Companies should always consider the required rate of return on investment while making any investment decisions. Relying on the cost of debt as the only measure to make investment decision could come with many risks. Other than the cost of debt, the required rate of return expected from an investment should play a significant role while making an investment decision. Even though a lower interest rate on loans could help reduce the cost of the loan, it would adversely affect the cash flows, especially where the company overborrows. While borrowing may be beneficial, it could lead to missed growth opportunities, reduced cash flows, and the overall low return to investors.
New business projects can only have an economic sense when the discounted net present value exceeds the cost of financing. When making an investment decision, the company should examine the future cash flows and profitability of the project. One of the best methods to analyze the profitability of an investment is the net present value ( Lane& Rosewall, 2015 ). A good investment should have a positive NPV, which is an indication that the projected earnings exceed the anticipated costs. Besides, the payback period is an important consideration for the profitability of an investment project. The payback period is an important measure of the risk of investment, especially when liquidity is an important criterion for choosing an investment. The rate of return of an investment is an important area, especially for the investors. The speed at which a project provides return to the investors should, therefore, form a significant investment decision. The weighted average cost of capital is majorly used by firms to determine the value of each of the components of the capital structure. While it combines all the costs of capital of the company, it would not entirely make the best investment decisions when used alone.
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References
Lane, K., & Rosewall, T. (2015). Firms’ investment decisions and interest rates. RBA Bulletin , 1-7.
