Question

By applying capital to investments with long-term benefits, the company is attempting to produce value. This value is dependent on expected future cash flows as well as on the cost of funds.” Explain this statement with regards to the role of cost of capital in financial management decisions.

Answer 1

The cost of capital of a company is defined as the Expected return on a portfolio of all the company's existing securities.In simple words, it is the return that is required by an investor or lender from the investment in a project. The cost of capital is therefore the opportunity cost of investing in firm's assets and may be commensurate with the project risk.

A company may finance its funds through solely equity or debt or a combination of both.All capital budgeting decisions are based on the risk of the project and the capability of the project to generate returns. The cost of capital in case of companies financed through combination of debt and equity may be the Weighted Average Cost of Capital(WACC).

A project should give a higher return than the cost of capital for it to be selected. Any project with a return lower than the cost of capital may not create value for the business. The cashflows arising from a project are discounted at the cost of capital to arrive at their present values.

Hence the cost of capital plays a crucial role in selecting the optimal portfolio structure, making proper capital budgeting decisions, analysing the financial performance and choosing the best sources of finance.