8.4 Applying Cost of Capital in Decision Making
4 min read•july 18, 2024
plays a crucial role in and . It sets the minimum required return for investments, helping companies decide which projects to pursue. By comparing a project's expected returns to the , firms can determine if it will create or destroy .
Changes in cost of capital significantly impact investment decisions. A higher cost of capital makes fewer projects viable, while a lower cost opens up more opportunities. Companies must regularly update their cost of capital to ensure investment choices align with current market conditions and shareholder expectations.
Capital Budgeting and Project Valuation
Role of cost of capital
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- Represents for company's investments
- Reflects of company's cash flows and opportunity cost of investing in project (bonds, stocks)
- Serves as benchmark to evaluate profitability and feasibility of investment projects
- Projects with returns exceeding cost of capital create value for shareholders ()
- Projects with returns below cost of capital destroy shareholder value ()
- Helps allocate limited to most promising investment opportunities
- Ensures company invests in projects that generate sufficient returns to compensate investors for risk they bear ()
Cost of capital for NPV
- (NPV) is sum of project's discounted future cash flows minus initial investment
- :
- : Cash flow at time (revenue, expenses)
- : (cost of capital)
- : Project's life span (years)
- :
- Discounting future cash flows using cost of capital accounts for and project's riskiness
- Time value of money: 1 in future due to earning potential (interest, investments)
- Riskiness: Higher risk projects require higher returns to compensate investors (startup vs established company)
- Positive NPV indicates project generates returns above cost of capital, creating value for company
- Example: NPV of 100,000
- Negative NPV suggests project's returns are insufficient to compensate for risk, destroying value
- Example: NPV of -50,000
Cost of capital as hurdle rate
- is minimum acceptable rate of return for investment project
- Often set equal to company's cost of capital (WACC)
- Compare project's internal rate of return () to hurdle rate to assess profitability
- IRR is discount rate that sets project's NPV equal to zero (breakeven point)
- If IRR > Hurdle rate, project is expected to create value and should be accepted
- Example: IRR of 15% vs hurdle rate of 10% means project generates returns above required rate
- If IRR < Hurdle rate, project is not expected to generate sufficient returns and should be rejected
- Example: IRR of 8% vs hurdle rate of 12% means project fails to meet minimum required return
- Using cost of capital as hurdle rate ensures company only invests in projects that meet or exceed its required rate of return
- Aligns investment decisions with shareholders' expectations (maximizing shareholder value)
Impact of Cost of Capital Changes on Investment Decisions
Impact of cost of capital changes
- Increase in cost of capital leads to higher discount rate, reducing present value of future cash flows
- Reassess investment decisions and prioritize projects with higher returns
- Some projects that were previously viable may become unprofitable due to higher required rate of return
- Example: Project with IRR of 12% becomes unviable if cost of capital increases from 10% to 14%
- Decrease in cost of capital results in lower discount rate, increasing present value of future cash flows
- Projects that were previously rejected may become viable as required rate of return decreases
- Example: Project with IRR of 9% becomes viable if cost of capital decreases from 11% to 8%
- Company may have opportunity to invest in broader range of projects and expand investment portfolio
- Projects that were previously rejected may become viable as required rate of return decreases
- Changes in cost of capital can be caused by various factors
- Shifts in (Federal Reserve monetary policy)
- Changes in company's capital structure (debt-to-equity ratio)
- Variations in perceived riskiness of company or its industry (economic conditions, competition)
- Regularly reviewing and updating cost of capital is crucial for making informed investment decisions and adapting to changing market conditions
- Ensures investment decisions align with current financial realities and shareholder expectations
Key Terms to Review (20)
Capital Budgeting: Capital budgeting is the process of planning and evaluating long-term investments in assets and projects to determine their potential profitability and feasibility. This process is essential for financial management as it aligns investment decisions with the company’s strategic goals, taking into account the time value of money, risk, and cost of capital to optimize resource allocation.
Cost of capital: Cost of capital refers to the minimum return that a company must earn on its investments to satisfy its investors or lenders. It acts as a benchmark for evaluating the profitability of new projects, influencing investment decisions and capital structure, as it affects the overall risk and return profile of the firm.
Cost of Capital: Cost of capital refers to the return a company needs to generate in order to satisfy its investors or creditors. This concept is crucial because it serves as a benchmark for evaluating the profitability of investment projects, directly influencing decisions related to financial markets, capital budgeting, capital structure, and risk management.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It plays a crucial role in financial decision-making, affecting how investments, loans, and other financial assets are evaluated by considering the time value of money.
Financial resources: Financial resources refer to the funds that individuals, businesses, and organizations can use to invest in assets, pay for operations, or finance growth. These resources can include cash, stocks, bonds, credit lines, and any other form of capital that can be mobilized for economic activities. The efficient allocation and management of financial resources are crucial for making informed investment decisions and maximizing returns.
Hurdle rate: The hurdle rate is the minimum required rate of return on an investment, which a project or investment must achieve for it to be considered acceptable. This rate is crucial because it helps in evaluating investment opportunities, as it acts as a benchmark for making decisions about whether to pursue a project. A hurdle rate typically reflects the cost of capital and the risk associated with the investment, linking it directly to concepts such as net present value and internal rate of return.
IRR: IRR, or Internal Rate of Return, is a financial metric used to evaluate the profitability of potential investments or projects by calculating the discount rate that makes the net present value (NPV) of cash flows equal to zero. This means that IRR represents the expected annual rate of growth an investment is projected to generate. It is often compared to the weighted average cost of capital (WACC) to determine if a project is worth pursuing, as a project with an IRR higher than WACC indicates that it may create value for the firm.
Market Interest Rates: Market interest rates refer to the rates of interest on loans or investments that are determined by supply and demand in the financial markets, rather than being set by a central authority. These rates fluctuate based on various factors, including economic conditions, inflation expectations, and monetary policy. Understanding market interest rates is crucial for assessing the cost of borrowing and making informed investment decisions.
Minimum Required Rate of Return: The minimum required rate of return is the lowest return an investor expects to earn from an investment, given its risk level. This rate serves as a benchmark for evaluating the attractiveness of investment opportunities and is crucial in decision-making processes involving capital budgeting and project selection, as it helps ensure that investments will yield returns that compensate for their risk.
Negative NPV: Negative NPV, or negative net present value, occurs when the present value of cash outflows exceeds the present value of cash inflows for an investment or project. This situation signals that a project's anticipated returns are not sufficient to justify the initial investment when considering the cost of capital, indicating that the investment may lead to a loss rather than a gain.
Net Present Value: Net Present Value (NPV) is a financial metric that calculates the difference between the present value of cash inflows and outflows over a specific period. It helps in evaluating the profitability of an investment by considering the time value of money, which means that money available now is worth more than the same amount in the future due to its potential earning capacity.
Npv formula: The net present value (NPV) formula is a financial calculation used to determine the value of an investment by considering the present value of its expected cash inflows and outflows over time. It helps investors assess whether an investment will generate more value than its cost by discounting future cash flows to their present values, using a specific discount rate. The NPV is crucial in evaluating investment decisions, as it informs whether to proceed with a project based on its profitability and alignment with the cost of capital.
Optimal Capital Structure: Optimal capital structure refers to the ideal mix of debt and equity financing that minimizes the overall cost of capital while maximizing a company's market value. Achieving this balance is crucial for firms as it impacts their weighted average cost of capital, investment decisions, and financial stability, influencing how they manage risk and leverage in practice.
Positive NPV: Positive NPV, or Net Present Value, occurs when the present value of cash inflows from an investment exceeds the present value of cash outflows. This indicates that the investment is expected to generate more value than it costs, making it a financially viable choice. A positive NPV is crucial for decision-making as it suggests that the project will add wealth to the firm and is likely worth pursuing, given that it surpasses the cost of capital.
Project Valuation: Project valuation is the process of determining the worth or potential profitability of a specific investment project, often through techniques that assess the expected cash flows and risks associated with that project. This assessment plays a critical role in decision-making by helping to identify whether an investment will generate a return that meets or exceeds the cost of capital. Understanding project valuation also involves applying concepts like present value and discounting, which allow for a more accurate estimation of future cash flows in today's dollars, as well as recognizing how the cost of capital influences the acceptance or rejection of projects.
Risk-return tradeoff: The risk-return tradeoff is a financial principle that suggests the potential return on an investment increases with an increase in risk. Investors must balance the desire for the highest return against the potential for loss, leading them to seek investments that align with their risk tolerance and return expectations.
Riskiness: Riskiness refers to the potential for financial loss or the uncertainty associated with an investment or decision. In finance, it plays a critical role in determining the cost of capital, as higher risk typically demands a higher return to compensate investors for taking on that uncertainty. Understanding riskiness helps in making informed decisions regarding investments, financing, and project evaluations.
Shareholder value: Shareholder value refers to the financial worth that a company's shareholders derive from their ownership in the firm, often measured by the stock price and dividends paid. It reflects the company's performance and profitability, and ultimately serves as a key goal for management, as enhancing shareholder value typically leads to greater investments and business growth. Decisions that improve shareholder value can include cost management, strategic investments, and optimizing the capital structure.
Time Value of Money: The time value of money is the financial principle that a sum of money has greater value today than it will in the future due to its potential earning capacity. This concept highlights the importance of understanding how money can grow over time through investments, interest rates, and inflation, influencing various financial decisions and evaluations.
Viable projects: Viable projects are initiatives that are deemed feasible and capable of generating a positive return on investment, often evaluated against the cost of capital. These projects typically align with an organization's strategic objectives and have the potential to deliver economic value over time. Assessing the viability of a project involves analyzing its expected cash flows, risks, and overall impact on the company's financial health.