Question

Cost of Capital – Write a paper about a firm’s cost of capital. Include discussions about debt, preferred stock, common stock and retained earnings. Keep in mind that the cost of capital is rate of return required by investors for a firm’s securities. When would you use debt, preferred stock, common stock or retained earnings?

Requirements:

500 words,

Answer 1

Cost of Capital is the basic input information in the capital investment decisions of a firm. It helps to decide the worth of an investment proposal and thus helps to decide whether to accept or reject an investment proposal. In the capital investment decisions the discounting rate of return that is used to calculate the present value of the future cash inflows is the cost of capital. It is related to the firm's objective of shareholder's wealth maximisation. If a firm takes up a project where the rate of return is higher than the cost of capital/ min. return required by the investors, then the share prices of the firm will increase and hence the shareholder's wealth and vice versa.

The cost of capital has different components. The components are the sources of funds for the company.The cost of each source is called the specific cost of capital. When the specific costs are combined to arrive at the overall cost of capital, then it is called the weighted cost of capital.

The cost of capital (k) consists of 3 components :

1)the riskless cost of particular type of financing r_f

2)the business risk premium (b)

3)the financial risk premium (f)

The business and the financial risk remaining constant, the changing cost of each sources of fund is affected by the demand & supply of that source of fund.

COST of DEBT

The debt carries a certain rate of interest which is the coupon rate. Debt means bonds and debentures, which can be issued at par, discount or premium.

Symbolically,

K_i = I / SV ; K_{d =} I/ SV * (1-t)

where,

_Ki = before tax cost of debt
K_{d =} after tax cost of debt

I = Annual interest payment
SV = Sale proceeds of bonds/debenture
t = tax rate

Cost of Preferred stock

It is the dividend expected by the preference shareholders.

Symbolically :

K_p = D_p / P₀ (1-f), K_{p =} D_p (1+ D_t) / P₀ (1 - f)

where,

K_p = Cost of preference capital
D_p = annual dividend payment
P₀ = Sale price of preference shares
f = floatation costs
D_t = Tax on preference dividend

Cost of Equity

The cost of equity is defined as the minimum rate of return a company must earn on the equity financed part of the investment project so as to leave unchanged the market prices of the shares.

Cost of Retained Earning

The retained earnings are the amount that the company has hold back and not distributed as dividends to the ordinary shareholders. Hence the cost of retained earnings is the opportunity cost in terms of the dividends forgone by the equity shareholders.

An optimal capital structure of a firm is the financing mix (debt and equity) that maximises the value of the shareholders wealth. As per the traditional approach, the optimal capital structure is where the marginal real cost of debt is equal to the real cost of equity.

Debt is the cheapest source of long term fund from the point of view of the company. It is also the safest mode of investment from the creditors point of view, since they earn a fixed amt. of interest and they are paid earlier than the dividend payout to the preference or equity shareholders  . Also, in time of insolvency, they get their money first by asset amortization or they are the first claimants to the firm's assets.Hence, the suppliers rate of return on debt instruments are lower that the other sources of fund. Hence the cost of debt is also low. Also, the interest payment are tax deductible. The tax benefit is available only when the firm is profitable and pay taxes. A firm which suffers losses would not be required to pay any tax & its cost of debt would be before tax cost (K_i) & not after tax cost of debt (K_d).