Foundations of Financial Management

Cost of Capital, Bond Ratings, Capital Budgeting

Mar 3, 2009 Gwendolyn Cuizon

Managing the finances of the company requires that management take into consideration different functions of cost capital, bond ratings and capital budgeting.

The relationship between the cost of capital, bond ratings, and the capital budgeting decision-making process is quite intricate. Cost of capital data is needed by the company before it can proceed with making a sound capital budgeting decision. These financial management functions are crucial to the financial stability of the company and the assurance of its continuous operations.

Cost of Capital

Companies finance their operations in three ways: Issuing stock (equity), issuing debt (such as borrowing from a bank), and reinvesting prior earnings. Re-invested money is part of the corporation’s retained earnings being used to invest or finance operations. It forms part of the cost of equity because if the money is not reinvested it will be declared as dividends to stockholders.

Investors often expect that retained earnings have a similar return rate as the original capital. The cost of debt means the cost of borrowing money. Companies often borrow money to finance further operations such as acquisitions or establishing new plants. The cost of capital is the total of cost of equity and cost of debt.

Bond Ratings

Organizations like Standard and Poor’s or Moody's and Fitch are rating services that rate the quality and safety of a bond. The bond rating is based on the company’s financial condition or the strength of its finances. The rating will determine the company’s ability to meet repayments of interest and principal per schedule. AAA is the highest rating, C is considered junk while D is the lowest. Having a rating of C or D means a very negative rating or reflection of the company’s financial capabilities. Often, lenders or potential investors will not buy stocks of companies with these kind of ratings.

Capital Budgeting

Capital budgeting is part of the planning process which pertains to the weighing of advantages before buying long term investments such as new products, undergoing research and development, new machinery and other investments that require appraisal.

Decision-Making Process

The relationship between these financial management functions of cost of capital, bond ratings, and the capital budgeting decision-making process revolve basically on the sound management of the company capital.

Cost of capital is concerned with securing the capital for operation expenditures of the company. Capital budgeting is the allocation of these cost of capital to viable investments that could enable the company to attain the highest possible gain for the capital invested. And bond ratings reflect the result of the financial management of the company involving the cost of capital and capital budgeting decision-making process.

The effect of the capital budgeting decision-making process will result in the generation of more capital needed for company operations in the form of retained earnings. This, in turn, will result in positive bond ratings, which will consequently lead to the pouring in of additional capital investments from new investors because a positive rating such as AAA will give investors confidence in the company’s operations and ability to pay debts such as bonds.

Also, it will be difficult for companies to make proper planning during the capital budgeting process if the cost of capital is low or incapable of meeting its required financial budget such as acquiring a new business. Capital budgeting relies on the money available for disposal. How much the company can borrow from lenders or re-invest from retained earnings will help in its final decision on investments. Lenders might decide not to lend money to companies that showed negative bond ratings.

Proper planning during capital budgeting will also make sure that the cost of capital is being used in the best possible way producing the maximum benefits to the company. Cost of capital therefore will not be successful on its own or will not generate positive bond ratings if the money is not be invested properly, which is the primary role of capital budgeting.

Positive bond ratings will not be attained if capital budgeting is weak and cost of capital is low. This means that investors are not confident of the company’s ability to generate profit and in the way it allocate its assets. All of these functions are therefore interrelated. The proper management of one will affect the functioning or the status of the other.

The copyright of the article Foundations of Financial Management in Business Management is owned by Gwendolyn Cuizon. Permission to republish Foundations of Financial Management in print or online must be granted by the author in writing.

Capital Budgeting

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