The Importance and Uses of Cost of Finance

The cost of finance or cost of capital is used by managers to make important decisions regarding investments and business operations. It is important for various reasons:

Evaluating Investments/Capital budgeting decisions

The cost of capital is used in various methods of evaluating investment projects such as IRR and NPV. In regards to the NPV method, cost of capital is used to calculate discounted cash flows and compare cash inflows and outflows. In terms of IRR, managers choose projects that have a higher internal rate of return than the cost of finance.

Designing Capital Structure

Another use of cost of finance is to design capital structure for the company. Cost of finance is one of the most effective factors used in designing an optimal capital structure of a company. While designing a capital structure, the company considers maximizing the value of the firm and minimizing cost of finance. By comparing the costs of different sources of capital, the managers can choose the least expensive methods and design an optimal capital structure.

Evaluating Financial Performance

Companies can use the cost of finance or cost of capital concept to evaluate the performance of various investment projects. This includes comparing profits and costs of particular projects. The importance of cost of finance is that it allows the company to calculate its financial performance in terms of profits and costs.

Creating Debt Policy

Another importance of cost of finance is to create a debt policy. Firms consider the cost of finance to create the right debt policy which ensures that the company has the right leverage. Excess debts may cause harm to shareholders’ wealth. The cost of capital is also used to determine the right proportion of debt and equity for the company.

Choosing the Method of Investment

Financing costs can also be used to compare different methods of raising finance. Its importance in financial management is to develop a criteria for analyzing various projects and help managers to determine the best alternative among various investments. For example, the costs of leasing and borrowing can be compared to choose one of the two methods which incurs less costs than the other.

Performance Appraisal

Another important use of cost of capital is to carry out performance appraisal – evaluating the performance of top managers. In this case, the appraisal of actual costs is carried out and compared to profitability. If the company has more profits than costs from financing, then the managers have made the best choices.

Dividend Decisions

Another importance of cost of capital is to make decisions regarding dividend payments. Firms create dividend policy based on the returns and costs of their investments. A company that incurs high costs of finance may have little profits to pay as dividends.

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