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Project Management

Notes capital would be more or less the same as its current cash, capital. On the other hand, if the
riskiness of its proposed investments is likely to be different from the riskiness of its
existing investments, its marginal cost of capital should reflect the riskiness of the proposed
investments.
2. Capital Structure Policy: To calculate the WACC we assumed a given target capital,
structure. Of course, a firm can change its capital structure and such a change is to affect the
cost of capital because the post tax cost of debt is lower than the cost equity and equity
beta, an input for calculating the cost of equity, is a function of financial leverage.
3. Dividend Policy: The dividend policy of a firm may affect its cost of equity.

9.5.5 Misconception Surrounding Cost of Capital

The cost of capital is a central concept in financial management linking the investment and
financing decisions. Hence, it should be calculated correctly and used properly in investment
evaluation. Despite this injunction, we find that several errors characterize the application of
this concept. The more common misconceptions, along with suggestions to overcome them, are
discussed here.

1. The concept of cost of capital is too academic or impractical: Some companies do not
calculate the cost of capital because they regard it as ‘academic’, ‘impractical’, ‘irrelevant’,
or ‘imprecise.’ These misgivings about cost of capital appear to be unjustified. Such
reservation can be dispelled by emphasizing the following points:
The cost of capital is an essential ingredient of discounted cash flow analysis. Since
discounted cash flow analysis is now widely used, cost of capital can scarcely be considered
‘academic’ or ‘impractical’.

Out of the various inputs required for discounted cash flow analysis, viz. project life,
project cash flows (consisting of initial investment, operating cash flows, and terminal
cash flow) and cost of capital, the last one, viz. the cost of capital can perhaps be calculated
most reliably and accurately. So a concern about its imprecision seems to be misplaced.
2. Current liabilities (accounts payable and provisions) are considered as capital components:
Sometimes it is argued that accounts payable and accruals are sources of funding to be
considered in the calculation of the WACC. This view is not correct because what is not
provided by investors is not capital.
Current liabilities arise on account of an operating relationship of the firm with its suppliers
and employees. They are deducted when the investment requirement of the project is
determined. Hence, they should not be considered in calculating the WACC. Of course,
current liabilities are not ignored in capital budgeting because they appear in the cash
flows of the project. Put differently, current liabilities affect a project’s cash flows, but not
its WACC.

3. The coupon rate on the firm’s existing debt is used as the pre tax cost of debt: The coupon
rate on the firm’s existing debt reflects a historical cost. What really matters in investment
decision making is the interest rate the firm would pay if it issues debt today. Hence use
the current cost of debt, not the historical cost of debt.

4. When estimating the market risk premium in the CAPM method, the historical average
rate of return is used along with the current risk free rate: Consider the following
information:

(a) Historical average return on common stocks = 19 percent
(b) Historical return on long term Treasury bonds= 10 percent

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