Question

1. What role does the cost of capital play in the overall financial decision making of the firm’s top managers?

2. Why do you think debt offerings are more common than equity offerings and typically much larger as well?

Answer 1

1. The cost of capital is very useful for decision making since it represents the opportunity cost of the funds used. It is highly useful for capital budgeting in which the management has to compare different projects and select the one which has the maximum value to the business. The net present value technique is used for this purpose under which future cash flows are discounted at the cost of capital. Hence cost of capital plays an important role in decision making.

2. Debt is more common than equity primarily because of the ease of raising Finance through borrowings. Raising finance to equity requires an elaborate legal process and is often cumbersome. Moreover cost of debt is lower than the cost of equity due to the tax benefits received on payment of interest.