SIGNIFICANCE OF THE COST OF CAPITAL

SIGNIFICANCE OF THE COST OF CAPITAL

The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision making:

(i) Evaluation of investment options: The estimated benefits (future cashflows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).

(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars project or business. The performance of a project or business in compared against the cost of capital which is known here as cut-off rate or hurdle rate.

(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/ profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.

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