Cost of capital is a crucial element in the process of investment decision making and valuation of firms. If a 
company invests in projects where the return is greater than the cost of capital, then there is value creation. 
On the other hand, if the return is less than the cost of capital, then there is value destruction. 
 

A  company  acquires  the  required  capital from various sources, such as by borrowing from outsiders or using 

funds from owners. These sources are mentioned in the following diagram.  

A company has to pay the following charges to both the sources for the risk that they assume by investing 
their capital in the company:  

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The risk assumed by debt providers is lower than the risk assumed by equity owners. Therefore, the cost of debt 
is lower than the cost of equity. 
 
The formula for calculating the weighted average cost of capital (WACC) is as follows:  
 
W ACC = (W eightage of debt x cost of debt) + (W eightage of equity x cost of equity) , where,  

Debt
○ Weight of debt ​is calculated as:
(Debt + equity)
and 
Equity
○ Weight of equity​ is calculated as:
(Debt + equity)
 

The  weighted  average  cost  of  capital  is  compared  to  the  return  on  investment  to  determine  the  feasibility  of  a 
project. ​To understand this better, refer to the points mentioned below. 

 
A few key points regarding the cost of capital are mentioned below.  

 
 
The techniques of project evaluation help in identifying whether an investment opportunity is profitable or 
not. Some of the key techniques of project evaluation are mentioned in the following diagram. 
 
 
 
 

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● Net present value (NPV) is the present value of the future cash flows minus the present value of the 
initial investment. ​NPV can be calculated using the following formula:  

, where,  

■ CF​t​= Cash flow for that year, 

■ R = Cost of capital, 
■ T = Time period, and 
■ Outlay = Present value of initial investment. 

According to the NPV technique of project evaluation: 

Other key points regarding the NPV technique of project evaluation are ​mentioned below.  

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● Profitability index (PI) is measured as the ratio of the present value of cash flows to the initial investment​. It 
P V of f uture cash inf lows
can be calculated as follows: P I = Initial investment
. ​Other key points regarding the PI 
technique of project evaluation are ​mentioned below.  

● The rate of return at which the present value of cash outflows is equal to the present value of cash 
inflows is known as the internal rate of return (IRR). ​IRR can be calculated using the following formula:  
 

C1 C2 CN
○ NPV = C 0 + + + ... + by substituting the value of NPV = 0  
(1 + r)1 (1+r)2 (1 + r) n
○ = IRR(Range of value)​, where range of values = initial investment and cash inflows for the year  

According to the IRR technique of project evaluation:  

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● The payback period of an investment refers to the time taken to recover the full cost of the 
investment. The drawbacks of payback period are mentioned below. 
 

 
 
 
 
The general principles of project evaluation are as follows:  
 

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Every project comes with its own set of risks. Some of the risks are visible to a project manager at the beginning 
of the project, while some risks are encountered while undertaking the project. 

There are two types of risks, which are as follows: 

● Internal risks: ​These are risks that can be controlled by the organisation. The different types of internal 
risks are ​mentioned below.  

● External risks: These are risks that cannot be controlled ​by the organisation. The different types of 
external risks are ​mentioned below. 
 

 
 
 
 
 
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There are certain risk evaluation techniques that can help a manager prioritise the risks affecting their 
project, thus enabling them to come up with mitigation strategies in order to counter the risk. ​The two 
techniques that can be used to evaluate the risks of a project are as follows: 

● Sensitivity  analysis:  It  refers  to  observing changes in the NPV by changing one input variable at a time. ​To 

understand this better, refer to the points mentioned below. 

● Scenario  analysis:  It refers to observing changes in the NPV by changing multiple input variables at a time. 

There  is  a  ​base-case  (expected  scenario  for  a  project)  situation,  a  ​best-case  (scenario  with  no  risks) 
situation and a ​worst-case (scenario with multiple major risks)​ situation. 
○ A firm assigns probabilities to the NPV values for all the scenarios to calculate the risk-adjusted 
NPV for a project. For this risk-adjusted NPV,​ refer to the points mentioned below. 

 
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