7.38 percent market risk premium. The cost of equity capital for our ac-
quiring firm is:

ke= .0515 + (.0738) .84 = .1135

The cost of equity capital, via the capital asset pricing model, is 11.35 per-
cent. The weighted average cost of capital may be calculated as:

The acquiring firm’s weighted average cost of capital is the appropriate dis-
count rate for calculating the profitability of investment opportunities or
valuating merger candidates.
Let us now discuss the capital budgeting, or investment decision. We
assume that management can correctly calculate the firm’s cost of capital,
and can use that discount rate for all projects. Given the cost of capital
(i.e., the appropriate discount rate), the determination of a worthwhile
capital investment is straightforward. An investment is desirable when the
present value of the estimated net inflow of benefits (or net cash inflow for
pure financial investments) over time, discounted at the cost of capital, ex-
ceeds or equals the initial outlay on the project. If the project meets this
criterion, it is potentially profitable or economically desirable; its yield
equals or exceeds the appropriate discount rate. On a formal level, it does
not appear too difficult to carry out the theoretical criterion. The stream
of the forecasted net future cash flows must be quantified; each year’s re-
turn must be discounted to obtain its present value. The sum of the pres-
ent values is compared to the total investment outlay on the project; if the
sum of the present values exceeds this outlay, the project should be ac-
cepted. The discounted cash flow approach has been widely accepted since
the 1950s.
The formula for obtaining the net present value (NPV) of a project
runs in this form:

(4.1)

PV

CF

i

CF

i

CF

i

S

i

NPV PV I

n

n

n

= + + + + + + + n

=−

12

() (^1) ()()() 1112
kk
E
DE
k
D
DE
ce= d t

• 
  

  
  
  
  
  
  + +
  
  
  
  
  
   −

  
  


• 
  

  
  
  
  

  
  


• 
  


• 
  

  
  
  
  
  −

  
  

  ()
  .
  ,
  ,,
  .
  ,
  ,,
  (.)
  .
  1
  1135
  9 063
  5 647 9 063
  056
  5 647
  5 647 9 063
  135
  084

  
  

Cost of Capital 51