The financial information from Midland Manufacturing Ltd. will be used as inputs in testing the application of the techniques. The advantages and disadvantages will be discussed in light of the results of the application of the appraisal methods and finally, a recommendation will be made based on a conclusion that will be made from the discussion and analysis previously made.
Firms’ cost of capital can be defined as the rate of return that could be earned in the capital market on securities of equivalent risk. In general, the higher the riskiness [sic] of the firms’ activities, the higher its cost of capital since investors typically require compensation for greater risk. For a firm financed by debt and equity, the cost of capital will be a weighted average of its cost of capital from both sources.
An example is when a businessman borrows money to put some business. When the money was borrowed at say 10% interest rate, this rate is the discount rate or cost of capital that the said businessperson must earn in the conduct of his business, otherwise, he should not go into business because he will be just wasting money and resources.
The cost of capital is important because it is used as a benchmark in evaluating various investment proposals that a businessperson may come to meet. Business life is a road of many decisions and not to have at least one tool or vehicle to endure the travel would be a big failure. Knowledge of the cost of capital, therefore, finds a great advantage.
Knowing the rationale behind each of the following investment appraisal methods, namely: payback method, accounting rate of return (ARR), net present value (NPV) and internal rate of return (IRR) requires one to relate the same with the cost of capital as discussed earlier. What then the relationship of the cost of capital is as expressed in percent or rate with these appraisal methods? . .