Net present value calculations take a certain dollar amount from a future period and discount the dollars to a current period’s value. In order to do this correctly, individuals must use an interest rate for the formula. A common interest used is a company’s cost of capital, which is the rate paid for borrowed money, whether debt or equity. Therefore, a direct connection exists between cost of capital and NPV. Companies can use multiple cost of capital rates in order to fully examine a potential project using the NPV formula.
In business, making decisions is often one of the most important — and hardest — activities in which a company’s management team engages. Almost all companies make decisions where looking at financial returns is a significant part of the process. The problem with looking at future financial returns is that a dollar tomorrow is not worth the same as a dollar today. Many different reasons exist for this difference, though inflation and other economic factors are among the most common. In order to make a dollar-to-dollar comparison, discounting future dollars back to current value is important using the cost of capital and NPV formula.
The cost of capital and NPV formula is often the most important tool used to make dollar-to-dollar comparisons when making decisions. A basic formula for this process multiplies the future dollar amount for a given period by the cost of capital, with the latter divided by one plus the interest rate, raised to the period of the cash flow. The result is a lower dollar amount the company can compare to the initial cash outlay for a given project. If a project will have multiple cash flows over several years, then a company needs to repeat this formula for each year, changing the formula to reflect the number of the years. Alterations may be necessary, though a company’s leaders need to make this decision about the formula.
Using a cost of capital and NPV formula is not without its flaws, which can lead to disastrous results. For example, poor estimates on future cash flows can result in lower funds received from a project. An inappropriate cost of capital formula can also lead to poor results; this is an especially important consideration as the cost of capital and NPV formula demands accuracy in order to produce sound results. In some cases, that is why a company uses multiple cost of capital rates. Each rate can provide an outlook that is low, average, and high, giving a company more information on the end result of cash derived from a project.