Financial Management

Cost of Capital formula & Solved Problems on Cost Of Equity, Debt, WACC - Financial Management notes on Cost of Capital, Cost of Debt, Equity and Preference Share, Weighted Average Cost of Capital Illustrations Kd Ke Kp Ko Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building. Cost of capital encompasses the cost of both equity and debt, weighted according to the company's preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).A company's investment decisions for new projects should always generate a return that exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will not generate a return for investors. Weighted Average Cost of Capital (WACC)A firm's cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital. Each category of the firm's capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company's balance sheet, including common and preferred stock, bonds, and other forms of debt .Finding the Cost of Debt The cost of capital becomes a factor in deciding which financing track to follow: debt, equity, or a combination of the two. Early-stage companies rarely have sizable assets to pledge as collateral for loans, so equity financing becomes the default mode of funding. Less-established companies with limited operating histories will pay a higher cost for capital than older companies with solid track records since lenders and investors will demand a higher risk premium for the former. The cost of equity is more complicated since the rate of return demanded by equity investors is not as clearly defined as it is by lenders. The cost of equity is approximated by the capital asset pricing model as follows:

Cost of Capital

Cost of Capital formula & Solved Problems on Cost Of Equity, Debt, WACC – Financial Management notes on Cost of Capital, Cost of Debt, Equity and Preference Share, Weighted Average Cost of Capital Illustrations Kd Ke Kp Ko Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment or constructing a new building. Cost of capital encompasses the cost of both equity and debt, weighted according to the company’s preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).

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A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations. A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income. Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio. Banks have regulatory oversight on the level of leverage they are can hold. There are three commonly used measures of leverages in financial analysis. These are: (i) Operating leverage, (ii) Financial leverage, and ADVERTISEMENTS: (iii) Combined leverage. (i) Operating Leverage: Operating Leverage is defined as “the firm’s ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes”. In other words operating leverage is the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales. The operating leverage shows the relationship between the changes in sales and the changes in fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs and also on variable costs and contribution. Of course, there will be no operating leverage if there are no fixed operating costs.

Leverage Analysis

Leverage reflects the responsiveness or influence of one financial variable over some other financial variable. The relationship between sales revenue and EBIT is defined as operating leverage and the relationship between EBIT and EPS is defined as financial leverage. The direct relationship between the sales revenue and the EPS can be established by combining the operating leverage and financial leverage and is defined as combined leverage.

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