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The Cost of Capital - Essay Example

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The Cost of Capital

Richard Brealey (2001) mentions cost of capital represents the interest paid for the borrowed funds. Cost of capital can also include focusing on Capital Asset Pricing Model (Sheridian, Martin & Keown, 2010). The formula determines the appropriate expected return of alternative projects. The cost of capital is the amount that the investor has to pay in order to generate a series of future dividend incomes, return of investments (Sheridian, Martin & Keown, 2010). For example, Geoff Black (2010) reiterated the business earns $1,000,000 in one year. The profits will grow by 2 percent per year, and the company generates a net worth of $16,666,667 after two years. The cost of capital is arrived at as follows: $1,000,000 /(X- 2%) = $16,666,667. X represents the cost of capital. After computing the formula, X is equal to 8 percent cost of capital figure. Further, the cost of capital can include the return that the stock market investors are expected to earn from their investments in a company. The firm that generates revenues more than the amount of cost of capital will entice the company’s current and prospective investors to invest additional funds into the invested company’s coffers. For example, Microsoft generated a 53 percent return on its equity. The company’s equity is $7.2 billion. Computing, the company’s return on equity is $3.8 Billion. ...
Brealey (2001) insists the managers can comment “I think I can understand a little of our shareholders’ worries,” the financial manager replies. “Just look at our return on assets. It’s only 6 percent, well below the cost of capital. Sure we are making a profit, but that profit does not cover the cost of the funds that investors provide. Our economic value added is actually negative. Of course, this doesn’t necessarily mean that the assets could be used better elsewhere, but we should certainly be looking carefully at whether any of our divisions should be sold off or the assets redeployed” Going further, the cost of capital can incorporate inventory storage costs. These amounts show that inventory capital investment contains both costs and benefits. The cost of the firm’s inventory investment in trade receivables is the interest figure that could have been earned when the clients paid their liabilities on an earlier date. The entity also forgets the issue of interest income when it includes idle cash amounts instead of investing the same amounts to generate profits in marketable securities. The cost of keeping product inventories embraces the opportunity cost of capital, storage costs, and insurance costs and the risk of spoilage or obsolescence. All of the carrying costs persuade the entities to keep the current assets to an allowable minimum level (Besley, 2008). When carrying costs prevent large investments in current assets, the very low level of current assets inventory makes it more probable that the entity will face shortage costs. For example, if the entity generates an empty inventory of raw materials, the entity can be ...Show more

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The cost of capital Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts 14 March 2012 Businesses can generate cash inflows from loans. The research focuses on the reasons for paying the cost of capital. The research includes different cost of capital sources…
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