Federal Budgetary Educational Institution of Higher Education

Financial University under the Government of the Russian Federation

Department of Corporate Finance and Corporate Governance

Discipline “Corporate Finance”

Essay on topic
“The impact of cost of capital on investments”

Student of the baccalaureate

of the International Relations Faculty

Group IFF18-2

Alexey Nikiforov

Academic supervisor

Candidate of Economic Sciences,

Senior Lector of Department of

Corporate Finance and Corporate Governance, Khrustova L.E.

Moscow 2021
 There are several factors affecting the investing, several indicators used for
analysis of relevance for investing. One of such indicators is Cost of Capital. In fact,
it is one of the most crucial tools in economy and accounting as it is used for
calculation of investment opportunity costs and at the same time may maximize
potential investments in the process. The cost of capital is pegged to the alternative
cost of money invested into a definite project or investment. After evaluation of such
costs the enterprises may take the decisions more wisely in order to maximize the
potential profit. In order to better understand the importance of cost of capital for
investing-or-not decision making process we need to understand the essence of cost of
capital and see how it can be used for investing purposes on examples provided.

So, the cost of capital essence may be mainly described as the amount a certain
investment could potentially generate if I t(investment) has been made. It may also be
defined as debt, equity or any other source of capital. Also, cost of capital may be
defined as the opportunity cost of investing the definite amount of cash into various
projects, while the real cost of capital represents the amount of money, which could
be earned having chosen one investment opportunity instead of other. Like other
principles being used in accounting, the sense of cost of capital indicator differs
depending on situation, as for instance it may be treated as ROI (return on
investment), which could be gained if the amount of money is controlled into definite
investment.

One more important thing to mention is that under the cost of capital two we
should understand at least two categories of this indicator: cost of equity and cost of
debt1. For the purposes of investing it is necessary to pay more attention to the second
definition as it represents the cost of enterprise that borrows money to invest them in

1
https://www.thestreet.com/investing/what-is-cost-of-capital-14814298#:~:text=The%20cost%20of%20capital
%20aids,company%20financial%20sources%20as%20capital
different investment projects. Financial lenders get their money back by interest paid
in composition with various charges and fees written in the contract if so.

Enterprises apply their costs usually in two possible definitions:

 Financing costs payable for money borrowed using equity financing or selling
bonds for funding big project or investment.

 For estimating the weight of big investment. In such cases cost of capital
represents the possible return the company could gain if the company have had
invested the same amount of cash into alternative project.

Now we may move to the main question of the work: why is cost of capital is so
important for investing. First of all, it is a tool for understanding where too allocate
money. Of the decision taken the capital structure of the firm will be dependent. The
ideal situation for a company is to find the balance when there is enough cash to be
invested and the lowest cost of financing. So the cost of capital is very crucial as:

 It aids investors in evaluating all investment opportunities by turning future

cash flows in to present value of such by discounting them

 Represents the opportunity costs. The cost of capital may be used for
evaluation of the progress of current projects and investments by matching
up the cost of capital and the progress of investments mentioned

Some examples are necessary to be provided. The Association for Financial

Professionals made a survey concerning the evaluation techniques: 90% of
respondents used the discounted cash flow analyses relying on free-cash flow
forecasts for estimation of the value of investment to a firm discounted by cost of
capital ( here WACC – weighted average cost of capital)2.
2
https://hbr.org/2012/07/do-you-know-your-cost-of-capital
In order to estimate the cost of equity, the most part of respondents use CAPM
(capital asset pricing model). Also the answers for the question techniques of
assumptions used in financial models of quantifying investment opportunities were
different from each other. And in fact it is kind of problem as assumptions concerning
the cost of capital affect the type and value of investments made. Possible
expectations determine not only where to invest, but the financial success of the
enterprise. If the cost of capital is such that makes the investing project just break-
even – is not, it too risky for the company to invest in it in a fast changing world of
stiff competition and serious consequences of any decision taken? The answer lies in
the technique of calculating cost of capital.

To sum up, I would like to say that I will not go deep into details, as I have
already exceeded the volume of current work)))). All the results of the survey could
be found in the references.

To conclude I just would like to state that the influence of cost of capital on
investing is undisputable. In order to take right decision for successive investment, it
is necessary to understand the essence and the techniques of calculating the cost of
capital.
List of sources

https://hbr.org/2012/07/do-you-know-your-cost-of-capital

https://www.thestreet.com/investing/what-is-cost-of-capital-14814298#:~:text=The%20cost%20of%20capital
%20aids,company%20financial%20sources%20as%20capital

https://core.ac.uk/download/pdf/234695348.pdf

https://www.researchgate.net/publication/5177807_The_impact_of_the_cost_of_capit
al_and_of_the_decision_to_invest_or_to_divest_on_investment_behaviour_an_empir
ical_investigation_using_a_panel_of_French_services_firms