Question: Explain the importance of cost of capital in financial decision making
(From KNEC past paper, Diploma in Business Management. Unit name: Business Finance)
Answer:
The cost of capital refers to the amount of money that a company needs to start a project and run it to earn profits. Cost of capital is important in financial decision making because it shows the minimum returns that a business needs to earn from its investments to satisfy shareholder needs. It is important for business in the following ways:
1) Investment decisions
Businesses use cost of capital to make crucial investment decisions, such as which project to pursue, which one to stop, and how much to invest in a project to earn profits. Cost of capital can be used as discount rate in capital budgeting to evaluate various projects and investments to determine their viability.
2) Financing Decisions
Cost of capital is also important for a company because it can be used to make sound financial decisions, such as deciding capital structure and debt v. equity as sources of finance. Cost of capital allows a company to know the mix of debt and equity that are necessary for financing.
3) Performance measurement:
Cost of capital can be used to measure the performance of a business, to assess its returns, and determine whether shareholder expectations are met. A business needs to generate enough returns to meet shareholders’ needs and build investor confidence. Cost of capital is used to assess the required return and determine whether a particular investment meets the required return to meet shareholder interests.
4) Valuation
Cost of capital can also be used in valuing a business using discounted cash flow analysis and risk assessment. Cost of capital is an important component used in various valuation models to estimate the present value of a firm’s future cash flows. It is also used to incorporate risks in the company’s operations.
5) Strategic planning
Cost of capital can be important when developing growth strategies such as mergers and acquisitions. A company can align its growth strategies with cot of capital such that low-cost capital can encourage aggressive investments.
