Cost of capital is considered to be the important component It plays a vital

Cost of capital is considered to be the important

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Cost of capital is considered to be the important component. It plays a vital role during the evaluation the corporation. It helps us in the business valuation work[Inv161]. Cost of capital is also used as a discount rate in order to calculate the fair value of an investment’s cash flows. As
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an investor we want the higher rate of return from our investment. So first choosing any firm before investment we need to evaluate the cost of capital. It shows the valuation of the firm. An investor expects their investment to grow by at least the cost of capital. Cost of capital is dependent on the uses of the fund that has been raised but not the funds that has been sources. The cost of capital is percentage which shows after-tax cost of a corporation's long-term debt, the weighted-average, cost of preferred stock and the cost of shareholder’s equity with respect to the capital[Acc162]. Cost of Debt: The effective rate that the company pays on its current debt which can be measured in either before or after tax returns are known as cost of debt. Here, interest expense is deductible and the after tax cost is seen most often. Company uses debt financing to give an idea to the overall rate paid by the company while using various bonds, loans and other forms of debt. [Inv163] Formulae: [Sit1]
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Cost of Equity It is also known as the dividend capitalization model. The compensation that the market demands in the exchange for owning the assets and bearing the risk of ownership is known as the firm’s cost of equity.[Inv162] It is also the rate of return that the investors require from the stock before exploring the opportunities. The Capital Asset Pricing Model (CAPM) is another method to measure the cost of equity. Formulae: [Inv164] Cost of Preferred Stock The preferred stock is the long term source of financing. Preferred stock dividend is distributed before distribution of common stock and after payment of interest. Formulae: [Sit1]
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Cost of Preferred Stock:
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Factors affecting Cost of capital 1. Level of Interest rate Interest rate is one of the factor that affects the cost of capital of the company or an organization. When the interest rate is higher the company or organization has to pay more interest to the debt holders as a result the total cost of the capital will also increase. Similarly when the interest rate falls down the company doesn’t have to as much of the interest as it used to pay which result the decrease in the cost of capital for the company. 2. Tax rate Tax rate is the percentage of the payment that should be made to the government. When there is increase in the tax rate the cost of debt of the company rises which results the increase in the total cost of debt of the company. Similarly when the tax rate decreases there is decrease in the cost of debt of the company which results the decrease in the total cost of capital of the company 3. Capital Structure Policy When the company has more debt than the equity the cost of debt increases and cost of equity decreases, similarly when the company has more equity than debt the cost of equity increases and the cost of debt decreases which results in the change in the cost of capital of the company.
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