I understand the layout of the Balance Sheet as follows (indicate to me if I am wrong):
Ordinary Shares – Equity
Short term Loan – Debts
Debentures – Debts
Preference Shares – ? (
Retained Earnings – Ordinary Shares
The official answer from wikipedia is… "The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt. It is also known as the "Hurdle Rate" or "Discount Rate".
The cost of debt is straightforward, and explicit. It is the interest rate on the loan or the bond.
The cost of equity is not straightforward. It is "imputed" by the expected return on investment for the company, which includes both the share price appreciation and dividend rate.
I will explain more later in this post, but if you want more of the official answer, see http://en.wikipedia.org/wiki/Cost_of_capital.
The first thing you have to understand is that there are only three ways for a corporation to get money to finance their operations:
1.) Issuing stock (equity),
2.) Issuing debt (borrowing from a bank is equivalent for this purpose) (those two are external financing)
3.) Reinvesting prior earnings (internal financing)."
W.r.t. balance sheet, I am sure that you know the fundamental accounting equation, but for completeness, I include it below…
Assets = Liabilities + Equity
or as they show it in Europe…
Assets – Liabilities = Equity
First a few comments about the balance sheet, and capital structure.
In your question prompt, you placed a question mark by preference shares… which I believe you meant to say "preferred stock." To understand preferred stock you should first understand the liquidation preferences in the capital structure.
If a firm goes out of business, and there is not enough money in the bank to pay-off all of its debt, then the most senior (usually secured) debt gets paid-off first, until the money runs out. If it does run out of money, then the more junior (usually unsecured) debt does not. In this case (of the money running out), the common stock holders (equity) get nothing (and lose everything they invested in the company). This is why we say that debt is "more senior" than equity, because in liquidation, debt gets paid before equity.
If there was money left over after paying off all the debt, then the stock holders split the remains, regardless of how much they paid for their shares.
Preferred stock is equity, but it get "preference" over common stock during liquidation. Preferred stock "sits" between the debt and the equity. So, if there is any money left over during liquidation, the preferred stock holders get first dibs. Only after the preferred stock holders are paid-off, will the common stock holders get any money.
The other thing you mention is retained earnings. Retained Earnings appears on the "equity" side of the balance sheet, but it has nothing to do with ordinary shares. Retained earnings what’s left over from last year’s profits and was put in the bank for use this year.
OK, with these fundamentals out of the way, let’s attack the cost of capital.
The cost of debt is easier to understand than the cost of equity, so let’s go there first…
If a firm issues debt, or takes a loan, the firm is required to pay interest on the debt. This is exactly like the interest you pay on your credit cards or home mortgage. The "cost of debt" is the interest rate. Simple as that! The lender (or bondholder) expects to get paid the interest.
Now, if someone invests in a firm as a shareholder (a/k/a, equity), the firm does *not* have to pay interest, because the shareholder is an owner of the firm. The investor "expects" the share price to go up, but there are no promises. While the debt holder’s expectation of return is explicitly represented by the interest rate (as promised), the equity holders expectation is imputed by the share price (no promises).
This expected return on equity cannot be calculated in isolation. One needs to calibrate the expected return based upon the riskiness of the firm, and its industry. Investments in public utilities are not as risky as investments in bio-technology companies. Thus, the expectation for return on investment in a public utility is much lower than that for a bio-technology company. This expectation for return on investment is the "cost" of equity.
Since the payment of interest on debt gives the firm the benefit of a tax deduction, the cost of debt is "cheaper" than the cost of equity, which does not offer any tax deductions. (There is an interesting theory by Mogliani and Miller that shows this is not an intrinsic difference, but merely an accident of the tax deduction).
The official answer from wikipedia is… "The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt. It is also known as the "Hurdle Rate" or "Discount Rate".
The cost of debt is straightforward, and explicit. It is the interest rate on the loan or the bond.
The cost of equity is not straightforward. It is "imputed" by the expected return on investment for the company, which includes both the share price appreciation and dividend rate.
I will explain more later in this post, but if you want more of the official answer, see http://en.wikipedia.org/wiki/Cost_of_capital.
The first thing you have to understand is that there are only three ways for a corporation to get money to finance their operations:
1.) Issuing stock (equity),
2.) Issuing debt (borrowing from a bank is equivalent for this purpose) (those two are external financing)
3.) Reinvesting prior earnings (internal financing)."
W.r.t. balance sheet, I am sure that you know the fundamental accounting equation, but for completeness, I include it below…
Assets = Liabilities + Equity
or as they show it in Europe…
Assets – Liabilities = Equity
First a few comments about the balance sheet, and capital structure.
In your question prompt, you placed a question mark by preference shares… which I believe you meant to say "preferred stock." To understand preferred stock you should first understand the liquidation preferences in the capital structure.
If a firm goes out of business, and there is not enough money in the bank to pay-off all of its debt, then the most senior (usually secured) debt gets paid-off first, until the money runs out. If it does run out of money, then the more junior (usually unsecured) debt does not. In this case (of the money running out), the common stock holders (equity) get nothing (and lose everything they invested in the company). This is why we say that debt is "more senior" than equity, because in liquidation, debt gets paid before equity.
If there was money left over after paying off all the debt, then the stock holders split the remains, regardless of how much they paid for their shares.
Preferred stock is equity, but it get "preference" over common stock during liquidation. Preferred stock "sits" between the debt and the equity. So, if there is any money left over during liquidation, the preferred stock holders get first dibs. Only after the preferred stock holders are paid-off, will the common stock holders get any money.
The other thing you mention is retained earnings. Retained Earnings appears on the "equity" side of the balance sheet, but it has nothing to do with ordinary shares. Retained earnings what’s left over from last year’s profits and was put in the bank for use this year.
OK, with these fundamentals out of the way, let’s attack the cost of capital.
The cost of debt is easier to understand than the cost of equity, so let’s go there first…
If a firm issues debt, or takes a loan, the firm is required to pay interest on the debt. This is exactly like the interest you pay on your credit cards or home mortgage. The "cost of debt" is the interest rate. Simple as that! The lender (or bondholder) expects to get paid the interest.
Now, if someone invests in a firm as a shareholder (a/k/a, equity), the firm does *not* have to pay interest, because the shareholder is an owner of the firm. The investor "expects" the share price to go up, but there are no promises. While the debt holder’s expectation of return is explicitly represented by the interest rate (as promised), the equity holders expectation is imputed by the share price (no promises).
This expected return on equity cannot be calculated in isolation. One needs to calibrate the expected return based upon the riskiness of the firm, and its industry. Investments in public utilities are not as risky as investments in bio-technology companies. Thus, the expectation for return on investment in a public utility is much lower than that for a bio-technology company. This expectation for return on investment is the "cost" of equity.
Since the payment of interest on debt gives the firm the benefit of a tax deduction, the cost of debt is "cheaper" than the cost of equity, which does not offer any tax deductions. (There is an interesting theory by Mogliani and Miller that shows this is not an intrinsic difference, but merely an accident of the tax deduction).
References :
There are two types of stocks in general. Common stock and preferred stock. At the time of distribution of dividend, prefered stock holders will always get the dividend first. If the company decides the reserve the profit in the form of retained earnings, prefered stock holders will have to be paid first.
References :