STUDENTS
Paper 14: The cost of capital This article examines the meaning behind the weighted average cost of capital with particular focus on AIA’s Paper 14 Financial Management.
I
first came across the term “cost of capital” 25 years ago, when I was a trainee accountant at the London headquarters of a global chemical manufacturer. My colleagues in the corporate reporting group and I were preparing the press release that announced the annual financial results to the London and New York stock markets and I saw the term in that release. Not knowing what it referred to, I asked a more experienced colleague to enlighten me and they responded: “It’s the return the investors need to justify putting their money in our business.” This struck me as an important piece of information. My instincts told me that keeping your investors satisfied was something that you should strive for. In this article, I will look at the meaning behind the weighted average cost of capital with particular focus on AIA’s Paper 14 Financial Management.
The golden rules
Every commercial business, incorporated or not and regardless of its size, has a capital structure. The capital structure refers to the source or sources of finance the business has raised from its investors. This affects everyone from sole trader businesses which use little more than the finance provided by their proprietors when setting up their businesses to multinational corporations with much more complex and varied sources of finance. Regardless of the size or simplicity of the capital structure, all capital structures have a cost. That is, as my former colleague pointed out to me nearly 25 years ago, the providers of finance expect a return from their investment. Rational investors do not provide their money for free. Based on the length of time they are parting with their money and a number of other factors generally relating to the riskiness
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of their investment, the rational investor will expect a reward in return for letting the business use their money. Generally, a rational investor only accepts higher risk if the reward is commensurately higher. The golden rules in relation to the cost of capital are as follows: 1. All providers of capital (investors) expect to be rewarded for their investment. 2. Higher risk means higher reward, which means higher cost of capital.
Cost of equity
In most exam questions that I have seen over the last 20 years, a company’s capital structure comprises: finance from the company’s owners (equity); one or two sources of debt; and maybe some preference share capital (which is not ISSUE 113 | AIAWORLDWIDE.COM
