Analyzing Cost of Capital 2

Analysing cost of Capital Capital is the most essential thing that is needed in order for a business to start. What differ is the options of financing that a company decides to choose, when looking for income sources. A company can go for two financial strategies: debt financing where it borrows in order to finance the business or equity financing where one injects personal or stakeholders’ cash into the business (Johnson, 2009).
Genesis, decided to take up both options but only to a certain degree. They were wary of using debt financing wholly, as it meant, some of the business’ profit would be lost and they were not sure of future cash flows in the business and whether they would be able to pay back the loan. The greatest advantage that one gets, in debt financing, is the maintenance of complete ownership of the business, in comparison to equity financing. It is of great importance to also note that, banks usually expect you to put up assets to back up loan, inform of security. These assets could include property, your personal investments, equipment or other tangible holdings that the bank could seize if you default on the loan (Pratt, 2010).
Equity financing is especially very common among small business owners, because of the concerns they have about either qualifying for a loan or having to channel too much of their profits into repaying the loan. Investors and partners can provide equity financing, and they generally expect to get profits from their investments. Moreover, if no profit materializes, you aren’t obligated to pay back equity contributions. The major drawback of equity financing is that, you are no longer the full owner of a business once you have other financial contributors who expect a share. As such, you will be relinquishing not just financial control, but will no longer be the sole arbiter of the business’s creative and strategic direction (Plath, 2006).
There are two main things to consider when working out the cost of capital: WACC, Weighted average cost of capital and the MCC, which is the marginal cost of capital. This basically is the comparison of how much of new capital is raised in comparison to what was injected at the start of the business. WACC on the other hand is basically the average rate of return a company expects to compensate all its different investors. The minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other capital sources.It aims at measuring the capital discount of the company’s income and expenditure and it represents the rate that a company is expected to pay to finance its assets (Pratt, 2010).
Johnson, H. (2009).Determining Cost of Capital: The Key to Firm Value. London: FT
Prentice Hall.
Pratt, S. (2010).Cost of Capital: Applications and Examples. Hoboken, Wiley.
Plath, S. (2000). The Cost of Capital, Corporation Finance and the Theory of Investment .New York,
NY: Anchor.