What is meant by the \"cost of capital\", as the term pertains to common shareho
ID: 2778160 • Letter: W
Question
What is meant by the "cost of capital", as the term pertains to common shareholders' equity? We can easily determine the cost of debt, which is the stated rate multiplied by one minus the marginal tax rate; and the cost of preferred stock is usually based upon the annual dividend plus the flotation cost per share for a new issue; but why do we also calculate a "cost" for issuing common stock, other than the flotation? As you may know, a company does not have to pay dividends, and some elect not to, period. With no obligation to "repay" the common shareholders, why do we still consider that there is a cost?
Explanation / Answer
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, thecost of capital is the rate of return required to persuade the investor to make a given investment.
•The cost of capital is the cost of using the funds of creditors and owners.
•Creating value requires investing in capital projects that provide a return greater than the project’s cost of capital.
-When we view the firm as a whole, the firm creates value when it provides a return greater than its cost of capital.
•Estimating the cost of capital is challenging.
-We must estimate it because it cannot be observed.
-We must make a number of assumptions.
-For a given project, a firm’s financial manager must estimate its cost of capital.
•The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contributions of capital.
-This cost reflects the opportunity costs of the suppliers of capital.
•The cost of capital is a marginal cost: the cost of raising additional capital.
•The weighted average cost of capital (WACC) is the cost of raising additional capital, with the weights representing the proportion of each source of financing that is used.
-Also known as the marginal cost of capital (MCC).
WACC = wdrd (1 - t) + wprp + were (3-1)
where
wd is the proportion of debt that the company uses when it raises new funds
rd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new funds
rp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new funds
re is the marginal cost of equity
We generally raise the common stock for the purpose of long term contracts/ investments purpose and the investors in commonstock may have some expectation regarding their investments in the companies shares which is nothing but the cost of equity.
We consider the cost of equity also as a part of WACC because while making any investment by company it want to cover atleast all the expected costs for the funds as the Shareholders also have some expectation of return for the money they invested and hence it also should be considered as cost .
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