What are the implications of the Cost of Capital in Budgeting Decisions?

Investment decisions are directly related to financial decisions influenced by the cost of capital. Management of a company is always anxious to maximize return on investments with a view to ensure that cost of capital is covered although management may alternatively decide to minimize investment which may yield highest returns for reasons of the high risk involved or it may decide to maximize investments for obtaining highest growth through expansion of the productive processes. Management is guided by such considerations as:

(1) Opportunities created by technological change requiring replacements, necessitating expansion, or taking up new activities.

(2) Competition strategies to avail of economic opportunities, the investment being planned by them, and the threat which may arise to the existing or proposed market shares of the firm;

(3) Short-term and long-term market forecasts with reference to sales, revenue proceeds, net profits, etc.;

(4) Incentives offered by the state to promote investment in particular areas of production required for meeting urgent local needs of the nation or for exporting to earn foreign exchange etc. Nevertheless, the management of a corporate enterprise while preparing capital outlays prepares the particulars of the expected receipts (cash inflows) generated from the activity through such investment. Both are compared over-time and for the optimum decision, receipts should cover the cost of financing the capital outlays. As such investment or capital budgeting decisions are directly linked with the cost of capital.

Implications in Budgeting Decisions

Despite the above objections, the cost of capital is used as the basis to evaluate investments whose cash flows are perfectly correlated with the cash flows from the company’s present assets. With a perfect correlation between the two sets of cash flows, the risk is the same. But if the timing of the cash flows is not also the same, the same discount rate cannot be used for both investments. But the weighted average cost of capital represents an averaging of all risks of the company and can be used to evaluate investments in much the same manner that the pay-back method. It gives some insight and guidance and to that extent, it is good to be used. The present value of an investment can be computed using a weighted average cost of capital and this can be compared with present values calculated using the other discount rates. It may be that an investment with a positive present value should be rejected because of its risk characteristics or that an investment with a negative present value using the weighted average cost of capital should be accepted. All this will differ from situation to situation and case to case. Nevertheless, evaluation of capital investment projects requires some basis which could serve as the minimum rate of return which a project should generate. In such cases, the weighted cost of capital could serve as an accepted discounting rate for evaluating investment decisions as no project will be acceptable which does not generate funds equal or greater to the cut-off rate represented by weighted cost.

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