Errors in estimation of cost of capital in investment appraisal and their significance
AbstractIn order to check out the significance of errors in the estimation of capital cost in investment appraisal, the simulation experiment has been presented in the paper. On the basis of the simulated development of the comparable firms, we have compared the end values of two simulated companies. Both companies encountered the same investment projects but they assess them differently – one firm with the proper cost of capital and the other with the cost of capital two times higher than it should use. The difference between the end value of such companies were not significant for firms which encounter many profitable investment projects (difference of only 3.3% in the company value after 25 years) and slightly higher for the companies which encounter more projects whose value is positive but is only slightly higher than zero (difference of 39.3% in the company value). Therefore, the significance of proper cost of capital estimation is more important for bigger firms in older economy segments which encounter lack of many highly profitable projects. This outcome is consistent with the pattern of use of advanced investment appraisal methods observed in the practice.
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Bibliographic InfoArticle provided by Wroclaw University of Technology, Institute of Organization and Management in its journal Operations Research and Decisions.
Volume (Year): 3 (2008)
Issue (Month): ()
estimation of cost of capital; investment appraisal;
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