While evaluating the profitability of venture capital investment proposals under the capital budgeting techniques such as Net Present Value (NPV) and Internal Rate of return are used. It should be noted here that these sophisticated methods use the “cost of capital” as the criterion to accept or reject an investment proposal.
Under the NPV method, the cost of capital is used to discount the future cash flows, whereas under the Internal Rate of return method, the cost of capital is compared with the calculated Internal rate of return in order to determine the efficacy of the capital investment proposals.
The minimum required rate of return that a firm must earn on its investments in order to keep the present wealth of the shareholders unchanged or keep the market value of the firm’s equity shares is referred to as “cost of capital”. In the context of evaluating the investment projects, cost of capital refers to the discount rate used for evaluating the desirability of the investment proposals.
Cost of capital plays a crucial role in the sphere of capital budgeting decisions. It serves as an important basis for financial appraisal of new capital investment proposals. For instance, the cost of capital is compared with the discounted rate of return to determine whether the proposed project satisfies one of the minimum acceptable standards. The expected rate of returns on a project must be greater than the cost of capital.
If the cost of capital of a firm is known, it is possible to make a fair estimation of the amount of risks that is involved in the company’s investment projects. For instance, if a firm were required to pay more than the market rate of interest in order to procure funds from the investors, this would show investors that the earnings rate of the firm is moderate or less and that the firm has limited opportunities to develop in future.
