Question

What role does the cost of capital play in the overall financial decision making of the firm’s top managers?

Why do you think debt offerings are more common than equity offerings and typically much larger as well?

Answer 1

The cost of capital is very important in financial management and plays a crucial role in the following areas:

1) Capital budgeting decisions:

The cost of capital is used for discounting cash flows under Net Present Value method for investment proposals. So, it is very useful in capital budgeting decisions.

2) Capital structure decisions:

An optimal capital is that structure at which the value of the firm is Value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure.

3) Evaluation of final Performance:

Cost of capital is used to evaluate the financial performance of top management. The actual profitabily is compared to the expected and actual cost of capital of funds and if profit is greater than the cast of capital the performance nay be said to be satisfactory.

4) Other financial decisions:

Cost of capital is also useful in making such other financial decisions as dividend policy, capitalization of profits, making the rights issue, etc.

The following points will help you to know about the debt offerings are more than the equity offerings:-

1) Typically, the cost (to the company) of a debt offering is significantly less than the cost of issuing new equity.

2) (Equity issuance involves significant legal, accounting and regulatory fees - i.e to prep an offering) Additionally, debt can be repaid from operations/ cash flow/ refinance, etc. and equity issues require giving up ownership interests, something many owners are loathe to do.

3) Also, interest on debt payments is often tax deductible, thus lowering the net effect of the ongoing costs to service that debt.

4)Perhaps you are familiar with the Weighted Average Cost of Equity (WACC) formula. It provides some hints to the answer.

w = weight
r = rate
t = tax rate
e= equity
d = debt
p = preferred stock

WACC = we*re wd* (rd * 1-t) wp*rp
(for the equity portion, r refers to the required rate of return)