Cost ofcapital is all about the costs of funds used to finance a company, for thelenders it’s the minimum rate of return that they require on their investedfunds to stop them investing elsewhere. To raise the capital any business likeGNCC will try to minimise its average cost of capital, this includes debt,ordinary shares and preference shares with equity being the highest risk butalso the highest return, this rate is determined by the returns offered onalternative securities with the same bank. “their cost of capital is primarilydependent upon the use of funds, not the source” (YouTube, 2018), this means that the cost of capitaldoesn’t depend on who gave the capital but more important is how the capital isused in risky projects. Firstly, the cost of equity is the returnthat GNCC would require to decide if an investment meets the capital return requirementsand it’s the rate of return that could’ve been earned if they instead chose toput the money in a different investment with equal risk. The directors of GNCCwould know the importance of this because any investors would want o make suretheir investment grows by at least the cost of equity.
To work this out thedividend growth model can be used but a certain disadvantage of this is that itassumes dividends grow at a set rate which is unlikely. Equity usually costsmore than debt as the dividends that are paid to equity holders are not tax-deductibleand so there isn’t the tax benefit debt has. Also, equity is riskier because ifa company goes bankrupt the equity holders lose out and so they have to putmore consideration into whether they take the risk of investing in a company. Theformula to work out cost of equity is For GNCC their cost of equity is4/45+0.
06 which equals 14.89%, and for their competitor Magnet it is 4/60+0.06=12.
67%,this shows that GNCC’s cost of equity is slightly higher than Magnets, thismeans that GNCC would have to pay a higher amount to their shareholders to sustainthe current investors as well as attract new investors. As the difference inpercentages isn’t huge I don’t think GNCC should be very concerned now as theyare receiving 200M from investment, they should just try and lower their costof equity so that investors don’t start looking for better investments that willpay more.Secondly, the cost of preferenceshares shows the total that is payable to preference shareholders which will bein the form of dividends with a fixed rate, these shareholders are entitled to afixed dividend but this can only happen if GNCC has enough profit and bylooking at their income statement they had 15M retained profits compared to 13Mfor magnet which suggests they are in a healthy position. Preference shareholdersget paid before equity shareholders. Preference shares tend to be irredeemable whichmeans they will not be bought back by a company and the shareholders will earndividends when profit is made.
It is worked out by using the formula For GNCCtheir cost of preference shares is 0.80/10.50=7.6% and for their competitor Magnetit is 0.98/12.25=8%, this shows that GNCC’s cost of preference shares is lowerthan Magnet’s which is good and means they should be less worried about theircost of capital.
GNCC’s is lower because they only pay 80p each in dividend as opposedto 98p by Magnet which means they have less of their profits to pay out asdividends, and get to retain more of it.Thirdly, the cost of debt is theinterest GNCC have to pay on their borrowing as a percentage and its usuallythe cheapest form of financing, it is calculated as For GNCC it is 10%X(1-0.25)=7.5% and for magnet it is also 7.5% which shows that they have thesame cost of debt. They both have an annual interest payment of 10%, so bothcompanies pay 7.5% on average on all of their debts which is a reasonableamount.