Why is the importance of Cost of Capital in Finance?

Although being a disputed matter in the financial world, the cost of capital is an important measure that helps the managers in decision-making in the correct manner. The following are the reasons why the cost of capital is an important measure −

Evaluation of Investment

The cost of capital is used in both NPV and IRR methods of investment evaluation.

  • In the NPV method, a project is accepted if it has a positive NPV. The project’s NPV is usually calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used to check the usability of a project.

  • In the IRR method, the project is accepted if it has a greater internal rate of return than the cost of capital. This rate of return is known as the cut-off rate.

  • A project with a positive NPV makes a net contribution to shareholders’ wealth. When the NPV is zero, it means that the project has yielded a return just equal to the cost of capital. In the case of zero NPV, the project makes no effect on shareholders’ wealth.

The cost of capital is the minimum rate of return on the investment project that keeps the net wealth of shareholders unchanged. Therefore, the cost of capital is an important part of evaluating an investment in the most profound manner.

Designing the Debt Policy

As debt helps to minimize the taxes, a company's debt policy should be formed by taking the right amount of debt.

  • Debts exceeding the limits can cause harm to shareholders’ wealth, as it increases the chances of default. Therefore, in building the project’s capital structure, an optimized debt inclusion is required to make an optimum impact on the investment policy.

  • In general, the proportion of debt and equity is a determinant of a firm’s value that is required for maximizing the value by minimizing the cost of capital.

  • The cost of capital also helps in determining the methods of investments in some cases. For example, costs may be used to compare between lease and borrowing.

  • The other important factors are control and risks of a project where the cost of capital can help the top management to choose between projects.

Performance Appraisal

The cost of the capital policy can be used to evaluate the performance of the top management. To do so, a comparison of the actual profitability of the project with the overall cost of capital, and the appraisal of actual costs incurred in raising the funds may be used. Performance appraisal is one of the most important functions of the cost of capital calculations.