In order that DCF calculations should lead to correct results, it is important that all factors affecting the calculations of cash flows should be taken into account. The most important of these factors is, of course, taxation. Indeed, we have assumed from the outset that the cash flow figures were net after tax. Apart from the direct effects of taxation, we should also adjust our figures for indirect aspects of taxation, such as investment grants, and the reader will recall that in calculating the net investment outlay, any recoveries in the form of investment incentives must be deducted from the amount brought into the DCF calculation. The effects of these incentives vary from project to project.

The cost of capital

The evaluation of an investment project by DCF analysis requires a firm to calculate its cost of capital. This is true in selecting the discount rate for appraisal by means of the net present value method, or for establishing the acceptability of the internal rate of return.

A full discussion of the concept of the 'cost of capital' is beyond the scope of this book; indeed, the subject is perhaps the most difficult and controversial topic in the Theory of Finance. Our discussion will be a very elementary one so as to provide the reader with some understanding of investment planning.

The first problem in discussing the cost of capital lies in different meanings which the term has acquired. From a lender's point of view, the cost of capital represents the cost to him of lending money which may be equated to the return which he could have obtained by investing in a similar project having similar risks. This concept of the cost of capital is founded on its 'opportunity cost'. The opportunity cost approach to the assessment of the cost of capital is one which a firm must always consider when evaluating an investment project. A firm may find, for example, that investing funds outside the firm may produce higher returns than an internal project. The main obstacle to a more widespread use of the opportunity cost concept is that of identifying investment of equal risks and hence measuring the opportunity cost.

Another concept in use is the actual cost incurred by a firm in borrowing money. A firm may obtain funds in a variety of ways: and each way has a different cost attached to it. Thus, a firm may issue shares and will pay a dividend on those shares, which must represent the cost of raising funds in that way. It may also borrow money, either by the issue of debentures, bank or other methods of borrowing, and in these cases interest is payable. The fact that the firm may have raised its finance in several different ways makes it more realistic to use the 'average cost of capital' which is based on an analysis of its capital structure.

Example

The Keystone Corp Ltd has a capital structure distributed as to 80 per cent share capital and 20 per cent loan capital. The dividend rate is 10 per cent and the interest payable on the loan capital is 8 per cent.

The average cost of capital so calculated would in the case of this firm represent the minimum acceptable rate of return.

The crucial test upon which the final acceptance of a project depends is whether or not the IRR compares favourably with the required rate of return. If the required rate of return is 20 per cent both projects qualify.

One of the problems of comparing rates of return on projects is that direct comparisons between two percentages are meaningless unless referred to the initial outlays, so that their true dimensions may be perceived. This problem should never be lost sight of when using IRR percentages.

With more complicated investment problems, for example, those which require... see: Analysis