Question

1*Explain the general theory of cost of capital and explain why businesses need to understand cost of capital.

Answer 1

Cost of capital theory advocates that the company should have an optimal mix of capital structure which will have an adequate mix of debt with the equity that will yield the maximum benefit to the firm and help in its growth.

The theory advocates that the cost of debt should be equated with the benefits at associated with the interest rate tax shield.

Usually the companies capital structure is a combination of debt capital and equity capital and the focus is made upon obtaining a rate of return on such cost of capital that should beat the overall cost of capital and the difference would be helpful in the growth of the company.

The major consideration is required with maintaining rate of return on the overall capital employed which should easily beat the cost of debt and hence the difference would be beneficial for maximization of the growth of the company and maximization of its shareholders value.

Businesses need to understand the importance of the cost of capital as it will help them to survive and sustain in the long run and it can use the debt financing without getting trapped into any risks of solvency so a company should determine and optical mix of its debt and equity to overall capital structure in order to succeed in the long run.