Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Leon Inc. has the following capital structure, which it considers to be optimal:
| Debt | 25% |
| 15 | |
| Common equity | 60 |
Leon’s expected net income this year is $34,285.72, its established dividend payout ratio is 30%, its federal-plus-state tax rate is 25%, and investors expect future earnings and dividends to grow at a constant rate of 9%. Leon paid a dividend of $3.60 per share last year, and its stock currently sells for $54.00 per share. Leon can obtain new capital in the following ways:
- New preferred stock with a dividend of $11.00 can be sold to the public at a price of $95.00 per share.
- Debt can be sold at an interest rate of 12%.
Determine the cost of each capital component.
Cost of Preferred Stock = %
Cost of Debt = %
Cost of equity is the rate which the company pays to equity shareholders for taking a risk. it is basically a sort of compensation for owning the asset of a company.
Cost of debt is the rate of return that a company pays to its debtholders for lending them money.
Cost of preference capital is the rate of return required by the preference shareholder.
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