question archive Swinburne University of TechnologyFIN 20014 1) What is the cost of capital? 2) What role does it play in making long term investment decisions? 3) Why is the use of the firm's weighted average cost rather than the specific cost of a project recommended?
Subject:FinancePrice:3.87 Bought7
Swinburne University of TechnologyFIN 20014
1) What is the cost of capital?
2) What role does it play in making long term investment decisions?
3) Why is the use of the firm's weighted average cost rather than the specific cost of a project recommended?
Answer:
1.
The cost of capital refers to the rate of obtaining funding from different capital sources. There are two ways to obtain capital: debt and equity. The cost of capital for debt financing is the interest rate, while the cost of capital for equity financing is the dividend yield.
2.
The cost of capital plays a major role in long term investment decisions because in order to finance these investments, the company would have to secure funding either from debt issuance or equity issuance, and each type has different cost.
3.
The weighted average is used because typically, a company maintains a capital structure partly comprised of debt and of equity. A company with no debt means that it is all equity financed, but it is not recommended due to its high cost. However, an all debt financed company is also not recommended because while the cost is cheaper, this will expose the company to a higher business risk.