Microlesson · 5-min read

Significance of Cost of Capital

## Significance of Cost of Capital

The cost of capital is the benchmark rate used across major financial decisions. It helps management in three principal areas.

### 1. Evaluating investment options (Capital Budgeting)

Future cash flows are discounted using the appropriate cost of capital to find their present value. Because different projects may carry different costs of capital, the relevant rate for each project must be used.

### 2. Financing decisions

When choosing among financing options, managers compare their costs to select the most cost-effective one — while also weighing financial risk and control.

### 3. Designing credit policy

The cost of extending credit to customers is weighed against its benefits. The cost of capital is used to find the present value of both the costs and the benefits of a proposed credit policy.

Worked example

### Example 1

Using cost of capital as a hurdle rate: A project's cash flows are discounted at the firm's cost of capital (say 12%). If the NPV at 12% is positive, the project earns more than the cost of funds and should be accepted; a negative NPV means it should be rejected.

⚠️ Common exam mistakes

Applying a single firm-wide cost of capital to every project regardless of differing project risk.
Ignoring financial risk and control implications when comparing financing options purely on cost.
Overlooking that credit-policy benefits and costs must both be brought to present value using the cost of capital.

Reference:

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