Question

PLEASE RESPOND IN 200 WORDS THANK YOU.

How can the cost of capital be used as a discount rate in analyzing investments?

Answer 1

Cost of capital is the interest rate calculated to know the total cost of capital for the firm. Cost of capital is comprised of debt and equity cost and it is also known as WACC or Weighted Average Cost of Capital.

Whenever a firm takes a project it tries to ascertain the cash flows of the firm and then works out the cost of the capital of the firm to understand the cost of running that project. As any project requires an investment and that investment either comes from equity or by debt and in either case cost of capital is applied. Both equity and debt carry its own cost hence it broadly defines the cost of capital for a firm.

The cost of capital is then used for discounting the expected cash flows of the firm to derive certain conclusion on Net Present Value (NPV) and Internal Rate of Return (IRR).

The formula for discounting cash flows:

Let > CFn = Cash flow at N^th Period

“CFn / (1+Cost of Capital rate)^Period”

Cost of capital helps a finance manager to determine the level at which it can accept the project or reject the project. If the interest rate of cost of the capital is more than expected return from project (IRR) then decision rule is to “reject the project”. If the interest cost of capital is less than the IRR then decision rule is to “accept the project”.

Weight Average Cost of Capital (WACC): WACC represents Weighted Average Cost of Capital. In nutshell WACC helps us to reach to the composite cost of capital of the firm.

WACC = w_dr_d (1 – T) + w_s r_s (New notation; T = Tax rate, w_{d =} Size of debt or weight of debt, w_s = Weight of common equity. Debt is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here. Cost of debt (r_d); Cost of common stock (r_s).