Question

3. What is Cost of Capital? What is its significance? How do you compute it?

Answer 1

Cost of capital refers to the cost of funds used in the business. There are various sources of funds namely equity and debt. These are used in various proportions and have different costs associated with them. Cost of capital is calculated as the weighted average cost of these different sources of funds used.

The computation of cost of capital is important because it enables the business to compare the returns with the cost associated. For instance in case of the new capital project, the project is profitable only if the returns are greater than the cost of capital. Accordingly choices of projects are made.