Cost of Capital - New

Question 1

What is Marginal cost of capital?

Answer 1

The marginal cost of capital is the cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted. Each additional dollar raised becomes increasingly expensive as investors demand higher returns to compensate for increased risk

While internally generated capital is the least expensive form of capital, a firm cannot rely solely on retained earnings to fund new projects. Retained earnings alone are rarely sufficient to fund all of a corporation’s long-term needs. Also, maintaining the firm’s optimal capital structure requires the issuance of new securities at some point

Question 2

What is the cost of new debt?

Answer 2

The cost of new capital (also called external capital) is the ratio of what the firm must pay to what the firm gets

Because of interest rate fluctuations, the cost of new debt will rarely be the historical (or embedded) rate. Also, if the firm’s debt load is already considerable, new debt holders will demand a higher interest rate to compensate for the increased risk

= Annual interest / Net issue proceeds

As tax rates rise, the deductibility of interest makes debt a more attractive financing option

Question 3

What is the cost of new preferred stock?

Answer 3

All new issues of equity securities involve the payment of flotation costs, which reduce the proceeds received, thereby raising the cost of capital. The cost of new preferred stock is calculated as:

= Next dividend / Net issue proceeds

Question 4

What is the cost of new common stock?

Answer 4

The cost of new common stock employs a form of the dividend growth model, which anticipates that common shareholders will demand steadily increasing dividends over time (while assuming that the dividend payout ratio will remain constant)

= (Next dividend / Net issue proceeds) + Dividend growth rate

An issue of new common stock is used mostly by young growing companies. Mature firms rarely issue new common stock to the general public because of the issue costs involved and the depressing influence a new issue can have on the stock’s price