Understanding the Cost of Capital - Essay Example

? Cost of Capital Finance is an inevitable requirement in an organization as businesses need money to undertake a numberof projects apart from running their daily activities (Millman, 2013). Right from the time a business is setup throughout its lifetime an organization will need funds. As the business grows need for funds even grows bigger as new areas for investments are explored. Key among the reasons why an organization may require additional funds include but not limited to funding an expansion through acquisition, expand production capacity, develop new products, move to new premises and or fund a change in business strategy. However before one chooses a particular fund source he/she needs to consider a number of factors with the first one being the risks associated with fund source. The organization in need of finance should also evaluate the kind of relationship they are likely to engage with the potential funder and most importantly, the costs associated with the financing requirements. The cost of fund source is an important consideration for an organization when in need of raising additional funds. The cost of capital, which is the cost of funds to be used for financing an operation undertaken by the organization can be understood from three main perspectives namely investor, company and mode of financing. From an investor point of view, cost of capital refers to the opportunity cost of choosing a particular investment over others. Most investors with a diversified portfolio often have a wide array of investment opportunities where they can invest their money but they often opt for a specific investment. Pratt and Grabowski (2010) assert that the decision to invest in a specific investment often made based on the rate of return earned over that specific investment compared to others. The rate of return that an organization could have earned by investing in other investment option that carry similar risks as that invested in presently is the cost of capital for an investor. This means that the cost of capital from investor perspective is that benefit that an organization in need of finance uses to persuade an investor to make a particular investment. . For instance, an investor OPQ with $10 million can choose to either invest the money in 7-year bond in ABC with returns of 15% annually or buy 20% stock in UVW to increase its production capacity. The rates of return from ABC inform of bond interest and UVW which is inform of divided will play a critical role in informing the investors decision to make investment especially if they are of similar risk considering that each comes with its own opportunity cost. In other words, cost of capital is comparable to the internal Rate of return (IRR) which measures the desirability of a wide range of projects. From a company perspective, cost of capital refers to the measurable cost of acquiring funds from a particular source in order to finance a particular project. For instance, company that uses loan from a bank to finance its projects, its cost of capital will be the money needed to compensate the bank inform of loan interest. Armitage (2005) elucidate that cost of capital is a crucial benchmark for making financial decisions relating to investments in a new project by companies. This is because it forms the minimum amount of return that the owner of funds will require before issuing funds to the company inform of capital. In other words, the company must be able to pay the cost associated with a particular fund source before acquiring funds. This means that the returns from the project to be financed must be higher than the average cost of obtaining the capital to finance it. Companies are known for borrowing money to finance different projects such as expansion programs, product development, and purchase assets and they often cost of acquiring funds as their basis for project evaluation as projects with low returns and high cost of finance cannot be financed (Lumby & Jones, 2003). For instance an organization that requires $2 million to purchase an information system that will enable them cut their operation cost by 20% will have to choose between issuing 5 years debenture with 9% per anum rate of return or borrowing 3 years bank loan with a 6% per anum interest rate. From the mode of financing point of view, cost of capital refers to a measurable cost of acquiring funds through equity, debt or a mix of both equity and debt. Cost of debt capital refers to the interest charged by the creditor on the money loaned to the company while cost of equity capital refers to the claim on the money invested by shareholders to purchase company assets and finance organization operations. Most of organizations around the globe are renowned for using a mix of both equity and debt to finance their projects. The cost of capital that involves a mix of both equity and debt can be determined through computation of Weighted Average cost of capital (WACC) which takes into consideration all the capital sources invested into the company (Armitage, 2005). Equity financiers unlike Debt financiers does call for an explicit return on their capital however, they carry an implicit opportunity cost just like debt holders considering that they could opt to invest in a different organization bearing the same risk profile. The cost of capital associated with a particular mode of financing may vary with different organizations. For instance, organizations with high net returns and strong credit rating are likely to have a low cost of capital compared to poorly performing and un-creditworthy ones. In summary, cost of capital can take three main perspectives namely investor, company and mode of financing. The investor point of view presumes that cost of capital is the opportunity cost of investing in a specific project instead of other available investment option bearing the same risk. The company point of view presumes that cost of capital is the measurable cost of acquiring funds from an investor. To an organization, cost of capital is equivalent to the terms and conditions attached to a particular fund source especially the rate of return stipulated by the investor (Pratt & Grabowski, 2010). For instance, a bank may only be willing to offer a credit facility to an organization at 8% per anum simple interest. From mode of mode of financing point of view, cost of capital is categorized based on source of funds that is from either equity or debt. Cost of equity capital refers to the rate of return expected by shareholders for their investments in terms of dividend payout. Cost of debt capital on the other hand refers to the measurable cost of obtaining credit from investors and it often comes inform of interest on loans. References Armitage, S. (2005). The Cost of Capital: Intermediate Theory. New York: Cambridge University Press. Lumby, S., & Jones, C. (2003). Corporate finance: Theory & practice. London: Thomson. Millman, G. (2013). Business Faces New Risk As Easy Money Ends: Costlier Capital. Wall Street Journal. Retrieved December 15 2013 from: http://blogs.wsj.com/riskandcompliance/2013/12/09/business-faces-new-risk-as-easy-money-ends-costlier-capital/?KEYWORDS=cost+of+capital Pratt, S. P., & Grabowski, R. J. (2010). Cost of capital: Applications and examples. Hoboken, N.J: John Wiley & Sons. Read More