Discounted method is used to calculate the present value of any future cash flows. The cost of capital at which the company borrows money determines the discount rate of return to calculate the discounted value of any cash flow. The discount rate used is equal to the working average cost of capital (WACC) or the marginal cost of capital (MCC).
Company uses different method to raise money from the market, it can be through debts, common shares or preferred shares. These are the capital components of the company and are shown under the liability section of the balance sheet. Any capital requirement is financed by any one of these or any combination of these capital components. The cost of each component is called the component cost of capital.
Let us check the capital cost of these components now
Kd = This is the cost of debt or the rate of interest at which the company issues new debts in the market. It is same as the yield to maturity. If the tax rate is t, then the after tax cost of debt will be Ke (1-t).
Kps = The cost of preferred stocks which represents the dividend payout ratio. For preferred stocks, the dividend payout rate is fixed and has to be paid every quarter after reporting the financial results.
Ke = This is the cost of equity capital or the rate of return the common shareholders want from the common shares. There are some methods to calculate the cost of equity, but it is much higher than the cost of debt and preferred stocks because of higher risk and lower priority over the assets of the company.
The relationship among them is
Kd <= Kps <= Ke
The company uses any combination of these three components to raise money from the market. That’s why the working average cost of capital (WACC) is used considering the weight of each component and their cost to calculate the final rate of return. The rate of return must be more than the borrowing cost to earn profit.
The mathematical formula to calculate the cost of capital is
WACC = (Wd)(Kd(1-t)) + (Wps)(Kps) + (We)(Ke)
Wd = The percentage of debt in the total capital used to raise money,
Wps = The percentage of preferred stock in the total capital used to raise money
We = The percentage of common equity in the total capital used to raise money
As debt is the cheapest source of money and keeping debt-equity ratio low is very much important to raise debt easily, the company’s management has to decide properly about the optimal capital structure before raising money. High debt component reduces the working average cost of capital but increases the debt-equity ratio. At the same time low debt component increases the working average cost of capital but reduces the debt-equity ratio. It is also required to keep a balance among all source of capital components.