Answer to Question #262817 in Accounting for kelly

Question

(Ignore income taxes in this problem.) Allen Company's required rate of return is 14%. The company is considering the purchase of a new machine that will save $10,000 per year in cash operating costs. The machine will cost $40,000 and will have an 8-year useful life with zero salvage value. Straight-line depreciation will be used.

Explain at least 3 points the meaning of cost of capital and its relevance in a net present value (NPV) analysis.

Answer 1

Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital project, such as purchasing new equipment,for example in the case above it's about purchase of new machine.

The importance of cost of capital is that, it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company.

Cost of capital is the required return needed on a project or investment to make it worthwhile.