Introduction
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.
