Question

Q-3 (a) What is the need to study valuation of bonds and stocks for an investor ?
(b)Define cost of capital .Explain the significance of cost of capital in financial
management

Answer 1

A)Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond valuation includes calculating the present value of the bond's future interest payments, also known as its cash flow, and the bond's value upon maturity, also known as its face value or par value. Because a bond's par value and interest payments are fixed, an investor uses bond valuation to determine what rate of return is required for a bond investment to be worthwhile.

B) Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of returnthat could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

The significance and relevance of cost of capital has been discussed below:

Investment Evaluation:

The primary objective of determining the cost of capital is to evaluate a proj­ect. Various methods used in investment decisions require the cost of capital as the cut-off rate. Under net present value method, profitability index and benefit-cost ratio method the cost of capital is used as the discounting rate to determine present value of cash flows. Similarly a project is accepted if its inter­nal rate of return is higher than its cost of capital. Hence cost of capital provides a rational mechanism for making the optimum investment decision.

Designing Debt Policy:

The cost of capital influences the financing policy decision, i.e. the proportion of debt and equity in the capital structure. Optimal capital structure of a firm can maximize the share­holders’ wealth because an optimal capital structure logically follows the objective of minimization of overall cost of capital of the firm. Thus while designing the appropriate capital structure of a firm cost of capital is used as the yardstick to determine its optimality.

Project Appraisal:

The cost of capital is also used to evaluate the acceptability of a project. If the internal rate of return of a project is more than its cost of capital, the project is considered profitable. The compo­sition of assets, i.e. fixed and current, is also determined by the cost of capital. The composition of assets, which earns return higher than cost of capital, is accepted.

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