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Company's Cost of Capital

Please need help formulating a complete and thorough response to the following questions:

1. Why is the cost of capital such a vital input when determining a company's capital structure?

2. How does this affect their decision making process?

3. How is the cost of capital derived?

For the 1st question, it is my understanding that one of the most important business concepts is the weighted average cost of capital to estimate a company's inherent worth and to determine whether the company's stock is a bargain. I am not sure how this would works.

For the 2nd question, I believe that the cost of capital can manipulate and alter the decision making processes for a company via numbers. As a result, the company is impacted in terms of profitability as a whole.

For the 3rd question, while I am not so sure but nevertheless I believe that at least at some point the cost of capital is derived from the issue of new common stock which I think is a part of three components: the cost of debt, the cost of perferred stocks and the cost of equaity.

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Cost of capital is a very important input in determining capital structure of an organization because it is essential for financial managers to keep the cost of capital at the lowest levels while deciding on the optimal capital structure or combination of debt and equity in the organization's capital structure. Any change in the capital structure impacts the cost of ...

Solution Summary

Why is the cost of capital such a vital input when determining a company's capital structure?

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