Determining Business Investment Decisions

When determining whether to invest in capital improvements or in acquisitions or projects, the concept of the time value of money should be considered. Money changes value over time. This brings into play the concept of the present and future value of money (McPherson, 2003). For example, if you have $500 and simply put it in a jar and bury it in your yard, in ten years you will have $500, right? Wrong! Inflation will have reduced the value of the original amount considerably. Therefore, the wise choice would be to invest the $500 at a high enough rate of return to offset the effects of inflation plus gain value for the investor.

The same holds true for a company, before a company can invest in projects that can add growth or value to a company, the cost of capital needs to be determined. Known as the weighted average cost of capital (WACC), this "reflects the expected average future cost of funds over the long run" (Gitman, 2008, p. 517). To calculate the WACC, you need to multiply the cost of the financing (as a percentage) times the company's weights (which totals to 1.0) of each source of funding using either historical weights (book or market value) or target weights (developed from a firms desired proportions) (Gitman, 2008, p. 519). Examples of sources for funding include long term debt, preferred stock, and common stock.

Something that should also be considered when deciding on a source of funding is the difference between using long term debt and equity when funding investments. There are tax benefits from using debt for financing; interest payments are deductable, equity has no deductions. Debt has a stated maturity but equity does not, and "[t]he costs of equity financing are generally higher than debt costs" (Gitman, 2008, p. 331).

To determine the suitability or value of a project, the weighted marginal cost of capital (WMCC) needs to be calculated. The marginal cost is the point where the cost for funding exceeds the optimal levels and increases the required internal rate of return (IRR). IRR is defined as the discount rate required from investment cash flows in order to obtain a net present value (NPV) on the investment cash flows of zero, which in effect, brings the value of the investment to the present value (PV) (Yost, 1999).

The relationship of the IRR to the WACC and WMCC determines whether a project will add value to the company. As long as the IRR of a project is above the WACC, the project will be a good investment and add to the value of the company. If there are projects that are the same in value but only one can be chosen, calculating the net present value (NPV) will be the deciding factor.

To determine whether a project should be undertaken, the IRR of each project must be determined and compared to both the WACC and WMCC. Using the information calculated for the WACC and WMCC, decisions can be made as to whether to accept or reject a project. Accepting projects that have a good IRR to WACC ratio adds value to the company.

References

McPherson, M. (2003). Understanding the time value of money, Women's center for financial information (WCFI). Retrieved December 4, 2008 from http://www.csuchico.edu/wcfi/time_value_-_money.htm

Gitman, L. (2009). Principles of managerial finance (12th ed.), Boston: Pearson Education, Inc.

Yost, C. (1999). Subject: Internal Rate of Return (IRR), The Investment FAQ. Retrieved December 4, 2008, from http://invest-faq.com/cbc/analy-int-rate-return.html.