Fundamentals of Corporate Finance: Cost of Capital Analysis

This assignment solution focuses on the concept of the cost of capital, specifically addressing the weighted average cost of capital (WACC) and the required rate of return (ROR). The solution explains the relationship between risk and return, highlighting how investors demand higher returns for riskier investments. It discusses the components of WACC, including the cost of debt and equity, and how these are combined to determine the overall cost of capital for a firm. The assignment emphasizes the importance of understanding the cost of capital for making informed investment decisions. The solution also references relevant financial theories and concepts, such as portfolio theory and business valuation, to support its arguments and provides a clear explanation of how to calculate the WACC and its significance in financial management. Furthermore, the solution highlights the importance of the cost of capital in financial decision-making, including its role in evaluating projects and determining the minimum rate of return a business must achieve to generate revenue. The solution also emphasizes that the cost of capital is equal to the required rate of return.

Running head: COST OF CAPITAL
COST OF CAPITAL
Name of Student
Name of the University
Author notes

1COST OF CAPITAL
Weighted average cost of capital (WACC) and Required rate of return (ROR)
Weighted average cost of capital is the amount that a company is anticipated to pay to
its investors. Rate of return is the amount of profit or loss from the asset over a specific time.
The first student said that the rate of return is dependent on the risk associated with the
investment and the investors prefers investments, which has high return (Lakshmi, Khan and
Vortelinos 2017). As per the business valuation theory, these statements is correct as this
theory noted that required rate of return matches with the risk of investment. This theory also
discussed that as the risk increases, the rate of return upsurges, producing lower value of the
investment (García 2017). Additionally, the first student stated that investors demand higher
rate of return from risky investment, which is a correct statement. As per portfolio theory, it
can be stated that the investors demands a specific rate of return from the investments when
the risk of the investment goes high. However, this concept only applies with the equity
investors. This idea does not apply for other type investors. Most of the investors ignores the
risk due to some complications in their future income stream. The first student also noted that
same theory with an example therefore the statement of the first student should be agreed.
The second student stated that all of the firms can finance its operations from through
debt, equity and mix of both which is a true statement therefore weighted average cost of
capital is evaluated by multiplying the cost of capital from each source( Debt and equity) by
its relevant weight. The total weighted average cost of capital should be calculated by
applying specific weights to the cost of equity and cost of debt (Frank and Shen 2016). The
cost of debt is multiplied with the corporate tax rate and finally the weight cost of equity and
debt should be added together to calculate the total weighted average cost of capital. It refers
to the yields on the securities issued by a firm and the required rate of return refers to the
return required on investment, justifying the risk taken by the investors. Theoretically, cost of

2COST OF CAPITAL
capital is equal to the required rate of return. The student also stated that, WACC is the least
rate of return that business must earn before generating revenue. This statement is also
correct. The capital structure of a organisation is made of different sources of funds such as,
bond, stock and retained earnings. The cost of capital relies on the approach of financing used
and the weighted average cost of capital. The investors gets assured by the higher required
rate of return before invest in an organisation (Dutta and Nezlobin 2017). The viewpoint of
second student on weighted average cost of capital is clear and concise as he described
weighted average cost of capital approach very well.

3COST OF CAPITAL
References
Dutta, S. and Nezlobin, A., 2017. Information disclosure, firm growth, and the cost of
capital. Journal of Financial Economics, 123(2), pp.415-431.
Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal
of Financial Economics, 119(2), pp.300-315.
García, F.J.P., 2017. The WACC. In Financial risk management (pp. 345-351). Palgrave
Macmillan, Cham.
Lakshmi, G., Khan, M. and Vortelinos, D., 2017. Cost of capital of stakeholders’ WACC.