Question

Explain the concept of cost of capital. How may cost of capital affect long-term financial decisions? Would a company prefer to have a high or low cost of capital? Why? What was the effect of cost of capital on long-term financial decisions for your company?

Answer 1

Cost of capital. In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company.Cost of capital refers to the cost or opportunity cost of making a particular investment. The cost of capital is the rate of return a company could have earned by putting the same money into an equally risky but different investment. Put another way, it is the rate of return the company requires to make a specific investment. The driving belief is that companies choose the investment that provides the higher return, given two investments of equal risk. Cost of capital depends on how a company uses funds, not how it sources its funds.

The cost of capital is estimated at a given point in time. It reflects the expected average future cost of funds over the long run. Although firms typically raise money in lumps, the cost of capital should reflect the interrelatedness of financing activities. For example, if a firm raises funds with debt (borrowing) today, it is likely that some form of equity, such as common stock, will have to be used the next time it needs funds. Most firms attempt to maintain a desired optimal mix of debt and equity financing. This mix is commonly called a target capital structure. This is how it affects long term financing decisions.

Company prefers low cost of capital. It affects in following ways:

Marketplace Changes--Although the cost of a loan might seem worthwhile based on the amount of profit you’ll make using the capital, long-term financing decisions must take into account potential changes in the marketplace.

Balloon Payments--Some long-term financing options come with large payments known as balloon payments. Unlike a constant monthly payment, a balloon might occur semiannually, annually or at the end of the loan. Depending on your projected sales and cash flow, you might not be able to make your balloon payment if you acquire capital to make long-term improvements to your equipment, website, building, fleet, staff or marketing that don’t provide revenues and profits soon enough to cover the balloon payments.

Risks to Your Business--The longer you carry debt, the longer the period during which you might miss a payment. Missing a payment, such as when you have a temporary decrease in cash flow, means your interest rate can rise, you might pay additional fees or penalties or a creditor might seize assets you used to secure a loan.