Financial Analysis

Financial Analysis

Cost of Capital

Cost of Capital shows the cost the company has to pay on its mode of financing. It could be either debt or equity or combination of both(Fromlet, 2001).. The company calculates Weighted Average Cost of Capital for calculating the total cost of debt and equity. This weighted average cost of capital is used as a discount rate to find out the value of investment(Robinson, 2006).

The weighted average cost of capital indicates that the average relative cost of capital involved in the financing of investments by the company. Individual component of capital in the financing of investment may vary from company to company. At the same time using each of these components is associated with incurring certain costs, such as payment of interest on the loan or payment of dividends from shares(Brealey et al, 1997) .

The weighted average cost of capital takes into account the financing structure of investment diversification and different costs of capital. It also considers the individual components, indicating the average relative cost borne by the company, involving capital.

Weighted average Cost of Capital is calculated by:

Here, 'W' is weight of or component of capital in the total financing of the company, while 'K' is the cost of capital for the particular mode of finance (debt or equity).

Or

Where: WACC - weighted average cost of capital ke - cost of equity kd - the cost of foreign capital EM - equity market value DM - the market value of foreign capital

Weighted average cost of capital is used in assessing the profitability of investments . Very often, the WACC is used to determine the discount rate when applying the methods of assessment of investment projects based on discounted cash flow methods (eg NPV ) (Fromlet, 2001).

If the internal rate of return on the investment is greater than the average cost of capital involved in its financing, the investment will bring a profit , but if the cost of capital financing exceeds the internal rate of return, the investment will not be profitable and revenues are too low to cover costs such as interest on the loan or the cost paid to the shareholders dividends .

Cost of capital is the most important factor that helps you make good investment decisions. When an investor decides to invest money in a venture, it may bring him profits in the future.

Cost of capital is often overlooked by aspiring entrepreneurs who forget its importance. The company's return/cost of capital is the minimum rate of return on equity for the investor (entrepreneur), who devoted their own or borrowed funds for the project. Business model that will not take into account the cost of capital for the company is doomed to fail sooner or later.

Cost of capital reflects the risk of capital investment and cost of alternative use of money in other ventures(Fromlet, 2001). This cost could include both the cost of equity and cost of debt. Equity comes mainly from the issuance of new ...