The purpose of this essay is to explain the relationship between the cost of capital, bond ratings, and the capital budgeting decision-making process.
Cost of Capital
Companies finance their operations by three mechanisms: Issuing stock (equity), issuing debt (borrowing from a bank is equivalent for this purpose), and reinvesting prior earnings. The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt. Re-invested money is also charged at the cost of equity, since if the money is not reinvested is will normally be returned to shareholders. Investors expect retained earnings to earn the same return as money initially invested. The cost of debt is the cost of borrowing money.
"Organizations like Standard and Poor's and Moody's rate the riskiness of corporate, municipal, and government issued securities and gives each security a Bond Rating. The risk is based on two elements: the probability the organization will file for bankruptcy before the final bond payment is due and what percentage of the bondholder's clams creditors will receive if a bankruptcy takes place."
The Capital Budgeting Decision-making Process
Capital budgeting is a formal means of analyzing long-range investment decisions. Through this process potential investments are identified and the investments to undertake are selected. It is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. Capital budgeting deals with the valuation of real assets. Cash outflows at time 0 and net cash flows over the specified time horizon are taken into account in capital budgeting. Essentially Capital Budgeting is the process of determining whether or not projects such as building a new plant or investing in a long-term venture are worthwhile.
Capital Budgeting is an extremely important aspect of a firm's financial management. This is because although the capital assets usually comprise a smaller percentage of a firm's total assets than do current assets, they are long-term. Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time.
The capital budgeting decisions perhaps the most important financial decisions that a company can make. This is because:
1) Capital budgeting affects the company for a long time. Once the investment in assets is made the decision is not easily reversible.
2) It involves many uncertainties:
a. consumer preferences may change over the life of the project affecting the viability of the project
b. technology may change rendering the product obsolete (reduced expected life of project)
c. competition may alter demand and therefore the assumptions of cash flow for the project ( reduce expectation of cash flow)
Retreived from About.com, on 07/10/2006, http://economics.about.com/cs/economicsglossary/g/bond_rating.htm
BlockÃ¢ÂÂHirt: Foundations of Financial Management, The McGraw Ã¢ÂÂ Hill