This article throws light upon the top four significances of cost of capital. The significances are: 1. As an Acceptance Criterion in Capital Budgeting 2. As a Determinant of Capital Mix in Capital Structure Decisions 3. As A Basis for Evaluating the Financial Performance 4. As a Basis for taking other Financial Decisions.
Significance of Cost of Capital:
- As an Acceptance Criterion in Capital Budgeting
- As a Determinant of Capital Mix in Capital Structure Decisions
- As A Basis for Evaluating the Financial Performance
- As a Basis for taking other Financial Decisions
Significance # 1. As an Acceptance Criterion in Capital Budgeting:
In the words of James T.S. Posterfield ‘the concept of cost of capital has assumed growing importance largely because of the need to devise a rational mechanism for making the investment decisions of the firm’. Capital budgeting decisions can be made by considering the cost of capital.
According to the present value method of capital budgeting, if the present value of expected returns from investment is greater than or equal to the cost of investment, the project may be accepted; otherwise; the project may be rejected.
The present value of expected returns is calculated by discounting the expected cash inflows at cut-off rate (which is the cost of capital). Hence, the concept of cost of capital is very useful in capital budgeting decision.
Significance # 2. As a Determinant of Capital Mix in Capital Structure Decisions:
Financing the firm’s assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing a firm’s assets. While designing an optimal capital structure, the management has to keep in mind the objective of maximising the value of the firm and minimising the cost of capital.
Measurement of cost of capital from various sources is very essential in planning the capital structure of any firm.
Significance # 3. As A Basis for Evaluating the Financial Performance:
In the words of S.K. Bhattacharya the concept of cost of capital can be used to ‘evaluate the financial performance of top management’. The actual profitability of the project is compared to the projected overall cost of capital and the actual cost of capital of funds raised to finance the project.
If the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be said to be satisfactory.
Significance # 4. As a Basis for taking other Financial Decisions:
The cost of capital is also used in making other financial decisions such as dividend policy, capitalisation of profits, making the rights issue and working capital.