Page 194 - DMGT521_PROJECT_MANAGEMENT

Unit 11: Project Cash Flow

Notes

Notes It is important to remember that cost of capital is not dependent upon how and
where the capital was raised. Put another way, cost of capital is dependent on the use of
funds, not the source of funds.

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Caution 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.
11.5 WACC

A calculation of a firm’s cost of capital in which each category of capital is proportionately
weighted. All capital sources - common stock, preferred stock, bonds and any other long-term
debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation
and a higher risk.
The WACC equation is the cost of each capital component multiplied by its proportional weight
and then summing:
E D
WACC = *Re + *Rd *(1 – Tc)
V V
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt

V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt

Tc = corporate tax rate
Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a
project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Did u know? Cost of capital is an important component of business valuation work.

11.6 Optimal Capital Budget

Up this point, we have discussed some of the issues regarding a firm’s cost of capital and capital
budgeting decisions. In the process, we have looked at some of the techniques a financial manager
can use in identifying the cost of various forms of capital and choosing projects that are
“profitable” to the firm. Based on our earlier discussions, we know there is a significant

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