The concept of cost of capital is very important and the central concept in financial management decisions. The decisions in which it is useful are as follows: 1. Designing Optimal Corporate Capital Structure: This concept is helpful in formulating a sound and economical capital structure for a firm. The debt policy of a firm is significantly influenced by the cost consideration. Capital structure involves the determination of the proportion of debt and equity in the capital structure that provides less cost of capital.
While designing a firm’s capital structure, the financial executives always keep in mind minimization of the overall cost of capital and to maximise the value of the firm. The measurement of specific costs of each source of funds and calculation of the weighted average cost of capital help to form a balanced capital structure. By comparing various (sources of finance) specific costs, he/she can choose the best and most economical source of finance and can succeed in designing a sound and viable capital structure. [ Importance Capital Cost ] 2. Investment Evaluation/Capital Budgeting: Wilson R.M.S., states that the Cost of Capital is a concept, which should be expressed in quantitative terms if it is to be useful as a cut-off rate for capital expenses. Capital expenditure means investment in long-term projects like the investment on new machinery. It is also known as Capital budgeting expenditure. Capital budgeting decisions require a financial standard (cost of capital) for evaluation. The financial standard is Cost of Capital. In the Net Present Value (NPV) method, an investment project is accepted, if the present value of cash inflows are greater than the present value of cash outflow. The present values of cash inflows are calculated by discounting the rate known as Cost of Capital. If a firm adopts Internal Rate of Return (IRR) as the technique for capital budgeting evaluation, investment should be accepted only when the cost of capital is less than the calculated IRR. Hence, the concept of cost of capital is very much useful in capital budgeting decisions, particularly if a firm is adopting discounted cash flow methods of project evaluation. [ Importance Capital Cost ] 3. Financial Performance Appraisal: Cost of the capital framework can be used to evaluate the financial performance of top management. Financial performance evaluation involves a comparison of actual profitability of the investment project with the project overall cost of capital of funds raised to finance the project. If the actual profitability is more than the
projected cost of capital, then the financial performance may say to be satisfactory and vice versa.
The above discussion clearly shows the role of cost of capital in financial management decisions. Apart from the above areas (decisions), the cost of capital is also useful in (distribution of profits), capitalization of profits, making to the rights issue and investment in owner assets. [ Importance Capital Cost ]