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PROJECT TOPIC – Implication of Cost of Capital on Project Financing

 Implication of Cost of Capital on Project Financing

 

ABSTRACT

The concept of Cost of Capital is of v i t a l importance in the financial decision making of any business because it is useful as a standard for evaluation of investment decisions. In fact the primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. Funds committed i n t o c a p i t a l expenditure of a firm have a long-term implication on the financial resources of the firm and may be irreversible. For t h i s reason, it is important that a firm properly analyses these capital funds in the light of their cost implications to the firms in raising the funds. I f it f a i l s , that
would give misleading information about the company’s yearly profit performance, It can also lead to wrong choice of projects, etc, Several concepts of cost of capital exist6 and there is virtually no uniformity as to the proper one to adopt, There may be other factors apart from cost of capital which could be  considered before financing a project. It is against t h i s background that the researcher want to find out :

  1. the relationship between cost of capital and a project to be financed by a firm;
    2, whether there are factors other than cost of capital that govern the financing of a project by a firm;
  2. whether firms consider cost of capital of a project before financing the project ;
  3. what firms consider to be the return on investment for a project.

Survey method was adopted for the study consisting of interviews and the use of questionnaire. The researcher also made use of secondary
source of information. Two hypotheses were formulated based on the problems identified. Cross tabulation, percentages and Chi-square t e s t of significance  were used to analyse the data. Specifically, Chi-square was used to t e s t hypotheses 1 and 2. The findings were as follows:
There is a strong relationship between the cost of capital of a firm and a project to be financed. Also a negative relationship exists between the cost of capital and the returns that t h i s project yields. As the cost of capital increases, the return on the project decreases end vice-versa. Apart from cost of capital, such factors as material availability, manpower requirement, Government policies, state of technology of the firm and competition also affect a firm’s decision to finance a project. Firms do consider cost of capital before financing a project but apply mainly interest on the borrowed fund as the project cost of capital. Baaed on the findings, the researcher is recommending that firms should use the weighted cost of capital instead of interest rate.

 

CHAPTER ONE

INTRODUCTION

The efficient allocation of capital is the most important finance function in the modern times. According to Pandy (P. 334). it involves decisions to commit the firm’s funds to the long-tern assets. Such decisions are of considerable importance to the f i r m since they tend to determine its value and size by influencing its growth, profitability and risk. This arises because a society’s productive resources such as land, machines, buildings, natural resources and manpower, are in short supply and have alternative uses. These resources once committed to capital expenditure decisions of the firm have long-term implications and the decisions may be irreversible except where project abandonment is profitable (van Horne, 1980). The concept of cost of capital is of vital importance in the financial decision making of any business because it is useful as a standard for evaluating investment decisions. In fact, the primary
purpose of measuring the cost of capital according to Pandey (P. 411) is its use as a financial standard for evaluating the investment ‘projects. Because of the long-term implication and the irreversibly of the funds committed into capital expenditure of a firm, there is the need therefore, for the firm to properly
analyse these capital or project funds in the light of their cost implication to the firm in raising them.

The cost of the funds available for investment to a firm is closely linked to the firm’s capital structure. Most companies have a variety of financing source, including short-term debts, long term debts, preferred stock, common stock and earning retained in the firm. Measuring the cost of t h i s capital becomes a part of the theory of capital structure, since each type of financing a firm will affect the other types ( ~ am~ t o nP,. 298). For example, a f i rm can borrow debt funds at relatively low interest rates of up to a certain point. Until t h i s point is reached, the use of debt financing w i l l lower the overall cost of capital. When the debt-equity r a t i o becomes too high, the firm may have to pay high rates of interest t o borrow. This w i l l raise the cost of capital. A t a high debt-equity r a t i o , the firm my not be able t o borrow at all. In t h i s situation, the firm may float stock t o bring the debt-equity r a t i o back into line
with expectations.

Even though the stock may be offered at relatively low market prices, the additional equity w i l l reduce the amount of risk faced by the firm’s creditors.
Without a knowledge of the firm’s approximate cost of capital, the firm w i l l have d i f f i c u l t i e s in deciding what security should be used t o raise additional funds and what cut-off point should be selected for capital-budget ing proposals. The cost of capital separates those proposals which maintain or increase the firm’s net present value from those which may decrease it. Again, knowledge of the existing cost of capital and the cost of raising additional funds can help the financial manager in selecting financing options. The use of the discounted cash flow techniques for evaluating an investment project requires the estimation of the project’s cash-flows and the discount rate and in t h i s case, the cost of capital is regarded as the discount rate. Cash-flow can simply be defined as the difference between naira received and naira paid out while the discount rate may be regarded as the project ‘s opportunity cost of capital (or simply the cost of capital) for discounting its cash-flows. The project’s cost of capital is the minimum acceptable rate, or the rate of return is a
compensation for time and risk in the use of capital by the project, A t t h i s juncture, we may t r y a description of what really is an investment project.

Investment in project is an example of what we c a l l “a real asset investment , Real asset investment is either on s i w l e fixed asset or. on a group of inter-related assets. Where the group of inter-related assets provides f a c i l i t i e s capable of completing a production or a service process, the investment activity is described as a project. A real asset investment also involves the commitment of funds i n productive tangible assets over which an investor exercises control. Investment projects according to Okafor (l983), axe such that the f a c i l i t i e s provided by the component assets can only be effective if operated as a unit. Hence the component assets must necessarily be “accepted or rejected’ as a set. A project to be financed by a firm may include one or more of the following categories by Hampton (P. 246). Replacements: A s fixed assets are used, they wear out or become outdated by new technology.

Money may be budgeted to replace worn out or obsolete equipment. Expansion: Successful firms tend to experience growth in the sale of primary products. I f a firm is experiencing shortages or delays in high-demand products due to inadequate production, f a c i l i t i e s , it w i l l consider proposals to add capacity t o existing product lines. Diversification: Firms seeking the f a c i l i t i e s to enter new markets w i l l consider proposals for the purchase of mw machinery and f a c i l i t i e s t o handle the new products. Research and Development: Firms in industries where technology is rapidly changing w i l l expend large sums of money for researching and developing new products. Miscellaneous: These are projects that do not directly help achieve profit-oriented goals, example, installation of pollution control equipment on a factory’s smokestacks. A decision by a firm to finance any of the above categories of investment projects requires that an appropriate discount rate (otherwise hewn as cost of capital) be selected or determined for discounting the stream of the cash flow arising from the project so as to know the implication of financing such project on the overall worth of the firm.

 

The Implication of Cost of Capital on Project Financing

 

 

STATEMENT OF THE PROBLEM

The primary purpose of measuring the cost of capital is it’s use as a financial standard for evaluating the investment projects of a firm. The capital structure of a firm can be decomposed into debt capital and Equity capital respectively. Each capital component has its associated coat. The cost of debt capital is the interest payment on the debt and it is contractual, while the cost of equity is estimated. The cost of capital for the firm therefore is the  weighted average of the individual cost components, where the weights are the proportions of each capital component in the capital structure. In capital budgeting analysis, the cost of capital is used to determine the “net present values of the future income streams associated with the projects in order to either accept or reject the project. I f the net present value of a project is greater or equal to zero, the project is accepted or i f the “internal rate of return” is greater or equal to the cost of capital, the project similarly is also accepted.

Following the above description, it may be stated that high cost of capital may reduce the level of investment projects to be financed by a firm and this also implies that only projects that w i l l give maximum expected u t i l i t y to the society and share holder8 in the firm are financed. This in turn may mean that resources are efficiently allocated by the firm. The reverse may be the case i f cost of capital is low. A number of investment projects may be financed by a firm without minding whether the firm or the shareholders and the society at large w i l l derive maximum u t i l i t y from the project or not. This is because Nigeria is said to be a ~ s e l l e r”s market, it is assumed that anything one produce8 at whatever price should be sold because of scarcity. It is therefore unlikely that high cost of capital w i l l prevent a firm from undertaking an investment project. It is against this background that the researcher wants to find out; the impact of cost of capital on project financing, other factor8 apart from cost of capital that govern project financing.

 

Implication of Cost of Capital on Project Financing

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