Significance And Components Of Cost Of Capital

Significance Of Cost Of Capital

Cost of capital is considered as a standard of comparison for making different business decisions. Such importance of cost of capital has been presented below.

1. Making Investment Decision

Cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a significant role in making investment decisions.

2. Designing Capital structure

The proportion of debt and equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to design the capital structure considering the cost of each sources of financing, investor's expectation, effect of tax and potentiality of growth.

3. Evaluating The Performance

Cost of capital is the benchmark of evaluating the performance of different departments. The department is considered the best which can provide the highest positive net present value to the firm. The activities of different departments are expanded or dropped out on the basis of their performance.

4. Formulating Dividend Policy

Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such projects which can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

Components Of Cost Of Capital

The individual cost of each source of financing is called component of cost of capital. The component of cost of capital is also known as the specific cost of capital which includes the individual cost of debt, preference shares, ordinary shares and retained earning. Such components of cost of capital have been presented below:

A. Cost Of Debt

* Cost of perpetual or irredeemable debt
* Cost of non-perpetual or redeemable debt
* Cost of debt issued on redeemable condition
* Cost of callable debt

B. Cost Of Preference Share

* Cost of perpetual preference Share
* Cost of redeemable preference Share

C. Cost of ordinary/equity shares or common stock

D. Cost of retained earning