What Does Cost of Capital Mean?
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Analysis
The Net Present Value is the sum of all the expected future cash flows in the present value minus the initial investment cost. If the Net Present Value for this project is greater than zero, it is worthwhile. As the NPV for this wine bottling business is $50281.66, it provides a substantial return for the business. However if the NPV is less than zero, the business will result in a loss as the returns received are less than the value invested and the expenses.
The cost of capital is extremely significant as it determines the present value of the cash flows, which in turn influences the profit of the wine bottling business. The cost of capital also helps to determine whether a project is profitable
(What Does Cost Of Capital Mean?
The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.
Investopedia explains Cost Of Capital
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.
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11. b) The NPV of the investment has increased by $5977.46 from the original -$37,266.82 when equipment was purchased upfront, to -$31,289.36 when a bank loan was taken. This means that by taking the loan, the business was able to generate fewer losses and increase the present value of the future cash flows. A main reason for this is because while the cost of capital was 11%, the interest rate charged on the loan was only 8.5%. Therefore, by paying $75300 upfront to purchase the equipment, the opportunity cost for the business would be losing out 11%p.a. interest on $75300 if the money was put in the bank. On the contrary, by taking a loan at 8.5%p.a. would cost less than the opportunity cost of the former option, therefore generating a higher NPV.
Furthermore, by spreading the repayments of the loan over a period of 7 years, the interest charged on the loan gradually decreases. As more loan repayments have been made, the principal outstanding is reduced and hence the interest components of repayments are reduced. Ultimately, the decreasing interest payments on the loan and also the lower cost of capital of the loan allow the loan option to result in a higher NPV than the original