Importance of Cost of Capital in Financial Decisions

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IMPORTANCE OF COST OF CAPITAL The determination of the firm's cost of capital is important from the point of view of both capital budgeting as well as capital structure planning decisions: (i) Capital budgeting decisions In capital budgeting decisions, the cost of capital is often used as a discountrate on the basis of which the firm's future cash flowsare discounted to find out their present values. Thus, thecost of capital is the very basis for financial appraisal of new capital expenditure proposals. The decision of thefinance manger will be irrational and wrong I case of cost of capital is not correctly determined. This is because the business must earn at least at a rate whichequals to its cost of capital in order to make at least a break-even. (ii) Capital structure decisions The cost of capital isalso an important consideration in capital structuredecisions. The finance manager must raise capital fromdifferent sources in a way that it optimizes the risk andcost factors. The sources of funds which have less cost involved high risk. Raising of loans may, therefore, be cheaper on account of income tax benefits, but it involves heavy risk because a slight fall in the earning capacity of the company may bring the firm near to cash insolvency. It is, therefore, absolutely necessary that cost of each source of funds is carefully considered and compared with the risk involved with it. (3) Deciding about the Method of Financing. A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may ave a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the

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