Would you please construct an example using information for our company in which you calculate the cost of existing capital? Once the cost of existing capital is calculated what does this tell us concerning future capital we might acquire?

Base, on this discussion :

When a company is planning for a financing there are lot of options available, like short term finance, finance to same sector, project loan, mortgage loan, equity, debentures etc.

In all the forms of loans they carry their own risk factors. One is market risk and the cost risk. Hence when a company is going to raise funds then they need to be very careful in deciding for the source of funds.

Cost of capital is calculated taking the weights of all the type of funds available, it gives the overall cost of capital.

“The cost of capital is also a factor in compensation plans, with bonuses dependent on whether the company’s return on invested capital exceeds the cost of that capital. This cost is also a key factor in choosing the firm’s mixture of debt and equity and in decisions to lease rather than buy assets”(1).

Cost and Risk go hand in hand, cost of the capital is a commitment from the company while raising loans in case of equity it is not required for a company to give returns commitment as it is directly related with the market and profitability of the company. But in other forms of loan like debentures and loans a fixed amount of interest is to be paid to the lenders and which is commitment. Hence companies will generally go with less debt.

Risk on the other hand is very important because the company is exposed to many such risks which actually can bring the profitability and the market of the company very down which can even pose risk of becoming bankrupt.

Hence the company should always be more cautious in these matters.

As suggested above equity is the most good form of raising funds, this is because company gets good amount of money from it with not much risk of paying back, means if the company is not earning good profits the company cannot give any dividends and nobody can ask about it if proper annual report is shown to share holder of the company.

Hence the company can decide which is the best form of finance for it keeping the various ratios in mind to show the companies performance.