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Importance of Cost of Capital in Decision Making

(i)                 Capital Budgeting Decisions. Cost of capital may be very much used as the measuring rod for adopting an investment proposal. Generally, the company has to choose project based upon the satisfactory return on investment. It measures the financial performance and also determines acceptability of the project by discounting cash flows under present value method. Commonly, it is the technique used to accept or reject the project.

 

(ii)               Designing the Optimal Capital Structure. The cost of capital is very much helpful in formulating firm’s sound and economic capital structure. An excellent financial expert keeps an eye on the capital market fluctuations and analyses the comparative interest rate, and trend of the capital movement. Based upon the analysis, finance manager comes to correct conclusion and forms a suitable capital structure of the firm.

 

(iii)             Deciding about the Method of Financing. An efficient financial manager has a thorough knowledge of the capital market fluctuation. The ultimate aim of the financial management is the wealth maximisation. In order to achieve these objectives, the financial manager finds the financing sources. Apart from these, comparing the specific cost of different sources of fmance, the finance manager can select the most economical source of finance in a particular situation.

 

(iv)             Helpful i n the Evaluation of Expansion Projects. With the help of the cost of capital the financial manager can easily examine the financial possibilities of a given expansion project. If marginal return on investment exceeds the cost of financing, the expansion project should be accepted, otherwise it should be rejected.

 

(v)               To Evaluate the Financial Performance of Top Management. The cost of capital can be used to evaluate the financial performance of top management people. It involves a comparison of actual profitabilities of the project undertaken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the expected funds.

 

(i)                 (vi ) Other Areas. The concept of cost of .capital is also important in some other areas of decision making of the firm such as dividend decision, working capital management policies etc. The value of the firm normally depends upon its cost of capital.