Question

4) Why do the capital components have different costs?

Answer 1

Equity capital usually consists of two components. The first is the amount of funds available in the form of net income that may be used to pay dividends or may be retained in the business for asset purchases. The second source of equity capital is the amount of funds raised by a new common stock issue. Generally, cost of debt capital refers to the total cost or the rate of interest paid by an organization in raising debt capital. However, in a real situation, total interest paid for raising debt capital is not considered as cost of debt because the total interest is treated as an expense and deducted from tax. This reduces the tax liability of an organization.In simpler terms, the marginal cost of capital is calculated in the same manner as the weighted average cost of capital is calculated by just adding additional capital to the total cost of capital