Question
When doing cash flow analysis to determine Net Present Value and IRR, a critical component of the calculation and resulting analysis is based on the
When doing cash flow analysis to determine Net Present Value and IRR, a critical component of the calculation and resulting analysis is based on the chosen or presumed Cost of Capital (namely your Discount Rate). Please note that this Discount Rate is NOT necessarily the actual specific loan cost of debt that will be used to finance this project nor an affirmed cost of equity for this potential project. We are simply trying to use historic internal cost and knowledge of the current capital markets to choose our presumed cost of capital (discount rate) for our cashflow analysis. The Cost of Capital used in project analysis is thus often a much more complex number derived from numerous other sources such as our overall existing corporate structure of debt (not for profit) overall cost of debt and equity (for-profit and is referred to as the Capital Asset Pricing Model (CAPM)), or in essence, some modified form of your historic costs of capital for a similar project of similar presumed average risk. (This risk factor of and its component parts is presented in Chapter 13 and varies on a project by project basis.) We may also choose to use a refinement of our selected discount rate based on historic divisional costs of capital within the organization or actual quoted and pre-determined debt or equity costs (attained from our investment bankers for this exact project). Note: these investment banker quotes generally only apply to this exact and current moment in time until we actually try to package the debt (bonds) or equities (stocks) and sell them in the stock and bond markets. Once we select a starting point cost of capital (discount rate), and perform our NPV of our expected case calculations, we can then easily proceed to a scenario analysis of best case, expected case and worst case cashflow to derive a statistical standard deviation and coefficient of variation. Those Risk-calculations then allow us to further risk-adjust, and refine our cost of capital (discount rate used) in 2nd and third pass cashflow projections and the resulting NPV or IRR. When thinking about actual access to capital, as well as a business operational risk (that can easily vary project by project), describe how you would support and explain your choice of a particular cost of capital used in your discounted cashflow analysis that you will present to your board of directors when asking for approval to proceed with or reject a particular project initiative.
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