Q. Importance of the cost of capital?
1. Evaluating financial performance: the actual profitability of the project is compared to the projected overall cost of capital and the actual cost of capital of funds raise to finance the project. if the actual profitability of the project is more than the projected and actual cost of the capital, the performance may be said to be satisfactory.
2. Acceptance criterion in the capital budgeting: Capital budgeting decision can be made by the considering the cost of the capital. Accounting to NPV methods of capital budgeting if the present value of the expected return from investment is greater than or equal to the cost of investment the project may be accepted, otherwise the project may be rejected. They present value of expected return is calculated by the discounting the expected cash inflow at the cut of rate (which is the cost of the capital).
3. Determination of capital mix in capital structure decision: financing the firm's assets. While designing an optimal capital structure, the management has to keep in mind the objective of maximizing the value of the firm and minimizing the cost of capital. Measurement of cost of capital from various sources is very essential in planning the capital structure of any firm.
4. Taking other financial decision: the cost of capital from various sources is very essential in planning the capital structure of any firm.