Question

Companies use the cost of capital formula/steps to make strategic decisions. Often, they may have a simple structure either common stocks or long-term debt. Why do think managers still use the complexity of the cost of capital to determine their long-term final position? How would managers determine the percentages of each source of capital to achieve the optimal weighted average cost of capital?

Answer 1

Cost of capital can be defined as the opportunity cost incurred with respect to a particular investment decision. It is calculated in % terms and is referred as the rate of return that could have been earned by putting the same money into a different investment with same amount of risk involved.

Companies use the cost of capital formula/steps to make strategic decisions The managers still use the complexity of the cost of capital to determine their long-term final position as it is an accurate and more reliable measure of evaluating the financial position of the company. The cost of capital aims at evaluating all investment opportunities made by the business. It also helps in deciding the budget constraints for the company.

In order to to achieve the optimal weighted average cost of capital different capital structures are examined and evaluated and the proporation with regard to avalability which gives the minimum cost of capital is adopted. As minimum cost of capital ensures maximum profits for the entity.