Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 37

Present value analysis—cost of capital National Leasing is evaluating the cost of capital to use in its capital budgeting process. Over the recent past, the company has averaged a return on equity of 12% and a return on investment of 9%. The company can currently borrow short-term money for 6%.

Required:

a. Which of the preceding rates is most relevant to deciding the cost of capital to use? Explain your answer.

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b. Without prejudice to your answer to part a, explain why the company might choose to use a cost of capital of 13% to evaluate capital expenditure opportunities.

Step 1 of 3

Present value analysis and cost of capital:

Present value:

An ordinary annuity’s present value is the value in today's dollars of an equal cash flow series, where each cash flow in the series takes place at the completion of one period in future. It represents the current period amount of cash that will provide for a receipt or payment of a series of equal cash flows at regular intervals, including compound interest

Present value analysis: It is a technique of evaluating the value of money currently with the value of money in a specified future date.

Cost of capital: The cost of capital is the required return essential to construct a capital budgeting project. It comprises of cost of debt plus cost of equity.