Question

“By applying capital to investments with long-term benefits, the company is attempting to produce value. This value is dependent on expected future cash flows as well as on the cost of funds.”

Explain this statement with regards to the role of cost of capital in financial management decisions.

Answer 1

Value of a company = Expected Future cash flows / WACC

where WACC is weighted average cost of capital i.e. cost of equity and cost of debt.

Now to generate long term benefits, company has to make investments in projects that can generate positive cash flow to company.

• Higher the value of cash flows, higher the value of company. (numerator value)
• Lower the cost of capital for a company, greater the benefits and higher the value of company.(denominator value)

Hence higher cash flows and lower WACC increases value of a company.

A company will try to invest in projects that gives highest cash flows at lowest cost of capital. Hence this is very important for management to make financial decisions to decide which project they would be investing in for long term benefits.

Now assume there are two projects available for investment for a company with same expected future cash flows but different cost of capital, hence the company will decide to invest in project that has lowest cost of capital and hence higher value.