The cost of capital is a practical concept of measuring what it costs a firm to raise capital. As the firm grows it will secure financing from first one source then another. But in the long run a balance will be found between internal and external sources and between debt and equity sources. This balance should be the mix that gives the lowest possible cost of capital consistent the attributes of the company. Remember the cost of capital defines the cutoff point for capital budgeting and the real growth prospects for the firm.
The company must get data from two sources to compute the cost of capital:
Follow these steps:
Short term bank loans leave out
Accruals leave out
Long Term Bonds 800,000
Preferred Stock 300,000
Common Stock 500,000
Retained Earnings 400,000
Total Permanent Capital; 2,000,000
Now we define W1 as the proportion from bonds = 40%
Now we define W2 as the proportion from Preferred Stock = 15%
Now we define W3 as the proportion from Common Stock = 25%
and W4 is the proportion form Retained Earnings or internally generated = 20%
AND we assume that we will continue to get out capital in the same proportions in the future. [If the management discussion in your project indicates otherwise change the proportions to match the plan]
The company will have to pay the current market yield on similar risk bonds to raise more capital. This varies daily with market conditions so ckeck it out with financial services. KB is defined as that current bond interest yield. Interest is tax deductable but dividends are not so a tax ajustment must be made. If t =the tax rate the the company only has to pay a rate of KB*(1-t). Investment banker charge a commission to float bonds, FB, so in the end the cost of bond financing is:
(KB*(1-t))/(1-FB)
The company will have to meet the market to issue more stock. Investors have already disclosed what they required by setting the current price for the preffered stock.
PP = price of preferred sharfe
DP = dividend per share
FP = floatation cost
(DP/PP)/(1-FP)
Common Stockholders get a dividend yield and an expected rate of growth, g. This growth rate is the only difficult number to nail down in the analysis. You can get it by measuring the annual rate of growth in the companies stock price over the last several years.
DC = dividend on common
PC = Price of common
g = anticipated growth rate
FC = floatation cost on common
((DC/PC)+g)/(1-FC)
The cost of retained earnings is very similar to common stock cost since the common stockholders own the retained earnings anyway. The differences lie in the fact that you don't have to pay to float retained earnings and the stockholders will let you use them a little cheaper because they differ taxes by reinvesting earnings rather than taking dividends.
st = stockholders marginal tax rate
(((DC/PC)+g)*(1-st)
Now combining the system of weights from the components with the component cost:
K=W1*(KB*(1-t))/(1-FB)+W2*(DP/PP)/(1-FP)+W3*((DC/PC)+g)/(1-FC)+W4*(((DC/PC)+g)*(1-st)
looks messy but computes rather easily on your project worksheet when you break the long formula into cells where the plus signs are.
Comments and Suggestions should may be sent togramborw@tiger.uofs.edu