Question

Why is it important to know how to calculate a firm's cost of money? Explain.

Answer 1

A firm uses different sources of finance for raising capital and incurs a certain cost on the capital raised. The business has different options as far as the use of this capital is concerned. Knowing the cost of capital allows the business to assess and select the correct option which will maximize the value of the business. The firm uses capital budgeting techniques for assessing different projects where cost of capital is necessary information. For instance a firm is able to assess the cash flows arising from a particular project and can then determine the internal rate of return from that investment. This return generated by the project must be higher than the cost of capital for the business to pursue that project. Only then will the value of the business be maximized and hence we see that knowing the cost of capital of the business is essential for the business to make the correct decision.