Financial Management

Topics: Finance, Corporate finance, Cash flow Pages: 10 (2540 words) Published: June 25, 2013
Answer Sheet:

1. What is the importance of cost of capital in Financial Decisions? Explain. The term “cost of capital” is defined as a the rate of return on investment projects nesscery to have unchanged market price of a firm’s share. It may be the rate at which funds can be borrowed on new equity capital or, it may be the rate at which futher cash flows are discounted to measure its present values. The cost of Capital of a firm is the weighted average of the cost of the various sources of finance that have been used by it. The cost of capital to a firm is the minimum rate of return that it must earn on its investments in order to satisfy the various catagories of investors who have made investments in the form of shares, debentures or term loans. Unless they company earns this minimum rate, the investors will be tempted to pull of the company. The optimum cost of capital is the financial break-even point. It represents a minimum rate of return. If the risk is involved, the minimum rate of returns should be higher in order to cover the business risk as well as the financial risk. Importance of cost of capital in Financial Decision refers to the concept of cost of capital is a very important concept in financial management decision making. The concept, is however, a recent development and has relevance in almost every financial decision making but prior to that development, the problem was ignored or by-passed. The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions. That are:

• Capital Budgeting Decision

• Designing the Corporate Financial Structure

• Deciding about the Method of Financing

• Performance of Top Management

• Other Areas

➢ Capital Budgeting Decision:- Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability of all investment opportunities. 

➢ Designing the Corporate Financial Structure:- The cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimise the cost of capital so as to increase the market price and the earning per share. 

➢ Deciding about the Method of Financing:-  A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may ave a better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk. 

➢ Performance of Top Management:- The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitabilities of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. 

➢ Other Areas:- The concept of cost of capital is also important in many others areas of decision making, such as dividend decisions,...
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