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Unformatted text preview: ompensation for taking on risk. They can either provide their funds to your company to make
investments or they could invest their funds elsewhere. Therefore, there is an opportunity cost to
consider: what the suppliers of capital could earn elsewhere for the same level of risk. We refer to the
return required by the suppliers of capital as the cost of capital, which comprises the compensation to
suppliers of capital for their opportunity cost of not having the funds available (the time value of money)
and compensation for risk.
Cost of capital = Compensation for the time value of money + Compensation for risk
Using the net present value criterion, if the present value of the future cash flows is greater than the
present value of the cost of the project, it is expected to increase the value of the company, and
therefore is acceptable. If the present value of the future cash flows is less than the present value of the
costs of the project, it should be rejected. And under certain circumstances, using the internal rate of
return criterion, if the project's return exceeds the project's cost of capital, the pr...
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- Spring '07