Present value analysis-cost of capital National Leasing is evaluating the cost of capital to use in its capital budgeting process. Over the recent past, the company has averaged a return on equity of 12% and a return on investment of 9%. The company can currently borrow short-term mA. Which of the preceding rates is most relevant to deciding the cost of capital to use? Explain your answer.oney for 6%.Required:
To determine the most relevant rate for deciding the cost of capital, we need to understand the concept of cost of capital and its components.
The cost of capital is the minimum rate of return that a company requires on its investments in order to create value for its shareholders. It is the cost of financing its operations and projects through a combination of debt and equity.
There are two main components of the cost of capital: the cost of debt and the cost of equity.
The cost of debt represents the interest expense the company pays on its borrowed funds. It is typically calculated by looking at the interest rate on debt instruments, such as loans or bonds, that the company has.
The cost of equity represents the return that investors require as compensation for taking on the risk of investing in the company's stock. It is usually estimated using the dividend discount model or by comparing the company's stock returns to a benchmark rate of return, such as the risk-free rate plus a risk premium.
In this case, National Leasing needs to determine the cost of capital to use in its capital budgeting process. They have been averaging a return on equity (ROE) of 12% and a return on investment (ROI) of 9%. They also have the option to borrow money at a short-term rate of 6%.
The most relevant rate to deciding the cost of capital to use is the cost of equity. The reason for this is that the cost of equity represents the return required by the company's shareholders, who provide the capital to fund the company's operations and projects.
The return on equity (ROE) of 12% is the rate of return that National Leasing has been generating for its shareholders. This indicates the level of profitability and value creation the company has achieved. Therefore, the ROE provides insight into the return that shareholders would expect in order to invest in the company.
On the other hand, the return on investment (ROI) of 9% represents the overall return on the company's total investment, which includes both debt and equity. While this is important for evaluating the company's overall performance, it does not directly represent the return required by shareholders.
The short-term borrowing rate of 6% is the cost of debt, which is relevant for determining the cost of debt capital but not the cost of equity capital. The cost of debt is usually lower than the cost of equity because debt is considered less risky than equity.
In summary, the most relevant rate for deciding the cost of capital to use is the return on equity (ROE) of 12%. This represents the return required by shareholders and provides a benchmark for evaluating the potential return on investments and projects in the capital budgeting process.