(144)---THE COST OF CAPITAL

The Cost of Capital

The opportunity cost of capital or simply, the cost of capital for a project is the discount rate for discounting its cash flows. The project’s cost of capital 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 of capital. It should be clear at the outset that the cost of capital 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 firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects. Thus the firms cost of capital is not the same thing as the project’s cost of capital.

Can we use the firm’s cost of capital for discounting the cash flows of an investment projects?

The firm’s cost of capital 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 firm’s cost of capital 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 cost of capital for projects, the firms cost of capital can be adjusted upward or downward to account for risk differentials of investment projects. That is, an investment project’s required rate of return may be equal to the firm’s cost of capital plus or minus a risk adjustment factor depending on whether project’s risk is higher or lower than the firm’s 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 (CAPM).