Friday, 9 November 2012

Cost Of Capital

 Cost Of Capital
The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar riskCost of capital is the minimum rate of investment which a company has to earn for getting fund .
When any company investor invests his money , he sees the rate of return . So , company has to mention , what will company pay , if investors provide their money to company . That average cost on the investment is called cost of capital . We calculate it with following way :-

Cost of capital = interest rate at zero level risk + premium for business risk + premium for financial risk

If a company has not power to earn , cost of capital , then this company can not get fund from public .

Importance of cost of capital

1. Basis of capital budgeting decisions:-

A company wants to invest his money in different project. Then it will compare their cost of capital and company will never invest his money in that project whose cost of capital is less than other project .

2. Basis of redesigning of capital structure :-

Cost of capital affects capital structure designing. Capital structure is just mixed of debt and equity sources which company wants to get from investors. At that time company selects that mixture of debt and equity in which cost of capital will be become minimum. With this company can increase the value of shares.

3. Basis of other decisions:-.
There are large number decision & like dividend policy, interest policy which is depend on correct calculation of cost capita
Factorsthe chice of source of finance 
1. Time factor
2. Cost of finance
5. Flexibility of the firm to use other sources
6. mode of repayment
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