Q. Importance of the Cost of Capital?
Importance of the Cost of Capital:-
(1) Useful in Designing the Capital Structure: - The perception of cost of capital plays a very important role in designing the capital structure of a company.
Capital structure of a business is the ratio of debt as well as equity. These sources be different from each other in terms of their respective costs. Since such a company will have to design such a capital structure which minimizes cost of capital.
(2) Useful in taking capital Budgeting Decisions: - Capital budgeting is the procedure of decision making regarding the investment of funds in long term projects of the company. The concept of cost of capital is extremely useful in making capital budgeting decisions for the reason that cost of capital is the minimum required rate of return on an investment project.
(3) Useful in evaluation of financial efficiency of top management:-Concept of cost of capital is able to be used to evaluate the financial efficiency of top management. Such estimation will involve a comparison of projected overall cost of capital with the actual cost of capital incurred by the management. Lesser the actual cost of capital is the better financial performance of the management of the firm.
(4) Useful in comparative analysis of various sources of finance: - Cost of capital to be increased from various sources goes on changing from time to time. Computation of cost of capital is helpful in analysis of usefulness of various sources of finance.
(5) Useful in taking other financial decisions: - The cost of capital concept is as well useful in making other financial decisions such as:
- Dividend Policy
- Right Issue
- Working Capital Decisions
- Capitalisation of profits.