Question

Investments require a large amount of initial capital expenditure and involves many uncertainties. This requires firms to carefully consider and critically evaluate the investment opportunities using many techniques including the net present value.

Critically discuss the factors must be taken into consideration in determining the discount rate used in NPV for the investment decisions. Provide examples in your answer.

Answer 1

Non-corpoarate or individual investors normally consider their opportunity cost of capital when determining the appropriate discount rate.Opportunity cost is the rate of return the investor could earn on an investment of comparable size and risk.

For example:if you have $100,000 to invest,what are all of your available investment alternatives with similar risk profiles?whatever the yield is on all of these alternatives opportunities is the appropriate discount rate.In other word,for the individual investor,the discount rate is simply the individual investor's required rate of return.

Corporations often use the Weighted average cost of capital when selecting a discount rate.Company's aaets are broadly financed by either debt or equity.

The WACC is weighted average cost of each of these source of financing.It is also a hurdle rate because for an enterprise to be profitable it has to earn a return greaater than the cost of capital.

Beside the cost of each source of financing corporation also consider the risk associated with the investment project and consequently adjust the discount rate.

For example:Suppose a project is financed with 80% equity and 20% debt.The cost of equity financing is 10% and after tax cost of debt financing is 8%.The WACC for the company is calculated as follows:

=After tax Cost of debt*weight of debt+cost of equity+weight of equity

=8%*.20+10%*0.80

=9.6%

Further corporation cosider 2% extra for rsik associated with the project,then discount rate for the project will be 11.6%(9.6+2).