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Financial Management - Capital Budgeting – A Conceptual Framework

Cost of Capital – Significance

   Posted On :  20.06.2018 01:02 am

The determination of the firm’s cost of capital is important from the point of view of both Capital Budgeting as well as Capital Structure planning decisions.

Cost of Capital – Significance
 
The determination of the firm’s cost of capital is important from the point of view of both Capital Budgeting as well as Capital Structure planning decisions.

Capital budgeting decisions. In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firm’s future cash flows are discounted to find out their present values. Thus, the cost of capital is the very basis for financial appraisal of new capital expenditure proposals. The decision of the finance manager will be irrational and wrong in case the cost of capital is not correctly determined. This is because the business must earn at least a rate which equals to its cost capital in order to make at least a break-even.

Capital structure decisions. The cost of capital is also an important consideration in capital structure decisions. The finance manager must raise capital from different sources in a way that it optimises the risk and cost factors. The sources of funds which have less cost involve high risk. Raising of loans may, therefore, be cheaper on account of income tax benefits, but it involves heavy risk because a slight fall in the earning capacity of the company may bring the firm near to cash insolvency. It is, therefore, absolutely necessary that cost of each source of funds is carefully considered and compared with the risk involved with it.

In order to compute the overall cost of capital, the manager of funds has to take the following steps:

1. To determine the type of funds to be raised and their share in the total capitalization of the firm.

2. To ascertain the cost of each type of funds.

3. To calculate the combined cost of capital if the firm by assigning weight to each type of funds in terms of quantum of funds so raise.
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