- Local Debt
The computation of cost of debt is relatively easy particularly when borrowings by
subsidiaries are from local banks, local financial institutions or from financial markets in
the host country. Both the types of cash inflows and of outflows are amenable to
accurate forecast and, therefore, the cost of local debt can be determined with a fair
degree of precision.
- Foreign Debt
More often than not, subsidiaries borrow from banks, financial institutions or financial
markets in the country of the parent company or tap international financial markets. For
the purpose of determining the effective cost of foreign debt in such a situation, the
expected rate of variation in the value of foreign currency (in which borrowings are
made) with reference to the currency of reference (known as base currency) should be
taken into account.
- Cost of preference shares
Computation of the cost of preference shares is similar to that of debt. Like debt holders
who are entitled to a fixed rate of interest, preference shareholders are also paid a pre-
specified rate of dividend (unless preference shares are participating; in general, most of
these shares are non-participating). However, unlike interest payments on borrowings,
dividends paid on preference shares are not tax-deductible. The reason is that dividend
payment is appropriation out of earnings. In contrast, interest payment is a charge against
profit. Since dividends are paid out of earnings (which obviously are after taxes), no
adjustment is required for taxes while computing the cost of preference shares.
The cost of preference shares is based on the ratio of preferred dividend and the net
proceeds received from the issue of preference shares.
- Cost of equity capital
At the outset, it may be mentioned that the cost of equity capital is the most difficult cost
to be computed. It is so because unlike debt and preference shares, equity shares do not
have contractual obligations to be paid at pre-determined rate of interest/dividend.
Besides, even if there are sufficient earnings warranting the payment of dividends, its
payment is at the discretion of the management (rendering forecast of future dividends
difficult). Above all, equity holders are residual claimants (after payment of debt and
preference) in the assets of the firm in the event of its liquidation (again the likely amount
to be received is more difficult to be forecast). Clearly, equity capital from the
perspective of investors is the most risky. In financial terms, the equity holders have a
higher degree of financial risk than debt holders and preference shareholders. For these
reasons, the required rate of return of equity-holders is higher than that of debt holders
and preference shareholders. Therefore, higher costs are associated with equity funds.