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Cost of Capital - Essay Example

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The challenges that companies face in their determination of cost of capital as well as determination of how to apply the available finances are numerous. However, the major challenge, which forms the basis of financial analysis for companies is the optimum capital structure…
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Cost of Capital
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Download file to see previous pages Nevertheless, for the companies operating in the high risk industries, it becomes necessary to consider not only the equity-to-debt ratio, but also the ratio of the liquid cash held versus the debt held by the company.
The consideration of the debt to cash ratio is important, owing to the fact that it enables such high-risk industry companies to plan on how to insure their R&D projects, depending on the nature of risks that is posed by the research. Balancing the cash that a company should hold in liquid with the debt owed by the company also presents some disadvantages to the high-risk companies, owing to the fact that there is always an opportunity costs (Eilenberger, 2010). For example, a company deciding to insure its R&D for its high risky projects requires to maintain a lot of liquid cash to pay for the insurance premiums, while that cash could have been invested elsewhere by the company, and generated some financial returns.
The other notable challenge faced by companies in their determination of the cost of capital and how to apply the capital, is related to the prioritization of projects. Companies require to determine which projects are most likely going to generate high returns compared to others, and then invest in them. The major challenge associated with such prioritization is when a company predicts that a certain project is likely to generate more returns than others, only to find that in reality the case is different. This is a high risk of opportunity costs, because it means that the company will have already foregone the benefits it would have obtained from the foregone project (Eilenberger, 2010).
Additionally, companies are also increasingly faced by the challenge of balancing between investing in projects that have a high potential for generating returns for the company, versus the projects that may not generate as much returns, but that are capable of benefiting a large number of people in the society. All these ...Download file to see next pagesRead More
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