TechWave Ltd. plans to buy new machinery worth 50 lakh to increase production. The Finance Manager says that before investing, the company must…

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the debt-holders) to the business as a compensation for their contribution to the total capital. The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision making: (i) Evaluation of investment options: The estimated benefits (future cash flows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. (ii) Financing Decision: When a finance manager has to choose one of the two sources of finance, he can simply compare their cost and choose the source which has lower cost. Besides cost, he also considers financial risk and control. (iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/ profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.