Cost of Capital^31
Significance of the Cost of Capital
It should be recognized at the outset that the cost of capital is one of the most difficult
and disputed topics in the finance theory. Financial experts express conflicting opinions
as to the way in which the cost of capital can be measured. It should be noted that
it is a concept of vital importance in the financial decision-making. It is useful as a
standard for:
l evaluating investment decisions,
l designing a firmís debt policy, and
l 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 evaluating the investment projects. In the NPV method, an
investment project is accepted if it has a positive NPY. The projectís NPV is calculated
by discounting its cash flows by the cost of capital. In this sense, the cost of capital
is the discount rate used for evaluating the desirability of an investment project. In the
IRR method, the investment project is accepted if it has an internal rate of return
greater than the cost of capital. In this context, the cost of capital is the minimum
return on an investment project. It is also known as the cutoff, or the target, or the
hurdle rate.
An investment project that provides .positive NPV when its cash flows are discounted
by the cost of capital makes a net contribution to the wealth of shareholders. If the
project has zero NPV, it means that its a return just equal to the cost of capital, and
the acceptance or rejection of the project will not affect the wealth of shareholders The
cost of capital is the minimum required rate of return on the investment project that
keeps the present wealth of shareholders unchanged. It may be, thus, noted that the
cost of capital represents a financial standard for allocating the firmís funds, supplied
by owners and creditors, to the various investment projects in the most efficient
manner.
Designing debt policy The debt policy of a firm is significant influenced 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 cost of capital. The relationship between the
cost of capital and the capital structure decision is discussed later on.
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.
Performance appraisal Further, the cost of capital framework can be used to evluate
the financial performance of top management. I Such an evaluation will involve a
comparison of actual profitability of the investment projects undertaken by the firm
with the project overall cost of capital, and the actual cost 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. The chapters dealing with these decisions show their linkages the
methods of financing with the cost of capital.