Finance for Managers - GVP8 - 05-11-21 - module 7

The cost of capital depends on the mode of financing used. The investment decision of a firm is separate from the financing decision. The cost of capital aids businesses in all investment opportunities in which investors are evaluating. It does so by turning future cash flows into present value by keeping them discounted. The cost of capital can also aid in making essential company budget calls that use company financial sources as capital. Here the underlying principle states that netting out the market value of non-equity claims from this estimate yields equity in the firm. Implicit in the cost of value approach is the assumption that the cost of capital captures both the tax benefits of borrowing and the expected bankruptcy costs. The cash flow discounted is the cash flow to the firm computed as if the firm had no debt and no tax benefits from the interest expenses. Cost of capital refers to the cost of equity if the business is financed solely through equity or the cost of debt if it is exclusively funded through debt. Many companies use a combination of debt and equity to finance their business. For such companies, the overall capital is derived from the weighted average cost of all capital sources. In other words, the cost of capital generally explains the cost associated with the capital structure. The change of capital structure may increase or decrease the cost of capital. However, the concept "the cost of capital depends primarily on the use of the funds, not the source" is totally against it. This concept enunciates that the investment decision or selection of equity or debt finance is purely based on the project's riskiness. Similarly, the amount of cost of capital is determined by the riskiness of the project. For Example, the cost of equity will change from investment to investment depending on the investment risk. Therefore, the cost of capital ultimately relies on the use of the funds, not the source. Corporate Finance Institute. (2021). Capital Structure: Financing assets with debt and equity. https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-overview/. Leonard, K. (December 18, 2018). Capital Budgeting Decision vs. Financing Decision. https://smallbusiness.chron.com/capital-budgeting-decision-vs-financing-decision-66730.html. McCamish, B. (March 22, 2021). Cost of Capital. https://investinganswers.com/dictionary/c/cost-capital.