Cost of capital in corporate finance

¶ … capital is described as the cost of using funds that are provided by shareholders and creditors by a company. Moreover, a company's cost of capital is the cost of the long-term sources of funds such as common equity, debt, and preferred equity. On the other hand, the cost of each of these sources of funds is an actual reflection of the risk of the assets the business invests in. For a company that invests in assets while having minimal risks in generating income, it will be able to lesser costs of capital as compared to those that invest in a higher risk of generating income (Drake, n.d.). In addition, the cost of every source of fund is a reflection of the hierarchy of risks linked to the seniority over the other sources of funds.

Cost of capital is important for a company because it specifies the minimum acceptable return to an extent that it's also referred to as the required return. This concept is primarily dependent on the use of funds instead of the sources of these funds. For instance, if a business raises equity capital, the cost of the equity is mainly based on the risks associated with the projects in which the funds will be invested. The cost of equity capital is computed through the use of two approaches i.e. The dividend growth approach and the security line models ("Cost of Capital," n.d.).

Weighted Average Cost of Capital is an estimation of the cost of finance of a company, which is expressed as a combination of debt and equity. The approximation of the company's cost of finance is conducted while ignoring the wide range of financing options that are available for the firm in the grey area between debt and equity. While the calculations can be data incentive, getting the accurate Weighted Average Cost of Capital is important for a company. In order to achieve the appropriate WACC, the right adjustments of debt and equity should be made by the company.

Since the Weighted Average Cost of Capital is determined through approximating a company's cost of finance by mixing debt and equity, there is a strong link between debt and WACC. Through this description, it can be assumed that debt is one of the major financial aspects for computing weighted average cost of capital. Therefore, the specific amount of debt within the firm has a strong impact on the determining the accurate weighted cost of capital. Actually, the determination of a firm's WACC is dependent on the debt value together with the value of equity.

While debt capital is the lower cost source of capital, debt is usually borrowed from sources outside the multinational enterprises since subsidiaries tend to borrow directly from markets. Therefore, multinational enterprises don't highly leverage their capital structure because of the source of debt. Moreover, MNEs don't highly leverage their capital structure because this is one of the most complex aspects of financial decision making that is closely linked to other financial decision variables ("Leverage and Capital Structure," n.d.). These enterprises don't highly leverage because poor capital structure decisions can contribute to high cost of capital, which in turn lowers the net present value of projects and makes them increasingly unacceptable.