The cost of capital Essay Example | Topics and Well Written Essays - 750 words

The cost of capital - Essay Example The formula determines the appropriate expected return of alternative projects. The cost of capital is the amount that the investor has to pay in order to generate a series of future dividend incomes, return of investments (Sheridian, Martin & Keown, 2010). For example, Geoff Black (2010) reiterated the business earns $1,000,000 in one year. The profits will grow by 2 percent per year, and the company generates a net worth of $16,666,667 after two years. The cost of capital is arrived at as follows:After computing the formula, X is equal to 8 percent cost of capital figure. Further, the cost of capital can include the return that the stock market investors are expected to earn from their investments in a company. The firm that generates revenues more than the amount of cost of capital will entice the company’s current and prospective investors to invest additional funds into the invested company’s coffers.For example, Microsoft generated a 53 percent return on its equit y. The company’s equity is $7.2 billion. Computing, the company’s return on equity is $3.8 Billion. If the company’s cost of capital is 14 percent, the company’s cost of capital is $1.0 Billion. The company’s residual income is $2.8 Billion. ($3.8 Billion - $ 1.0 Billion). Another term for the $2.8 Billion net income is residual income or Economic Value Added (EVA). Under the Economic Value Added (EVA), management is faced with the financial question whether the assets can be better used in other areas or by fresh management.