Importance Of Cost Of Capital

Improved Essays
Corporate Decisions are influenced by a firm’s cost of capital for an aim to reach a stage of profitability and hold the objective of reaching its potential wealth maximum. These are the costs incurred by companies used to finance a firms assets and activities The Cost of Capital is important in analysing the financial aspect of a business by measuring and evaluating business plans and activities. A firms cost of capital is affected by influences from financing, investment and dividend policies.
Projects cost of capital rate of return indicate the riskiness of a project involved where “The firms cost of capital is the overall or average required rate of return on the aggregate of investment projects.” Cost of Capital is a useful method used
…show more content…
The costs of capital plays an intergral role in dividend and investment decision making.
Cost of capital is the expected rate of return attracting funds to a particular investment or asset, also known as the opportunity cost. The cost of capital comes from the marketplace where investors asses the risk or a particular asset representing the investors or firms expectations based on the market data. Cost of capital is market driven and forward based through focus on the expected return from the market for an asset, compared effectively with the market value. The cost of capital links the expected future returns of an asset with its present value.
Cost of Capital applications are mainly used for valuations for any prospective decisions made on projects or asset investments. Net Cash flow is used for discounting or capitalising a project or investments valuation and through use of the discount rate, returns are discounted by using the present value to the specific asset investment or project. Cost of Capital is used for capital budgeting purposes, accompanied with the internal rate of return. The Cost of capital is compared with the internal rate of return for different projects, these projects are accepted when the internal rate exceeds the cost of
…show more content…
The risk adjusted cost of capital gives the risk of the project as the greater the risk is equal to the higher cost of capital. The CAPM is used by firms estimating the cost of capital and the NPV method assumes that cash flows will be reinvested for the firm’s cost of capital. Reinvesting the cost of capital is a closer approximate to the actual figures. A projects required rate of return can be equal to the firms cost of capital but the risk is adjusted if the risk of the project is higher or lower than the firms risk through the use of

Related Documents

  • Decent Essays

    Qualitative aspect implies the quality in terms of their realization into cash considering time dimension involved in maturing different components of current assets. Profitability is the capacity of earning profits and it is most important measure of performance of a firms. It is generally assumed that there is negative relationship between liquidity and profitability i.e. higher liquidity results in lower profitability and vice-versa. Objectives of the Study  To study the growth and development of the company.…

    • 1614 Words
    • 7 Pages
    Decent Essays
  • Improved Essays

    Profitability Index (PI) The profitability index is the ratio of the present value of future expected cash flows subsequent to initial investment divided by the amount of the initial investment. This measure shows the relative profitability of any investment by showing the ratio of the benefit from an investment to the cost. In other words, the index represents the value for each invested dollar. The profitability index considers all cash flows, the timing of cash flows, and the riskiness of cash flows – the same way as NPV does. PI is a ratio and relative amount, whereas NPV is a difference and as an absolute amount.…

    • 873 Words
    • 4 Pages
    Improved Essays
  • Decent Essays

    Ratios related to financial decision process The table 2 below indicates three types of investment ratios and their implications. Fixed assets turnover is sometimes highly emphasized while making investment decision as it measures the relationship between fixed assets invested and profits generated, which may interest those investors and shareholders who have invested its property or fixed assets into the business and also it could be also significant to the financial manager as he may make an decision on external investment by investing the organization’s fixed assets outside. Debt to assets ratio is a financial indicator to measure the risk of the business. It highlights an important financial message to the financial manager and shareholders…

    • 816 Words
    • 4 Pages
    Decent Essays
  • Improved Essays

    Earned capital is the actual profit the company is making from their operations. A company that makes high-earned capital is more likely to pay out dividends. For an investor dividends are very important because this is how investors make profits. To an investor, paid-in capital will turn to earned capital, which then should result in dividends and higher stock…

    • 719 Words
    • 3 Pages
    Improved Essays
  • Great Essays

    Long term sustainability of a company depends on various factors. Strategic capital structure would cater long term financial solution for the company. Capital structure of a company will be consisting of both debts and equity. The ratio between debt and equity will be decided based on number of strategic factors such as industry, PEST factors, legal and corporate governance of the company. When deciding the capital structure, organizations should understand both positives and negatives of the capital structure selected.…

    • 1544 Words
    • 7 Pages
    Great Essays
  • Great Essays

    Cost Of Carry Essay

    • 1803 Words
    • 8 Pages

    When the future prices are lower than what they should be according to the cost of carry model, the action of buying future contracts by arbitrageurs will put upward pressure on the price. The cost of carry model can also be used to price the different future contracts, contracts on the same commodity but with different maturity dates. Equation (4) below represents such a model, F_t=F_x (1+C_(t-x)) where Fx is the price of a future contract which will mature at x, and Ct-x is the cost of carry between the period t and x. Just like the model looking at future prices in terms of spot prices, should the future price at maturity t not be equal to the future price at maturity x there will be arbitrage opportunities which when exploited will force the price into equilibrium. Cost of Carry and Convenience Yield Looking at the futures on commodities, a contrast should be made between the consumption and investment commodities.…

    • 1803 Words
    • 8 Pages
    Great Essays
  • Improved Essays

    Net Present Value is the difference of present value of cash inflows and outflows; it’s used to analyze the success of an anticipated investment. The Discounted Cash Flow is used to estimate the appeal of an investment opportunity, it analysis free cash flow projections of the future. If the value attained through DCF analysis is higher than the current cost of the investment, that’s an indication of a good opportunity investment. The Weighted Average Cost of Capital is the company’s cost of capital which all of the company’s assets are respectively weighted; bonds, common and preferred stocks, and long-term debts are involved in the Weighted Average Cost of Capital calculation. The Equivalent Annual Annuity is a calculation of the annual cash flow of an annuity investment over its existence.…

    • 854 Words
    • 4 Pages
    Improved Essays
  • Improved Essays

    There are two potential costs when firms are choosing external markets to raise capital. They are information asymmetry costs and transaction costs. These two costs are the reason why external capital cost more than internal capital which make the firm choose internal over the external. Information asymmetry occurs when there is a split-up between ownership and management. Meaning managers know more about the firm value and at the same time would try to issue equity when the market value is high (Myers and Majluf, 1984).…

    • 1225 Words
    • 5 Pages
    Improved Essays
  • Superior Essays

    The procedure relies on the initial cost of the capital that the firm may incur when undertaking a project and the cash proceeds to come up with a reliable and informed decision (accept or reject) concerning the investment plan. When an organization computes and get the IRR for one investment program, it also calculates the IRRs for other proposals for comparison to identify the most valuable option to invest on (Berk & DeMarzo, 2016). Furthermore, an organization needs to compare the IRR of an investment to the average weighted cost of capital (minimum required…

    • 1345 Words
    • 6 Pages
    Superior Essays
  • Great Essays

    Costco Capital Structure

    • 1954 Words
    • 8 Pages

    The proportion of short and long term debt is considered while analyzing the capital structure. It provides an insight of the leverage that a company has and how prone…

    • 1954 Words
    • 8 Pages
    Great Essays