Abstract This paper mainly examines about how important the cost of capital is for organizations and why it is a key element in many business decisions. In this paper, I will investigate different types of cost of capital used by various corporations based on their mode of financing. Besides, there are many factors related with the companies’ cost of capital such as risk management , public and private information of the organization.
I will also find out these relationship in general. But my main focus is on the different components of cost of capital and the various approaches to calculate those components.Cost of Capital It is important for all managers to strive to increase their corporate valuation that is determined by firm’s size, its financial assets, period of cash flow matters, the rate of risk exposure, free cash flows , etc.
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The cost of capital is a critical element used for financing a business. It is essential for corporations to determine whether the company’s return on their investment exceeds the cost of capital or not. The types of cost of capital vary from one organization to another according to their mode of financial investment, operating history, rate of profitability or credit worthiness ( the valuation that a borrower may default on the debt). If the corporation is financing only on equity, that corporation’s cost of capital is called the cost of equity.
If a firm’s investment is solely through debt, we can call it the cost of debt. But most of the organizations use the combination method of both debt and equity to finance their firms and that type of cost of capital is known as weighted average cost of capital ( WACC ). Cost of capital or the hurdle rate is always fundamental for many business decisions from determining the minimum rate of return in a project or investment to deciding the firm’s capital structure.
Not only that, cost of capital influences both the functions and operations of the organization and the profitability of the firm. Therefore, organizations should decide their financial track carefully – debt or equity or the combination of two.Cost of Debt Cost of debt can be defined as the rate that the company must pay for its current debt. Mostly, cost of debt refers to after-tax amount but sometimes it refers to the amount before deducting taxes. It is also one of the important parts of company’s structure. Besides, the cost of debt can help investors predict the riskiness of the business compared to others.
It is very useful and essential for investors to know the level of riskiness because riskier companies have higher cost of debt than the less risky ones.