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Write about cost of capital in financial management.
Cost of capital is an alternative investment that an investor can invest to get equal rate of return. In other words, it is the opportunity cost that an investor can invest the same money in another investment which is having similar risk and other characteristics. It plays an important role in capital budgeting decisions. It provides guidelines to determine optimal capital structure for a company.
Significance of cost of capital is mentioned below
Helpful in making capital budgeting decisions by using discount rates to calculate future cash flow using present values.
Helpful in making capital structure decisions by raising its source of funds with minimum risk and other cost factors.
Calculation process of cost of capital is as follows −
- Calculate cost of equity.
- Calculate cost of retained earnings and depreciation funds.
- Match between marginal and average cost of capital (for decision making).
- Assigning weights to each type of funds (in complex issues).
Types of cost of capital are given below −
- Cost of equity.
- Cost of debt capital.
- Weighted average cost of capital.
In manager’s point of view
Generally weighted average cost of capital is used as benchmark for selecting new projects or to evaluate existing projects. If, internal rate of return (IRR) is less than weighted average cost of capital, it states that, it diminishes investors wealth, company is not using investor’s capital at its best.
It indirectly sends negative signals to investors. There is a chances that an investor may not get the rate of returns.
In investors’ point of view
Cost of capital tells about risk in investment in a company stock.
Factors affecting the cost of capital are as follows −
- Market opportunities.
- Capital providers.
- Risk of investment.
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