Cost of Capital

Essay by ajschaeferUniversity, Bachelor'sA, May 2007

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The cost of capital and bond rating are very important in the capital budgeting process. “Capital budgeting is the planning process used to determine a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects.” ( Most companies finance their capital projects by either issuing stock, issuing debt, and reinvesting prior earnings. There are many formal methods used in today’s capital budgeting process, these include the classic rule which is to take on only projects with positive Net Present Value (NPV). The project's cost of capital is the rate investors require to undertake the investment, and should discount all future cash flows at this rate key input to the capital budgeting process is the cost of capital. The cost of capital for a company is based on the cost of equity and the cost of debt which is a weighted sum of these two factors.

Money that is Re-invested is also listed at the cost of equity; since the money was not reinvested it would normally be returned to the firm’s shareholders. Investors in a company expect the retained earnings to earn a return similar to money initially invested. The cost of debt to a company is the cost of borrowing that money.

Standard and Poor's and Moody's are among the groups which rate the risk of corporate, municipal, and government issued securities. These companies give each security a bond rating which determines the risk factor. The rating is based on two key elements. The first element is the probability or possibility that the company will file for bankruptcy before making the final bond payment. The second key element is the percentage of the bondholder's clams creditors would receive if the company files for bankruptcy.

Capital budgeting is the process...