Opportunity Cost of Capital

The difference in return between an investment one makes and another that one chose not to make.
This may occur in securities trading or in other decisions. For example, if a person has $10,000 to
invest and must choose between Stock A and Stock B, the opportunity cost is the difference in their
returns. If that person invested $10,000 in Stock A and received a 5% return while Stock B makes a
7% return, the opportunity cost is 2%. One way of conceptualizing opportunity cost is as the amount
of money one could have made by making a different investment decision. Importantly, opportunity
cost is not a type of risk because there is not a chance of actual loss.
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Different Types Of Preference Shares are:
1. Convertible preference shares have the privilege of being converted into ordinary shares at a
specified date and rate. The terms of conversion are also being stated when the shares are issued.
2. Cumulative preference shares allows the company to pay any dividends that have not being
paid in one year to be carried forward or cumulated to the following years for payment.
3. Participating preference shares are PRIVILEGE shares where the shareholders enjoy
additional dividends besides the fixed rate. The amount of additional dividends is specified in the
Articles and generally it is a proportion of dividend declared on ordinary shares. However, note that
these participating preference shareholders will only be paid after all dividends on all other classes of
shares have been paid.
4. Redeemable preference shares are shares that the company can buy back or redeemed at a
specified future data at a predetermined price. The redemption details or terms are stated in the
Articles when these shares are issued.
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Debt Capital
Debt can be seen as a financing option available to a firm desiring to get extra cash to fund new
investments, as well as ongoing business activities.
Debt capital is redeemable, since the loan principal has to be paid back at some given future date,
however, the debt capital may have rights which are to be changed to equity stock.
Advantages of debt capital
They are less expensive compared to the firms shares and common stock chiefly because of:
Expense on interest is an allowable tax expense. Thus, the actual debt cost is lower
compared the effective payable rates. That should be adjusted in order to reflect that
expenses on interest are an allowable tax expense.
The debt is superior to both preference and ordinary shares since it ranks ahead when
liquidation and interests is paid as well, before dividends are to be paid out. It therefore
implies that debt holders bear low risk as compared to preference and ordinary shareholders
and therefore demand low return rates so as to show the low risk levels inherent in the debt.
In case the firm raising finances expands significantly due to the funding, the firm shares
not the additional money with the debtors. This is a great advantage as the outflow from the
firm to debt holders has limited contractual obligation, i.e. Interest.
Debt capital holders do not have any voting rights. Hence they have low influence in the
firm when compared to the ordinary shareholders.
Disadvantages of debt capital
The debt capital holders, legally possess cash flow rights, the firm using the debt
equipment is committed to pay the interest in future. Obligations on interest are contractual,
therefore, must be paid whether the firm makes profit or not. The debt holders therefore have
a right to take action legally as well as ask for the payment of loan principal or appoint an
administrator in case interest is not paid.
The firm using the debt capital has high chances financial distress and insolvency
compared to a firm financed via ordinary shares. This can result in the firm passing up
profitable investment.
Financial promises can lead to financial, strategic and operational inflexibility dut utilizing
debt equipment. The debt holders can push an organization into specific strategic options,
and forgo opportunities which are profitable. Some financial promises can push the firm into
not making specific decisions without consulting the creditor. This shows the huge power they
have due to financial covenants.
Different from preferential share capital or ordinary share capital debt exists as temporary
capital. A loan principal would require the payment to the creditor in the future. This implies
that debt finance necessitates the requirement for renegotiation of refinancing or loan
agreement, which attracts arrangement costs.