Question

What is the cost of capital and why is it important to a business? What are the different capital financing options available to organizations? What is working capital for short term business decisions? If interest rates in the market rise, what does that mean for the cost of capital of a business trying to raise funds?

Answer 1

When a company raises capital (may be through equity or debt) to use them, the rate that the company pays to use the capital is called cost of capital. The cost of each source of fund is different.
The importance of cost of capital are:

Cost of capital rate is used while taking capital budgeting decisions.
It helps in taking right decision on capital structure (proportion of debt and equity) of a company.
Companies use cost of capital to determine whether its investments are profitable.

The two major capital financing options are debt financing and equity financing. Companies use bank loans, company bonds, raise funds via capital markets etc.

Working capital is calculated as current assets-current liabilities. Working capital is required for smooth running of business operations. Working capital management becomes very important in case of short-term decision-making. Working capital is used in making payments to suppliers so that their will be regular supply of raw materials, used to pay short term liabilities, wages etc.

If interest rate rises then cost of raising funds will increase and hence the cost of capital will also increase.
For example, suppose a firm has both debt and equity in its capital structure. Weighted average cost of capital for the company is calculated as:
Weighted average cost of capital=Weight of equity*cost of equity + weight of debt*cost of debt*(1-tax).
Now, if the interest rate on bank loan rises and the company is raising funds by taking bank loans. Then the cost of debt will increase and the weighted average cost of capital will also increase.