Hedging With Forward Contract
The term cost of capital, as a decision criterion, is the overall cost. This is the combined cost of the specific costs associated with specific sources of financing. The cost of the different sources of financing represents the components of the combined cost. The computation of the cost of capital, therefore, involves two steps:
(i) The computation of the different elements of the cost in terms of the cost of the different sources of finance (specific costs), and
(ii) The calculation of the overall cost by combining the specific costs into a composite cost.
The first step in the measurement of the cost of capital of the firm is the calculation of the cost of individual sources of raising funds. Apart from its relevance to the measurement of the combined cost, the specific cost will also indicate the relative cost of pursuing one line of financing rather than another. From the viewpoint of capital budgeting decision, the long-term sources of funds are relevant as they constitute the major sources of financing of fixed assets. In calculating the cost of capital, therefore, the focus is on long-term funds. In other words, the specific costs have to be calculated for (i) long-term debt (including debentures); (ii) preference shares; (iii) equity capital; and (iv) retained earnings.
Cost of Preference Shares
The computation of the cost of preference shares is conceptually difficult as compared to the cost of debt. In the case of debt; as shown above, the interest rate is the basis of calculating cost, as payment of a specific amount of interest is legal commitment on the part of the firm. There is no such obligation in regard to preference dividend. It is true that a fixed dividend rate is stipulated on preference shares. It is also true that holders of such shares have a preferential right as regards payments of dividend as well as return of principal, as compared to the ordinary shareholders. But, unlike debt, there is no risk of legal bankruptcy if the firm does not pay the dividends due to the holders of such shares. Nevertheless, firms can be expected to pay the stipulated dividend, if there are sufficient profits, for a number of reasons. First, the preference shareholders, as already observed, carry a prior right to receive dividends over the equity shareholders. Unless, therefore, the firm pays out the dividend to its preference shareholders, it will not be able to pay anything to its ordinary shareholders. Moreover, the preference shares are usually cumulative which means that preference dividend will get accumulated till it is paid.
There are two types of preference shares:
(i) irredeemable, and
(ii) redeemable. The first category is a kind of perpetual security in that the principal is not to be returned for a long time or is likely to be available till the life of the company. The redeemable preference shares are issued with a maturity date so that the principal will be repaid at some future date. Accordingly, the cost of preference is calculated separately for these situations.
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