Determining the Cost of Capital
Firms can either use debt financing and/or equity financing sourced from capital markets as the sources of capital and their proportions of use may be different. The equity providers require a return on their investment while the creditors also require a minimum return from their borrowings. Pratt (5) points out that the cost of capital is dependent upon the use of the funds and not from their source. Pratt (6) also emphasizes that cost of capital is a representation of the expectations of investors. Therefore, the basis for calculation is market expectations, and use of the market value rather than book value. When determining the cost of capital, a firm will decide the minimum return required by the equ...
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...o of debt to equity (the optimal capital structure) that minimizes the cost of capital, and maximizes the value of the firm and shareholder’s wealth.
In conclusion, the minimum rate required by a firm to maximize the value for its shareholders is the cost of capital. Determination of the cost of capital has been the discussion of many scholars, and they acknowledge that firm’s raise capital by either debt or equity. Therefore, the average cost of capital represents the cost of these respective components. Firms have to pay attention to the cost of capital because it determines whether a firm meets its objectives of maximizing its shareholder’s wealth.
I believe that the policy manual I have presented will become part of the strategic planning material, assist in the on-going management development process, and improve communication and understanding on this topic.
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