SHAH SIR’S
ARIHANT COMMERCE CAREER ACADEMY
-a step towards excellence
Campus 1: C/o Mahatma Fule School, Mudholkar Peth, Amravati.
Campus 2: Raghunandan Terminal, Opp. Govt. Polytechnic,Amravati.
Class: - MBA 2Nd Year 3Rd Sem Subject:- International Finance Management
Cost of Capital
Cost of Capital
Meaning
The cost of capital of an investor in financial management is equal to the return an investor can
fetch from the next best alternative investment. In simple words, it is the opportunity cost of
investing the same money in a different investment having similar risks and other characteristics.
From a financing angle, it is simply the cost paid for using the capital. Alternatively, a
percentage return on investment that convinces an investor to invest in a particular project or
company is the appropriate cost of capital for that investor.
Definition of Cost of Capital
Cost of Capital is the rate of return the firm expects to earn from its investment in order to
increase the value of the firm in the market place. In other words, it is the rate of return that the
suppliers of capital require as compensation for their contribution of capital.
Types of Cost of Capital
The term cost of capital is vague in general. Does it not clarify which capital we are talking
about? It could be equity or debt, or any other source of capital. We can classify the cost of
capital into the following broad classifications.
Cost of Equity
The cost of equity is the cost of using the money of equity shareholders in the operations. We
incur this in the form of dividends and capital appreciation (increase in stock price). Most
commonly, the cost of equity is calculated using the following formula:
The formula for Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk Premium – Risk-
Free Rate)
Cost of Debt
The cost of debt capital is the cost of using a bank’s or financial institution’s money in the
business. The banks get their compensation in the form of interest on their capital. The formula
for calculating the cost of debt is as follows.
Cost of Debt Capital = Interest Rate * (1 – Tax Rate)
Weighted Average Cost of Capital (WACC)
Most of the time, we also use WACC in place of the cost of capital because of its frequent and
vast utilization, especially when evaluating existing or new projects. As the term itself suggests,
WACC is the weighted average of all types of capital present in the capital structure of a
company. Assuming these two types of capital in the capital structure, i.e., equity and debt, we
can calculate the WACC using the following formula:
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt.
The Capital Structure for a Multinational Corporation
Multinational corporations leverage their financial position and access to global markets to raise
capital in a cost-effective and efficient manner. This gives these companies an advantage over
small domestic operators that do not have the same level of credit or cash, but there are risks
associated with international finance. The capital structure multinationals use directly impacts
profitability, growth and sustainability.
Invested Capital
A multinational’s capital structure comprises the sources of money used to finance operations,
expand production or purchase assets. Companies acquire capital through the sale of securities in
financial markets such as the New York Stock Exchange or the London Stock Exchange. Debt
and equity are the two forms of capital that multinationals have to choose from, and each form
has its advantages and disadvantages. The cost of raising capital is an important component of
financing decisions.
Debt Financing
Acquiring debt capital is a process that is contingent on the availability of funds in the global
credit markets, interest rates and a corporation’s existing debt obligations. If credit markets are
experiencing a contraction, it may be difficult for the corporation to sell corporate bonds at
favorable rates. In particular, it may be challenging to get high advance rates for asset-backed
securities. If a firm becomes over-leveraged, it may be unable to pay its debt obligations leading
to insolvency. However, debt costs less to acquire than other forms of financing.
Equity Financing
Preferred stock, common stock and components of retained earnings are considered equity
capital. It is important for a multinational to carefully analyze its equity cash flows and mitigate
the risk associated with currency fluctuations. Otherwise, it may lose equity due to changes in
exchange rates. Also, the issuance of new shares may cause stock prices to fall because investors
no longer feel company shares are worth their pre-issuance price. Offering stock in global
financial markets costs multinationals more than acquiring debt, but it may be the right financing
option if a corporation is already highly leveraged.
Tax Considerations
Multinationals have the option to shift income to jurisdictions where the tax treatment is the most
advantageous. As a result, debt and equity financing decisions are different relevant to solely
domestic companies. If income is reported in the United States, it may be beneficial to obtain
debt financing, because the interest is tax-deductible. When making capital structure decisions,
multinationals must evaluate their tax planning strategies to minimize their tax liabilities.
