Sunday, February 21, 2010


Significant of the Cost of Capital

Financial experts express conflicting options as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital important in the financial decision making. It is useful as a standard for:
  • Evaluating investment decisions.
  • Designing a firm’s debt policy.
  • Appraising the financial performance of top management.

Investment evaluation

The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. In the net present value (NPV) method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital.

Designing debt policy

The debt policy of a firm is significantly influence by the cost consideration. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing 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.

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 useful role in dividend decision and investment in current assets.

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