It is essential to calculate the cost of capital to ensure that you have invested in a suitable venture and the cost that you are paying for raising capital is fair. The cost of capital includes identifying the cost required to raise both debt and equity capital. Firms generally prefer employing a combination of debt and equity to raise large sums for big ventures. Raising new capital very often results in changing the capital structure of an enterprise. The capital structure of any enterprise includes the long-term, short-term debts of a company along with the common and preferred equity of the firm.

Debt capital for a firm is generally by way of bonds issues or payable long-term notes. Equity on the other hand is stock holdings in a company or retained earnings. The cost of debt, as a part of cost of capital, is the interest that is paid on that debt. This cost is a tax deductable expense for companies. The cost of equity, on the other hand, is calculated by adding the risk free rate of return and premium expected for risk.

The cost of capital in any firm is impacted by the following:

  • Capital Structure policy
  • Dividend Policy
  • Investment Policy
  • Interest rates
  • Tax Rates

 The weighted average cost of capital is used in most cases to take all these factors in consideration. The concept of cost of capital is not just important for companies, but also for investors, since they can calculate the minimum returns that they should expect on an investment to make the deal profitable.

Significance of calculating cost of capital

Calculating the cost of capital is extremely beneficial for firms. This solves the following purposes:

  • Helps firms to effortlessly make capital budgeting decisions
  • Helps in redesigning the capital structure of an enterprise
  • Also acts as the basis for several other company decisions including the dividend policy.

Only when you know the opportunity cost of the capital that you have raised from the lenders and from the market, you will be able to reach the correct investment decision. We will help you in choosing the most appropriate way of raising capital and calculating your cost of capital. All you need to do is send us a query, or simply place an order for assistance with an assignment.

Assignment

  1. Calculate the weighted average cost of capital for the following:

W

X

WX

Long term liabilities

Amount

Capital Structure proportion

Cost of capital

Debentures

$200,000.00

$50.00

$20.00

$1000.00

Pref. Share capital

$400,000.00

$100.00

$40.00

$4,000.00

Equity Share Capital

$200,000.00

$50.00

$20.00

$1000.00

$800,000.00

$200.00

$6,000.00

Weighted Average cost of capital = 6000/200 = 30

 

2.  How do firms raise capital?

Capital for firms can be either in debt or equity form. Debt includes bond issues or payable long-term notes while equity includes shares or retained earnings.