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The importance & significance of the concept of cost of capital can be stated in term of the contribution it makes towards the achievement of the objective of maximization of the wealth of the shareholders. If a firm’s actual rate of return exceeds its cost of capital and if this return is earned without of course, increasing the risk characteristics of the firm, then the wealth maximization goal will be achieved. The reason is obvious. If the firm’s return is more than its cost of capital, then the investors will no doubt be receiving their expected rate of return from the firm. The excess portion of the return will however be available to the firm and can be used in several ways e.g.

i)    For distribution among the shareholders in the form of higher than expected dividends
ii)    For reinvestment within the firm for increasing further the subsequent returns.

In both cases, the market of the share of the firm will tend to increase and consequently will result in increase in the shareholders wealth.
Moreover, the cost of capital when used as a discount rate in capital budgeting, helps accepting only those proposals whose rate of return is more than the cost of capital of the firm and hence results in increasing the value of the firm. Similarly, the firm’s value is reduced when the rate of return of the proposal falls below the cost of capital. Thus, the concept of cost of capital is consistent with the goal of maximization of shareholders wealth and it works as a tool to achieve this goal. It may be noted that in order to maximize the value of the firm, the cost of all the different sources of the funds must be minimized. The cost of capital of different sources usually varied and the firm will like to have a combination of these sources in such a way so as to minimize the overall cost of capital of the firm.        

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