© 2000 John Petroff
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© 2000 John Petroff |
The cost of capital which is the discount rate for NPV and the required rate of return for IRR, is an opportunity rate of return for the firm. There are two general ways of looking at it. The first is to turn to sources of funds, under the assumption that the cost of capital for any individual project should be the same as the cost of obtaining funds for the entire company. In this case, management can choose either the average cost of capital or the marginal cost of capital. These have been presented in the case of mergers and acquisitions in Section F-1 of this chapter (as well as in the discussion of bank cost of funds in Section C of this chapter) and will be further studied in Chapter 11 Section D-1. In the average cost of capital, proportions of debt and equity may be modified to reflect the anticipated capital structure after the new projects are funded.
The second method (which is justified in Chapter 10 Section E-1) looks at the projects as competing in their respective markets and assigns to each project the BETA of the particular industry in which the item will be competing. Here the cost of capital is a risk adjusted average cost of capital.
See review questions Q-3G3.1.
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