Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Cost of capital and Time value of money
- This topic has 1 reply, 2 voices, and was last updated 7 years ago by John Moffat.
- AuthorPosts
- February 23, 2017 at 7:06 am #373763
Dear sir,
Para 1
The cost of capital (discount rate for investment appraisal) is the investors required rate of return. The components of the cost of capital are:
1. Risk-free rate of return – Return required from an investment if it were completely risk-free i.e., yield on government security
2. Premium for business risk – An increase in SRRoR due to the Existence of uncertainty about the future business.
3. Premium for financial risk – This relates to the danger of high debt levels (high gearing).Para 2
When discounting we consider the time value of money. The reason that the time value of money is considered are:
Potential for earning interest as we borrow to invest
Impact of inflation
Effect of riskDoes it means that risk-free rate gives a minimum return and it incorporates the inflation?
The premium for business and financial risk incorporates the total risk and gives the return that we need above the minimum return i.e., to pay the interest on borrowing and to earn return for shareholders?I was confused how to link the cost of capital and its components and the time value of money, So I made the above summary.
You comments needed. Thanks as always.
February 23, 2017 at 9:14 am #373783Your first paragraph is correct.
For your second paragraph, the reason for discounting is purely to account for the cost of money i.e. the cost of borrowing it.
The cost of borrowing is affected by the risk and the rate of inflation, but that in itself is not the reason for discounting.Are you watching my free lectures, because of all this is explained in the lectures. They are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
- AuthorPosts
- The topic ‘Cost of capital and Time value of money’ is closed to new replies.