ROMEO S. MARTIN, JR.

BS ACCOUNTANCY

FIN3N FINANCIAL MANAGEMENT 2 PROF. MICHAEL AUDITOR, CPA, MBA Synthe ! "n C" t "# C$%!t$&

One of the fundamental concerns of entities is to find financing on projects in need of relatively large sums. As such, entities often resort to long-term financing. Cost of Capital is the cost incurred upon the use of long-term financing. Venture capitalists, investors, fund providers and money providers, among others are the sources of these monies. The cost of using new and long-term financing money is termed as the marginal cost of capital. The expected return on investment without impairing the principal value of money invested is the cost of capital. t is the return that investors demand for a given level of ris!. The investors" expected return on their investment is the #usiness" cost of capital. $ong-term creditors expect for interest% dividends for preferred stoc!holders% and dividends and growth for common stoc!holders. The view upon which cost of capital is computed is prospective, which means interests and dividends calculated are future amounts. &usinesses aspire for lower cost of capital. The cost of capital serves as a #enchmar! in evaluating proposed investment. To #e accepta#le, a project"s return of investment must #e greater than the cost of capital. 'or long-term lia#ilities, the cost of capital is the cost of de#t. nterest is a tax deducti#le expense, as such, the cost of de#t should #e determined net of tax. The effective interest rate is preferred in computing the cost of de#t. (ffective interest rate is interest expense paid divided #y the mar!et price of the de#t, net of floatation costs. 'or preferred stoc!holders" e)uity, the cost of capital is computed as the preferred stoc!

ROMEO S. MARTIN, JR. BS ACCOUNTANCY

FIN3N FINANCIAL MANAGEMENT 2 PROF. MICHAEL AUDITOR, CPA, MBA

*yield rate+. The mar!et price of the stoc!, net of floatation, serves as the cost of investment. The #rea!ing points and weighted marginal cost of capital #rea!ing point reflect the level of that new financing at which the cost of one of the financing components rises, there#y, giving rise to the new marginal cost of capital. nvestment opportunities schedule is a ran!ing of investment possi#ilities from #est ,highest returns- to worst ,lowest returns-. The internal rate of return is used in the ran!ing of investment proposals. .ormally, the internal rate of return on investment will decrease as the firm accepts additional projects. The marginal cost of capital resem#les that of a saucer or /-shaped. The /shaped curve indicates that the cost of capital is )uite high when the de#t-to-e)uity ratio is )uite low. As de#t increases, the cost of capital declines #ecause the cost of de#t is less than the cost of e)uity. (ventually, the decline in cost of capital levels off #ecause the cost of de#t ultimately rises as more de#t is used #ecause too much use of de#t increases the insolvency ris!. Additional increases in de#t relative to e)uity will then increase the cost of capital. The implication is that some de#t is present in the optimal capital structure #ecause the cost of capital initially declines when de#t is added. 0owever, a point is reached at which de#t #ecomes excessive and the cost of capital #egins to rise. The point at which the cost of capital is at the lowest is the optimal financing mix. /se of some de#t financing will enhance the value of the firm. n reflection, #elieve that financial managers hurdle the #iggest responsi#ility of loo!ing into lowering cost of capital #y choosing among several alternatives the #est deals.