Cost of Capital Essay
Despite the apparent difficulties that businesses face in the calculation of the specific cost of capital, the analysis is imperative to any entity. As it was pointed out in the article,capital is a scarce and risky resource. Therefore, expending it comes at a cost that cannot be ignored by a business. Before the start of any business, an analysis of the profitability and viability of the company is necessary. The cost of capital is a significant factor in the analysis because it is necessary when evaluating investment options.
Additionally, future cash flows are converted into the present value by way of discounting. Furthermore, the cost of capital is used to make budgeting decisions. More so, for a new business venture, the investors are not aware of the costs involved in running the business. The specific cost of capital is calculated by cumulating the value of debt incurred to start the project and the cost of equity spent. Equity and debt are the main capital structure of any entity. In many instances, the cost of debt is cheaper than that of capital (Lapidus, 2018). Many businesses prefer to use debt financing because the interest expense is tax deductible. However, small businesses may use more of equity capital on short-term debt.
Risk is inevitable in any profitable business venture. However, not all risks are equal. Adjustments can be made in the business to make the risk more tenable. A risk adjustment can be made by injecting capital to the entity partially after an evaluation of success in bits. Either way, the calculation of the specific cost of money can be evaded, but it is beneficial to any business venture.
Lapidus, B. (2018). Cost of capital: How relevant is it for your organization. Association for Financial Professionals. Retrieved from https://www.afponline.org/ideas-inspiration/topics/articles/Details/fp-a-survey-how-relevant-is-your-cost-of-capital