Cost of capital is the rate of return that the equity and debt holders demand ag
ID: 2462050 • Letter: C
Question
Cost of capital is the rate of return that the equity and debt holders demand against the funds they have supplied to the company. It is the minimum return that a company must earn on its existing asset base to satisfy creditors, owners, and other providers of finance. Consider the aspects of cost of capital and respond to the following: How does the cost of capital serve as a screening tool when using the net present value (NPV) method? How does the cost of capital serve as a screening tool when using the internal rate of return (IRR) method?
Explanation / Answer
First let us understand each of the terms Cost of Capital, Net Present value (NPV) and Internal Rate of Return (IRR)
Cost of Capital – it is the cost or rate of interest for accumulating funds through debt or equity for financing an investment. In simple words, it is the interest that will be required to pay for acquiring a loan or capital for the purpose of an investment.
Net Present Value (NPV) – Every project will have a useful life and the cash flow may differ in each year after the initial investment is made. The time value of the cash flow in Year 1 will not be same as cash flow in the later years. So the cash flows need to be discounted at an interest rate to arrive at net present value. Even the cash flows are even throughout the project because of the time value of money, net present value in each year will differ.
Internal Rate of Return (IRR) – It is a rate of return at which NPV of a project will be Zero. For calculating NPV we will know the interest rate at which the cash flows will be deducted. But in the case of IRR, it is an expected rate at which total NPV of the cash flows of a project will become zero.
A Company should select a project, where NPV of the project is more than zero. If the NPV is zero or less than zero it means the project is not profitable or feasible. As discussed above, Cost of capital is an interest rate applicable for an investment. So, when we discount the NPV of the project at cost of capital and if it results in zero or negative NPV, then that project is not feasible and should be rejected. To put it simple,
If NPV <= 0, then that project should be rejected.
Higher the interest rate, lower the NPV. So it is better to have interest rate of a project be less than the cost of capital.
As explained above, IRR is the rate at which the NPV of the project becomes zero. That is the minimum rate required to make the project a breakeven. It may be simple and straight forward, but if decision is taken based upon IRR, it may result in investing in projects with higher cost of capital. However, If IRR is less than the Cost of Capital; NPV will be less than zero. So project should be rejected. If IRR is greater than cost of capital, then NPV will be more than zero and the project will be acceptable.
In any case, screening a project in comparing Cost of Capital with NPV or IRR is not full and final. Further screening of the factors that would affect the project needs to be done before deciding to go with a project or not.