The cost of capital is a long-term Investment decision-making is an important evaluation parameters.

Under the
net present value method to the cost of capital as the discount rate on the investment program of discounted
net cash flows, according to the discounted value of the positive and negative to determine whether the
investment feasible; the internal rate of return method, will the internal rate of return investment program
compared with the cost of capital in order to choose the best investment programs. In accordance with the
current "financial management" material described in long-term investment decision-making methods, when a
firm source of funding for long-term investment is not the same time, the various sources of funding should be in
accordance with the cost of its share of total investment in the calculation of the weighted average, and then the
weighted average the cost of capital for investment decisions.
The weighted average of a source of funding sources of the funds in the investment
= Σ (×)
Cost of capital, the proportion of the total capital cost of the individual
Example 1: Let the Great Wall company intends to invest in building C projects a total investment of 1,000
million, of which its own funds and borrowed capital of 5 million yuan. Shareholders expect return on investment
rate of 40%, the borrower interest rate is 10%. The project construction period is 0, production and operation
period of 10 years. Net annual cash flow from 2.85 million yuan. Test the feasibility of investment projects in the
decision-making.
The weighted average 500 500
= × 10% × 40% = 25%
The cost of funds 1000 1000
Net Present Value (C) = 285 × (P / A, 25%, 10) - 1000
= 285 × 3.571 - 1000 = 17.74 (million)
According to 285 × (P / A, r, 10) = 1000, (P / A r, 10) = 3.509, obtained the project internal rate of return r =
25.68%.
Based on the above results, C project net present value greater than 0, internal rate of return is greater than the
weighted average cost of capital, thus, the investment project feasible.
The author analysis found that decision-making process and conclusions of the above is wrong, for example, as
follows:
[Example 2] based on the cases of Great Wall, the company's C project by the A, B two supporting projects
constitute, A project investment of 500 million to borrow to raise capital, the net annual cash flow 800,000 yuan;
B Investment of 500 million to their funds for investment, the net annual cash flow from 2.05 million. Test,
respectively A, B decision-making to determine the feasibility of the project.
Net Present Value (A) = 80 × (P / A, 10%, 10) - 500
= 80 × 6.145-500
= -8.4 (Million)
Net Present Value (B) = 205 × (P / A, 40%, 10) - 500
= 205 × 2.414 - 500
= -5.13 (Million)
500
According to (P / A, r, 10) = = 6.250, obtained A project internal rate of return r = 9.62%;
80
500
According to (P / A, r, 10) = = 2.439, obtained B project internal rate of return r = 39.59%.
205
Based on the above results we can see, A, B two projects are less than the net present value 0, internal rate of
return are less than its cost of capital, so A, B two investment projects are not feasible. This is contrary to the
conclusions of Example 1.
Table 1 Investment Project Decision Analysis Table Unit: RMB
Project A Project B Project C Project
The total investment 500 500 1000
Construction period (years) 0 0 0
Production and operation period (years) 10 10 10
Cost of capital 10% 40% 25%
Annual net cash flows 80,205,285
Net Present Value -8.4 -5.13 17.74
Internal Rate of Return 9.62% 39.59% 25.68%
The feasibility of the decision-making is not feasible feasible feasible

Why is an investment on the same project will come to two different conclusions? In my view, the problem lies
in the weighted average cost of capital. The cost of capital is calculated each year by using tariff (without regard
to financing costs) with the ratio between the total amount of funds raised. In the financing decision-making,
usually assume that with the tariff schedule with the payment of principal repayment due time. Therefore,
according to the weighted average cost of capital calculated periods of cash outflows with a variety of funding
sources in accordance with the cost of capital calculation for individual phases of the same amount of cash
outflows.
[Example 3] Suppose the above example the Great Wall company to 10 million yuan of bank loans, banks now
offer two loan programs Great Wall Industry Corporation, a program to the Great Wall Industry Corporation by
10% and 40% of the interest rate of 2 T the amount of five million yuan of loans totaling 10 million yuan loan; B
program by 25% to the Great Wall Industry Corporation to provide loans to 10 million yuan interest rates. Great
Wall asked what choice should be made.
(1) If the annual interest payments, principal repayment due time, then the two fund-raising programs of the
cash outflows from debt service are as follows:
A program of interest payments per year = 500 × 10% 500 × 40% = 250 (million)
B Program each year to pay interest = 1000 × 25% = 250 (million)
Two programs with the annual payment with the tariff is 2.5 million yuan, the weighted average cost of capital is
25%, from the financing point of view, two programs exactly the same.
(2) if we adopt the matching principal and interest repayment method, the two fund-raising programs of the cash
outflows from debt service are as follows:
A program of 500 500 per year
= = 288.5 (million)
Debt service (P / A, 10%, 10) (P / A, 40%, 10)

B per year from a 1000

= = 280.03 (million)
Debt service (P / A, 25%, 10)
A program of annual debt service amounted to 2.885 million yuan, B program debt service amounted to 2.8003
million yuan a year, B per year from a low debt-service program Bijia 84.7 thousand yuan, from the financing
perspective, the Great Wall should be Select B program. Reposted elsewhere in the paper for free download

(3) If a debt service due, then the two funding programs of the cash outflows from debt service are as follows:
A program of debt service due time = 500 × (1 10%) 10 500 × (1 40%) 10
= 500 × 2.5937 500 × 28.926
= 15,759.85 (million)
B program expires once a debt service = 1000 × (1 25%) 10
= 1000 × 9.31323
= 9313.23 (million)
A program expires once a debt service amounted to 157.5985 million yuan, B program debt service amounted
to 93.1323 million yuan due time, the program B program Bijia a debt service payments due less 64.4665
million yuan, from the fund-raising perspective, the Great Wall, the company should choose B program.
Can be seen, in equal installments or expiration of a debt service debt service under the condition, according to
the weighted average cost of capital calculation does not mean that annual cash outflows (usually less than
that) by the weighted cost of capital calculated by the individual's annual cash outflows.
Table 2 Cash Flow Financing Program servicing unit: million yuan
Life
Program 1 2 ... ... 910
Regular Interest
A program of maturity Amortization 250 250 ... ... 250 1250
B program 250 250 ... ... 250 1250
Equal installments
A program of debt service 288.5 288.5 ... ... 288.5 288.5
B Program 280.03 280.03 ... ... 280.03 280.03
Maturity time
A program of debt service / / ... ... / 15,759.85
B Program / / ... ... / 9313.23

The weighted average cost of capital is only applicable to scheduled interest payment due a repayment of the
principal fund-raising program decision-making, does not apply to investment programs in decision-making.
Because investment decisions need to consider the time factor, according to the cost of funds will be cash
inflows and cash outflows from the value converted into the same point in time (usually present value).
According to the previous example, we can see that the same cash flows in accordance with the weighted
average cost of capital calculated the present value is greater than the cost of capital were calculated according
to the individual present value of accumulation, according to the weighted average cost of capital calculated the
final value should be less than the respective merits of individual the cost of capital calculated the final value of
accumulation. Therefore, the weighted average cost of capital can not be used to determine
the Economic viability of investment projects.
A project put into operation, we must first recover the cash used to repay debt principal and interest, and then
the investment is recovered the cost of investment income paid to shareholders. When the enterprise long-term
investment of funds from a variety of channels, the policy makers should stand in the position of the
shareholders assess the feasibility of investment projects. The merits of an investment project to shareholders
of the net present value (or shareholders of the net present value index) of the size or the level of the
shareholders to determine the internal rate of return, rather than the total investment of the net present value
terms (or the net present value index) the size or high and low to determine the Internal Rate of Return. That
should be used net present value of shareholders (or shareholders net present value index) and shareholders
of internal rate of return indicators to carry out investment decisions.
Z1 as a liability-based investment, Z2 for the equity investment, I1 as a liability the cost of capital, I2 for the
equity cost of capital, X for the full year net cash flows, X1 as the net cash flow debt service liabilities, r for
shareholders in with rate of return, then:
Z1
Debt servicing net cash flow (X1) =
(P / A, I1, n)
Shareholders, the net present value = (X-X1) × (P / A, I2, n)-Z2
Z2
According to (P / A, r, n) = calculate shareholder IRR r.
X-X1
As cases of C shareholders of the project net present value and internal rate of return of shareholders are as
follows:
Liabilities, debt service 500 500
= = = = 81.37 (million)
Net cash flow (P / A, 10%, 10) 6.145
Shareholders, the net present value (C) = (285-81.37) × (P / A, 40%, 10) - 500
= 203.63 × 2.414 - 500
= -8.44 (Million)
500
According to (P / A, r, 10) = = 2.4554, calculate the internal rate of return to shareholders of r = 39.30%.
285-81.37
Based on the above results we can see, C shareholders of the project net present value is less than 0, the
shareholders equity internal rate of return is less than the cost of capital, thus, the investment program is not
feasible.
The analysis concluded that with the A, B independent decision-making program of the same conclusions.