Cost of capital refers to the minimum rate of return the company should earn to on investment to meet the expectation of investors or stakeholders. It represents the cost of long term funds such as cost of equity, cost of debt, cost of retained earnings etc. It is useful for the company to make financing decisions, to optimize the capital structure and to evaluate investment opportunities.
Importance Of Cost Of Capital
The main objectives, uses or importance of cost of capital can be described as follows:
1. To Measure The Effectiveness Of Investment
Cost of capital assists the management to determine the effectiveness of funds employed in the business. Rate of return higher than the cost of capital will be beneficial for the company and investors.
2. Helpful To Optimize The Capital Structure
Cost of capital ensures proper mixing of debt and equity finance by measuring the effectiveness of the capital investment. It helps to form ideas capital structure that lowers the costs and increases the profitability of the business.
3. To Make Capital Budgeting Decisions
Another importance of cost of capital is that it helps to determine the feasibility of capital projects. Internal rate of return (IRR) is compared with cost of capital to accept or reject the project. On the other hand, cost of capital is used to determine the net present value (NPV) . Project with higher IRR and NPV is selected and others are rejected. Therefore, cost of capital is useful for making capital budgeting decisions.
4. To Evaluate Financial Performance
It helps to evaluate the performance of the company. Actual financial performance is compared with the projected cost of capital to find out the deviation. It helps the management to make optimum use of fund to improve the performance.
Also Read
Importance Of Optimal Capital Structure
Features Of Ideal Capital Structure
5. To Make Leasing Decision
Cost of capital is also useful for the firms to make lease or buy decisions.
6. To Make Dividend Decisions
Cost of capital is a major factor that should be considered while making dividend policy of the firm. Dividend and other various financial decisions are made on the basis of cost of capital.
