Question

 

How does the cost of capital affect capital investments that the firm makes? Cost of Capital refers to the amount of money a company spends to get its operations underway and in order to earn profit they must surpass this cost. This cost of capital is determined by and makes up its overall capital structure. A company adjusts its debts and equities within the capital structure to minimize the cost of capital. This balance is important because as a company takes on more debt, the costs are cheaper than equity but it increases the risk of default and at a certain point the premium associated with the risk becomes higher than the cost of introducing new equities. A firm must learn to balance these debts and equities in order to prevent higher premiums and lower the cost of capital. Some examples of types of firms with high costs of capital would be chemical companies as they require high amounts of capital for research equipment and factories. The low cost of capital firms would be financial services. To give an example of how a company's cost of capital affects its investments if a firm has the option of investing in debt that has an after-tax cost of 7% and 10% for equities, at some point the premium associated with that cheaper debt prevents a company from continuing to use debt and will introduce new equities. A split could be 70% debt 30% Equities. The total costs associated with each represents its cost of capital.

Answer 1

In above scenario of taking cost of capital's example, the company's coat of capital is weighted average of cost of capital.

Hence cost of capital in the given case would be:

=(7*30%)+(10*70%)

= 2.1% + 7%

    = 9.1%

Hence the cost of capital of a company whose example has been taken in the question would be 9.1%.

About the cost of capital following additional facts may be better for further understanding:

• In determining the feasibilty of any project the cost og capital must be analysed first and then decision must be taken with respect to investment in such particular product.
• A person with less cost of capital will remain on edge in the competetive market.
• The cost of capital is highly sensitive to the tax effects. If tax effects the cost of capital then it will be reduced and if not then it will remain at highet side.
• The capital can be arranged from many sources and to arrive at cost of capital of each such source finance provider's expectation of returns from finance must be considered.
• Cost of capital can be of total project,particular finance like cost of preference capital (Kp), cost of borrowing (Kb), cost of equity (Ke),cost of firm (Ko)