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Understanding Cost of Capital in Business Finance

Cost of capital is the price a company pays to raise funds from debt and equity sources. It is crucial for decision-making, as it helps determine the minimum return needed on investments to satisfy stakeholders. Calculation involves assessing risk and determining weighted average cost of capital (WACC). This information guides companies in financing decisions, maximizing profitability, and achieving financial goals.

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Understanding Cost of Capital in Business Finance

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  1. COST OF CAPITAL

  2. COST OF CAPITAL Cost of capital is the price a company incurs to borrow money or raise capital from investors to fund its operations or investments. This cost includes both the interest rate paid on debt and the return expected by investors for providing equity financing. Basically, it’s the price a company pays for the privilege of using other people’s money. Cost of capital refers to the total financing amount a company incurs to raise funds from both debt and equity sources. It represents the minimum rate of return a company must achieve on its investments to satisfy the expectations of its investors and lenders. Calculating the price of capital involves assessing the risk associated with each funding source and determining the appropriate capital cost for each. This information is essential for a company when deciding which projects to pursue, as it allows them to assess the potential profitability of each investment opportunity. By understanding the capital requirements, a company can make informed decisions about how to finance its operations and investments, and ensure that it is maximizing its financial returns.

  3. HOW TO CALCULATE OF COST OF CAPITAL In calculating the cost of capital, the following methods can be used: Computation of Specific Cost of Capital Specific Cost refers to the cost which is associated with the source of capital. Eg. Cost of equity. Computing specific cost summing up of all forms of capital listed below  Cost of debt  Cost of preference shares  Cost of equity shares  Cost of retained earnings of capital involves

  4. COMPUTATION OF COMPOSITE COST OF CAPITAL Composite capital is the combined cost of different sources of capital taken together. It is also called a Weighted Average Cost of Capital (WACC). Following are steps involved in the calculation of WACC. The formula to arrive is given below: Ko = Overall cost of capital Wd = Weight of debt Wp = Weight of preference share of capital Wr = Weight of retained earnings We = Weight of equity share capital Kd = Specific cost of debt Kp = Specific cost of preference share capital Kr = Specific cost of retained earnings Ke = Specific cost of equity share capital

  5. IMPORTANCE OF COST OF CAPITAL FOR BUSINESS Cost of capital is like a compass that guides a company toward its financial goals. It’s important because it helps a company determine the minimum return it needs to generate from its investments to satisfy the expectations of its investors and lenders. By calculating this cost, a company can also make informed decisions about which funding sources to use and which projects to pursue. Ultimately, understanding the price of capital can help a company maximize its profitability and avoid getting lost in the financial wilderness.

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