Evaluating investment decision.
The primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. In the NPV method, an investment project is accepted if it has a positive NPV. The project's NPV is calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used for evaluating the desirability of an investment project In the IRR method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In this context, the cost of capital is the minimum required rate of return on an investment project. It is also known as the cutoff rate, or the hurdle rate.
Designing a firm's debt policy.
The debt policy of a firm is significantly influenced by the cost consideration. As we shall learn later on, debt helps to save taxes, as interest on -debt is a tax-deductible expense. The interest tax shield reduces the overall cost of Capital; thought also increases the financial risk of the firm. In designing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at maximizing the firm value by minimizing the overall cost of capital. Cost of capital can also be useful in deciding, about the methods of financing at a point of time. For example, cost may be compared in choosing, between leasingand borrowing. Of course, equally important consummations are control and control and risk.'
Appraisingthe financial performance of top management.
The cost of capital framework can be used to evaluate the financial performance of top management. such an evaluation will involve a comparison of the investment project understand by the firm with the overall projected cost of capital.
Determining the value of the firm.
The objective of financial management is wealth maximization. Cost of Capital is the important element for valuation of firms and it plays significant role in the case of valuation of firms.
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