Cost riskier because if a company goes bankrupt the

Cost of
capital is all about the costs of funds used to finance a company, for the
lenders it’s the minimum rate of return that they require on their invested
funds to stop them investing elsewhere. To raise the capital any business like
GNCC will try to minimise its average cost of capital, this includes debt,
ordinary shares and preference shares with equity being the highest risk but
also the highest return, this rate is determined by the returns offered on
alternative securities with the same bank. “their cost of capital is primarily
dependent upon the use of funds, not the source” (YouTube, 2018), this means that the cost of capital
doesn’t depend on who gave the capital but more important is how the capital is
used in risky projects.

Firstly, the cost of equity is the return
that GNCC would require to decide if an investment meets the capital return requirements
and it’s the rate of return that could’ve been earned if they instead chose to
put the money in a different investment with equal risk. The directors of GNCC
would know the importance of this because any investors would want o make sure
their investment grows by at least the cost of equity. To work this out the
dividend growth model can be used but a certain disadvantage of this is that it
assumes dividends grow at a set rate which is unlikely. Equity usually costs
more than debt as the dividends that are paid to equity holders are not tax-deductible
and so there isn’t the tax benefit debt has. Also, equity is riskier because if
a company goes bankrupt the equity holders lose out and so they have to put
more consideration into whether they take the risk of investing in a company. The
formula to work out cost of equity is For GNCC their cost of equity is
4/45+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, this
means that GNCC would have to pay a higher amount to their shareholders to sustain
the current investors as well as attract new investors. As the difference in
percentages isn’t huge I don’t think GNCC should be very concerned now as they
are receiving 200M from investment, they should just try and lower their cost
of equity so that investors don’t start looking for better investments that will
pay more.

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Secondly, the cost of preference
shares shows the total that is payable to preference shareholders which will be
in the form of dividends with a fixed rate, these shareholders are entitled to a
fixed dividend but this can only happen if GNCC has enough profit and by
looking at their income statement they had 15M retained profits compared to 13M
for magnet which suggests they are in a healthy position. Preference shareholders
get paid before equity shareholders. Preference shares tend to be irredeemable which
means they will not be bought back by a company and the shareholders will earn
dividends when profit is made. It is worked out by using the formula For GNCC
their cost of preference shares is 0.80/10.50=7.6% and for their competitor Magnet
it is 0.98/12.25=8%, this shows that GNCC’s cost of preference shares is lower
than Magnet’s which is good and means they should be less worried about their
cost of capital. GNCC’s is lower because they only pay 80p each in dividend as opposed
to 98p by Magnet which means they have less of their profits to pay out as
dividends, and get to retain more of it.

Thirdly, the cost of debt is the
interest GNCC have to pay on their borrowing as a percentage and its usually
the 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 the
same cost of debt. They both have an annual interest payment of 10%, so both
companies pay 7.5% on average on all of their debts which is a reasonable
amount.