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

Capital investments are often investments made in long term projectswhich in turn bring in long term benefits.. Firms often make capital investments for expanding their production base ,to improve thier competitive effectiveness and to comply with regulatory ,health and enviornmental requirements.Firms often use capital budgeting, which is management accounting tool that is intended to identify such investments , evaluate the costs and benfits ,selecting and monitoring them post implementation.

The future cash flows generated from these investments are often considered as an indicator of their value.The cost of capital of a firm can be refered to as the finance costs a company has to bear for raising funds for such long term investments.Cost of capital can also be considered as the opportunity cost(cost of next best alternative)of investing in other business opportunities.

Cost of capital is of great importnace to companies because it helps companies by providing them with an evaluation of aforemenioned investment oppurtunities by discounting the cashflows that arise from investments in the future,it serves for the purpose evaluating such ongoing projects by matching their progress with the cost of capital.Thus cost of capital plays a crucial role in capital investment as they are used to determine their viability.