test, the business must determine the cost of its funds, or, more properly stated, the cost of capital.
The business owner must ascertain which combination of debt and equity will result in the lowest cost of capital.
How is it computed?
The best way to calculate a business’ cost of capital is to examine each element of its capital structure. The capital structure of a business may be based on long-term debt, preferred stock and common stock. (Stock may only be issued by a corporation.) Capital structure is the mix of long-term debt and equity used by the business to finance.
The cost of debt is the interest rate paid to noteholders. The simplest case would be a $1,000 note paying $100 annually and thus costing the business 10 percent. The holder of the note would then say that the note’s yield is 10 percent. The after-tax cost of the debt to the business is the yield to maturity times 1 minus the tax rate. The formula is:
Cost of debt = Y (1 – tax)
where Y is the yield.
The cost of preferred stock is similar to the cost of debt in that a constant annual payment is made only if the stock pays dividends. Note, however, that preferred stock has no maturity date, so the business owner merely has to divide the annual dividend by the current price to calculate the annual percentage cost of the preferred stock. Costs are converted to percentages so that they may be compared. The formula is:
The cost of common stock is similar to the cost of preferred stock in that an annual dividend payment may exist. Like preferred stock, common stock has no maturity date, so the business owner merely has to divide the annual dividend by the current price to calculate the annual cost of the common stock. The formula is:
A business corporation that issues notes, preferred stock, and common stock would combine all elements to arrive at a weighted-average cost of capital. It would be calculated as follows:
Example 1
The Max Clothing Company signed a note for $10,000 at 10 percent. The business is in the 15 percent corporate tax bracket. The after-tax cost of the note is 8.5 percent, calculated as follows:
| Cost of debt | = | Y (1 – tax) |
| = | 10%(1 – 0.15) | |
| = | 10%(0.85) | |
| = | 8.5% |
Example 2
The Palo Wire Company sold 100 shares of preferred stock for $100 a share to an investor. The preferred stock will pay a guaranteed annual dividend of $9 per share. The cost of the stock is 9 percent annually, calculated as follows:
Example 3
The Rex Photo Development Company sold 100 shares of its common shares for $100 a share to an investor. All common shareholders expect a guaranteed annual dividend of $7.50 per share. The cost of the common stock is 7.5 percent annually, calculated as follows:
Example 4
The Halo Paint Company raised capital by issuing a $20,000 bond at 11 percent; selling $20,000 of $100-par-value, 8 percent preferred stock, and selling $10,000 of 6 percent common stock. The company is in the 25 percent tax bracket and estimates that it will earn 10 percent on its capital. The company’s weighted-average cost of capital is 7.7 percent, and it is earning 2.3 percent more than its cost of financing. Halo’s weighted-average cost of capital is determined as follows:
Cost of $10,000 common stock:
How is it used and applied?
The weighted-average cost of capital is compared to the business’ return on capital to see whether the business owner is at least earning the cost of financing his/her operations.
A business owner may need a certain amount of money to develop a new product and in so doing has to weigh the costs of various funding sources.
The minimum expected rate of return of any business must exceed its cost of capital if the business is to survive. While debt is usually the easiest form of financing because it merely entails borrowing money, excessive debt may increase the financial risk of the business and drive up the costs from all sources of financing.
9. Establishing a Budgeting System for Profit Planning
Introduction
Business managers should adopt a budgeting procedure almost immediately after they start in business. Deviations from what has been budgeted enable business managers to anticipate potential serious financial problems early enough to take corrective action. A comprehensive (master) budget is a formal statement of management’s expectations regarding sales, expenses, volume, and other financial transactions of an organization for the coming period. Simply put, a budget is a set of pro forma (projected or planned) financial statements.
How is it computed?
The budget is classified broadly into two categories:
1.Operating budget, reflecting the results of operating decisions.
2.Financial budget, reflecting the financial decisions of the firm.
The operating budget consists of:
