Question

Importance of Cost of Capital: Why is the cost of capital important to an organization, and what does it measure?

Meaning of Calculations: How do organizations calculate various costs, and what do these calculations mean to business?

Answer 1

Cost of capital is an important measure for the company because it is used to calculate the overall cost associated with various kinds of project the company is going to undertake, and it should always be compared with the required rate of return in order to arrive at a profit for the company.

It can help in measuring the required rate of return as the company should atleast generate, so that it will be beneficial, and it will also help the calculation of the break even point, and it is also helpful in determination of present value of various contracts and ascertainment of capital budgeting decisions.

an organisation can calculate various kinds of cost associated with its operation by weighting of different types of capital used and it can also use risk weighting of asset in order to arrive at a proper risk weighted average cost of capital.

An organisation can also use these cost calculation to make various decisions regarding to capital budgeting and undertaking of various other projects, as well as discounting of free cash flows, which are available to the firm.

It can be said that the cost of capital is an inherent part of Business and a business should be proactive in ascertainment of cost of capital in order to generate higher rate of return which could easily beat the cost of capital, and help the company in achieving a growth and expansion of its business.