Which statement about the cost of capital as used in capital budgeting is correct?

Which statement about the cost of capital as used in capital budgeting is correct?

• A. The interest rate charged on a specific loan.
• B. The rate used to calculate depreciation.
• C. The cost of goods sold divided by average inventory.
• D. The required return by investors; used as a discount rate for capital budgeting.

Answer: (D)

In capital budgeting, the cost of capital is the return that investors require on the firm’s overall financing, and it is used as the discount rate when evaluating new projects. This rate reflects the opportunity cost of using funds now rather than elsewhere with similar risk, and it combines the costs of debt and equity in the firm’s capital structure (often as the weighted average cost of capital). Using this rate to discount expected project cash flows sets the hurdle a project must clear: if the present value of inflows exceeds outflows, the project adds value and should be pursued. It isn’t simply the interest charged on a single loan, nor does it relate to depreciation or to the ratio of cost of goods sold to average inventory. Therefore, describing the cost of capital as the required return by investors used as the discount rate for capital budgeting best captures its role.

In capital budgeting, the cost of capital is the return that investors require on the firm’s overall financing, and it is used as the discount rate when evaluating new projects. This rate reflects the opportunity cost of using funds now rather than elsewhere with similar risk, and it combines the costs of debt and equity in the firm’s capital structure (often as the weighted average cost of capital). Using this rate to discount expected project cash flows sets the hurdle a project must clear: if the present value of inflows exceeds outflows, the project adds value and should be pursued. It isn’t simply the interest charged on a single loan, nor does it relate to depreciation or to the ratio of cost of goods sold to average inventory. Therefore, describing the cost of capital as the required return by investors used as the discount rate for capital budgeting best captures its role.