Economic Analysis of Investment Projects

FINANCE
DISCUSSION: THE COST OF CAPITAL

The weighted average cost of capital refers to the overall cost of capital of the firm, as
composed of the different sources of finance, in which the book value weights, market value
weights, or the decided weights are assigned as per the discretion of the management. The
required rate of return denotes the minimum rate desired to be achieved by the investor, on
the contemplation of the investing in a certain project.
In order to understand the rationale behind the said phenomena, it must be imagined
first that an organization is composed of single source of finance, say equity. In such a case if
the required rate of return would be computed for the evaluation of a proposal, the same
would be exactly equal to the cost of finance of the equity (Frank & Shen, 2016). This is
because an organization does not have another source of finance in its capital structure. Now,
as the sources of finance would get expanded in the capital structure, so the required rate of
the return or the expected rate of return would change. This is because with the inclusion of
new source of finance, there is not only the expansion of the investment base, but the
financial risk as well. It can be imagined that the new source of finance is in the form of the
borrowings or debt. The computation of the new required rate of return would also require the
effects of the new source being added in the capital structure (Bierman Jr & Smidt, 2012.
This can be done by assigning the weight to the cost of debt either in the proportion of the
book value of the debt portion or the market value of the bonds. This weighting process
would ensure that the cost of capital or the required rate of return is averaged to include the
pros and cons of both debt and equity. Similarly, if yet another source of finance is desired to
be included, say mezzanine financing, the weights must also be assigned to the same to
reflect the true expectations of the investor from a proposal.
Hence, as per the discussions conducted in the previous parts, it can be concluded that
the required rate of return is equivalent to the weighted average cost of capital of a firm, as
understood by taking a single finance source initially and expanding it gradually.

References
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of
investment projects. UK: Routledge.
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of
capital. Journal of Financial Economics, 119(2), 300-315.