Analysis and Interpretations

Determining WACC
 Measure internal risk
 Provide reliable measure to calm shareholders
 Win investors

Importance of Cost of Capital

 Provide a benchmark for performance evaluation
o Value creation: Business return > cost of capital
o Value destroying: Business return < cost of capital

One of the importance of estimating a firm’s cost of capital is can provided an appropriate
benchmark by managers to properly assess the profitability of the firm’s overall operations.
The cost of capital is the rate of return required by a capital provider in exchange for
foregoing an investment in another project, asset, or business with similar risk. For that
reason, it is commonly called the opportunity cost of capital. Since the cost of capital is the
minimum return required by investors, managers should invest only in projects that
generate returns more than the cost of capital.

 Provide an estimation of required return

o Assess profitability of the business’ operations
 Understand the financial status of the business
 Opportunity cost of total business capital
o Rate of return of existing project in comparison on foregone investment in
another project
o The prevailing return that could be earned on alternative investment of
similar risk
 Determined by the market force, not by the company
 Cost of capital can be used to evaluate the NPV of projects

Estimating a firm’s cost of capital is very important especially when the firm want to know
their return from the investment of all projects. When a firm want to decide whether to
accept the project or not, they should do a capital budgeting. In capital budgeting, a firm
should determine the relevant cash flows, discount them, and, if the net present value
(NPV) is positive, take on the project. In corporate finance, the cost of capital usually would
be used as a discount rate to evaluate the NPV of the project. As we all know, the cost of
capital is the same meaning with discount rate and/or required return on the overall firm.
For instance, when the required return is 10 percent, the investment will have a positive
NPV only if its return exceeds 10 percent. The firm must earn 10 percent on the investment
just to compensate its investors for the use of the capital needed to finance the project.
Therefore, we could say that 10 percent is the cost of capital associated with the
investment.
The mixture of cost of debt and cost of equity is the overall cost of capital. Therefore, the
cost of capital will be a mixture of the returns needed to compensate its
creditors and its stockholders.