Significance of the Cost of Capital

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Financial experts express conflicting options as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital important in the financial decision making. It is useful as a standard for:

• evaluating investment decisions,

• designing a firms debt policy,

• Appraising the financial performance of top management.

Investment evaluation

The primary purpose of measuring the opportunity cost is its use as a financial standard for evaluating the investment projects. In the net present value method, an investment project is accepted if it has a positive net present value. The projects net present value is calculated by discounting its cash flows by the cost of capital.

Designing debt policy

The debt policy of a firm is significantly influence 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 maximizing the overall cost. The cost of capital can also be useful in deciding about the methods of financing at a point of time.

Performance appraisal

The cost framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management in raising the required funds. The capital cost also plays a useful role in dividend decision and investment in current assets.

The Concept of the Opportunity Cost

Decision making is a process of choosing among alternatives. In the investment decisions, an individual or a manager encounter innumerable competing investment opportunities to choose from. For example, you may invest your savings of 1000$ either in 7% 3 year postal certificates or in 6.5% 3 year fixed deposit in a nationalized bank. In both the cases, government assures the payment; so the investment opportunities reflect equivalent risk. You decide to deposit your savings in the bank. By this action, you have foregone the opportunity of investing in the postal certificates. You have, thus, incurred an opportunity cost equal to the return on the foregone investment opportunity. It is 7% in case of your investment. The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk. Thus, the required rate of return on an investment project is an opportunity cost.

Source by Randika Lalith Abeysinghe

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