Question

• The Cost of Capital is obviously sensitive to interest rates. Discuss the significance of the cost of debt, the cost of equity and the weighted average cost of capital (WACC) when calculating a discount rate to be used in cash flow analysis.
• Describe the differences between the Payback Period and NPV? Which would you use?

Answer 1

Cost of capital is required to make capital budgeting. The cost of capital determine whether a project is worthy to be expended with resources. The cost of capital is financed through equity and the cost of debt is financed through debts. So, sometimes, companies uses both the debt and equity to finance the company and this is known as weighted average cost of capital. In economics and accounting, cost of capital is used.

The difference :-

1. NPV estimates the cash flows of a company whereas Payback period determines the needed time to complete a project in a business.
2. Payback period can't determine the time value of money which NPV can do.

In my opinion NPV would be a better option to choose among the two. NPV is the most realistic method as it can discount each of the cash flows of a company thereby making it a better option. When a project has NPV more than 0, then it is worthy to carry on the project.

Hope this helps :)