are the largest earning asset and the biggest source of risk. A rising NPL ratio signals poor credit appraisal, weak recovery and possible capital erosion. It is the single most watched indicator of a bank's health.

4. Profitability Ratios

• Return on Assets (ROA) = Net Profit after Tax / Total Assets × 100
• Return on Equity (ROE) = Net Profit after Tax / Total Equity × 100
• Net Interest Margin (NIM) = Net Interest Income / Total Earning Assets × 100
• Reason: ROA shows how efficiently assets are used, ROE shows the return to shareholders, and NIM shows the spread earned between lending and borrowing rates. These indicate earning capacity and management efficiency.

5. Efficiency / Productivity Ratios

• Non-Interest Expense to Total Assets
• Operating Expense to Net Interest Income
• Reason: They show how economically the bank is run. A high operating expense ratio eats into profit and signals poor cost control.

6. Activity / Turnover Ratios

• Loan to Total Assets Ratio
• Investment to Total Assets Ratio
• Reason: They reveal the deployment pattern of funds — how much of the resource base is put into earning assets and how much kept in low-yield assets.

7. Market / Valuation Ratios

• Earnings per Share (EPS), Price-Earnings (P/E) Ratio, Dividend Payout Ratio, Book Value per Share
• Reason: For listed banks these indicate shareholder value and market confidence.

8. Risk and Coverage Ratios

• Provision Coverage Ratio, Capital to Total Deposit Ratio, Interest Rate Spread
• Reason: They measure the ability to absorb shocks and the cost efficiency of fund management.

Conclusion: For a financial institution, capital adequacy and asset quality ratios are the most critical because they determine solvency and depositor safety; liquidity ratios determine day-to-day survival; and profitability and efficiency ratios determine long-term sustainability. A sound bank must satisfy all these dimensions simultaneously, as weakness in any one — especially capital adequacy or NPL — can quickly threaten the whole institution.