Week 4 Discussion 2: Cost of Capital

What role does the cost of capital play in the firm’s long-term investment decisions?  How does it relate to the firm’s ability to maximize shareholder wealth?

Cost of Captital-Sample Solution

Role of Cost of Capital on Long-term Investment

The cost of capital refers to the minimum rates of return that businesses expect from their securities before generating revenue. Xu (2020) observes that it determines a business’s capital structure, meaning that every business must opt for a financing option that can adequately fund its operations to reduce the cost of capital. In this case, the cost of capital is a significant aspect of a firm’s long-term investment decisions. It helps firms determine the potential investment rates of returns by guiding investors to only invest in projects with a higher rate of return than the cost of capital. Moreover, the cost of capital is essential in opportunity cost scenarios for evaluating ongoing long-term projects (Xu, 2020). This can help it identify and put more resources on the project with the potential of higher returns and lower cost of capital.(Cost of Capital Essay Example)

Additionally, the cost of capital is necessary for capital budgeting decisions for long-term projects (Xu, 2020). Investors use it to evaluate and select investment projects with higher return rates than the cost of capital. Lastly, investors use it to compare sources of finance for long-term projects. They can compare various sources of financing and identify the source which constitutes the minimum cost of capital. Based on its roles, the cost of capital guarantees increased value of the company by ensuring the selection of investment projects with higher returns and lower cost of capital. Xu (2020) explains that investing in high-value projects results in increased returns, maximizing shareholder value. It also maximizes shareholder value by ensuring that selected projects require low operating costs. Minimizing the operating margin of a project, such as reducing the cost of goods and other administrative expenses, ensures an increase in profit margins, which translates to increased shareholder value.(Cost of Capital Essay Example)

Reference

Xu, Z. (2020). Economic policy uncertainty, cost of capital, and corporate innovation. Journal of Banking & Finance, 111, 105698.