Question

Answer the following questions based . Write your response in a separate Microsoft Word document: o Importance of Cost of Capital:

THE ANSWER SHOULD BE BASED ON AMAZON

Why is cost of capital important to an organization, and what does it measure?

o Meaning of Calculations: How do organizations calculate various costs, and what do these calculations mean to business?

Answer 1

The minimum return expected by the investors, which in turn, is the cost of procuring funds for the firm, is termed as the cost of capital of the firm. Thus , the cost of capital of a firm is the minimum rate of return that it must earn on its investments in order to satisfy the expectation of the various categories of investors who invested in the firm.

Firm Procures the funds from various sources and the overall cost of capital of a firm will be weighted average of the cost of different sources of finance.

Components of cost of capital:-

1. Cost of Equity Share Capital: It is the minimum return expected by the equity investors. which is depend on the risk preception of the investor as well as on the risk-return complexion of the firm.

2. Cost of Preference Share Capital; It is the rate of return required by the preference shareholders in the form of dividends.

3. Cost of Debentures or Bonds:- It is the discount rate which equates the net proceeds from the issue of debentures to present calue of the expected cash outflows in the form of interest and principal repayment.

Organisation calculates the weighted average cost of capital by multiplying the cost of each capital source (equity, preference and debt) by its relevant weight like (0.4*10%) + (0.3*7%) + (0.3*9%) = 8.8% is the WACC.

The cost of capital means to business as it aids businesses and investors in evaluating all investment opportunites, it is also a important component of business valuation work. It also indicates that the return should be more then the wacc of the organisation in order to make profits.