7.1 SIGNIFICANCE OF COST OF CAPITAL
The concept of the cost of capital is significant not only for capital budgeting. It is also indispensable in other areas of financial management. In the context of capital budgeting, cost of capital forms the basis of the discount rate, that is, the rate at which future cash flows are discounted (brought down) to the present value for comparison with the initial investment and for arriving at the net present value (NPV). It is the cost of capital with which the internal rate of return (irr) is compared. A project adds to the corporate wealth if it has a positive npv, or if the irr exceeds the cost of capital.
The concept of the cost of capital is also used for designing the firm’s capital structure. Debt and ...
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