Cost of Capital: Applications and Examples, Essay Example

While investors need to know whether their investments are earning profits, the stock market proves to be very unpredictable. Consequently, they requires tools that enable them to measure the extent to which securities respond to the swing in the market. Beta is an important tool that has assisted shareholders to predict the volatility of their investments to the market. As a matter of fact, the reliability of a firm’s beta can be affected by several factors. A look at the recent trend in the global market indicates that the recent global financing had great impacts on firms’ beta, their equity and the cost of their capital. Additionally, implied some concepts for both the firms and their providers.

Firstly, financial flexibility of the firm is a factor that can affect the reliability the firms’ beta. A financially flexible company usually enjoy a more reliable beta that affect more investors to the company. Most of the companies experience negligible challenges in establishing a stable beta during when the sales are good. However, this overturns when the sales get lower and the firm is forced to borrow funds for maintenance. Firms suffer s from this problem especially when they extend their markets too wide during the period when the business is doing good. To maintain this market when sales declines, the firm is forced to get into debts in order to maintain the market. Consequently, its competitive ability declines.

Additionally, the growth rate of the company is influential in determining the reliability of the company’s beta. Slow growing firms have less stable betas because of the unreliable nature of their capital. Most of these companies have to depend on debts in order to maintain growth. Unstable beta exposes the company to losses and possibility of collapsing hence they cannot be relied upon. On the other hand, mature companies with stable growth rates requires less debts because their financial growth is stable. This makes them enjoy a stable cash flow that invites investors. Undoubtedly, the company enjoys a relatively reliable beta that makes it compete with the broader market positively.

Thirdly, Pratt and Grabowski (2010) polemicizes that the reliability of a firm’s beta is dependent on the market conditions at the time it is being measured. The volatility of the firm’s securities is measured against the condition of the market capital. Therefore, if the market is strong and the firm’s capital is weak, the beta will be unstable. On the other hand, both the capital market and the firm’s capital are stronger, the firm’s capital will be relatively balanced to the market, hence the beta will be stronger and reliable.

Undoubtedly, the financial crisis experienced in 2008 had intense impacts on the firms’ beta, the cost their equity and capital. For example, major companies in the USA lost large percentages of their value. This reflected to an increase in the strength of the firms’ beta, while the cost of their equity and capital declined (Poirson and Schmittann, 2013 p. 113). Banks lost trust in clients since they did not believe in their ability to repay the debts. As a result, firms were required to provide their own cash flow in the business, otherwise they could not do business. Share prices went down throughout the world, with company’s such as Dow Jones Industrial Average in the U.S. losing 33.8% of their value. The likely implications of this financial crisis to the firms and their capital providers was a large loss in profits. Companies lost most of their revenue due to decline in the share prices. Capital providers on the other hand lost a substantial part of their investments in the companies that they invested in.

Conclusively, it is evident that the reliability of a firm’s beta depends on the various factors such as financial flexibility, business growth and market conditions. The paper has explained how each of these variables affect the reliability of the beta. In addition, it is clear the financial crisis of 2008 had a great impact on firms’ betas, the cost of their equity and the capital. Firms and their providers lost a lot of capital and profits as a result.

Bibliography

Poirson HM and Schmittmann JM, 2013, Risk Exposures and Financial Spillovers in Tranquil and Crisis times: Bank-Level Evidence, International Monetary Fund.

Pratt SP and Grabowski RJ, 2010, Cost of Capital: Applications and Examples. New York, John Wiley & Sons.