Hello, what is the cost of capital? In economics and accounting, the cost of capital is the cost of a company’s fund. – Which (both debt and equity), or, from the perspective of an investor, “the required rate of return on the existing securities of the portfolio company”. It is used to evaluate new projects of any company. And it is the minimum return, which investors expect to provide capital to the company, which thus sets a benchmark for what a new project should accomplish.
Computation of cost of capital is a very (four) important part of financial management to decide the capital structure of the business concern.
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What is four importance of cost of capital?
1. Importance to Capital Budgeting Decision
The capital budget decision largely depends on the cost of capital of each source. According to the net present value method, the present value of cash inflow must be more than the present value of cash outflow. Hence, the cost of capital is used to capital budgeting decisions.
2. Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses a particular type of source if the cost of capital is suitable. Hence, the cost of capital helps to take decision regarding structure.
3. Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital structure, and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
4. Importance to Other Financial Decisions
Apart from the above points, the cost of capital is also used in some other areas such as the market value of a share, earning capacity of securities, etc. hence, it plays a major part in financial management.
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