The cost of capital Assignment Example | Topics and Well Written Essays - 750 words

The cost of capital - Assignment Example Another problem which may appear by considering the cost of new debt as the hurdle rate is the difficulty of quantifying this cost because debt is often not traded, and also yield to maturity is not available because there is no market price for the debt. Moreover, in the case of bank loans, the interest rates may be subject to reconsiderations over the life of the new investment due to changes in firm’s financial statements or general deterioration of its financial condition. So, it would not be in the interest of shareholders to not take into account all this issues when considering capital budgeting decisions. Furthermore, considering this approach of taking into account only the cost of new debt used to fund the investment, it would be a disproportionate allocation to the new investment, which would result in overestimating the shareholders wealth. The cost of capital should play an important role in the committee’s work and in their decision making process. This committee must decide the best alternatives to finance the firm, at the minimum cost of capital in order to maximize the shareholders’ wealth (Reilly & Brown, 2002). This concept is also related to capital budgeting because the cost of capital is an opportunity cost, a hurdle rate used for comparison with rates of return and also a discount rate used for evaluating projects. Estimation of the cost of capital is a central issue for investment decision making. If a firm is investing in projects with rates of return higher than the cost of capital, the firm has created value, whereas if the firm is investing in projects with rates of return lower than the cost of capital has actually destroyed value. An increase in the capital budget of the firm determines an increase in the WACC due to the following reasons. If the new investment is financed by issuing new equity, this involves additional flotation costs,