Question

“By applying capital to investments with long-term benefits, the company is attempting to produce value. This value is dependent on expected future cash flows as well as on the cost of funds.” Explain this statement with regards to the role of cost of capital in financial management decisions

Answer 1

To explain the role of cost of capital in financial management decisions with the respect to the Investments with long term benefits, we need to understand what comes under the long term investments. Long term investments could be Mutual Funds, Real estate, Gold, Debentures for long term, Shareholder's Equity which are all intended to be invested more than a year.

We'll see how long term investments contribute to the company with regard to it's value by some of these below subheadings:

Chances of Investment Risk to be subdued:

Long term Investments do not need to be sold off in an unfavorable position, since the plan of the investment is held for longer than an year. This decreases the mistakes made in short term investments yielding capital losses. Staying invested for longer years could turn up more than expected returns and not to miss the big gains.

Tax Advantages over Capital Gains:

Many long term investments offer lower tax rates than the short term capital investments. This adds on to the advantage of not losing money over massive tax pays.

Volatility:

Market value for any stock can be erratically volatile at times that short term cannot make it through. But a long term investment cannot miss the gains that could be achieved. Control over the volatility could be much better when compared to the short term volatility of the market.

Long Term Capital Investments support for Working Capital:

Returns on long term could be used for Working capital which will put the financial risk off the table.

Better ROI:

Company with many projects needs financial support and long term investments can yield better Return on Investments which would suffice the financial needs.

Better Interest Rates:

When we talk about bonds, short term bonds naturally adopt the floating rate interest rates and as they fluctuate, the benefits may slump over. Whereas Long term bonds depend on fixed rate of interest and consists stability and manages with the long term risks involved within a company.

Now we'll see the role of cost of capital in the long term investments:

Equity Recapitalization:

This is a financial acquisition technique used by the private companies as to restructure the company's debt to equity ratio. This is a long term financing where it'd influence the major implications over the cash flows of the company as well as saves the company from the shares dripping their market values off.

Refinancing:

To take an advantage of adopting different interest rates, companies some times replace the old debt obligations for another debt obligations under some conditions. This is also called as Debt Restructuring. This may balance the expected cost of capital by paying off old debts by new debt obligations and enhancing the value of a company.

Share Repurchase:

When shareholder's value is undervalued, company at times buybacks the money it's invested in the equity in order to reduce it's cost of capital. This is a temporary workout done by the company's management where they repurchase the stock held by the investors.Share repurchase affects the cash held by the company and reduce the assets base and Earnings per share.