Capital refers to sources of corporate funds (liabilities of the balance sheet) that generate income. These sources are the means of well-being of the owners of the enterprise in the current and upcoming period. Sources of corporate financing are one of the main criteria that determine the value of a business. Some of them also affect the volume of net active assets of the enterprise.
The cost of capital reflects the amount of cash that should be given (paid) for attracting a certain amount from sources of corporate funds.
As you know, the company has various sources of financing. Each of them has its own price.
For example, the cost of equity of a firm is the sum of dividends on shares (in the case of share capital) or the amount of profit paid on shares and expenses associated with them.
The company may attract borrowed funds. In this case, their price is the sum of the interest paid on the loan or bond loan, as well as the costs associated with them.
The company can use the borrowed funds as a source of financing. In this case, the cost of capital (accounts payable) is the sum of penalties for accounts payable not repaid for a period exceeding three months from the moment of its occurrence, or within the period provided for in the agreement (contract).
Each enterprise has its own financial structure, consisting of various sources of cash. When evaluating the funds raised, the concept of the weighted average cost of capital is used. It combines the prices of all monetary sources.
It should be noted that the concept of "cost of capital" can be interpreted in different ways. When evaluating managers' investments, they are more interested in the marginal, marginal price of corporate funds. Due to the fact that the cost of capital is the weighted average price of the various components included in the financial structure of the organization, it is often called marginal.
If, in the financial system of the enterprise, certain types of securities are present, their price should be calculated separately and weighted taking into account the share that falls on these securities in the total amount of corporate funds.
Before determining the weighted average cost, they determine the long-term sources of finance, determine the price of attracting sources and their market value.
The main sources of long-term financing include bonds, loans, preferred and ordinary shares.
The price of these sources is compiled on the basis of dividends paid on shares, as well as in accordance with the interest on the loan. Interest is recorded in the reports on the results of financial and economic activities and (unlike dividends) are included in the cost. This is called the "anti-tax effect." Thanks to this, a loan is usually cheaper than raising finance through a share issue.
The price of corporate funds raised by the issue of shares for companies that are included in the official list of stock exchange quotes will depend on the level of dividends, the price of placement and issue, as well as the market value of the shares.
The share for each source of receipt of financial resources in the total amount of all borrowed funds is determined in accordance with the price of placement and issue of shares, but not at their face value.
Thus, the weighted average cost of corporate funds is affected by the share of each source of financing.