RISK AND RETURN IN CAPITAL EXPENDITURES

RISK AND RETURN IN CAPITAL EXPENDITURE PROJECTS



RISK AND RETURN IN CAPITAL EXPENDITURES

Introduction

This assignment will study about the different concepts of risk and return in finance, from the international perspective. The concepts such Required rate of return have been discussed in detail in this assignment, then the effect of factors such as WACC, cost of equity, cost of debt, on the required rate of capital have also been analyzed. Towards the end of the assignment, the effect of different risk factors has been studied.

Discussion

Required rate of return is the minimum acceptable return, which an investor is expecting from a particular investment project. It is also known as the “minimum expected return on capital.” Every investor calculates this percentage according to his own requirements, and investors reflect their anticipated risk from the investment through the figures that they have calculated. The degree of risk in a project, as perceived by the investor, is reflected in the Required Rate of Return. In evaluating a project, an investor uses the Required Rate of Return (RRR) for discounting back the cash flow expected from the project and calculate the Net Present Value (NPV) of the project. By discounting of the cashflows, we mean that the investor is calculating the value of the money, which we will get in the future from the project as returns, in the present. NPV is the actual value of a project today; it is calculated by deducting the present value of the cash flows of the project from the initial cost of the project.

The required rate of return of an investment should be more than the cost of capital of the project. The cost of capital is the minimum return that a company has to attain so as to cover the cost incurred in generating funds for the company. Depending on the calculation of the risk involved in the companies, investors will invest their money to a company, if the company is paying them more than the RRR. The WACC is the minimum return that a company must generate from its projects; therefore, it has become a guideline for different capital expenditure projects, especially while talking about international investment projects.

If the structure of a project is similar to the capital structure of the firm, then the Cost of Capital or WACC (Weighted Average Cost of Capital) of the firm can easily be used to determine the WACC of that particular project. WACC is the calculation of the average cost that a firm has to pay for acquiring the funds from the market, and the company has to earn more than that percentage to earn profit. The WACC of a company, therefore, becomes the benchmark for an investor. The WACC has two components, i.e. cost of equity and the cost debt.

The basis of determining WACC is to determine the costs of each of the individual sources of long term financing for the firm, weight those costs by the degree to which the firm ...