Finance Cost of Capital the Capital Which

Finance

Cost of Capital

The capital which is used by a firm, and shown n the balance can be divided into two main classifications; debt and equity. When a firm assesses its total cost of capital, this will usually be calculated on a weighted basis, using the costs of the different types of capital (Elliott and Elliott, 2011). An understanding of this can be appreciated by looking at some of the main sources of capital and the costs associated with each type of capital.

Debt

One of the most common forms of capital is debt. Debt is capital that is obtained through borrowing. There are many kinds of debt, which may include long-term debt such as structured loans from banks or other financial institutions, and short-term debt, such as overdraft facilities and credit agreements with suppliers. The cost of debt is relativity simply to calculate, with most debts having an associated rate of interest which is payable. The cost of the debt starts with this interest rate. However, where the firm is paying tax, the interest paid will usually be an allowable expense to be held against tax, so the real cost to the firm will be the interest rate less that tax allowance, which may also be referred to as the after tax cost of debt (Hillier et al., 2010). To illustrate this, an example can be used. Acme has a loan, on which it pays 15% interest. If the corporate tax rate is 33%, the cost of debt will be 10% less 33% of that interest rate that is claimed against tax giving an after tax cost of 10%.

When calculating the cost of debt there may also be the inclusion of any other costs that may have paid as a result of that debt. For example, costs such as the costs incurred to raise the debt, such as fixed fees should also be included where appropriate.

Preferred Stock

Preferred stock (or preferred shares) is stock that is issued by a firm that wishes to raise capital. Preferred stock is technically classified as an equity, as they can be traded on the stock market, but they have many characteristics which are aligned with debt. When a firm issues preferred stock it will be issued with a 'par value'. The dividends that are paid are usually fixed to that par value, usually as a percentage of that par value which may be fixed or variable depending on other factors, such as inflation plus a set percentage. Fixed percentages are most common. The dividends payable on preferred stock have priority over common equity, and if they are not paid in any year will accumulate for later payment (Hillier et al., 2010).

The cost of the preferred stock is the cost of the interest paid to the stock holders plus the costs associated with the issuing of the stock. As dividends paid to stockholders are not tax deducible there is no need to make any adjustment for tax. For example, if the preferred stock has an interest rate of 7%, and over the life of the preferred stock it is estimated the cost of issuance was 0.5%, the cost of the preferred stock to the firm will be 7.5%. However, in many cases it is difficult to calculate the issue cost of preferred equity and for practical reasons it may not always be included on cost of capital calculations.

Common Stock

Common stock is a form of equity and the cost of the common stock is the amount that the firm pays to the stockholders for the use of that capital. This is a relativity simply calculation which uses the dividends that are paid. The cost of the common stock is the dividends divided by the current market price of the stock, and then adding the expected rate of growth of the dividends.