Cost of Capital

5329 Words Nov 23rd, 2009 22 Pages
INTRODUCTION
The long-term investments that make today will determine the value of business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must know the cost of obtaining funds to acquire these assets. The cost associated with different sources of funds is called the cost of capital. . If the business earns more than its cost of capital, the market value of the business will increase. Likewise, if returns on long-term investments are below the cost of capital, market values will decline. Therefore, how we manage capital is extremely important to fulfilling the basic objective of increased shareholder value.

This report is basically concentrated on the topic of “Firm &
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Financial experts express conflicting opinions as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital importance in the financial decision making. It is useful as standard for:

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Evaluating investment decisions. Designing a firm debt policy. Appraising the financial performance of top management.

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Evaluating investment decisions: The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. In the NPV method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting it s cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the desirability of an investment project. The cost of capital is the minimum required rate of return on the investment project that keeps the shareholder 's present wealth unchanged. It may be thus, noted that the cost of capital represents a financial standard for allocating the firm’s funds, supplied by owners and creditors to the various investment projects in the most efficient manner. Designing Debt Policy: The debt policy of a firm is significantly influenced by the cost consideration. Debt helps to save taxes, as interest on debt is a tax deductible expense. The interest tax shield reduces the overall cost of capital, though it also increases the financial risk of

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