Describe the term cost of capital

Question

Briefly describe the term cost of capital and also illustrate out its significance?

Answer 1

Cost of the capital is the rate of return that is minimum that has to be earned on investments in order to assure the investors of different types who are making investments in the company from debentures, shares and loans. It is employed in financial investment that refers to the cost of a company's funds or the shareholders return on the company's accessible deals. It is the necessary rate that a company should attain to cover the cost of generating funds in the market. Through seeing this only the investor invests the money in the company if the company is giving the necessary rate of return. It is a guideline to evaluate the profitability of various investments.

The significance of cost of capital is that it is employed to measure new project of company and permits the computations to be simple so that it has least return that investor expect for providing investment to the company. It has such significance in financial decision making. It really employed in managerial decision making in certain field like-

i) Decision on capital budgeting - It is employed to evaluate the investment proposal to select a project that satisfies return on investment.

ii) Employed in designing corporate financial structure - it is use employed to plan the market changeability and try to accomplish the economical capital structure for firm.

iii) Top management performance - It calculates the financial presentation of top executives. It engages the comparison of real profit of the projects and taken projects entire cost.