Financial managers consider various parameters when deciding on the best source of capital. Ordinarily, their intention is to ensure corporations employ sources of capital with the least costs enabling the attainment of the shareholders objective of wealth maximization. However, the use of low cost sources of capital such as debt capital may lead to high risks of bankruptcy due to illiquidity of the firm. This necessarily requires corporations to use various sources of capital that not only minimizes the cost, but also keeps risks at bay. It is for this reason that knowledge on the costs of individual sources of capital should be within the scope of financial managers. The optimum capital structure would be arrived at by employing proportions of capital that result to the least costly overall cost of capital. In addition, it should be appreciated that financial managers are guided by principles such as the pecking order theory which advocates for the use of internal sources of capital exhaustively before using the external sources of capital.
Cost of capital gives the actual rate of return for each source of capital at the option of the corporation. Ordinarily, corporations have the options of employing the following sources of capital: preferred stock, debt, retained earnings and common stock. The source of capital employed depends on factors such as costs of capital, the liquidity position of the firm, the application of the pecking order theory and the optimal capital mix. Ultimately, it should be appreciated that cost of capital suffices as a factor for decision making purposes.
Cost of debt
The cost of debt depends on the required rate of return that the debt holders expect a corporation to a pay. Debt, at first instance, is usually considered a secure source of capital hence low risk to the debt holders. It should be noted that debt enjoys tax deductibility. The tax deduction reduces its cost. The cost of debt can be computed by different formula, which, however, can be reduced to the following:
Cost of debt Kd = ((I/ D)x 100)(100-T)%
Where:
Kd is the cost of debt
I interest rate payable on the debt
D par value of debt
T tax rate as a percentage
Cost of Preferred stock
The cost of preferred stock refers to the required rate of return on preference shares. Preference shares enjoy primary consideration to ordinary stock. As such, preference shareholders get paid fixed amounts of dividends at the preferred rate. Therefore, the cost of preferred stock is lower when compared to common stock costs. The inherent risk in preferred stock is lesser and consequently yields less returns. The cost of preferred stock is computed as follows:
Kp = d/ P (1-f)
Where:
Kp = cost of preferred stock
d = dividend paid per unit of preference share
P = par value of preferred stock
f = floatation costs as a ratio of the issuing price.
Cost of common stock
Common stock refers to equity capital. These segments of stock holders are the defacto owners of the corporation. They enjoy decision making rights which come with residual claims to capital and rights to participate in surplus capital. Cost of common stock usually is highest factoring in the risks inherent in it. The cost not only factors in the floatation costs, but also considers the growth factor of the stock. The formula for computing cost of common stock is as follows:
Kc = (do/P (1-F)) + g
Where:
Kc = cost of common stock
Do = dividend paid per unit of common stock
P = par value of common stock
F = Floatation cost as a percentage of the common stock par value
g = growth factor of the common stock
Cost of retained earnings
The cost of retained earnings (Kr) is similar to the cost of common stock. However, since the retained earnings are readily available, the corporation does not incur any floatation costs. This reduces the cost of retained earnings insignificantly. According to the pecking order theory, retained earnings constitute the first source of capital. The retained earnings are in essence the portion of profitable interest not declared as dividends. The cost of retained earnings is computed as follows:
Kr = (do/P) + g
Kr = cost of retained earnings
P = par value of common stock
Do = dividend paid per unit of common stock
Conclusion
Ultimately, the overall cost of capital of corporations usually is a mix of the mentioned individual costs of capital. The finance manager has to settle on the optimum capital mix that does not only minimize the costs of capital, but also considers the liquidity risk. According to the pecking order theory, internal sources of capital should be exhausted before venturing into the external sources of capital. The cost of capital of each individual source usually incorporates the par value of capital, the risk involved and the duration of the capital in the corporation.
References
Babu, R. G. (2012). Financial Management. New York: Concept Publishing Company.
Banks, E. (2007). Finance: The Basics. New York: Taylor & Francis.
Besley, S., & Brigham, E. F. (2008). Principles of Finance. New York: Cengage Learning.
Shim, J. K., & Siegel, J. G. (2008). Financial Management. New York: Barron's Educational Series.
Thukaram, R. M. (2007). Management Accounting. New York: New Age International.
