What is the relationship between cost of capital and investment decisions?

The relationship between cost of capital and investment decisions is crucial for effective financial management. A higher cost of capital represents the rate of return required by investors to compensate for the risk of the investment. When the cost of capital is high, it sets a benchmark for the minimum return that any potential investment must generate to be deemed acceptable or worthwhile.

Choosing to invest in projects or assets that are expected to yield returns below this higher cost would result in value destruction for the firm. Therefore, if anticipated returns from an investment do not meet or exceed the cost of capital, it can deter management from proceeding with that investment. This principle is fundamental in capital budgeting, where decision-makers assess the viability of projects based on whether they can generate returns sufficient to cover their capital costs.

This understanding underscores why the higher cost of capital can serve as a significant barrier to undertaking new investments, thereby influencing the company's growth and expansion strategies.

In contrast, other options suggest alternative scenarios that do not accurately reflect this relationship, particularly how cost of capital functions as a critical threshold for making investment decisions.