Importance of Cost of Capital

According to economists and accountants, cost of capital is the cost of the total funds in a company that includes debts and equities that the company owes. Cost of capital is also necessary in the investment world. According to investors, the cost of capital is the minimum amount of returns that investors who have provided capital to the company usually expect. Investors, therefore, set some requirements that the new project has to meet. Hence, for an investment to be productive, the returns investors get, have to be more than the cost of capital used in investing (Gitman & Mercurio, 1982). Cost of capital benefits organizations in different ways such as making dividend decisions, making capital budgeting decisions and evaluation of financial performance to mention but a few.

First, the cost of capital is used in making dividend decisions. One factor that determines the dividend policy of a firm is the nature of the organization (Stulz, 1999). Nature of an organization varies in that an organization can be either declining, normal or growing leading to different decisions being made. The nature of an organization is therefore measured by making comparisons between the rate of return(r) and the cost of capital (k). If r>k, r=k and r<k it means that there is a growing organization, stagnant organization and declining organization respectively.

Secondly, the cost of capital can be used in evaluating and understanding the financial performance of a firm.  Evaluation can be carried out by comparing the actual profit of the investment project with the cost of capital (Gitman & Mercurio, 1982). Proper financial performance occurs when there are profit maximization and cost of capital minimization in an organization.

Lastly, the cost of capital can be used in the determination of capital budget decisions (Stulz, 1999). Cost of capital, also referred to as the discounting rate when determining the net present value about a projects’ expected future cash flows is used to evaluate how desirable an investment project is. Therefore, a project will be highly accepted if the rate of return is higher than the cost of capital making the cost of capital a standard means for disbursing investible funds in an optimum manner.

The above examples show some importance of cost of capital in the finance and investment field. Hence, it is essential for investors to be able to determine their cost of capital to enhance better investment decisions.

 

References:

Gitman, L. J., & Mercurio, V. A. (1982). Cost of capital techniques used by major US firms: Survey and analysis of Fortune’s 1000. Financial management, 21-29.

Stulz, R. M. (1999). Globalization, corporate finance, and the cost of capital. Journal of applied corporate finance, 12(3), 8-25.

 

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