I’m gonna explain to you, the cost of capital. The capital structure of a firm refers to the specific combination of long-term capital used
The Firm’s Capital Structure
to finance its operations and growth. When you run a business, you need money. That’s what we call capital. The problem is, how to get the capital? There are three sources of long-term capital. First, long-term debt, which comes in the form of bond issues or loans. When company needs money, it can either borrow money from the bank,
which is what we call bank loan. Or the company can borrow money from the public by issuing bonds. When we buy bonds, we are basically lending money to the company.
Second, preferred stock. This is a form of equity. Preferred stockholders are a
special group of investors who have special privilege compared to common stockholders. Preferred stockholders will receive dividends before the common stockholders. If the company does not pay preferred stock dividends, it is not allowed to pay common stock dividends as well. In the case of bankruptcy, the company will have to sell the assets and pay the preferred
stockholders first. Then only it can pay the common stockholders. In short we say, preferred
stockholders have a higher claim to dividends or asset distribution than common stockholders.
Next, about common stock, this is another form of equity, that’s the shares that we
are commonly trading in the market. Under common stock, it has two subcategories.
First, retained earnings. Every year when company makes profit, the company will pay
a portion of the profit to the stockholders as dividend. The balance of the profit will go into
the account of retained earnings. So, retained earnings is basically the savings of a company.
Second, new common stock. When company needs capital to run a new project,
it can issue new common stocks to the public to raise new fund. In short, common stock equity = retained earnings + new common stock.
An Overview of the Cost of Capital
For using the funds contributed by bondholders or stockholders,
the company will have to pay for the cost. That’s what we call the cost of capital. Just like when you borrow money from the bank to buy a car or a house,
you will have to pay for the loan interest. Loan interest is the cost of capital. Generally, the cost of capital is the minimum rate of return that a firm must earn on the projects,
that means what the company earns must be at least equal to what it pays.
At the same time, this is the required return that the company must pay to the fund providers. The cost of capital is used to determine whether a proposed
investment will increase or decrease the firm’s stock price, i.e., the firm’s value.
If the rate of return is higher than the cost of capital,
the firm’s value will increase when investing in the projects.
If the rate of return is lower than the cost of capital, then, the firm’s value will decrease. However, the cost of capital is not exactly the same as the investor’s
required rate of return because of the following two reasons.
First, there are taxes.
When a firm borrows money to finance the purchase of an asset,
the interest expense is deductible for the purpose of income tax calculation,
which means for making the interest payment, the company can reduce the tax payment.
So, the cost of capital is measured based on an after-tax basis.
Second, there are flotation costs.
Flotation costs are the transaction costs paid by a firm when it issues new bonds or new shares. These include the expenses such as underwriting fees, legal fees, and registration fees.
Usually, we calculate weighted average cost of capital, in short we call it WACC,
to represent the combined costs of all the sources of financing used by the firm. The weighted average cost of capital is the weighted average of the after-tax costs of each of
the sources of capital used by a firm to finance a project. The weights reflect the proportion of total financing raised from each source. Consequently, the weighted average cost of capital
represents the rate of return that the firm must earn on its investments to compensate both
its creditors and stockholders, each with their individual required rates of return. Now, let’s
turn to a discussion of how the costs of debt and costs of equity can be estimated or calculated.
The Cost of Long-Term Debt
First, the cost of long-term debt, in short we say, cost of debt.
The pretax cost of debt is equal to the yield-to-maturity YTM on the firm’s debt,
adjusted for flotation costs, which means when you calculate the pretax cost of debt,
the flotation costs have to be deducted.
Bond’s yield-to-maturity depends upon a number of factors, including the bond’s coupon rate,
maturity date, par value, current market conditions and selling price. These factors will affect the YTM or the cost of debt. After obtaining the bond
