calculating part Costs of Capital
Generally, the part cost of a specific source of capital is equal to the investors’ required rate of return, and it can be determined by using equation present above post. But the investors’ required rate of return should be modificated for taxes in practice for calculating the cost of a specific source of capital to the firm. In the investment examination, net cash flows are computed on an after tax basis, consequently, the part costs, used to determine the discount rate, should also be expressed on an after tax basis.
In our next posts we covered,
• Cost of debt
• Cost of equity capital
• Cost of preference capital
• Weighted average cost of capital
Cost of Debt
A company may raise debt in a variety of ways, it may borrow funds from financial institutions or public either in the form of public deposits or debentures (bonds) for a stated period of time at a certain rate of interest. A debenture or bond may be issued at par or at a discount or premium as compared to its confront value. The contractual rate of interest or the coupon rate forms the basis for calculating the cost of debt.
See our next post for calculating below points
• Debt issued at par
• Debt issued at discount or premium
• Tax adjustment for cost of debt
• Calculating cost of the existing debt
• Cost of Preference Capital
• The measurement of the cost of preference capital poses some conceptual difficulty. In the case of debt, there is a binding legal obligation on the firm to pay interest, and the interest consists of the basis to calculate the cost of debt. However, in the case of preference capital, payment of dividends is not legally binding on the firm and already if the dividends are paid, it is not a charge on earnings; rather it is a dispensing or appropriation of earnings to preference shareholders. One may, consequently, be tempted to conclude that the dividends on preference capital do not constitute cost. This is not true.
• The cost of preference is a function of the dividend expected by investors. Preference capital is never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to pay dividends on preference capital, however it is generally paid when the firm makes sufficient profits. The failure to pay dividends, although does not case bankruptcy, however it can be a serious matter from the ordinary shareholder’ point of view. The not payment of dividends on preference capital may consequence in voting rights and control to the preference shareholders. More than this, the firms credit standing may be damaged. The accumulation of preference dividend errors may adversely affect the prospects of ordinary shareholders for receiving any dividends, because dividends on preference capital represent a prior claim on profits. As a consequence, the firm may find difficulty in raising funds by issuing preference or equity shares. Also, the market value of the equity shares can be adversely affected if dividends are not paid to the preference shareholders and consequently, to the equity shareholders. For these reasons, dividends on preference capital should be paid regularly except when the firm does not make profits, or it is in a very tight cash position.