Cost of Capital and Its Application to Business Managers - Paper Example

The operations of the business are financed either by equity, debt or both. Therefore, when computing the cost of capital, it is important to consider the source of capital, which includes equity financing and debt financings like loans, debentures, and preference share capital CITATION Pra08 \l 1033 (Pratt & Grabowski, 2008). Weighted average cost of capital refers to the average rate of return a business expects to get from all its source of financing. The company receives funds from the different source, which have different proportions. The weighted average is fractions of each source of financing company target to raise the capital. The weighted average helps the business to access how expensive it is to fund the business. It is used to measure the expense of financing a project the lower the WACC, the cheaper the project CITATION Kap15 \l 1033 (Kaplan & Atkinson, 2015).

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The manager uses the cost of capital to evaluate the business performance and profitability. The management achieves this by comparing the profit of business to the financing cost. If the return on investment is more than the cost of capital the, it is prudent to invest in the project CITATION AlA091 \l 1033 (Al-Ajmi & Al-Saleh, 2009).

Cash Flow versus Accounting Profit

In capital budgeting, we do not focus on accounting profit, but instead, we focus on cash flow because it measures the liquidity of the business. The cash flow allows the manager to know the timing of the cost and the benefit that is when the cost was incurred, and the time the income is received. In other words, it considers the time value of money which accounting profit does notCITATION Bro09 \l 1033 (Brown & Petersen, 2009).

The managers determine whether the business can meet its financial obligations by use of Cashflow. The manager also applies the concept of cash flow helps to identify cash flow challenges of the company, the required rate of return and to determine how timely the project can pay back the capital invested. The managers use the business profitability to ascertain it liquidity. A company my collapse despite being profitable due to inability to meet its short-term goals which require cash. In another term, the cash flow concept is the only way the wealth of business can be measured CITATION AlA11 \l 1033 (Al-Ajmi & Abo Hussain, 2011). It considers wealth maximization other than increasing profits.

References

BIBLIOGRAPHY \l 1033 Al-Ajmi, J. A., & Al-Saleh, N. (2009). Decisions o capital structure in a Zakat environment with the prohibition of riba: the case of Saudi Arabia. The Journal of Risk Finance, 10(5), 460-476.

Al-Ajmi, J., & Abo Hussain, H. (2011). Corporate dividends decisions: evidence from Saudi Arabia. The Journal of Risk Finance, 12(1), 41-56.

Brown, J. R., & Petersen, B. C. (2009). Financing innovation and growth: Cash flow, external equity, and the 1990s R&D boom. The Journal of Finance, 64(1), 151-185.

Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting. PHI Learning.

Pratt, S. P., & Grabowski, R. J. (2008). The cost of capital. John Wiley & Sons.