The Cost Of Capital Is A Critical Element In Business Decisions

3689 words - 15 pages

The Cost of Capital is a Critical Element in Business DecisionsMark FrystakAmerican Public University SystemFINC 600 Corporate FinanceMany of the critical decisions that business owners and senior management face can be categorized as investment opportunities. Whether building a new facility, taking over another business or expanding their investment portfolio, managers and owners are frequently making investment decisions that shape their business's future. Investment in capital assets naturally requires some form of finance, and "since the method of finance that is employed by a particular firm defines their cost of capital (which in turn affects the amount of investment undertaken), it is obvious that the investment and finance decisions of the firm are inexorably linked" (Brewster, 1999).Finance can be raised internally and externally by a firm. The two main external sources of finance include 'equity' (the issuing of ordinary and preference shares) and 'debt' (issuing of bonds, debentures, short-term loans). A company's shareholder funds are an example of internal financing, but typically the prime source of internal funds for investment purposes is the company's retained earnings. The relative costs of these funds may vary, depending on the prevailing market conditions. Therefore, the aim of management or business owners is to determine the most efficient mix of these funds in order to obtain the optimal capital structure with which to execute their particular investments.The cost of capital is the "rate of return that a company must earn on an investment to maintain the value of the company" (Belk, 2004). To borrowers, it is the rate of return required attracting potential investors and obtaining required capital, and to suppliers of money, it is an opportunity cost or the return available on investments of a similar risk. The cost of money is primarily determined by the exchange of capital in equity and bond markets that will vary over time as a function of the changing market forces for money. The Weighted Average Cost of Capital (WACC) measures the cost of the various types of capital companies' use. The WACC represents the opportunity cost of using capital to purchase fixed assets and reflects the average risk and overall capital structure of a firm. According to Graham (2002), the cost of capital is affected by a number of factors. Some are beyond the firm's control (Interest Rates, Tax Rates, Market Risk Premium), but others are influenced by its financing and investment policies (Capital Structure Policy, Dividend Policy, Investment Policy).As identified, the cost of capital and business decisions are linked, but whether the cost of capital is a 'critical' element in business decisions is another matter. A rudimentary analysis would be that the non-static nature of the Cost of Capital can be problematic (i.e. critical) in investment decisions, as with capital markets constantly fluctuating, a decision based...

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