Significance of the cost of Capital
We should recognize that the cost of capital is one of the most difficult and disputed topics in finance theory. There are conflicting opinions among the financial experts about measuring the correct way of cost of capital. Financial experts express conflicting opinions as to Irrespective of the measurement problems, it plays vital role in financial decision making. It is useful as a standard for:
1. Investment evolution:
The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. It represents a financial standard for allocating the firm's funds, supplied by owners and creditors to the various investment projects in the most efficient manner. It plays a very vital role in investment decisions. It helps the management to ascertains the acceptance /rejection decision for any new investment proposals. With the help of acceptance-rejection rule management can determine the profitability of the new proposals and can select the most profitable proposals out of so many alternatives.
2. Formulating Capital structure:
The concept of cost of capital is very important in formulating the capital structures of the company. This is a useful concept as it helps the management in deciding the future capital structure of the company. The capital structure includes both borrowed capital and own capital. Every source of capitals or funds has its own cost.
3. Designing debt policy:
The debt policy of a firm is significantly influenced by the cost consideration. Debt helps to save taxes, as interest on debt is a tax-deductible expense. The interest tax shield reduces the overall cost of capital, though it also increases the financial risk of the firm. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing the firm value by minimizing the overall cost of capital. The cost of capital can also be useful in deciding about the methods of financing at a point of time. For example, Cost may be compared in choosing between leasing and borrowing. Of course, equally important considerations are control and risk.
4. Performance Appraisal:
The cost of capital framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management in raising the required funds. The cost of capital also plays a very useful role in dividend decisions and Investment in current assets.
Don't Miss A Single Updates
✓Remember to check your email account to confirm your subscription.
