The investments made by the company are fundamental for the development of the corporate purpose of the organization, the cost of capital arises as a relevant factor in the evaluation that the financial administrator makes of the investment projects that are held in the short term
Capital cost
The cost of capital is the rate of return that the company must obtain on its investments so that its market value remains unchanged, taking into account that this cost is also the discount rate of future business profits, which is why the The manager of business finances must provide himself with the necessary tools to make the decisions about the investments to be made and therefore those that are most convenient for the organization.
The study of the cost of capital is based on the specific sources of capital to search for the fundamental inputs to determine the total cost of capital of the company, these sources must be long-term, since these are the ones that provide permanent financing.
The main sources of long-term funds are long-term debt, preferred stock, common stock and retained earnings, each associated with a specific cost and leading to the consolidation of the total cost of capital.
Fundamental implicit factors of cost of capital
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The degree of commercial and financial risk.
Taxation and taxes.
The supply and demand for financing resources
Capital sources costs
Below is a small theoretical approach to the costs of these sources, but it should be borne in mind that the study of each of these costs has deeper connotations in their application.
- Long-term borrowing cost
This source of funds has two primary components, the annual interest and the amortization of the discounts and premiums received when the debt was contracted.
The cost of borrowing can be found by determining the internal rate of return on debt-related cash flows. This cost represents for the company the annual percentage cost of the debt before taxes.
Comment: Calculations to find the rate of return can be done by the "interpolation" method.
- Preferred Stock Cost
The cost of preferred shares is found by dividing the annual dividend of the preferred share by the net proceeds from the sale of the preferred share.
CAP = Annual dividend per share / Net product for sale of AP
- Cost of common shares
The value of the cost of common shares is a bit complicated to calculate, since the value of these shares are based on the present value of all future dividends to be paid on each share. The rate at which future dividends are discounted to convert them to present value represents the cost of common shares.
- Cost of retained earnings
The cost of retained earnings is intimately linked to the cost of common shares, since if profits were not retained, these would be paid to common shareholders in the form of dividends, therefore, the cost of retained earnings is considered as the opportunity cost of dividends assigned to existing common shareholders.
Capital cost calculation
In determining the costs of specific long-term financing sources, the technique usually used to determine the total cost of capital used in the financial evaluation of the company's future investments is shown.
The main method of determining the total and appropriate cost of capital is to find the average cost of capital using historical or marginal costs as a basis.
The financial manager must use the cost of capital analysis to accept or reject investments, since they are the ones that will define the fulfillment of the organizational objectives
Average cost of capital
The average cost of capital is found by weighing the cost of each specific type of capital by the historical or marginal proportions of each type of capital used. Historical weights are based on the company's existing capital structure, while marginal weights consider the actual proportions of each type of financing expected when financing a given project.
1. Historical weightings
The use of historical weights to calculate the average cost of capital is quite common, they are based on the assumption that the existing composition of funds, that is, their capital structure, is optimal and must therefore be sustained in the future. Two types of historical weightings can be used:
- Book value weightings:
This assumes that new financing is obtained using exactly the same proportion of each type of financing that the company currently has in its capital structure.
- Market weights:
For financiers this is more attractive than the previous one, since the market values of the securities are closer to the real amount received for the sale of them. Furthermore, since the costs of different types of capital are calculated using prevailing market prices, it seems reasonable to use market value weights as well, however it is more difficult to calculate market values from sources of capital financing of a company that uses book value.
The average cost of capital based on market value weightings is normally higher than the average cost based on book value weightings, since most preferred and common shares have market values that are much higher than the Value in books.
2. Marginal weightings
The use of marginal weights implies the weighting of specific costs of different types of financing by the percentage of total financing expected to be achieved with each method of historical weightings. When using marginal weights, it refers primarily to the actual amounts of each type of financing used.
With this type of weighting, there is a real project financing process and admits that the funds are actually obtained in different amounts, using different sources of long-term financing, also reflecting the fact that the company does not have much control over the amount of financing obtained with the surplus
One of the criticisms made of the use of this system is that it does not consider the long-term implications of the company's current financing.
