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Oliver Oil Rigs is considering the purchase of a new drill for its mining operation. Oliver...

Oliver Oil Rigs is considering the purchase of a new drill for its mining operation. Oliver is currently financed 100% with equity and the new drill investment has similar risks to Oliver's prior investment projects. What cost of capital measure should Oliver use to calculate the NPV of the drill purchase?

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Answer #1

For calculating the NPV, the future cashflows of the project are required to be discounted at a given rate to estimate the present value.

This discounting rate can also be termed as the Cost of Capital. This is not the rate of return from other investments; This rate is the cost at which the company is able to infuse / fund the capital - both equity as well as debt, to suppor the project; Hence, WACC (Weighted Average Cost of Capital) is generally used for calculating Present Value.

In this given case, Oliver's project is currently financed fully with 100% equity. Also, the estimated risk of the project is similar to the current situation of Olvier. Hence, the cost of capital in this case is the cost of equity.

Hence, Cost of Equity should be used by Oliver as discounting factor / cost of capital, to calculate the NPV of the drill purchase.

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