Explain cost of capital and its importance.
Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is used in financial investment which refers to the cost of a company's funds or the shareholders return on the company's existing deals. It is the required rate that a company must achieve to cover the cost of generating funds in the market. By seeing this only the investor invests the money in the company if the company is giving the required rate of return. It is a guideline to measure the profitability of different investments.
The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. It actually used in managerial decision making in certain field such as-
1) Decision on capital budgeting- It is used to measure the investment proposal to choose a project which satisfies return on investment.
2) Used in designing corporate financial structure- it is used to design the market fluctuations and try to achieve the economical capital structure for firm.
3) Top management performance- It evaluates the financial performance of top executives. It involves the comparison of actual profit of the projects and taken projects overall cost.