The capital structure of a firm tells us how a firm finances its operations and growth. Before we get into intricate concepts, we should evaluate the different sources of funds and implications of such sources. The cost of capital for a firm reflects the aggregate expectations of the sources of capital depending on the market conditions, the financial standing of the firm and other investment opportunities available to the funders.
SOURCES OF CAPITAL
A firm can access capital by various avenues – the fundamental classification is internal i.e. the money the company has already generated, and external. The external sources can be further classified as debt, equity and preference share capital.
1. Internal - Retained Earnings
Retained earnings are the part of the income which the firm chooses to reinvest in the business after distributing dividends to preferred and common shareholders.
On the outset, it may seem like the retained earnings do not involve any cost to the firm. This notion is erroneous. By reinvesting the earnings (after paying contractual obligations to debt and preferred shareholders) the firm is effectively raising capital from the common shareholders who could otherwise claim the earnings as dividends. From a common shareholder’s point of view, the opportunity cost for the retained earnings depends in the expected market return (or return from any other comparable investment), dividend distribution tax and income tax on received dividends.
A representative opportunity cost would be
= (Expected Market Return) X (1 - % div. distribution Tax) X (1 - %income tax on dividend)
The expected return on equity for the firm should be higher than the opportunity cost.
Debt means the sources of funds which the firm is contractually obligated to repay. A firm can raise capital using debt in various ways – bank loans, debentures & bonds, commercial papers etc. The basic idea is that the repayment amount and schedule is predefined and the firm is contractually obligated to repay.
Firm’s cost of debt is the aggregated value of all the cost of debt issued by the firm. Now, the cost for each instrument will depend on prevailing market rates, assets pledged in form of security, seniority of the instrument and credit rating for the instrument etc.
Apart from these, we should also consider that issuance of debt costs money and the cost of debt should consider that cost of issuance as well.
As interest payments reduce the taxable income for the firm thus reducing the tax liabilities. So, the after-tax cost of debt
= (Pre-tax cost of debt) X ( 1 - % Income tax rate for the company)
Equity does not represent any contractual obligation to repay but involve ownership in the firm. As there is no predefined rate of return, it may seem that the equity comes for free. In reality, equity involves opportunity cost for investors.
The cost of equity can be estimated based on the principle that the return from an investment should adequately compensate for the risk involved in the investment. Capital Asset Pricing Model (CAPM) is based on this principle which estimates the
Cost of Equity = (Risk-Free Rate) + Beta X ( Expected Market Return – Risk-Free Rate)
Beta is a measure of the sensitivity of return compared to the market return.
Note: CAPM only considered the systematic risk to the company and ignores the idiosyncratic risks.
Although, in practice, companies can use dividend yield or earnings yield as a proxy or use average historical returns as Cost of Equity.
4. Preference Share Capital
Preference shares are shares which has a preference over the common shareholders over the dividends. The predefined dividend rate is generally considered as the cost of preference share capital.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC represents the overall cost of capital for the firm from all the sources. WACC is calculated as the weighted average of the costs for the sources of funds mentioned above.
The weight for each source is calculated by dividing funds from an individual source by the sum of all funds. For equity we can consider either the book value or the market value for the calculation of the weights – market values are more reasonable because it represents the expectations for the investors in the market for any new fundraising.
For the debt, the after-tax cost of capital should be used to reflect the tax saving effect of interest payments.