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The cost of capital is important because of its application in the following areas:
i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the cost of capital is used to discount the cash flows. Under IRR method the cost of capital is compared with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is determined by the cost of each capital component.
iii) Evaluation of performance of management – A high cost of capital is an indicator of high risk attached to the firm. This is usually attributed to poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is low compared to the cost of
new ordinary share capital, the firm will retain more and pay less dividend. Additionally, the use of
retained earnings as an internal source of finance is preferred because:
- It does not involve any floatation costs
- It does not dilute ownership and control of the firm, since no new shares are issued.
v) Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or borrowing
long-term debt to buy an asset. In lease or buy decisions, the cost of debt (interest rate on loan
borrowed) is used as the discounting rate.
Wilfykil answered the question on August 5, 2019 at 05:31