What is capital, types of capital & cost of capital?

We know that the two main tasks of a finance manager are the procurement of funds and their utilization. Proper procurement and utilization help in the maximization of the wealth of any business. Therefore, the finance manager has to select such a capital structure that can bring the minimum expectation of the investors and maximum wealth to the firm.

So, to execute the task effectively, the finance manager should understand the various cost of capital such as cost of debt, cost of equity, cost of preference shares, and cost of retained earnings.

MEANING OF COST OF CAPITAL

In simple terms, think of the cost of capital as the minimum return expected by the providers of the capital. In a corporate world what happens is that when an entity procures capital then it has to pay some additional money over and above the procured money.

Example

Suppose, entity A needs \$100,000 to finance its raw material procurement. Entity A approaches Mr. B who is an investor and offers 5% interest per annum on \$100,000 if Mr. B agrees to invest. Mr. B gives a counteroffer by asking for 6% interest at least in return for \$100,000. Since entity A is in urgent need of money, it agrees at 6% interest.

Here, we call \$100,000 as capital and 6% interest as the cost of capital as it is the minimum return expected by the provider of the capital.

Don’t get mistaken here by thinking that since the entity is paying 6% interest then it is their cost of capital. No, in reality, since 6% interest is the minimum requirement of the investor hence, we are calling it as cost of capital. In the future, if 6% becomes 7% then the cost of capital for the entity will get changed due to the change in minimum expectation of the investor.

IMPORTANCE OF UNDERSTANDING COST OF CAPITAL

Every Entity must understand how much they are earning and how much cost they are paying. It is a simple phenomenon that if the cost exceeds income, then loss incurs and when income exceeds the cost, Income generates.

Hence, at first, every entity should strategically understand how much cost they will incur after procuring finance from different sources and whether they can generate enough income to pay off the estimated cost of capital. This way, they will better judge the profitability of the business.

FORMS OF COST OF CAPITAL

There are two major forms of cost of capital:

1. Cost of Debt
2. Cost of Equity

• Cost of Debt (Kd)

Debt is a form of capital where the provider of such capital becomes the lender to the business. Such capital providers do not enjoy ownership in the company.

For an entity, the cost of debt can be of two types:

• Cost of Irredeemable Debt

Irredeemable debt is a type of debt where the entity is not required to pay off the principal debt. In the previous example, suppose Mr. B granted a loan of \$100,000 with 6% interest to entity A and in return ask for only interest amount during the lifetime of entity A. Here, entity A shall call \$100,000 as irredeemable debt.

Further, 6% of \$100,000 is \$6,000 is the cost of entity A but since interest is charged on profit it means every year the entity will save \$1,800, assuming the income tax rate is 30%. Hence, the after-tax cost of \$100,000 is \$4,200 which comes to 4.2%.

The cost of Irredeemable debt not redeemable during the lifetime of the entity is calculated as below:

Kd= $ \frac{Interest}{Net\: Proceeds\: of\: Debt} $ x (1- tax)

• Cost of Redeemable Debt

Redeemable debt is a type of debt where the entity is required to pay off the principal debt along with the interest amount. Continuing the previous example, suppose Mr. B granted a loan of \$100,000 with 6% interest to entity A and in return ask for both the principal amount at the end of the loan period and interest every year till the end of the loan period then Entity A shall call \$100,000 as Redeemable debt.

In the case of redeemable debt too, the tax benefit is also given on interest payments

The cost of Redeemable Debt is calculated as follows:

Kd = $ \frac{I(1-t)+\frac{RV-NP}{N}}{\frac{RV-NP}{2}} $

Where,
I       =   Interest Payment
NP   =   Net proceeds from Debt
RV   =   Redemption value of Debt
T      =   Tax Rate
N     =   Remaining life of Debt

Continuing the previous example, suppose Mr. B granted a loan of \$100,000 with 6% interest to entity A and in return ask for both the principal amount at the end of the loan period which is five years, and interest every year till the end of the five years. But instead of asking \$100,000 at the end, Mr. B asked for a 5% premium on debt.

Here, the cost of redeemable debt would be after assuming tax rate as 30%:

Kd= $ \frac{$6000(1-0.30)+\frac{$105000-$100000}{5}}{\frac{$105000-$100000}{2}} $

Kd  =          5.07%

• Cost of Equity (Ke)

Equity is a form of the capital where the provider of such capital becomes the owner of the business. Such capital providers enjoy ownership in the company. They can also participate in the decision-making of the company.

Example

Suppose, entity A requires \$200,000 to finance its expanding business. Entity A approaches Mr. C who is an investor and offers 1000 common shares in return for \$200,000. Here, Mr. C won’t receive a fixed interest return but rather receive part ownership and dividend out of profits of the company. Just like any other source of finance, the cost of equity is the expectation of equity shareholders.

Cost of Equity can be calculated using the following methods:

1. If the dividend is expected to be constant, then Dividend Pricing Model should be used
2. If earnings per share are expected to be constant, then Earning Pricing Model should be used.
3. If dividends and earnings are expected to grow at a constant rate then Gordon’s Model should be used.

• Dividend Pricing Model

It is also known as the Dividend Valuation Model. In this model, an assumption is being made is that the company will pay the same dividend constantly every year. Here, the cost of equity is computed by dividing the expected dividend by the market price of the share.

Ke = $ \frac{D}{P_{0}} $

Where,

Ke = Cost of Equity
D = Expected Dividend
P₀ = Market Price of Equity

Example: ABC Company is expected to give a dividend of \$1.5 and its current market price is \$50. Therefore, its cost of equity is 3%.

• Earnings Pricing Model

In this model, an assumption is being made is that the company will pay the same earnings (whether distributed in form of dividends or not) constantly every year. Here, investor advocates that it doesn’t matter whether the company is giving dividend or not. They are more interested in the total earnings that the company is generating. So, they value the cost of equity-based on earnings and not dividends.

Here, the cost of equity is computed by dividing the expected earnings by the market price of the share.

Ke = $ \frac{E}{P_{0}} $

Where,

Ke = Cost of Equity

E = Expected earnings

P₀ = Market Price of Equity

Example: ABC Company is expected to earn $3 and its current market price is \$60. Therefore, its cost of equity is 5%.

• Gordon’s Model

Gordon’s model is a growth-based model which attempts to derive a future growth rate. This model says that an increase in the level of investment will give rise to an increase in future dividends. As per this model, the rate of dividend growth remains constant. The cost of equity capital is calculated as follows:

Ke = $ \frac{D1}{P_{0}} $ + G

Where,

D1 = [ D0 ( 1 + g) ] i.e. next expected dividend
P₀ = Current Market Price per Share
G = Constant growth rate of dividend

Example: A company has paid a dividend of $2 per share (of the face value of \$20) last year and is expected to grow by 10% every year and the current market price of a share is \$110. Here cost of equity shall be calculated as follows:

Ke = $ \frac{D1}{P_{0}} $ + G

Ke = $ \frac{\$2(1+0.1)}{110} $ + 10

Ke = 12%