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Importance of cost of capital in decision making


  • Since the business should atleast  be capable of earnings so much revenue has to be able to meet its cost of capital and to finance its growth ,cost of capital of a firm constitutes a crucial factor in most financial decisions.
  • It is  relevant both to capital budgeting and capital structure planning, the main areas in financial management.
  • In Capital budgeting decisions, cost of capital may be taken has the discounting rate .Obviously ,if a particular project gives an internal rate of return higher than its cost of capital, it should be an attractive opportunity.
  • Capital structure decisions, the cost of capital is an important consideration along with the risk factor . For example loan maybe cheaper but it entails higher risk of  cash insolvency as also of variation in the earnings per share due to the financial leverage effect. It is therefore essential that the cost of each source of funds is carefully considered and compared with the risk involved in it.
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