Assignment 1: Discussion in Managing Finance

            The cost of capital refers to the debt, equity or a combination of two used by a business in funding its operations. The cost in using debt in financing the business is normally clear and known as the interest. The cost of using equity is not always clear but can be calculated and it normally appears to be higher than the cost of using borrowed money (Baker & Powell, 2005). The cost of capital therefore means the cost of goods or services that are to be sold. It is normal that businesses aim at selling at higher prices than the cost of goods in order to maintain the business. Cost of capital may also refer to the value of the total assets in the business and it is measured using the return on assets. Firms that have their return on assets higher than cost of capital have their economic value of the book increasing, those with return on asset equal to the capital have their economic value of the book unchanged (Baker & Powell, 2005). Whereas those with their return on assets lower than the economic value of the book have their assets being destroyed.

            To calculate the difference in cost and risk, we must put into consideration that the higher the expected risk the lower the present value thus the level of riskiness is measured by the returns expected from an investment. The cost of capital is got by calculating the debt and equity separately

Where Debt capital = interest on the debt

              Equity           = return from risk-free

               Cost of capital equity =risk free rate + market price premium (Baker & Powell, 2005)

            It is important for organizations to understand the external financing costs and risks helps the business to decide on whom to borrow basing on the costs and the returns (Baker & Powell, 2005).

            Rapid growth plans are important to a small company because they are motivating factors to employees and give a positive image to customers which can eventually result into a faster success (Baker & Powell, 2005).

            The best ways to fund a growing business is through self funding the business until it is evidently realistic. Growing businesses can also be funded through friends to gather up the initial capital (Baker & Powell, 2005). They can also be funded through small business loans or angel investors. These forms of funding are basic for a growing company since it cannot go for a big loan for the start due to uncertainty of the business.

References

Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management: A Practical Guide. Oxford: Blackwell Pub.