Question

600 - 800 words

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? Explain in details with examples.

Answer 1

Answer :

Connection between Capital Budgeting Decisions and Enterprise's Cost of Capital :

Capital Budgeting Decision :

Company does Capital Budgeting when they are about to undertake any Project on Long term Basis.

So, Capital Budgeting decisions are taken to evaluate wheter it will be profitable for the company to invest in such a project . So, Company evaluate bycalculating the Future Cash Flows and Outflows and thus Calculate the Net Present Value.

NET PRESENT VALUE (NPV)

Net Present Value(NPV)= Present Value Of Cash Inflows - Present Value Of Cash Outflows

Accept/Reject Criterion :
NPV > 0 Accept the proposal ;
NPV = 0 Indifference point ;
NPV < 0 Reject the proposal

So, there are other evaluation technique also like Payback Analyses, Throughput Analysis but this NPV analysis also known as Discounted Cash Flow Analysis is widely used .

For Discounting , Risk Free Rate is used because it is expected that the project must earn at this rate of return.

Now, Capital Budgeting Decisions are important due to following reasons :

1. Such Decisions have Long Term Implication on the Financial Performance of the Company .

2. Huge amount of money is invested

3. These Decisions are irreversible. (that means careful analysis of Project is to be done).

Now, Capital Structure of a company reflcts the bifurcation of its capital into Equity and Debt .

So, Whether its Equity or Debt Financing both Expect certain Required Rate of Return and Total of their Rate of Return is known as Cost of Capital .

Cost of Capital :

Ko = Cost Of Equity * Weight Of Equity + Cost Of Debt * Weight Of Debt
  =   Ke * We + Kd * Wd
Where ,

Ko = Overall Cost of Capital of the company

Ke = Rate of Return expected by Equity Shareholders

and Ke = Risk Free Rate + Equity Beta ( Market Return * Risk Free Rate )

Kd = Rate of Return desired for the Debt financed

And Weights is assigned on the basis of How much Capital comprises Equity and debt.

Noe, Cost of Capital is the Minimum Rate of Return Company must Earn in order to choose a project .

Return less than cost of capital would not be choosen because company is not able to meet or cover the cost of financing .

So, infact company must try to earn rate of return which is more than the Cost of Capital (which is the minimum rate to be earned ) beacuse higher rate of return will help in creating value for the company.

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?

So, as discussed above Cost of capital is the minimum rate of return of a company beased on its capital structure which is required to be earn .

So,an enetrprise would never wish to embark a project whose rate of return is less than the required cost of capital.

Conclusion : For a Project to be economically feasible , the profit or arte of return is even expected to exceed the Weighted Average Cost of Capital (In short , Cost of Capital of Company).

Example :

We are analysing a Project P , Assuming Cost of Capital @ 12%, and Intial Investment of $ 1,00,000 .

Future Cash Inflow will be $ 30,000 from Year 1-5.

Npv is as Calculated below :

Year	Cash Flow	Cost of Capital @ 12%	PV
0	(1,00,000)	1	(1,00,000)
1-5	30,000	3.605	1,08,150
		NPV	8,150

So, NPV of Project P is +ve , so, Company must invest its capital intio this Project .

But the Cost of Capital is 12 % , any rate below this rate of 12% would impact the Market position of the Company as it is below the desired minimum rate of Return by its Equity Financers and Debt financers.

As a resuly, they will take out their investment from the company and will choose other options.

So, A company must Invest in the Project which has Positive NPV and also has equal or more rate of return as of cost of capital .

Note : It is Assumed that risk free return rate is also equal to 12%.