Page 193 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes alternative investment of equivalent risk. If a project is of similar risk to a company’s average
business activities it is reasonable to use the company’s average cost of capital as a basis for the
evaluation. A company’s securities typically include both debt and equity, one must therefore
calculate both the cost of debt and the cost of equity to determine a company’s cost of capital.
However, a rate of return larger than the cost of capital is usually required.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In
practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk
component (risk premium), which itself incorporates a probable rate of default (and amount of
recovery given default). For companies with similar risk or credit ratings, the interest rate is
largely exogenous (not linked to the company’s activities).
The cost of equity is more challenging to calculate as equity does not pay a set return to its
investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted
projected return required by investors, where the return is largely unknown. The cost of equity
is therefore inferred by comparing the investment to other investments (comparable) with similar
risk profiles to determine the “market” cost of equity.
Once cost of debt and cost of equity have been determined, their blend, the Weighted Average
Cost of Capital (WACC), can be calculated. This WACC can then be used as a discount rate for a
project’s projected cash flows.

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with
equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make
a given investment.

11.4.1 How it Works

Cost of capital is determined by the market and represents the degree of perceived risk by investors.
When given the choice between two investments of equal risk, investors will generally choose
the one providing the higher return.

Let’s assume Company XYZ is considering whether to renovate its warehouse systems. The
renovation will cost $50 million and is expected to save $10 million per year over the next 5
years. There is some risk that the renovation will not save Company XYZ a full $10 million per
year. Alternatively, Company XYZ could use the $50 million to buy equally risky 5-year bonds in
ABC Co., which return 12% per year.
Because the renovation is expected to return 20% per year ($10,000,000/$50,000,000), the renovation
is a good use of capital, because the 20% return exceeds the 12% required return XYZ could have
gotten by taking the same risk elsewhere.
The return an investor receives on a company security is the cost of that security to the company
that issued it. A company’s overall cost of capital is a mixture of returns needed to compensate
all creditors and stockholders. This is often called the weighted average cost of capital, and
refers to the weighted average costs of the company’s debt and equity.
11.4.2 Why it Matters

Cost of capital is an important component of business valuation work. Because an investor
expects his or her investment to grow by at least the cost of capital, cost of capital can be used as
a discount rate to calculate the fair value of an investment’s cash flows.
Investors frequently borrow money to make investments, and analysts commonly make the
mistake of equating cost of capital with the interest rate on that money.

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