Question

Explain why a financial manager needs to consider the cost of capital in his financial decision making.

Answer 1

Financial managers need to consider the cost of capital in their financial decision making because it helps them determine the most efficient way to raise money for investments and evaluate the profitability of a project.

Step-by-step explanation:

Financial managers need to consider the cost of capital in their financial decision making because it helps them determine the most efficient way to raise money for investments and evaluate the profitability of a project. The cost of capital is the minimum rate of return that a project must earn to cover its financing costs and satisfy the expectations of investors and lenders. By considering the cost of capital, financial managers can make informed decisions about which investment opportunities to pursue and whether to finance them through debt or equity.

For example, let's say a financial manager is evaluating two projects. Project A requires an investment of $100,000 and is expected to generate annual cash flows of $20,000 for five years. Project B requires an investment of $150,000 and is expected to generate annual cash flows of $30,000 for five years. The cost of capital for the company is 10%. By calculating the net present value (NPV) of each project using the cost of capital as the discount rate, the financial manager can determine which project is more financially beneficial.

In this case, the NPV of Project A would be calculated as follows:

1. Year 1: $20,000 / (1 + 0.10) = $18,182
2. Year 2: $20,000 / (1 + 0.10)^2 = $16,534
3. Year 3: $20,000 / (1 + 0.10)^3 = $15,030
4. Year 4: $20,000 / (1 + 0.10)^4 = $13,664
5. Year 5: $20,000 / (1 + 0.10)^5 = $12,405

Summing up the present values of the cash flows, the NPV of Project A would be $18,182 + $16,534 + $15,030 + $13,664 + $12,405 - $100,000 = $7,815.

The NPV of Project B would be calculated in the same way, and then the financial manager can compare the NPVs of both projects to determine which one has a higher value. By considering the cost of capital, financial managers can make more informed decisions that maximize the value of the company.