IMPORTANCE OF COST OF CAPITAL
Computation of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to
net present value method, present value of cash inflow must be more than the present
value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities.
A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital
helps to take decision regarding structure.
68 Financial Management
Importance to Evolution of Financial Performance
Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market
value of share, earning capacity of securities etc. hence, it plays a major part in the financial
COMPUTATION OF COST OF CAPITAL
Computation of cost of capital consists of two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:
• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return
that a firm must earn on the equity financed portion of an investment project in order to
leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.