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Riphah International University

Lahore
Strategic Finance
Assignment No 1

Submitted By
Name: Zain-ul-Islam
CMS No: 400633

Submitted To: Prof, Sajjad Nazir

DATE: 28-05-2016

What are different sources of


capital for a company?
Financing is needed to start a business and ramp it up to portability. There are several sources
to consider when looking for start-up enhancing. But first you need to consider how much
money you need and when you will need it.

Personal Savings
Friends and Relatives
Venture Capital
Government Grants

What is the cost of capital from


each source?
A firm's cost of capital is the cost it must pay to raise fundseither by selling bonds,
borrowing, or equity financing. Organizations typically define their own cost of capital in
one of two ways:
Cost of capital may be taken simply as the financing cost the organization must
pay when borrowing funds, either by securing a loan or by selling bonds, or
equity financing. In either case, cost of capital would be expressed as an annual
interest rate, such as 6%, or 8.2%.
Alternatively, when evaluating a potential investment (e.g., a major purchase),
the cost of capital is considered to be the return rate the company could earn if it
used money for an alternative investment with the same risk. That is, the cost of
capital is essentially the opportunity cost of investing capital resources for a
specific purpose.

What is WACC?
A firm's cost of capital from various sources usually differs somewhat between the
different sources of capital used. Cost of capital may differ, that is, for funds raised with
bank loans, sale of bonds, or equity financing. In order to find the appropriate cost of
capital for the firm as a whole, weighted average cost of capital (WACC) is calculated.
This is a simply the arithmetic average (mean) capital cost, where the contribution of
each capital source is weighted by the proportion of total funding it provides.

How cost of capital can be


calculated?
Once cost of debt and cost of equity have been determined, their blend, the weighted
average cost of capital (WACC), can be calculated. This WACC can then be used as a
discount rate for a project's projected cash flows.

What is the usage of cost of


capital?
The cost of capital of using internal funds is not as straightforward as it would be when
borrowing money. Internal funds represent using equity either the firms or the firms
owners financial resources to finance the project. However, internal funds also cost
you even if you contribute those funds
The opportunity cost of funds you invest in the firm is the interest you could have earned
if you had invested those funds elsewhere. This cost is very real, and your investment
project has to generate enough cash to offset this lost opportunity.
Because the cost of using internally generated funds or equity is the lost opportunity for
you to invest these funds in the next best alternative, you must use a method that
estimates the return the next best alternative generates. Typically, one of three methods
risk-premium, dividend-valuation, or capital-asset pricing is used to determine the
cost of internal or equity capital.

Significance of cost of capital?


Financial experts express conflicting options as to the correct way in which the cost of
capital can be measured. Irrespective of the measurement problems, it is a concept of
vital important in the financial decision making. It is useful as a standard for:
Evaluating investment decisions.
Designing a firms debt policy.
Appraising the financial performance of top management.

Impact of high/low cost of capital


on firm?
One component of the cost of capital is the cost of debt financing. For larger
businesses, debt usually means large loans or bonds. For very small companies, the debt
can mean trade credit. For either, the cost of debt is the interest rate the company pays on
debt. Another component of the cost of capital is the cost of equity financing if your company
is a public company; in other words, if you have investors in your company who provide
money in exchange for an ownership stake in the company. There are several components
of the cost of equity capital. First, there is the cost of retained earnings or the money that the
company invests back into the company, instead of paying out dividends. Next, there is the
cost of new common stock or stock that the company issues to raise money. Last, the
company may even issue preferred stock to raise money. For very small firms, the cost of
capital may be much simpler. There are advantages and disadvantages to both debt and
equity financing, including cost that any business owner must consider before adding them
to the capital structure of the company. Very small firms may just use short term debt, in
which case we have to establish a cost for this capital component.