Source Of Capital

One source of new capital is outside loans. Interest on such loans is usually at a fixed rate, and the annual cost can be determined directly.

New capital may also be obtained from the issue of bonds, preferred stock, or common stock. Interest on bonds and preferred-stock dividends must be paid at fixed rates. A relatively low interest rate is paid on bonds because the bond-holder has first claim on earnings, while higher rates are paid on preferred stock because the holder has a greater chance to lose the entire investment. The holder of common stock accepts all the risks involved in owning a business. The return on common stock, therefore, is not at a fixed rate but varies depending on the success of the company which issued the stock. To compensate for this greater risk, the return on common stock may be much higher than that on bonds or preferred stock.

Income-Tax Effects

The effect of high income-tax rates on the cost of capital is very important. In determining income taxes, interest on loans and bonds can be considered as a cost, while the return on both preferred and common stock cannot be included as a cost. Since corporate income taxes can amount to more than half of the gross earnings, the source of new capital may have a considerable influence on the net profits.

If the annual income-tax rate for a company is 34 percent, every dollar spent for interest on loans or bonds would have a true cost after taxes of only 66 cents. Thus, after income taxes are taken into consideration, a bond issued at an annual interest rate of 6 percent would actually have an interest rate of only 6X = 4.0 percent. On the other hand, the dividends on preferred stock must be paid from net profits after taxes. If preferred stock has an annual dividend rate of 7 percent, the equivalent rate before taxes would be 7 X ^ = 10.6 percent.

Despite the fact that it may be cheaper to use borrowed capital in place of other types of capital, it is unrealistic to finance each new venture by using borrowed capital. Every corporation needs to maintain a balanced capital structure and is therefore hesitant about placing itself under a heavy burden of debt.

A comparison of interest or dividend rates for different types of externally financed capital is presented in Table 10.

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