Significance of cost of finance, Finance Basics

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Significance of Cost of Finance

The cost of capital is Significance since of its application in the following areas as:

i) Long-term investment decisions - In capital budgeting decisions, with NPV method, the cost of capital is required to discount the cash flows. Under IRR method the cost of capital is compared along with IRR to determine where to reject or accept a project.

ii) Capital structure decisions - The composition/mix of different components of capital is determined with the cost of each capital component.

iii) Evaluation of performance of management - A high cost of capital is a shows of high risk attached to the firm. It is generally attributed to poor performance of the firm.

iv) Dividend decisions and policy - as if the cost of retained earnings is low compared with the cost of new ordinary share capital, the firm will retain extra and pay fewer dividends.  Additionally, the utilization of retained earnings like an internal source of finance is preferred since:

  1. It does not contain any floatation costs
  2. It does not dilute control and ownership of the firm, while no new shares are issued.

v) Lease or buy decisions - A firm may finance the acquisition of an asset with borrowing and leasing long-term debt to buy an asset. So in lease or buy decisions, the cost of debt interest rate on loan borrowed is used like the discounting rate.


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