Question

"By applying capital investments with long - term benefits, the company is attempting to produce value. This value is dependent on expected future cash flows as well s on the cost of funds". Explain this statement with regards to the role of cost of capital in financial management decisions. The subject is financial management

Answer 1

Long term investment proposals are accepted if, they would result in positive net present value and positive net present value represents the absolute addition to owners' wealth, if the project is undertaken.

Positive net present value is the excess of PV of expected cash inflows over the present value of the cash outflows. To find these present values the appropriate discount rate is the cost of capital [WACC] of the firm.

When positive NPV results, after discounting the cash flows with the WACC, it means that:

1] the contracted return to the debt suppliers and the normal return to the equity suppliers have been fully met,

2] the capital [principal amount] supplied by them has been repaid, and

3] a surplus remains [the NPV], which will go to the owners [shareholders].

Thus, the overall cost of capital [WACC] is a critical variable in capital budgeting analysis. The WACC should be so determined that it reflects the return payable to the investors ane the risk associated with the cash flows.