The cost of capital is very important concept in the financial decision making. Cost of capital is the measurement of the sacrifice made by investors in order to invest with a view to get a fair return in future on his investments as a reward for the postponement of his present needs. On the other hand from the point of view of the firm using the capital, cost of capital is the price paid to the investor for the use of capital provided by him. Thus, cost of capital is reward for the use of capital. The progressive management always likes to consider the cost of capital while taking financial decisions as it’s very relevant in the following spheres:
- Designing the capital structure: The cost of capital is the significant factor in designing a balanced and optimal capital structure of a firm. While designing it, the management has to consider the objective of maximizing the value of the firm and minimizing cost of capital. Comparing the various specific costs of different sources of capital, the financial manager can select the best and the most economical source of finance and can designed a sound and balanced capital structure.
- Capital budgeting decisions: The cost of capital sources as a very useful tool in the process of making capital budgeting decisions. Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines acceptability of all investment proposals by discounting the cash flows.
- Comparative study of sources of financing: There are various sources of financing a project. Out of these, which source should be used at a particular point of time is to be decided by comparing costs of different sources of financing. The source which bears the minimum cost of capital would be selected. Although cost of capital is an important factor in such decisions, but equally important are the considerations of retaining control and of avoiding risks.
- Evaluations of financial performance: Cost of capital can be used to evaluate the financial performance of the capital projects. Such as evaluations can be done by comparing actual profitability of the project undertaken with the actual cost of capital of funds raise o finance the project. If the actual profitability of the project is more than the actual cost of capital, the performance can be evaluated as satisfactory.
- Knowledge of firms expected income and inherent risks: Investors can know the firms expected income and risks inherent there in by cost of capital. If a firms cost of capital is high, it means the firms present rate of earnings is less, risk is more and capital structure is imbalanced, in such situations, investors expect higher rate of return.
- Financing and Dividend Decisions: The concept of capital can be conveniently employed as a tool in making other important financial decisions. On the basis, decisions can be taken regarding dividend policy, capitalization of profits and selections of sources of working capital.
Credit: Financial Management-MGU MBA