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 bonds or 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 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.
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 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.