How to calculate the cost of capital investment and financing for companies
Define the cost of capital
The cost of capital is known as the cost that the organization incurs to finance its projects. Within this framework, the intended capital is the funds raised by the Foundation to finance its long-term projects. The cost of capital varies according to the structure and sources of financing, and financing is usually done through a combination of different sources of financing. The cost of capital is considered one of the most important factors affecting investment decision-making from the point of view of the institution or from the viewpoint of the investor or financier.
The investors or financiers are given funds to the institutions on the basis that these institutions will use these funds in a manner that secures the rate of return that the investor requires from investing in the enterprise’s activity (Required Rate of Return). From the point of view of the corporation, the rate of return required by the investor represents the cost that the corporation must bear to secure financing, and therefore it is called the cost of capital because in the event that the corporation is unable to provide this return, the investor will withdraw his investments from the corporation and direct it to another investment that provides him with the required return.
The capital is funded from two major sources, Equity Instruments, and Debt Instruments.
As for financing through equity, it is done by issuing the capital shares of the corporation.
These are shares in the capital of the company, and the investor who is the shareholder is the owner of the corporation in partnership with the rest of the shareholders, but the percentage of ownership varies based on the number and type of shares owned by each investor. Shares are usually issued by way of subscription, whereby the institution announces its desire to raise capital to invest in a specific activity, and the investor’s contribution will be through buying the subscribed shares.
Types of shares, There are two types of shares:
Usually, it gives the right to its owner to vote in the general assembly to appoint the board of directors and the important decisions of the institution. The return from it will be the dividends decided by the management. Also, in the event of the bankruptcy of the corporation, the owners of ordinary shares will be the last to be paid their dues after paying all other debts owed to the corporation.
Also read: Why You Should Take Forex Trading Seriously
It does not give its owner the right to vote in the general assembly. The return from those shares is a specific percentage of the institution’s nominal value, which is calculated annually regardless of whether a dividend is declared or not, and in some cases dividends may be distributed to the distinguished shares. The type of shares “by the distinction” because it is distinguished in the event of the bankruptcy of the corporation, and the owners of the privileged shares take precedence over the owners of ordinary shares in paying their dues from the corporation.
In the event that the capital of the institution consists of ordinary shares only, it is called Simple Capital. In the event that the capital consists of ordinary shares in addition to distinguished shares or any other type of equity tool, it is called complex capital.
As for financing by long-term borrowing, it is usually through the issuance of bonds or through long-term loans from financial institutions. The bonds are considered a debt note at a specified interest rate and a specific period of time after which the borrowed amount will be refunded. There are different types of bonds with different payment methods, and there are some types of bonds that can be transferred to shares in the Corporation's property rights (Convertible Bonds).
Capital cost elements
As mentioned, financing is done using basic tools, which are bonds or long-term borrowings, common stocks, and preferred shares. The cost of capital consists of the average cost of these tools. The cost of financing instruments is the rate of return required by investors for investment in the institution. The first step in calculating the cost of capital is to determine the cost of each financing instrument. The cost is calculated as follows:
1. Bonds or loans
Its cost is represented in the annual interest rate on the loan instrument, and in the case of taxes on corporate profits, the benefits on borrowing tools contribute to reducing net profits and thus reducing the cost of taxes and therefore in the case of taxes on net profit, the effect of this is calculated in calculating the cost of borrowing by multiplying the rate Interest in (1- tax rate). Thus, the cost of borrowing is calculated as follows:
(Interest paid annually / (issuance receipts - issue cost)) * (1- tax rate)
For example, assuming that bonds were issued with a nominal value of 1000 dirhams, at an interest rate of 10%, the proceeds of the issuance were 990 dirhams (issuance discount), and that the cost of issuance was 2 dirhams, and the prevailing tax rate is 30%, then the cost of the borrowing tool is calculated as follows:
(100 / (990-2)) * (1--30%) = 7.1%
2. Premium Shares
The cost of the distinct shares is the cash dividends required to be distributed to the distinguished shareholders, divided by the net share price, some deduction for the costs of its issuance, as shown by the following equation:
Cash Dividend / (Issue Price - Issue Cost)
For example, assuming that company-issued distinct shares at 50 dirhams per share, that the cost of issuing one share was 2 dirhams, and that the specified dividends for those shares are 5 dirhams per year, so the cost of financing privileged shares is calculated as follows:
5 / (50-2) = 10.4%
3. Ordinary shares
The cost of ordinary shares is the rate of return required by investors and is calculated via the Growth Model by the following formula:
(Expected Distributions for the next period / (Issue Price - Issue Cost)) + Expected Growth Rate for Distributions
For example: Assuming that a company-issued ordinary share at 100 dirhams per share, the issue cost was 2 dirhams per share, and the expected dividends for the next period are 10 dirhams per share, and distributions are expected to grow by 5% annually, so the cost of financing is calculated through ordinary shares (required rate of return) as Follows:
(10 / (100-20)) + 5% = 15.2%
Retained Earnings is considered a tool of equity for financing, and its cost is exactly the same as the cost of ordinary shares, where retained earnings are a return that has not been distributed to investors in ordinary shares and was held with the institution to re-invest in the company's activity and therefore investors expect to achieve The same required return on these profits.
Calculation of Weighted Average Cost of Capital “WACC”
The weighted average cost of capital is the general measure of the cost of capital that is funded through a mixture of financing sources and instruments. The weighted average of the total capital cost resulting from finding the relative weight of each financing instrument relative to the total financing and multiplying the cost of each instrument by its relative weight as the following statement shows:
(1) (2) (3) (2) * (3)
Mail instrument Market value 1 Relative weight 2 Tool cost 3 Weighted cost
3.000 Bond 30% x 7.1% 2.13%
Preferred Shares 1.000 10% x 10.4% 1.04%
Ordinary shares 4,000 40% x 15.2% 6.08%
Retained earnings 2,000 20% x 15.2% 3.04%
Total 10,000 100% 12.29%
1 Note that for the purposes of calculating the weighted average cost of capital, the market value of the financing instrument is used, not the book value.
2 It is calculated by dividing the market value by the total market value of all financing instruments.
3 Based on the previous examples.
Thus, it is clear from the example that the weighted average cost of capital is 12.29%, which means that each dirham that this institution collects to finance its activities costs it 0.1339 dirhams annually and it has to achieve a net profit that covers this cost.
Financing structuring is the process of selecting a mixture of financing sources and tools and their relative weight so that this combination leads to the lowest weighted average cost of capital. This is done by knowing the cost characteristics of each instrument and its impact on the weighted average cost of capital. The cost characteristics of the core capital financing tools are as follows:
Equity instruments and their characteristics by type are as follows:
It is considered the highest cost, as the risks surrounding investing in ordinary shares are higher than all other tools. For example, in the event of the bankruptcy of the corporation, the ordinary shareholder will be reimbursed after all other debts have been paid. Also, distributing dividends to the ordinary shareholder is not compulsory, as the management decides not to distribute dividends in a year.
Finally, you can find this for investing with no capital:
Investing in online projects without capital.