Task 3 – Cost of capital

Cost of capital is the minimum percentage of revenue or profit a business must generate before
creating value. The Department of Accounts calculates the cost of capital to resolve whether the
financial risk and investment are justifiable. 

Investors justify the cost of capital of equities with higher returns. Therefore, the investor first
identifies the volatility of a business’s financial reports and assesses whether the reports show the
worst or best results of the stock’s cost are justifiable by the returns they will earn.

Types of capital.
Capital structure is a method that businesses use to raise capital. There are two main types of capital:

 Debt capital is raised by taking loans or debts. It depends on interests on payments that depend on the
debtor’s creditworthiness.
 Equity capital is the usage of shareholder’s equity in the business and the costs are paid as dividends
and capital appreciation.

Weighted average cost of capital is a business’s total debt capital and equity capital cost that the investors are
paid for taking risks by a company. It indicates the business’s condition.

Factors affecting the cost of capital.

a. Opportunities in the market- The law of supply and demand is the most essential price determinant
in any market. As the demand for capital raises, the cost of capital also raises and when the demand
for capital drops, the cost of capital drops. Demand is highly affected by the accessible options in the
market. Entrepreneurs examine possibilities to gain more profits when there are many manufacturing
options in the market. Therefore, entrepreneurs need capital to execute their business strategies.
b. Preference of the capital provider- Those with little more money have two direct choices: reserve
or spend. It is a wholly individual decision, but largely influenced by the lifestyle of a society. The
usefulness of capital is the rate of interest return available on the money. Of course, higher returns
force higher savings.  
c. Risk- The principle of “high risk, high reward” applies. If the company you want to invest in is high
risk, the return required from the investor will also be very high to offset the risk. Company founders
 must not decide on too high a cost of capital as it may jeopardize the profitability of the entire project.
As such, risk plays an important role in determining capital transactions in the market. 
d. Inflation- All investors seek to invest in ways that maximize their returns. The floor criterion for
investment is always inflation. At the very least, the investment should beat inflation and have some
actual income. Actual income is simply the actual rate of return minus inflation. 

Importance of cost of capital.

1. It influences the investment decisions of a business. Analysts use the cost of capital to
assess the return rate for capital budgeting projects. A worthwhile investment has
anticipated returns that are more than the cost of capital
2. It affects the valuation of a business. Businesses with a rising cost of capital are likely
to be riskier and have the lowest valuation. Therefore, there is a risk of investors charging
businesses with a heftier cost of capital.
3. It influences the discount rate of a business. Analysts use the weighted average cost of
the capital to anticipate the rate of discounts for cash flows in discounted cash flow
analysis in the future. Further, when calculating the net present value of a company, the
weighted average cost of capital acts as a discount rate.

How financial management is affected by cost of capital

1. Financial management is the main element of the business, which controls the cost of
capital.
2. The cost of capital impacts on the capital budgeting, capital structure and value of the
company.
3. It assists in the evaluation of the financial performance of a company.
4. Calculation of cost capital is a key factor in financial management.
5. This calculation is vital for assessing the capital structure of a business.

Relation between efficiency and profitability.

Profitability is an estimate of efficiency and a major factor in determining the success or failure
of a business.
Efficiency can increase profitability in three ways.

1. Increase sales faster than costs.

2. Reduced Spending - Employees are generally the biggest expense in any business. Excluding
team members increases available cash. However, this is inefficient for long-term growth and
sustainability leading to a culture of stress.

3. Improve efficiency – is the best way to increase profitability. Being efficient and well
organized is essential for a successful business.