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Cost of Capital Essay

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Updated: May 8th, 2022

Every investment decision involves cost analysis and opportunity cost. This necessitates a comprehensive analysis of market situations and dynamics before committing funds. The cost of capital is the driving force behind investment decisions, as it is responsible for persuading investors to invest their funds in specific projects instead of others (Rossana 2011, p. 144). When confronted with two risky investment decisions to choose from, investors will always go for the one that promises high returns. Financing options are, therefore, subjected to scrutiny by investors to come up with the most profitable and reliable financing option. Essentially, all financing options have risks associated with them. However, the level of risk and efficiency varies with each financing method. Below are a few financing options open for most firms with their respective pros and cons.

Initial public offering (IPO)

An Initial Public Offering occurs when a company places its shares, for the first time, on the stock market for members of the public to buy. Lately, IPOs have become effective tools for small firms to expand their capital base. The advantages of IPOs are numerous. First, it helps a firm generate capital for funding its operations. Secondly, it promotes a firm as it raises public awareness about it and its products. Finally, it may lead to increased performance and market share. On the negative side, increased awareness comes with added responsibilities, especially to investors. By going public, firms are expected to comply with stringent international accounting regulations, which is a cumbersome task for small firms. The cost of complying with such regulations can be extremely high. Lastly, the management of public firms faces immense pressure to perform, which could be detrimental to inexperienced managers.

Retained Earnings

Retained earnings, which are funds plowed back by firms from their profits, can be of great help in times of financing problems. The advantages of retained earnings include their availability. Retained earnings are readily available considering that the money is generated internally. Secondly, as compared to external funding, retained earnings are cheaper. Additionally, it eliminates any fears of receivership resulting from loan defaults and carries a positive connotation. On the negative side, however, retained earnings provide limited finance. A firm cannot retain more than it earns. Another disadvantage of retained earnings is its high opportunity cost implication. To plow back profits, investors must forego taking the profits home.

Bonds

When accompanying issues with a corporate bond to finance its operations, it opens up avenues for many benefits as well as problems associated with bonds. The main advantage of bond financing is that it provides capital for the company. Bonds also have fixed interest rates, which enable planning and budgeting. Bonds are amortized, hence, no surprise package at the end. Repayment is flexible as one can increase the amount remitted in times of high income. Bond financing also has its disadvantages. The first disadvantage is its fixed-rate policy. Regardless of company earnings, bond interest must be repaid (Bannock 2005, p. 32). Moreover, bonds affect a firm’s balance sheet, thereby hindering it from securing other commercial loans.

Long-Term borrowings

The advantages of long-term borrowings include its ability to provide huge capital for major projects, lower cost of debt resulting from its risk deductibility, and freedom of operation, as lenders do not take part in the management of the firm, as is the case with share financing. Its disadvantages are many. First, since long-term loans come with fixed interest rates, failure to remit loans could lead to receivership or bankruptcy. The funds usually have fixed maturity, which means that the principal must be paid back by the firm at a future date. Considering the high rates of interest, a firm’s ability to acquire huge long-term loans is limited.

References

Bannock, G 2005, The economics and management of small business: an international perspective, Routledge, London.

Rossana, J 2011, Macroeconomic, Routledge, New York.

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