Importance of Cost of Capital in Decision Making

Top–management of a company always considers its capital cost while taking any important financial decision related to their company. The significance of cost of capital in decision making process of a company can be described as follows-

  1. Capital Budgeting Decisions

Capital cost is often taken into consideration as an assessment tool before taking any investment proposal. After evaluation, a company opts for a project which offers a reasonable return on that investment. It is seen that this return is no way less than that capital cost which was incurred during the financing.

Thus, this cost of capital forms to be an important determinant before a top-management of a company. Other than evaluating its financial performance, it even assesses various investment opportunities.

  1. Framing the Corporate Financial Structure

Capital cost forms to be an important element while designing the financial structure of any organization. A financial manager always keeps an eye on the fluctuations in capital market and tries to attain the economical capital structure for his company.

  1. Deciding the financing method

A capable finance manager is one who holds thorough knowledge about various fluctuations prevailing in the capital market. Since profit maximization is his ultimate motive, he keeps on looking for suitable finance sources. Further, he can even choose the best and economical financial source during a specific situation.

  1. Determining the performance of Top-management

Through capital cost, even the performance of top management of a company is judged. It is used to determine the financial performance of people in the top-authority. This is done by comparing actual profitable earnings of these projects with the overall capital cost.

  1. Evaluating the progress of expansion projects

The capital cost helps a finance manager to evaluate various financial possibilities of projects which are on expansion. He needs to remember that only if the marginal cost is higher than the financing cost, it should be accepted.

  1. Other Areas

Capital cost is even vital in other areas in the decision making process of the company. This includes decision regarding policies on working management, dividend decision, etc.


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