The cost of capital of the firm Essay
This is the preference that can be seen in individual such that they prefer cash inflow now rather than in the future. This concept acknowledges the fact that any currency losses value with time and as such if it is to be compared with a amount to be received in Nth year then the two must be at the same time value. This means that an investor’s analytical power is increased by his/her ability to compare cash inflows and outflows separated from each other by time. He/she should be able to work in the reverse direction i. e.
from future cash flows to their present values. Any company will invest finance for the sake of deriving a return which is useful for four main reasons: 1. To reward the shareholders or owners of the business for staking their money and by foregoing their current purchasing power for the sake of current and future return. 2. To reward creditors by paying them regular return in form of interest and repayment of their principal as and when it falls due. 3. To be able to retain part of their earnings for plough a back purpose.
This facilitates not only the company’s growth at present
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Investments are important because: i) They influence company’s size ii) Influence growth iii) Influence company’s risks In addition, this investment decision making process also known as capital budgeting, involves the decision to invest the company’s current funds in viable ventures whose returns will be realized for long term periods in future. Capital budgeting as financial planning is characterized by the following: 1. Decisions of this nature are long term i. e. extending beyond one year in which case they are also expected to generate returns of long term in nature.
2. Investment is usually heavy (heavy capital injection) and as such has to be properly planned. 3. These decisions are irreversible and any mistake may cause the company heavy losses. The cost of capital of the firm is the best to be used as the discounting rate for a given project if project risk is equal to business risk of the firm. If a project has a higher risk than the business risk of the firm, then a percentage risk premium is added to the cost of capital to determine the discounting rate.
The weighted average cost of capital (W. A. C. C. ) and the marginal cost of capital represent the cost of capital under certain conditions. The weighted average cost of capital It is also called the overall or composite cost of capital. It represents the cost of existing finance in the organization (Cornelius P and Kogut B (2003)). Since various capital components have different percentage cost, it is important to determine a single average cost of capital attributable to various costs of capital.
This is determined on the basis of percentage cost of each capital component multiplied by its relevant weight. Overall cost of capital has the following problems as a discounting rate: 1) It can only be used as a discounting rate assuming that the risk of the project is equal to the business risk of the firm. If the project has higher risk then a percentage premium will be added to WACC to determine the appropriate discounting rate. 2) It assumes that capital structure is optimal which is not achievable in real world.
3) It is based on market values of capital which keep on changing thus WACC will change over time but is assumed to remain constant throughout the economic life of the project. 4) It is based on past information especially when determining the cost of each component for instance, in determining the cost of equity the past year’s DPS is used while the growth rate is estimated from the past stream of dividends. The amount to be received should be discounted to the present using this weighted cost of capital so that the initial cost can be comparable to the cash inflows.