Explain the relationship between a company's financial policy and it's cost of capital.

Financial Policy and the Cost of Capital Financial policy is used by companies or investors in order to determine the best way to allocate their resources. In regard to cost of capital, financial policy must be utilized in order to decide which investments have the highest return, given that resources are limited. To analyze various options, managers use valuation techniques, such as the capital asset pricing model or discounted cash flow analysis. As opposed to strictly using cost of capital, decisions must be made using opportunity cost of capital. Opportunity cost of capital is the amount of money foregone by investing in one asset compared to another. As an investor, this can simply be a choice of one asset over another. As a company, this choice can also involve the use of current assets in new investments. For example, an idle piece of land could be used for a new factory, however, the opportunity cost of what else it could have been used for must be taken into consideration during analysis. Other Roles of Financial Policy The use of financial policy in decision making does not only involve valuation. Other facets include portfolio theory, hedging. and capital structure. 55.00 50.00 45.00 40.00 35.00 30.00 25.00 20.00 15.00 66000 35000 2002 2003 2004 Oil Prices: Companies often use hedging techniques to offset price fluctuations for commodities. The fluctuation of oil prices can be seen in the above graph. Portfolio Theory Portfolio theory is a mathematical formulation of the concept of diversification in investing. It attempts to maximize the expected return of a portfolio, or a collection of investments, for a given amount of risk by carefully choosing the proportions of various assets. In other terms, portfolio theory attempts to minimize risk for a given level of expected return. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can, in theory, face lower overall risk than either could individually. Hedging Along the same lines, companies use hedging techniques to offset potential gains and losses. Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. Simply put, a hedge is used to reduce any substantial gains or losses suffered by an individual or an organization Companies often use hedging techniques to offset the risk of price fluctuation for commodities, such as oil or agricultural products https://youtu.be/Xwcyparto Capital Structure The capital structure of a company refers to the way it finances its assets through some combination of equity, debt, or hybrid securities. Capital structure may be highly complex and include dozens of sources. A simple example, though, would be a company that sold $20 million in equity and $80 million in debt. This company would be 20% equity financed and 80% debt financed. A company's ratio of debt to total financing is referred to as its leverage. Key Points As opposed to strictly using cost of capital, decisions must be made using opportunity cost of capital, Opportunity cost of capital is the amount of money foregone by investing in one asset compared to another. . Facets of financial policy include valuation, portfolio theory, hedging, and capital structure. Key Terms leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk)