After doing a little analysis, you, the wily new division manager, decided that a small investment of $300,000 in a new product line could result in annual sales of over $150,000 for the next two years and $250,000 per year for the following three. With your numbers in tow, you met with the company’s Chief Financial Officer and were inundated with finance terms you have never heard before. To those outside the finance department, the calculation of costs and benefits seems fairly straightforward. The finance department, on the other hand, uses terms like time value of money, weighted average cost of capital, and marginal cost of capital to describe the benefit of your new product line.
One of the most important financial concepts is the time of value of money. Money received today is more valuable than money received in the future because interest can be earned on the money you have (Freeman, 2000). The importance of this concept can not be understated. After all, your argument for making the investment is based on the anticipated return. The concern of the finance department in this case is whether or not they can use the proposed $300,000 investment in another way to generate a higher return. In this case, the return rate to grow $300,000 into $1,050,000 over 5 years would be slightly less than 29 percent. Knowing this information before meeting with the finance department will give the savvy division manager a leg up.
In order to expand in the new product line, the initial $300,000 investment in machinery will have to be raised. Unfortunately, this money does not come without a cost. Publicly traded companies have three main avenues for funding: long-term debt, sale of preferred stock, and sale of common stock. Each method for raising capital has an associated cost including interest and taxes. A company tries to maintain a mix of different funding called a target capital structure. When raising money for investment, the company assigns a weight, or percentage, to each kind of funding to determine the weighted average cost of capital. This cost, expressed as a percentage, is compared to the expected return to determine whether or not the investment should be made (Gitman, 2009).
As a company continues to raise capital, the cost of capital increases. In other words, the company’s risk has changed with each of financing, therefore a larger return is expected by those infusing new capital into the company. The marginal cost of capital is simply the weighted average cost of capital associated with the company’s next round of financing. As long as the internal rate of return for an investment outweighs the marginal cost of capital, the company is encouraged to make the investment (Gitman, 2009).
Freeman, L. (2000). How to assess investments with time value of money.. Ophthalmology Times, 25(2), 34. Retrieved December 5, 2008, from Health Source – Consumer Edition database.
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.