Firms calculate weighted average cost of capital is completed to account for debt and equity. It provides metrics to the investors regarding the risk/reward before investing in a business. This allows businesses to balance between the investing needed so that they are not too heavy on, and it considers the inventory of the business. This helps with the future expected capital and expenses. It also allows business to find the balance between equity and debt. This will give the business time to evaluate the future going forward, so they are not carrying an extensive load of debt.
Sources of capital that should be considered is equity and debt sources. They all impact capital resources and should be considered when computing the cost of capital. The cost of bond capital would also be allocated for the bond issuance. When companies decide on what capital to use, they would be best to consider the tax-savings associated with debt interest expense.
Interest is tax-deductible this can contribute to lowering the capital expenses. The flotation cost will drive up the cost of debt. In debt financing though, the company financially, unlike equity sourcing. Some analysts argue that including flotation costs in the company's cost of equity implies that flotation costs are an ongoing expense, and forever overstates the firm's cost of capital. A firm pays the flotation costs one time upon issuing new equity. To offset this, some analysts adjust the company's cash flows for flotation costs (Kenton, 2020).
Why do firms calculate their weighted average cost of capital?
By utilizing a weighted average cost of capital, a company can better compare the return on investment of multiple projects under consideration. This evens the playing field allowing the organization to make better, more standardized financial decisions about how to achieve the best returns with their available capital. Without factoring an average cost of capital into the decision-making process, decisions would be more capricious and impulsive. Kenton (2021) states that cost of capital is used by companies “to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return” (para. 2).
In computing the cost of capital, which sources should be considered?
To compute the weighted average cost of capital, the financial manager should look at the cost of debt for the company, the cost of common stock equity, the cost of issuing new common stock, and the cost of preferred stock. The cost of debt would include the cost of raising capital through bond issuance or by taking out loans. When companies decide how much of their capital should be obtained from debt versus equity (common and preferred stocks), they should consider the potential tax savings associated with debt interest expenses.
How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue on a firm’s weighted average cost of capital?
Because interest is tax deductible, companies can utilize debt to lower the amount of taxes they must pay. This may entice an organization’s finance department to utilize more debt as opposed to stocks to fund their capital requirements. When a company issues new stock, there are costs associated with the distribution; flotation costs cover the expenses incurred by the underwriter of the new stock offering. For companies offering stock to raise capital, flotation costs would increase the weighted average cost of capital.
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