Components of Cost of Capital
The cost of capital is the minimum return rate required by the business to be earned in order to meet the expectations of its investors.
Businesses to progress well and move with the industry need to undertake new investments, new opportunities, and new projects. However, these new opportunities and investments need some funds as well; you can’t simply start any project without injecting funds into it. In such a situation, the businesses make the use of the funds to be taken from a group of people like equity investors, preference shareholders and debenture holders. This group of investors never offers the funds without any return and the return being demanded by the investors is the cost of capital for the investment.
Components of Cost of Capital
Even to think about the components of the cost of capital, the best thing is to get the notation out of the way. So, we can talk in terms of notation and everybody knows what we’re really are talking about. So, we’re going to think as we said before. On the most typical task. On a company that is financed by debt and by equity, and as we said before there are companies that are only fully financed by equity. Well, that notation would be contained, in what we are going to discuss, and there are companies that are actually financed by more sources of financing. And, and again as we said before and we’ll probably highlight that again a little bit later. You only need more terms that have the same structure, as the terms that we are going to discuss. So for all our practical purposes data and equity. And the two terms that we’re going to be dealing with, are far more than, than enough. So. That is the expression that we’re going to use to calculate the weighted average cost of capital, and let me start on the left-hand side. What is on the left-hand side? Many times, more often than not, I would probably admit, you actually see only what on the left-hand side? The reason I want to put an R before the what is to remind you at the end of the day this is a required return. And required returns are always related to risk. So, you know, you can take the R out if you don’t like it and just leave the WACC part. The notation that I am going to use keeps the R and again, keeps the R just to remind you that this is a required return. On the capital invested. So, the RWACC that we’re going to have on the left-hand side is basically the weighted average cost of capital or the cost of capital that we want to estimate. What is on the right-hand side? Well, on the right-hand side as you see there are two terms. One term is for debt, and one term is for equity. And by terms I mean, one thing on the left-hand side of the plus sign, and one thing on the right-hand side of the plus sign. Now, what is on the left-hand side of the less sign? Well, let us take it the other way around. Instead of thinking of debt and equity, let us think in terms of, the, the terms that we have. In that WACC. Everything that is an R, again and it is just that you need to keep this in the back of your mind, is a required return. So we said on the left-hand side, this is a required return on the capital investment, well but as you see, there are two Rs on the right-hand side. There is Rd and there is Re. Generally, d stands for debt and e stands for equity. That is the way we typically use the notation in corporate finance, which means that Rd and Re, are the required return on debt and the required return on the equity. So everything that has an R is a required return. As it will become clearer as the discussion goes by, everything that is a required returned is related to the risk perceived by investors that provide that particular source of capital. So, for as far as a notation goes, Rd is going to be the required return on debt, Re is going to be required return on equity, and sometimes you can see people referring to these simply as the cost of debt and the cost of equity. So, we’re going to be using those terms interchangeably. The required return on debt, on the cost of debt. And the required return on equity, and the cost of equity, all these things are going to be denoted by Rd and Re. They come the, then comes the corporate tax rate. You know, we have to pay taxes on a personal level. Corporations have to pay taxes. And there’s no getting away from that. Some corporations pay more. Some corporations pay less. But at the end of the day, there is what we call a corporate tax rate. This is what presumably; corporations would actually have to pay. Of course, you know, some corporations may have to pay more, because there are state taxes, and municipal taxes, and so forth. Some corporations pay less because they get all sorts of tax breaks and all sorts of ways of reducing. Not the taxes that they have to pay, but the recent corporate tax rate that we’re going to denote as TC. A, and that TC you are seeing there is simply the notation for the corporate tax rate. And it’s going to become important for the following reason. And we’re going to see an example. A little bit later on. It’s going to become important because in just about every tax code in the world there’s an asymmetry. And the asymmetry means that, the following. That when you pay interest on the debt, you do that before taxes. But when you pay dividends, you do that after taxes. What is the meaning of that? Well, it means that when you pay your dollar of interest, that actually reduces your profits and that means that you pay, you pay fewer taxes. However, when you pay, a dollar of dividends, you do it after taxes. Which means that it’s an actual dollar. So in the first case, the dollar that you pay you’re really effectively paying a little bit less. Because you get a little bit of a tax break, which we are going to quantify. A couple of minutes from now. So basically when you pay $1 of interest and $1 of dividends, the $1 of dividends is just a net dollar of dividends. But that $1 of interest you need to account for the fact that you get a tax break on that. And so we can actually calculate, the after-tax cost of debt. And by after-tax, we mean taking into account that tax break, that tax shelter that we get when we have debt as opposed to equity in the capital structure. So the notation that you see there, one minus TC multiplied by RD. That is what we are going to call, the after-tax cost of debt. After taking into account that when we pay interest on the debt, we get a tax break on that debt. We are going to see a numerical example in a minute. And this will become much more clear than it is now. Again, we’re only defining notation at this point. And that notation is TC, is going to be the corporate Tax rate, and 1 minus TC multiplied by Rd is going to be the after-tax cost of them. Finally the proportions, again remember that is why we call it a weighted average cost of capital. We need to take into account, how much we are using, in relative terms, in this case, of debt and equity. And, and we do that in a very simple way. First we, we add up all the debt and all the equity that we have. And that’s what some people would call the capital invested, the capital that we have to invest in long term projects. And then we calculate, simply, the proportion D divided by the sum of D plus E, as you see that we are going to call Xd, and E divided by the sum of D plus E, as you see there also, that’s what we’re going to call Xe. So, XD and Xe are the proportions of debt and equity. That a company is using to finance their investment activities. Now there is one important thing here. The, and this is just a side comment because again this is not one of the issues that we’re going to explore. But the issue of capital structure is all about determining the optimal proportions of xD and Xe. In other words, you want to find.
What proportion of debt you need to have and what proportion of equity you need to have in order to minimize that cost of capital? Capital structure is all about that. It is about minimizing the cost of capital, and one of the things that you have to choose is what proportions you are going to have of debt and equity in your capital structure?
The term “cost of capital” is the combination of three different investors and their returns over the investments also called the components of the Cost of Capital.
1. Cost of Debt
The cost of debt is a part of the company’s cost of capital and forms to be an important component. The cost of debt is defined as the rate of interest required to be paid by the company over the current debt it has taken out to fund the investment. The cost of capital considers the after-tax cost of debt for the calculation purpose. The funds can be borrowed from financial institutions by taking a loan or by issuing debentures or bonds.
2. Cost of Preference Share Capital
The cost of debt and cost of preference share capital are more or less the same concept. However, there are a few confusions in the concept of preference share capital in a sense that the debenture holders have a legal right to interest payments, whereas, the preference shareholders have no legal right. However, when compared to the equity shareholders the preference shareholders are considered as a priority.
3. Cost of Equity
The cost of equity amounts to the return being expected by the equity holders of the shares being funded by the investments. The cost of equity if provided to the equity shareholders is in the form of dividends however, there is no legally binding obligation to the dividend payments.