Question

Hello, please 200 words at least, thank you:

Q: What is meant by the "cost of capital", as the term pertains to common shareholders' equity? We can easily determine the cost of debt, which is the stated rate multiplied by one minus the marginal tax rate; and the cost of preferred stock is usually based upon the annual dividend plus the flotation cost per share for a new issue; but why do we also calculate a "cost" for issuing common stock, other than the flotation? As you may know, a company does not have to pay dividends, and some elect not to, period. With no obligation to "repay" the common shareholders, why do we still consider that there is a cost?

Answer 1

Cost of Capital is the discount rate used in taking capital budgeting decisions. It is calculated by taking weighted average of cost of debt, cost of preferred shares and cost of equity.

All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a Weighted Average Cost of Capital calculation.

Cost of debt : which is the stated interest rate paid on debt multiplied by one minus the marginal tax rate, as interest on debt is reduced before calculating Profit before tax.

Cost of Preferred stock: It is usually based upon the annual dividend plus the flotation cost per share for a new issue

Cost of Equity: We generally use Capital Asset Pricing Model (CAPM) to calculate cost of equity -

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

Cost of Equity = Risk free rate of return + βeta* [Market Return – Risk free rate of return]

Where,

Risk-Free Rate of Return: The return expected from a risk-free investment, investment in government securities

Beta: The measure of systematic risk (the volatility) of the asset relative to the market. Higher the beta, more the volatility, more is the risk, thus more will be the cost of capital

Expected Market Return: This value is typically the average return of the market.