The Cost of Capital is a Critical Element in Business Decisions

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The Cost of Capital is a Critical Element in Business Decisions

Mark Frystak

American Public University System

FINC 600 Corporate Finance

Many of the critical decisions that business owners and senior management face can be categorized as investment opportunities. Whether building a new facility, taking over another business or expanding their investment portfolio, managers and owners are frequently making investment decisions that shape their business's future. Investment in capital assets naturally requires some form of finance, and "since the method of finance that is employed by a particular firm defines their cost of capital (which in turn affects the amount of investment undertaken), it is obvious that the investment and finance decisions of the firm are inexorably linked" (Brewster, 1999).

Finance can be raised internally and externally by a firm. The two main external sources of finance include 'equity' (the issuing of ordinary and preference shares) and 'debt' (issuing of bonds, debentures, short-term loans).

A company's shareholder funds are an example of internal financing, but typically the prime source of internal funds for investment purposes is the company's retained earnings. The relative costs of these funds may vary, depending on the prevailing market conditions. Therefore, the aim of management or business owners is to determine the most efficient mix of these funds in order to obtain the optimal capital structure with which to execute their particular investments.

The cost of capital is the "rate of return that a company must earn on an investment to maintain the value of the company" (Belk, 2004). To borrowers, it is the rate of return required attracting potential investors and obtaining required capital, and to suppliers of money, it is an opportunity cost or the return available on investments of a similar risk. The cost of money is primarily...