Cost of capital Essay Example | Topics and Well Written Essays - 750 words

Cost of capital - Essay Example e returns to the company and the risks involved in the investment on purchasing the supplier has to be analysed and this process is known as the investment appraisal. Investment Appraisal is defined as; â€Å"Evaluation of the attractiveness of an investment proposal, using methods such as internal rate of return (IRR), net present value (NPV), or payback period (PP). Investment appraisal is an integral part of capital budgeting, and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training† (Gotze, Northcott, & Schuster, 2009, p24). Payback period, as the name indicates, computes the time taken for the project to generate cash flows to break even. In other words, it is the number of years that will be taken by the project to pay back the initial investment to the company (Emery, 2007). The payback period for this proposal is found to be 4 years (4 * $ 500,000). Net Present Value utilizes the discounted cash flows and computes the total worth of the project to the company. The cash flow estimates for the life of the project are discounted to present values and the net sum of the cash flows (including any outflows) provides the Net Present Value of the project (Gillespie, Lewis, & Hamilton, 1997). It indicates that the project will increase the worth of the company by this value. In this case, the NPV of the proposal is computed as shown below: The cost of capital in most cases is volatile and changes during the life of the project. This can affect the returns and the Net Present Value computed during the project start up. The internal rate of return is used to compute a maximum discount rate that can be applied to the project without incurred any losses and gives an indication of the margin of safety of the project (Emery, 2007). IRR calculation works on trial and error basis. Initially the NPV for an assumed rate is determined and based on this value; another rate is selected so that the new NPV