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Classification & Importance of Cost of Capital Video Lecture | Accountancy and Financial Management - B Com
FAQs on Classification & Importance of Cost of Capital Video Lecture - Accountancy and Financial Management - B Com
| 1. What is the cost of capital, and why is it important for businesses? |  |
Ans. The cost of capital refers to the minimum return that a company must earn on its investments to satisfy its shareholders and other capital providers. It is important for businesses because it serves as a benchmark for evaluating investment opportunities. If the expected return on an investment exceeds the cost of capital, the investment is considered worthwhile, while investments that do not meet this threshold can erode shareholder value.
| 2. How is the cost of equity calculated? | |
Ans. The cost of equity can be calculated using several methods, the most common being the Capital Asset Pricing Model (CAPM). The formula is: Cost of Equity = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate). Here, the risk-free rate represents the return on government securities, beta measures the stock's volatility relative to the market, and the market return is the expected return on the market as a whole.
| 3. What are the different components of the cost of capital? | |
Ans. The cost of capital is typically composed of three main components: the cost of equity, the cost of debt, and the cost of preferred stock. The cost of equity is what shareholders expect to earn, the cost of debt is the effective rate that a company pays on its borrowed funds, and the cost of preferred stock is the return that preferred shareholders expect. Each component reflects the risk and return expectations of different capital providers.
| 4. How does the cost of capital impact investment decisions? | |
Ans. The cost of capital impacts investment decisions by serving as a critical criterion for assessing potential projects. Companies compare the expected returns of new investments against their cost of capital. If the return on investment exceeds the cost of capital, the project is likely to add value to the company; if not, it may be better to forgo the investment or seek alternatives that offer higher returns.
| 5. Why is the weighted average cost of capital (WACC) used, and how is it calculated? | |
Ans. The Weighted Average Cost of Capital (WACC) is used to reflect the average rate of return a company is expected to pay to its security holders, weighted by the proportion of each source of capital in the overall capital structure. It is calculated as follows: WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc), where E is the market value of equity, D is the market value of debt, V is the total market value of the firm (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. WACC is essential for assessing investment performance and making financial decisions.
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