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Cost of capital and the capital asset pricing model (CAPM) are two items that relate to the review and valuation of an investment. Cost of capital represents the interest rate paid for funds used to engage in a certain business activity. The CAPM is a specific formula used to assess the risk versus return of an investment. Therefore, the connection between cost of capital and CAPM is the necessity of the former in order to compute a reasonable CAPM. The other connection is that cost of capital and CAPM has a connection where one can substitute the cost of capital with an interest rate that indicates a future financial return.
CAPM is a formal measure that takes into account the time and money for a given project. The longer an investment takes to reach completion should reward companies with higher financial returns. This basic concept is a common assumption with different time value of money techniques. When a company expects to pay large amounts of money to start a project, more external funds are usually a requirement as companies are usually unable to pay for the project. The cost of capital and CAPM can help a company select from a number of different projects that may or may not bring strong financial returns.
In most cases, there is no single benchmark that draws a trigger when reviewing cost of capital and CAPM. For example, a company may use these pieces of information to determine the total rate of return for a project. Each formula may be slightly different due to initial cost of capital or any premium related to the interest rate for future financial returns. Once a company has the answer for each formula, it must make a selection regarding the projects. Companies often look to select a project based on the cost of capital and CAPM that is higher than the internal rate of return.
Like many mathematical corporate finance formulas, there is not a 100 percent guarantee that a project will actually result in computed financial returns. The cost of capital and CAPM analysis cannot estimate any external, unexpected factors, such as extreme increases in inflation or heavy competition from other businesses or a lack of consumer demand due to decreased consumer wages. Companies must have backup plans or other analyses for looking into these factors. Few — if any — mathematical formulas can achieve this result.
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