Question

Please write at least three well composed paragraphs that discuss the connection between capital budgeting decisions and the enterprise’s cost of capital. Would an enterprise ever decide to embark on a project whose rate of return would be less than its cost of capital? Why or why not?

Answer 1

Capital budgeting decisions are decisions that a company needs to take when it has to choose between investing in a few avaialble projects and to evaluate if a project is profitable enought to invest its capital. Many projects may be profitable to invest in, but it has to beat the cost of raising that capital being invested. Capital can be raised through either debt or equity and both comes with a cost. Cost of debt is the interest paid on the debt availed and cost of equity is the return on equity that the equity investors expect from the company. And, the enterprise's cost of capital is the weighted average cost of capital considering both the cost of debt and equity.

Capital budgeting decisions involve calculating Net present value (NPV), which is the present value of all the inflow from the new project, net of present value of all the outflow related to the project. A positive NPV suggests investing in the project. Similary several measures like internal rate of return are used to decide whether to invest in a project or not. And it is very important to compare the returns from the project against the enterprise's cost of capital. The rate of return of the project should exceed the enterprise's cost of capital.

An enterprise would never embark on a project whose rate of return would be less than its cost of capital, because the income from the project will not be even sufficient to pay the debt holders and equity holders who funded this project. Thus no additional value is created for the company from the project, and insteat its value gets eroded since it has to pay the debt and equity holders who funded the project, using income or funds from sources other the project.