Why is cost of capital important?

Cost of capital is crucial because it represents the return rate that investors expect as compensation for the risk they undertake when providing capital to a company. This concept is foundational in financial management as it serves as a benchmark for evaluating investment opportunities. When a company seeks to finance a project or overall operations, it must consider whether the expected returns from that investment will exceed the cost of funds required to finance it. If the return does not exceed the cost of capital, the investment may not be viable, potentially leading to a loss of value for shareholders.

Understanding cost of capital helps management make informed decisions about capital budgeting, capital structure, and overall financial strategy, ensuring that resources are allocated efficiently to maximize shareholder value. It plays a vital role in guiding companies to pursue projects that are likely to enhance profitability and support sustainable growth.