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Project Returns and The Cost of Capital: Some Simple Examples

Example 1: A company has a £10m project for which it is seeking financial assistance. The cost and benefits of the project to the company are outlined in the table below. (This information can usually be derived from the applicant's financial forecasts and NPV calculations).

  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Turnover £k 6000 6000 6000 6000 6000
Variable Cost £k -3000 -3000 -3000 -3000 -3000
Overheads £k -362 -362 -362 -362 -362
Capital Cost £k -10000
Net Cashflow -10000 2638 2638 2638 2638 2638
Return (IRR) 15%

If the company has a cost or internal hurdle rate of 12% then it is clear that the project should generate a satisfactory return for the firm's investors without the aid of financial assistance. (The relevant return is normally the Internal Rate of Return, i.e. the discount rate at which the NPV of a project is zero).

On the other hand if, say, access to finance was the factor underpinning the additionality argument then there might still be a role for financial assistance. In this event assistance in the form of loans would tackle the market failure without the need to resort to more costly forms of assistance such as grant aid.

Example 2: A company has a £10m project for which it is seeking financial assistance. The costs and benefits of the project to the company are outlined in the table below.

  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Turnover £k 6000 6000 6000 6000 6000
Variable Cost £k -3000 -3000 -3000 -3000 -3000
Overheads £k -362 -362 -362 -362 -362
Capital Cost £k -10000
Net Cashflow -10000 2638 2638 2638 2638 2638
Return (IRR) 10%

If the company has a cost of capital or internal hurdle rate of 12% then the project would not go ahead, as the return from the project would be insufficient to provide the return expected by its investors or financiers.

However, if financial assistance in the form of, say, a capital grant were offered to the company then the effective capital cost of the project to the firm is reduced and the return on the project for its investors is increased.

  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Turnover £k 6000 6000 6000 6000 6000
Variable Cost £k -3000 -3000 -3000 -3000 -3000
Overheads £k -362 -362 -362 -362 -362
Capital Cost £k -10000
Capital Grant 490
Net Cashflow -9510 2638 2638 2638 2638 2638
Return (IRR) 12%

The table above indicates that if a grant of £490k were offered to the firm then the return on the project would become 12%. A return at this level would be sufficient to persuade the company's investors and financiers to fund the project. In this example, £490k would represent the minimum Government assistance required to bring about the project.