0The importance of the concept of cost of capital can be seen under the following heads:
- Helpful in capital budgeting process - Cost of capital is quite helpful in capital budgeting process. It works as basis for decisions. For example in present value method or discounted cash flow method the future cash inflows of a project are discounted by this rate.
- Helpful in capital structure decisions - Cost of capital is helpful in capital structure decisions. When the management of the firm is to decide the optimum capital structure for the company then cost of capital should be minimised and the value of the firm should be maximised.
- Helpful in comparative analysis of various sources of finance - Cost of capital is helpful in comparative analysis of various alternative sources of finance. Which source should be chosen, can be determined on the basis of cost of capital.
- Helpful in evaluation of financial efficiency of top management - Cost of capital is helpful in evaluation of financial efficiency’ of top management. The top management prepares investment budgets for various projects. In these budgets future profitability and costs are estimated. After implementation of the project, by comparison of estimated and actual costs, it can be seen how much the top management has been successful in preparation of budgets and implementation of projects. Ability to generate profit is no longer a test of profit adequacy. Ability to generate Economic Value Added is the only test of profit adequacy. “Any surplus generated from operating activities over and above the cost of capital is termed as Economic Value Added (EVA)”. EVA is defined as - “Excess Profit of a firm after charging Cost of Capital”.
- Useful in other areas - Cost of capital is useful in dividend policy and working capital policy decisions also.
Explicit Cost:
Explicit cost of capital is “the rate of return that an entity pays to procure finance. The explicit cost of any source of capital is “the discount rate that equates the present value of cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outflows.
Implicit cost:
The implicit cost may be defined as “the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted.” The retained earnings are undistributed profits of the company belonging to the shareholders.
