Guide on How to Write University Essays, Courseworks, Assignments and Dissertations

Understanding the Cost of Capital

Home
Articles Library
Medicine, Psychology and Sociology Articles
Business Articles
Economics Articles
Industry Lifecycle
Marketing Mix
McKinsey 7S Framework
Product Life Cycle
Ansoff Analysis
BCG Growth-Share Matrix
Value Chain
Porter's Generic Strategies
Scenario Planning
PEST analysis
SWOT Analysis
Porter's 5 Forces analysis
Sitemap
Comments about this web site
Favorite Links
How to write an Essay
How to Write the Coursework or Report
How to write the Marketing or Marketing Communications Campaign
How to write the Dissertation
Where to start?
How to choose an area of research
How to define Issue or Argument
How to define Issue or Argument
How and where to review the literature
Research Methods
Dissertation Structure
Some tips to survive your dissertation: some predictable crisis
Important tips to succeed the dissertation
Databases of Academic Journals and Publications; Market Data
Essay Sites
Student Tricks
Exam Preparation Tips
Company-Based Reports
BALANCED SCORECARD
Critical Success Factors
Competitor Analysis
Review

Every decision, whether personal, organizational, or business, is not without cost. In our analysis of what needs to be done and when things need to be done, we look at every opportunity or variable. This is the meat of the cost of capital.

 

The cost of capital is the opportunity cost of an investment (Investor Words 2007 [online]). It is the rate of return that a company would otherwise earn in an alternative investment decision for the same risk level that the primary investment decision was made. The cost of capital therefore, is not only an exercise of the monetary cost of a good but also the foregone benefit when a capital good is selected.

 

The opportunity cost of capital can be illustrated in such simple terms. For example, Mr. Sam is peddling shoes. Being hard at work walking around the city, he decided to buy a bicycle. The monetary cost of capital is the price of the bicycle. However, the opportunity cost of capital is the benefit that he could have gotten if he used the money to buy the bicycle for some other things (like a wagon for his shoes). The opportunity cost of capital is therefore, an economic fabric in every business decision.

 

In another viewpoint, the cost of capital is the weighted sum of the cost of equity and the cost of debt. It is also known as the discount rate (Wikipedia 2007 [online]). For an investment to be feasible, the return of capital should be in excess of the cost of capital. These factors are governed by probabilities and projections over a set period of time known as investment appraisals.

 

The cost of equity and the cost of debt are valuable variables in determining the cost of capital. For any business, capital can be acquired by loans (debt) against the value of assets (equity). The cost of debt is calculated with the risk associated or interest rate in giving debts. Meanwhile the cost of equity is the perceived return of a capital investment. This value is taken from other investments with similar risks to arrive at a certain cost of equity.

 

The weighted average cost of capital is used to determine a company’s cost of capital by using different weights of various components such as equity and debt. The equation for weighted average cost of capital uses the cost of equity and cost of debt as coefficients. In this equation, an increase in the cost of equity or the cost of debt increases one’s cost of capital.

 

The cost of capital is therefore, central to different business decisions. In essence, the cost of capital is affected by risk or interest rate, the value of the capital good, and its value in the future. At the same time, the opportunity cost of capital is governed by the different values of alternative investment decisions. Thus, for an executive tasked to make an investment call, approximating an accurate cost of capital can go a long way in making smarter business decisions.

References

 

InvestorWords. (2007). Cost of Capital. Available: http://www.investorwords.com/ 1153/cost_of_capital.html. Last accessed 18 October 2007.

 

Wikipedia. (2007). Weighted Average Cost of Capital. Available: http://en.wikipedia.org/wiki/ Weighted_average_cost_of_capital. Last accessed 18 October 2007.

 

Wikipedia. (2007). Cost of Capital. Available: http://en.wikipedia.org/wiki/cost_of_capital. Last accessed 18 October 2007.

 

 

S/F/131. Consultation analysis of John Deere Component Works costing structure

C/F/209. easyJet Valuation

C/F/194. Investment project evaluation and calculation of WACC

C/F/190. Jerome Private Equity case study

C/F/168. Estimate the average return, standard deviation and coefficient of variation for two assets

S/F/109. Corporate Financial Analysis of weighted average cost of capital (WACC)

C/F/151. Describe the main sources of finance available to companies. Evaluate the advantages and disadvantages of raising finance via equity or via debt.

C/F/157. Can the CAPM serve as the basis for discounting multi-period risky cash flows? Explain the problem, and state and justify your answer to question

E/F/61. DOES CAPITAL STRUCTURE INFLUENCE FIRM'S VALUE?

C/F/129. Buying existing business: case study

C/F/125. Venture Capital Fund Raising; Mobile TV and Internet TV Broadcasting industry.

P/F/424. Critique of CAPM theory

C/F/115. Capital maintenance is it important?

P/F/359. Understanding CAMP and cash flows

P/F/326. Analysis of Capital asset pricing model (CAPM)

C/F/102. Valuation models

P/F/278. Beta: Is it Useful or not?

C/F/96. Is capital budgeting suboptimal?

C/F/83. Is the CAPM dead?

P/F/258. 'Do we need CAPM for Capital Budgeting?' Critical Review of the Article

C/F/71. The analysis of the long - term financing funds raise

C/F/65. CAPM Essay

C/F/64. Cost of capital and minimization of it by increasing of debt

S/F/31. The Cost of Capital is a Critical Element in Business Decisions. Discuss.

P/F/225 Dissertation. CAPM: Validity Examination with Reference to Recent Academic Literature

P/F/137. Miller and Modigliani's Criticisms of the Concept of WACC

P/F/129. The Impact of IT Capital on the Firm's Productivity in Financial Sector: UK case

S/F/12. Dissertation. The Influence of the Asset Valuation Methodologies on Investment Decision - Making in Energy and Utilities Industry

C/F/28. 1) How useful is the assumption of mean-variance preferences? 2) Does the Capital Asset Pricing Model hold?

P/F/65 Advantages and Disadvantages of Capital Funding Methods

Enter supporting content here