International Finance and Accounting Handbook

(c) Cost of Capital. Cost of capital is the discount rate used to equate present and
future cash flows. This discount rate is more properly called the “weighted-average
cost of capital” (WACC). It is found by combining the cost of the firm’s equity with
the cost of its debt in proportion to the relative weight of each in the firm’s optimal
long-term financial structure. More specifically:

where

The essence of this calculation is that the firm determines a mix of debt and equity
for its capital structure such that the resulting weighted average of the costs of equity
and debt are minimized. With interest costs adjusted for the fact that interest is de-
ducted before calculating income taxes, the resultant WACC indicates the minimum
rate of earnings on any project necessary if the value of the firm is to be maintained.
The WACC thus becomes an acceptable “hurdle” rate, usable as a cutoff criteria for
evaluating new projects.

(d) Combining Cash Outflows, Cash Inflows, and the Cost of Capital. Traditionally,
cash outflows, cash inflows, and the weighted-average cost of capital are combined
in one of two ways to determine the feasibility of an investment proposal. The two
approaches are net present value (NPV) and internal rate of return (IRR). The in-
teraction of cash outflows, cash inflows, and the cost of capital is shown in Exhibit
4.1.
The operating rule for the net present value (NPV) approach is:

If present value (cash inflows discounted at the cost of capital) is greater than project

cost (cash outflows discounted at the cost of capital), make the investment because net

present value is positive.

The operating rule for the internal rate of return (IRR) approach is:

If the internal rate of return (the discount rate which equates cash inflows and cash

outflows) is greater than the firm’s weighted-average cost of capital, make the invest-

ment.

V 
total market value of the firm’s securities 1 E D 2.

D
market value of the firm’s debt

E 
market value of the firm’s equity

t 
marginal income tax rate

Kd
before-tax cost of debt

Kc
risk-adjusted cost of equity

K 
weighted-average cost of capital 1 WACC 2 , after tax

K 
Ke

E

V

Kd 11 t 2

D

V

4.2 GENERAL METHODOLOGY FOR ONE-COUNTRY CAPITAL BUDGETING 4 • 5

in the foreign country is deducted from the tentative U.S. charge in determining the actual additional U.S.
tax paid. The effect of this is that annual earnings retained in foreign countries are taxed only at the for-
eign rate, but the income from which dividends are declared back to the United States is taxed at the
higher of the foreign or the U.S. rate.