8.4 Applying Cost of Capital in Decision Making

Cost of capital plays a crucial role in capital budgeting and project valuation. It sets the minimum required return for investments, helping companies decide which projects to pursue. By comparing a project's expected returns to the cost of capital, firms can determine if it will create or destroy shareholder value.

Changes in cost of capital significantly impact investment decisions. A higher cost of capital makes fewer projects viable, while a lower cost opens up more opportunities. Companies must regularly update their cost of capital to ensure investment choices align with current market conditions and shareholder expectations.

Capital Budgeting and Project Valuation

Role of cost of capital

• Represents minimum required rate of return for company's investments
  • Reflects riskiness of company's cash flows and opportunity cost of investing in project (bonds, stocks)
• Serves as benchmark to evaluate profitability and feasibility of investment projects
  • Projects with returns exceeding cost of capital create value for shareholders (positive NPV)
  • Projects with returns below cost of capital destroy shareholder value (negative NPV)
• Helps allocate limited financial resources to most promising investment opportunities
  • Ensures company invests in projects that generate sufficient returns to compensate investors for risk they bear (risk-return tradeoff)

Cost of capital for NPV

• Net present value (NPV) is sum of project's discounted future cash flows minus initial investment
  • NPV formula: $NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} - Initial Investment$
    • $CF_t$: Cash flow at time $t$ (revenue, expenses)
    • $r$: Discount rate (cost of capital)
    • $n$: Project's life span (years)
• Discounting future cash flows using cost of capital accounts for time value of money and project's riskiness
  • Time value of money: $1 today is worth more than $1 in future due to earning potential (interest, investments)
  • Riskiness: Higher risk projects require higher returns to compensate investors (startup vs established company)
• Positive NPV indicates project generates returns above cost of capital, creating value for company
  • Example: NPV of $100,000 means project is expected to increase company's value by $100,000
• Negative NPV suggests project's returns are insufficient to compensate for risk, destroying value
  • Example: NPV of -$50,000 means project is expected to decrease company's value by $50,000

Cost of capital as hurdle rate

• Hurdle rate is minimum acceptable rate of return for investment project
  • Often set equal to company's cost of capital (WACC)
• Compare project's internal rate of return (IRR) to hurdle rate to assess profitability
  • IRR is discount rate that sets project's NPV equal to zero (breakeven point)
  • If IRR > Hurdle rate, project is expected to create value and should be accepted
    • Example: IRR of 15% vs hurdle rate of 10% means project generates returns above required rate
  • If IRR < Hurdle rate, project is not expected to generate sufficient returns and should be rejected
    • Example: IRR of 8% vs hurdle rate of 12% means project fails to meet minimum required return
• Using cost of capital as hurdle rate ensures company only invests in projects that meet or exceed its required rate of return
  • Aligns investment decisions with shareholders' expectations (maximizing shareholder value)

Impact of Cost of Capital Changes on Investment Decisions

Impact of cost of capital changes

• Increase in cost of capital leads to higher discount rate, reducing present value of future cash flows
  1. Reassess investment decisions and prioritize projects with higher returns
  2. Some projects that were previously viable may become unprofitable due to higher required rate of return
     • Example: Project with IRR of 12% becomes unviable if cost of capital increases from 10% to 14%
• Decrease in cost of capital results in lower discount rate, increasing present value of future cash flows
  1. Projects that were previously rejected may become viable as required rate of return decreases
     • Example: Project with IRR of 9% becomes viable if cost of capital decreases from 11% to 8%
  2. Company may have opportunity to invest in broader range of projects and expand investment portfolio
• Changes in cost of capital can be caused by various factors
  • Shifts in market interest rates (Federal Reserve monetary policy)
  • Changes in company's capital structure (debt-to-equity ratio)
  • Variations in perceived riskiness of company or its industry (economic conditions, competition)
• Regularly reviewing and updating cost of capital is crucial for making informed investment decisions and adapting to changing market conditions
  • Ensures investment decisions align with current financial realities and shareholder expectations