IMPORTANCE AND CONCEPT
As mentioned above, the cost of capital is an important element, as a basic input information, in capital investment decisions. In the present value method of discounted cash flow technique, the cost of capital is used as the discount rate to calculate the NPV. The profitability index or benefit cost ratio method similarly employs it to determine the present value of future cash inflows. When the internal rate of return method is used, the computed IRR is compared with the cost of capital. The cost of capital, thus, constitutes an integral part of investment decisions. It provides a yardstick to measure the worth of investment proposal and, thus, performs the role of accept-reject criterion. This underlines the crucial significance of cost of capital. It is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return and so on.
The cost of capital, as an operational criterion, is related to the firms objective of wealth maximization. The accept-reject rules require that a firm should avail of only such investment opportunities as promise a rate of return higher than the cost of capital. Conversely, the firm would be well advised to reject proposals whose rates of return are less than the cost of capital. If the. firm accepts a proposal having a rate of return higher than the cost of capital, it implies that the proposal yields returns higher than the minimum required by the investors and the prices of shares will increase and, thus, the shareholders wealth. By virtue of the same logic, the shareholders wealth will decline on the acceptance of a proposal in which the actual return is less than the cost of capital. The cost of capital, thus, provides a rational mechanism for making optimum investment decisions. In brief, the cost of capital is important because of its practical utility as all acceptance rejection decision criterion.
The considerable significance of cost of capital in terms of its practical utility notwithstanding, it is probably the most controversial topic in financial management., There are varying opinions as to how this can be computed. In view of the crucial operational significance of this concept, our focus is on the general framework for the computation of cost of capital. We first define the term cost of capital in general terms. This is followed by a detailed account of the measurement of cost of capital both specific as well as overall of different sources of financing.