Definition
This is the price the company pays to obtain and retail finance. To obtain finance a company will pay implicit costs which are commonly known as floatation costs. These include: Underwriting commission, Brokerage costs, cost of printing a prospectus, Commission costs, legal fees, audit costs, cost of printing share
certificates, advertising costs etc. For debt there are legal fees, valuation costs (i.e. security, audit fees, Bankers commission etc.) such costs are knocked off from:
i) The market value of shares if these have only been sold at a price above par value.
ii) For debt finance – from the par value of debt.
I.e. if flotation costs are given per share then this will be knocked off or deducted from the market price per share. If they are given for the total finance paid they are deducted from the total amount paid.
Cost of Retaining Finance
This will include dividends for share capital and interest for debt finance (tax deducted) or effective cost of debt. However, when computing the cost of finance apart from deducting implicit costs, explicit costs are the most central elements of cost of finance.
Importance of Cost of Finance
The cost of capital is important because of its application in the following areas:
- Long-term investment decisions – In capital budgeting decisions, using NPV method, the cost of capital is used to discount the cash flows. Under IRR method the cost of capital is compared with IRR to determine whether to accept or reject a project.
- Capital structure decisions – The composition/mix of various components of capital is determined by the cost of each capital component.
- Evaluation of performance of management – A high cost of capital is an indicator of high risk attached to the firm. This is usually attributed to poor performance of the firm.
- Dividend policy and decisions – E.g if the cost of retained earnings is low compared to the cost of new ordinary share capital, the firm will retain more and pay less dividend. Additionally, the use of retained earnings as an internal source of finance is preferred because:
It does not involve any floatation costs
It does not dilute ownership and control of the firm, since no new shares are issued. - Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt (interest rate on loan borrowed) is used as the discounting rate.
