Business Management ABCs

The Cost of Capital

The opportunity cost or simply, the cost of capital for a project is the discount rate for discounting its cash flows. The projects capital cost is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. Since the investment projects undertaken by a firm may differ in risk, each one of them will have its own one unique cost. It should be clear at the outset that the capital cost for a project is defined by its risk, rather than the characteristics of the firm undertaking the project.

The firm represents the aggregate of investment projects undertaken by it. Therefore, the firms cost will be the overall, or average, required rate of return on the aggregate of investment projects. Thus the firms capital cost is not the same thing as the projects cost of capital. Can we use the firms cost of capital for discounting the cash flows of an investment projects? The firms cost can be used for discounting the cash flows of those investment projects, which have risk equivalent to the average risk of the firm.

As a first step, however, the firms cost can be used as a standard for establishing the required rates of return of the individual investment projects. In the absence of a reliable formal procedure of calculating the capital cost for projects, the firms cost can be adjusted upward or downward to account for risk differentials of investment projects. That is, an investment projects required rate of return may be equal to the firms cost of capital plus or minus a risk adjustment factor depending on whether projects risk is higher or lower than the firms risk. There are does exit a methodology to calculate the cost of capital for projects. The objective method of calculating the risk-adjusted cost of capital for projects is to use the capital asset pricing model.

Varying Opportunity Cost of Capital

Evaluation investments we have made a simple assumption that the opportunity cost of capital remains consistent over times. This may not be true in reality. If the capital cost varies over time, the use of the internal rate of return rule creates problems, as there is not a unique benchmark opportunity cost to compare with internal rate of return.

There is no problem in using net present value method when the it is various over time. Each cash flow can be discounted by the relevant opportunity cost. It is clear that for each period there is a different cost of capital. With which of the several opportunity costs do we compare the internal rate of return to accept or reject an investment project? We cannot compare internal rate of return with any of these costs. To get a comparable opportunity cost of capital, we will have to, in fact, compute a weighted average of these opportunity costs, which is a tedious job. It is, however, much easier to calculate the net present value with several opportunity costs.

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