01.10.2019 F nanc al Pol cy & the Cost of Cap tal - V deo & Lesson Transcr pt | Study.

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Financial Policy & the Cost of Capital

Lesson Transcript

In this lesson, we'll be learning about nancial policy and the cost of capital. A nancial policy is very
important to any company, and it helps to drive the decisions alongside the cost of capital.

What Is a Financial Policy?

You may not have realized it, but most adults have their own nancial policy. When you bring
home your check each week, you decide how to use your money. Are you going to invest in a
new car? Do you have a loan you're trying to pay o early? These decisions are part of your own
nancial policy.

It's the same in the business world. In simple terms, a nancial policy is the policies, or rules,
that govern the nancial part of a company. When you think of a company and you think of
anything that is related to money, you're thinking of the nancial part of the company. Financial
policies establish guidelines for the nancial goals of the company, decide who makes the
nancial decisions, and detail how to manage the company's funds. Many companies use a
combination of debt and equity to nance their businesses.

What Is Cost of Capital?

Cost of capital is the opportunity cost of funds that a company invests. Opportunity cost is the
money that you would have received back in return for your investment. The return earned on
investments depends on the risks of those investments. In many cases, the higher the risk, the
higher the return. If we know the cost of capital, we can determine the required return for
budgeting investments. A simple way to look at this is that cost of capital is a way to evaluate
new projects of a company. Is it worth the company's money to invest in the project?

Relationship
A company's nancial policy determines how the company will invest their funds. This policy will
determine which investment will have the highest return given the company's resources. In
other words, it will determine which investment will earn the customer the most money on the
money that it invests. One way that the company can determine this is by using the cost of
capital method. They can apply this to the di erent investments to see which yields the best
return.

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01.10.2019 F nanc al Pol cy & the Cost of Cap tal - V deo & Lesson Transcr pt | Study.com

As mentioned, many companies will use both debt and equity to nance their business. This is
also called a capital structure. One very important part of capital structure is the cost of
capital. The cost of capital helps to achieve the prime capital structure of the rm. It is the goal
of the company to invest in the investments that increase the value of the company while
minimizing the cost of capital. The nancial manager will decide which investments will create a
balanced capital structure.

As with your own personal nances, budgeting is important to a company. A company has to
decide (or budget) its capital expenditures. The cost of capital information can be used to make
those capital budgeting decisions. Deciding to accept or reject an investment depends on the
cost of capital.

Think of the last time that you purchased a vehicle for your own use. Before making the
purchase, you considered many di erent options and the cost of each car, the nancing, and
many other factors that a ected your decision. You accepted or rejected each car based on
whether its rate of return was greater than its cost of capital. Then, when you purchased your
vehicle, you had di erent nancing options available to choose from. Likewise, a company has
options when they invest in an asset. The management team will compare the di erent types of
nancing and choose the one that has the minimum cost of capital.

In addition to being used as a budgeting tool, cost of capital can be used to evaluate the
nancial performance of the investments. When you are evaluating the investments, you
would want the pro tability of the project to be more than the actual cost of the capital. This is
how you know the investment was a good decision.

Investors can also use cost of capital to determine the rate of return. If the cost of capital is
imbalanced, the investor can expect a higher rate of return because there is more risk involved.
As you can see, the cost of capital and the nancial policy of a company are very important.
They both are tools that help the company make sound business decisions and the best
investments to earn the best returns.

Lesson Summary
In this lesson, we learned about nancial policy and the cost of capital. A company's nancial
policy and cost of capital are directly linked. The nancial policy provides guidelines for the
company's nancial funds, and cost of capital is the opportunity cost of these funds.

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