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Home / Issues / № 2, 2014

Economics

THE ROLE OF COST OF CAPITAL IN THE EFFECTIVE USE OF FINANCIAL RESOURCES
Podkopaev O.A.

 

The efficiency of use of financial resources can be evaluated by mapping the achieved results with the amount of financial resources, which were at the disposal of the enterprise during the relevant period. However, it is not always the result of economic activity depends on the effective use of financial resources. So, optimally allocating and using financial resources, the company may incur losses as a result of lower labor discipline, violations of manufacturing technology, excess materials, raw materials and other reasons. Therefore, in order to consider in more detail the problem of effective use of financial resources, it is necessary to evaluate the efficiency of all the components that form the overall financial resources of the enterprise.

The structure of the sources of financial resources is of great importance in assessing the effectiveness of their use. The company, which uses only equity capital, has the highest financial stability, but limits the speed of its development and does not use financial capacity of increase profits on invested capital. The company to improve profitability of own funds is possible, and sometimes necessary, to use not only their own, but borrowed funds. Proper and careful use of leverage allows the company to streamline its operations and maximize profits, both in the short and in the long time interval.

The conditions of forming the high end of the company's results largely depend on the structure of capital employed. Capital structure represents the ratio of own and borrowed funds used by the company in its activities. Thus, the borrowed funds is an important lever that allows you to soften the conflict between owners (shareholders) and managers. Debt capital is characterized by the following positive features: ample opportunities to raise, especially with high credit ratings of the company, the availability of collateral or guarantees of the guarantor; the growth of the financial potential of the company, if necessary, a substantial expansion of its assets and the increase in the rate of growth of its business; lower cost compared to private capital by providing effect, «tax shield» (withdrawal costs for maintenance of the taxable base for tax on profit); the ability to generate  increment of financial profitability (return of equity). But the borrowing of funds creates a new set of contradictions between managers and creditors, which forms an additional source of risk in the enterprise (leverage financial leverage should be within normal limits and not to go beyond the «red line»).

Despite the fact that the foundation of any business is its own capital, enterprises number of sectors of the economy, the volume of the borrowed funds far exceeds the amount of equity. In this regard, management involvement and effective use of leverage is one of the most important functions of financial management, aimed at achieving high end results of economic activity of the enterprise.

As payment for the use of financial resources, the company pays interest, dividends, royalties. Each funding source has its price as the sum of the charges on the use of this financial resource. The relative level of total expenditure on the use of sources of financing for the company characterizes the index – weighted average cost of capital (WACC), and shows the price of capital, invested in the company. This index must be less than the return on assets, calculated on the net profit. Otherwise, there will be a reduction of equity of the enterprise.

The concept of cost of capital is one of the basic in the theory of capital. First, the price of capital represents the relative magnitude of cash payments, which need to list owners who have provided the financial resources. Secondly, the price of capital characterizes the level of profitability of invested capital, which should provide the company, in order not to reduce its market value. So, if the company engages in the investment project, the yield of which is less than the price of capital, its capitalized cost for the completion of this project will decrease. Thus, the price of capital is a key element of the theory and practice of making decisions of investment character.

The index of the price of capital characterizes the activity of the commercial organization with the position of the long-term prospects. Thus, the cost of the company's equity shows its attractiveness to potential investors, which have the opportunity to become its owners. The price of some of borrowed sources characterizes the ability of the company to raise long-term capital. In turn, the weighted average cost of capital of the firm is one of the key indicators in the preparation of the investment budget.

The need to calculate and determine the price of the capital of the company is arises from many reasons. First, the price of equity, in fact, represents the minimum return on invested by the investors in the company's activities resources and can be used to determine the market valuation of equity and forecasting of possible changes in stock prices of firms depending on changes in the expected value of profits and dividends. Secondly, the use of debt requires interest payments, so you need to be able to choose the best opportunity of several options for raising capital. Thirdly, the maximization of the market value of the firm is achieved by a number of factors, in particular, by minimizing the rates of all sources used. Fourth, the price of capital is one of the key factors in the analysis of investment projects.

Thus, the use of borrowed capital can significantly extend the amount of economic activity of the enterprise, to ensure more efficient use of equity capital, to accelerate the formation of various trust funds, and, ultimately, to increase the market value of the company. The skillful use of borrowed sources can provide a high return on equity.



Bibliographic reference

Podkopaev O.A. THE ROLE OF COST OF CAPITAL IN THE EFFECTIVE USE OF FINANCIAL RESOURCES. International Journal Of Applied And Fundamental Research. – 2014. – № 2 –
URL: www.science-sd.com/457-24653 (24.08.2019).