Cost of Capital

Introduction

Financial debt is a liability with a contractual interest rate and is expected to generate interest charges. There is a difference between the market cost of debt and the contractual cost of debt. The market cost is the discount rate used to determine the bond’s value, while the contractual cost is the interest rate used to calculate interest charges. The latter is used to estimate debt value and tax savings. Current practitioners use the contractual cost of debt as a proxy.

Cost of Capital

The cost, the firm pays for the resources that it must obtain to make the investments is not so evident. Here it is necessary to consider not only what is paid in terms of interest on a financial debt, but also what the shareholders expect to earn. In any case, firms pay for the use of funds from third parties and that price is the cost of capital.

Cost of Capital is the cost of acquiring the funds. On raising funds from various sources, the business has to pay some additional amount in the form of interest apart from its principal amount.

Additional amount is nothing but the cost of using the funds.

“Cost of capital is the minimum required rate of return that a firm must earn on its investment to maintain the market value of its shares.”

Cost of Debt

In this context we call debt the financial debt. Financial debt is a liability that has a contractual interest rate and has to be paid in some period of time. It is not just any liability, but the one expected to generate interest charges.

Although in practice there is not a real distinction, we introduce a subtle but theoretically relevant difference: the market cost of debt and the contractual cost of debt. Market cost of debt is the discount rate the market uses to determine the value of a bond. This is the Internal Rate of Return. IRR obtained when the future cash flows for the bond are compared with the price today. Contractual cost of debt is the rate of interest that is effectively used to calculate the interest charges. This distinction is of utmost importance because the former, market cost of debt, is used to estimate the value of debt and the later is used to calculate the tax savings as discussed in Velez Pareja and Tham (2010). There are other approaches to defining the market cost of debt: 1) to ask the lenders. 2) To estimate the grading of the firm issued by independent rating agencies such as Moody’s, Fitch Investor Services or Standard and Poor’s and using the Merrill Lynch Bond Index usually reported in The Wall Street Journal. However, current practitioners and firms use the contractual cost of debt as a proxy to the market cost of debt.

Debt is basically of two types: 1) Cost of Irredeemable Debt 

                                                2) Cost of Redeemable Debt 

1) Cost of Irredeemable Debt-: Such loans which are not redeemed on a particular time period during the lifetime of the company but redeem at the liquidation of the company. There is no maturity date on that instrument.

2) Cost of Redeemable Debt-: Such loans which are redeemed on a particular time period during the lifetime of the company. There is given a maturity date on that instrument.

Differences between Kd and Ke

The firm receives funds from two sources: shareholders and debt-holders. The funds are a basket of funds which the firm uses to make investments. For the purpose of defining the cost of capital for a firm we distinguish between the cost of financial debt and the cost of equity.

 Which is the difference between financial debt and equity? Debt is a source of funds regulated by a contract. On the other hand, equity has a residual return. This means that there is a difference in risk associated with each source of funds. As a consequence, the cost of equity is greater than the cost of debt.

Characteristics of Financial Debt:

1. It is regulated by a contract. The firm and the creditor define dates for paying back principal and interest charges.

2. The creditor receives his money without mattering if the firm has earnings or not.

3. The creditor has priority upon the payment of distributed dividends or net income.

4. Creditors require a warranty, usually based on tangible assets. Another requirement is to have consigners to insure the debt payment.

Characteristics of Equity

1. Equity has a residual return. The firm will pay shareholders after it pays other creditors.

2. In case of bankruptcy or liquidation of the firm shareholders are the last to receive their money back.

3. The firm is not obliged to pay dividends.

4. The funds invested by shareholders have no term to be received back from the firm.