IAI Actuarial Core Principles · Business Finance
Cost of Capital and Evaluating Investment Projects
Cost of capital is the return a company must earn to satisfy its investors. You find the cost of equity and debt, combine them into a WACC using market-value weights, then use it to discount project cash flows. Accept a project if its NPV is positive.
What this chapter covers
This chapter links how a company raises money with how it decides where to invest it. You start with sources of finance and capital structure. Then you price each source: the cost of equity and the cost of debt. You combine them into the weighted average cost of capital (WACC).
The second half uses that rate to judge projects. NPV and IRR are the main methods. Payback, discounted payback and accounting rate of return are simpler measures with known weaknesses. The chapter ends with risk, capital rationing and adjustments to project cash flows.
In CB1 this chapter feeds directly into the syllabus areas on how corporates are financed and on evaluating projects. It also ties to company accounts, because you need to read profit and balance sheet figures to get cash flows and market-value weights. Your CM1 interest rate work helps here, since NPV and IRR are present-value and yield calculations.
The chapter mixes theory and calculation, so it suits both the multiple-choice section and the written questions. A calculation question is often worth solid marks, and the method is repeatable once you practise it. The discussion parts, such as why one method is better than another, reward clear reasoning. Many students lose marks through small errors like wrong weights, forgetting tax, or mixing nominal and real rates. Drilling this chapter removes those errors, and it also strengthens your grasp of the financing topics around it.
Cost of capital and evaluating investment projects: topics in the order to study them
- 1Sources of Finance and Capital StructureYou need to know what each source is and how it ranks before you can price it.
- 2Cost of Equity and Cost of DebtThese are the inputs to WACC, so you must be able to estimate each one first.
- 3Weighted Average Cost of Capital (WACC)It combines the two costs and gives the discount rate used in appraisal.
- 4NPV and IRR Investment AppraisalThe core decision methods, which use the WACC as the discount rate.
- 5Payback, Discounted Payback and Accounting Rate of ReturnSimpler measures are easier to learn once NPV is clear, and you compare them against it.
- 6Risk, Capital Rationing and Project AdjustmentsIt builds on all earlier methods by adding uncertainty and limited funds.
How to prepare Cost of capital and evaluating investment projects
Treat this chapter as a chain: each topic produces an input for the next. Work in that order and practise numbers every session.
- Read the sources of finance topic once for understanding, then list each source with its cost, risk to the investor and effect on control.
- Learn the cost of equity and cost of debt methods and write down the formula and assumptions for each. Say clearly whether tax is included.
- Compute a WACC from scratch several times. Use market values for weights, and check that the weights add to 1.
- Practise NPV and IRR on cash flow tables. Set out the timeline, discount factors and total in the same layout each time.
- Do payback, discounted payback and ARR on the same projects you used for NPV, so you can compare the answers and write about the differences.
- Finish with risk and capital rationing questions. Practise sensitivity analysis and ranking projects when funds are limited.
- Mix MCQs and written past-style questions weekly, and time yourself on the written ones.
Common mistakes in Cost of capital and evaluating investment projects
Using book values instead of market values as WACC weights.
Fix: Use market values whenever they are given, and state the choice if only book values are available.
Forgetting tax on the cost of debt.
Fix: Check whether the question gives a tax rate, and adjust the cost of debt for it before using it in WACC.
Including interest payments or depreciation in project cash flows.
Fix: Build cash flows from scratch: revenues, costs, tax effects and working capital. Leave out financing flows and non-cash charges.
Choosing between projects on IRR alone.
Fix: For mutually exclusive projects, compare NPVs at the required rate and explain any conflict with IRR.
Treating payback as a full appraisal method.
Fix: Always note what payback ignores and pair it with NPV in a written answer.
Mixing real cash flows with nominal discount rates.
Fix: Match them: nominal flows with a nominal rate, real flows with a real rate. Write down which one you are using.
Last-day revision: Cost of capital and evaluating investment projects
- WACC weights use market values of each source, not book values, where they are available.
- Interest on debt is tax-deductible, so the after-tax cost of debt is lower than the pre-tax cost.
- Equity is riskier than debt for the investor, so the cost of equity is higher than the cost of debt.
- NPV = Σ of discounted cash flows minus the initial outlay. Accept if NPV > 0.
- IRR is the discount rate at which NPV = 0. Accept if IRR exceeds the required return.
- Use cash flows, not accounting profits, in NPV and IRR. Ignore sunk costs and include opportunity costs.
- Do not include financing costs in project cash flows, because the discount rate already covers them.
- Payback ignores the time value of money and cash flows after the payback date.
- Discounted payback fixes the time value issue but still ignores later cash flows.
- ARR uses accounting profit, so it depends on accounting policies and is not a cash measure.
- Mutually exclusive projects: rank by NPV, as IRR can mislead when scales or timing differ.
- With capital rationing, choose the mix of projects that gives the highest total NPV within the budget.
Cost of capital and evaluating investment projects practice questions
- Using the Capital Asset Pricing Model, Kaveri Textiles Ltd has an equity beta of 1.2. The risk-free return is 7% per annum and the expected …
- Which item should be used to compute the equity weight in a WACC calculation?
- Under the Modigliani-Miller propositions with corporate tax, if a firm replaces some equity with debt, what happens to its WACC and value, o…
- A company ranks two mutually exclusive projects. Project X has the shorter payback period and the higher ARR, while Project Y has a higher N…
- A project has an IRR of 14% and the firm's cost of capital is 11%. Which statement is correct for a conventional project with an initial out…
- Arjun Infra Ltd has irredeemable debentures with a coupon of 10% on a nominal value of Rs 100. They trade at Rs 80 ex-interest. The corporat…
- Which statement about using WACC as the discount rate for a new project is most appropriate?
- Sundaram Foods Ltd expects next year's dividend of Rs 6 per share. Dividends have grown at a steady 5% per annum and are expected to continu…
Cost of capital and evaluating investment projects in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Cost of capital and evaluating investment projects: frequently asked questions
Which topics in this chapter should I master first?
Start with the cost of equity, cost of debt and WACC, because every appraisal question depends on the discount rate. Then move to NPV and IRR. Leave the risk and rationing topics until the core calculations are secure.
Is this chapter calculation-heavy or theory-heavy?
It is both. You will meet numerical questions on WACC, NPV and IRR, and written questions that ask you to compare methods or discuss their limits. Prepare for both formats.
Why is NPV preferred to IRR and payback?
NPV measures the value added in money terms and uses all cash flows with the time value of money. IRR can give conflicting rankings for mutually exclusive projects. Payback ignores cash flows after the cut-off date.
How should I practise this chapter for the exam?
Do short MCQs for definitions and quick calculations. For written questions, set your working out neatly, state your assumptions and write a final recommendation. Practise under time limits closer to the exam.