Tools Used in Financial Management

625 Words Feb 2nd, 2018 3 Pages
(a) Cost of capital
Cost of capital is an important element in investment decision or basically in business.
It is used to measure the value of investment proposal provided by investment concern. It is used as discount rate in defining the present value of future cash flow which is associated with capital projects. Cost of capital is the required rate of return in an investment which owned to equity, debt and retained earnings. The market value of an organization will fall and eventually reduce the wealth of shareholder when the firm fails to earn expected return. There are three basic assumption in cost of capital. Firstly, it is not a cost as such and merely a hurdle rate. Secondly, it is the minimum rate of return. Lastly, it consist of three important risks such as zero risk level, business risk and financial risk. The cost of capital can be measured by the following equation. K= r_j+b+f Where, K = Cost of capital, r_j = the riskless cost of particular type of finance, b = the business risk premium and f = the financial risk premium.
(b) Financial leverage
Financial leverage refers to leverage activities with financing activities. It signifies the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity…
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