Cost of Capital
Cost of capital refers to the minimum rate of return demanded by the capital holders (shareholders and debt holders). Here we have discussed about four types of cost of capital.
Cost of Equity
It is the minimum rate of return required by the equity holders. Equity share, also known as common stock, is the financial security that represents the ownership in the company and especially issues to finance long term assets. By investing in company’s common stock investor get chance to be an owner of the company. It is one of the major long-term sources of financing which is not repaid to the investors in the normal course of business operation. Investor who want to get back their investment can sell it in the secondary market.
Cost of equity is generally higher than that of cost of debt and cost of preferred stock.
Cost of Debt
It is the minimum rate of return required by the debt holders. When the company uses debt capital in its capital structure by issuing bonds and other debt securities, it pays certain percentage of cost annually, semiannually or quarterly to the debt holders which is known as cost of debt.
Debt capital is that portion of capital which are raised by issuing debt instruments like debentures, bonds etc. Debt capital is considered as a cheap source of financing so most of the company prefer to include debt capital in their capital structure to minimize the overall cost of capital. Generally, the cost of debt capital is less than that of equity and other capital due to the certainty of its return.
Uses of debt in capital structure provides the benefit of tax saving. So after tax cost of debt is used while calculating weighted average cost of capital. Kdt = Kd(1-T).
Cost of Preference Share
It is the minimum rate of return required by the preference shareholders. Preference share is that type of share which has generally fixed dividend rate and may redeemable and irredeemable in nature. It also provides its holders the preferential rights over equity share. So, preference shareholders get dividend before equity shareholders. They have also given priority at the time of company liquidation as well. Cost of preference share is, generally, denoted by Kp.
Cost of Retained Earnings
Retained earnings is the part of net profit that left after distributing dividend to the equity shareholders. In other word, it is the part of net profit which is ploughing back in the company.
Cost of retained earnings is the opportunity cost of company’s fund. For example, suppose the company have an opportunity to get 10% return by investing it’s retained earnings amount in another project. But it doesn’t invest in that project instead invests in its own company. In this situation, the cost of retained earnings will be 10% equal to the project return that the company ready to scarify.