Explain the meaning of the term “cost of capital” and explain why a company should calculate its cost of capital with care.

CPA-Financial-Management-Section-3 Revision kit

Cost of capital
• This is the rate used to discount the future cash flows of a business, to determine the value of the firm. The cost of capital can be viewed as the minimum return required by investors and should be used when evaluating investment proposals.
• In order to maximize the wealth of shareholders, the basic decision rule is that if cash flows relating to an investment proposal are negative, the proposal should be rejected. However, if the discounted cash flows are positive, the proposal should be accepted. The discounting is carried out using the firm‟s cost of capital.

Why cost capital should be calculated with care:
• Failure to calculate the cost of capital correctly can in incorrect investment decisions being made.
• Where the cost of capital is understated, investment proposals which should be rejected may be accepted.
• Similarly, where the cost of capital is overstated, investment proposals may be rejected which should be accepted. In both cases, the shareholders would suffer a loss.

Note There is an inverse relationship between N.P.V. and cost of capital. The higher the cost of capital, the lower the N.P.V. and vice versa.

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