Relation of Cost of Capital and Life Cycle Analysis

Abstract

"Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise." Opportunity cost is what you give up as a consequence of your decision to use a scarce resource in a particular way. All capital invested is the total amount of cash invested into a business. In an enterprise this refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity. An organization's cost of capital is the cost it must pay to raise funds. This item defines and explains cost of capital, with examples, along with similar and related terms. Very briefly, however, these similar-sounding terms are defined as follows: Cost of Capital is the cost an organization pays to raise funds (e.g., through bank loans or issuing bonds), expressed as an annual percentage. Organizations typically define their own cost of capital in one of two ways.

• Cost of capital may be taken simply as the financing cost the organization must pay when borrowing funds, either by securing a loan or by selling bonds, or equity financing. In either case, cost of capital would be expressed as an annual interest rate, such as 6%, or 8.2%.
• Alternatively, when evaluating a potential investment (e.g., a major purchase), the cost of capital is considered to be the return rate the company it could earn if it used money for an alternative investment with the same risk. That is, the cost of capital is essentially the opportunity cost of investing capital resources for a specific purpose.

life cycle analysis  is often used for option evaluation when procuring new assets and for decision-making to minimize whole-life costs throughout the life of an asset. It is also applied to comparisons of actual costs for similar asset types and as feedback into future design and acquisition decisions.

The primary benefit is that costs which occur after an asset has been constructed or acquired, such as maintenance, operation, disposal, become an important consideration in decision-making. Previously, the focus has been on the up-front capital costs of creation or acquisition, and organizations may have failed to take account of the longer-term costs of an asset. It also allows an analysis of business function interrelationships. Low development costs may lead to high maintenance or customer service costs in the future. When making this calculation, the depreciation cost on the capital expense should not be included

In many organizations cost of capital (or, more often weighted average cost of capital) serves as the discount rate for discounted cash flow analysis of proposed investments, actions or business case cash flow scenarios. Cost of capital (or weighted average cost of capital) is also used sometimes to set the hurdle rate, or threshold return rate that a proposed investment must exceed in order to receive funding. Cost of capital percentages can vary greatly between different companies or organizations, depending on such factors as the organization's life stage. A company at initial stage want  to run business on least cost so he could choose risky source of capital but when organization on growth stage then he organization run business on less risky source so these two things are inter related.