A company can increase its common equity either by reinvesting its earnings or issuing new stock. The cost of equity will, therefore, be the rate of return that its shareholders require. Three methods are used to estimate the cost of…

The concept of cost of capital informs the investment decisions that a company’s management makes. Similarly, it is useful in the valuation of a company by investors and analysts. A company that invests in a project that produces a return…

A company’s liquidity determines its creditworthiness and capacity to borrow at cheaper rates and with better credit conditions, increasing its flexibility. The less liquid it is, the more likely a corporation is to go bankrupt. Similarly, the less liquid a…

Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. In the same vein, real options are capital allocation options that allow managers the…

The degree to which a corporation can satisfy its short-term obligations using cash flows and assets that it can quickly convert into cash is referred to as liquidity. In this context, liquidity refers to the available cash, borrowing power, and…

Successful businesses aim to strike a balance between funds set aside for current assets and the risk of current asset shortages. Each company has different needs for working capital. Retail enterprises, for example, focus on inventory and receivables, whereas software…

“Breakeven point” or “breakeven quantity of sales” refers to the number of units of a company’s product that is produced and sold, at which point the company’s net income becomes zero. Computing Breakeven Quantity of Sales At the point where…

Current assets less current liabilities equals working capital. $$\text{Working capital = Current assets – Current liabilities}$$ A company’s short-term assets and obligations are managed through working capital management. Its objective is to prevent excess reserves that might be expensive and,…

If a business can make an investment that generates more revenue than its opportunity cost of capital, the investment is beneficial to all parties involved and is, therefore, viable. An investment might reduce stakeholder value, i.e., it might generate less…

Some of the common capital allocation pitfalls or mistakes are: Inertia By comparing the current capital investment to the amount from the previous year and the return on investment, analysts can determine the presence of inertia. An analyst should evaluate…