A Company procures Capital from various sources viz. Shareholders, Borrowings from Banks, Borrowings from the Public among others. Each source of capital involves some cost. This cost to the company is the "minimum rate of return" which it must earn on its investments in order to satisfy the various categories of investors who have made investments in the form of shares, debentures or term loans. Unless the Company earns this minimum rate, the investors will be tempted to pull out of the company. This cost is referred to as the Cost of Capital.
IMPORTANCE OF COST OF CAPITAL
1) Capital Budgeting Process
Cost of Capital works as a helpful tool in the Capital Budgeting Process. For Example in the Net Present Value Method (NPV) or in the discounted Cash Flow Method, the Future Cash Inflows of a Project are discounted by this rate.
2) Capital Structure Decisions
Cost of Capital also plays a pivotal in the Capital Structure Decisions. When the Management of the firm is to decide the optimum Capital Structure for the Company, then the Cost of Capital should be minimized and the value of the firm should be maximised.
3) Comparative analysis of various sources of finance
The Cost of Capital Concept can also be used in comparative analysis of various sources of Finance. Which source should be chosen can be determined on the basis of Cost of Capital.
4) Evaluation of Financial efficiency of Top Management
Cost of Capital is also helpful in evaluating the financial efficiency of the top management. The surplus generated over and above the cost of capital is used in determining the efficiency of the Management.
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1) Capital Budgeting Process
Cost of Capital works as a helpful tool in the Capital Budgeting Process. For Example in the Net Present Value Method (NPV) or in the discounted Cash Flow Method, the Future Cash Inflows of a Project are discounted by this rate.
2) Capital Structure Decisions
Cost of Capital also plays a pivotal in the Capital Structure Decisions. When the Management of the firm is to decide the optimum Capital Structure for the Company, then the Cost of Capital should be minimized and the value of the firm should be maximised.
3) Comparative analysis of various sources of finance
The Cost of Capital Concept can also be used in comparative analysis of various sources of Finance. Which source should be chosen can be determined on the basis of Cost of Capital.
4) Evaluation of Financial efficiency of Top Management
Cost of Capital is also helpful in evaluating the financial efficiency of the top management. The surplus generated over and above the cost of capital is used in determining the efficiency of the Management.
Ask our finance experts for FREE here:
http://www.transtutors.com/forums/
For more info please visit:
http://www.transtutors.com/finance-homework-help/cost-of-capital/
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