RATE OF RETURN

The rate of return (or the cost of capital) to be used for discounting the project's cash flows will depend on how high the rate of return the investors require to compensate for the degree of risk borne by them. In case, if there are exist investment opportunities that are comparable to the project under consideration that the rate of return for the project should be at least as great as the of the comparable investment opportunities. If there exist no comparable investment opportunities, then the rate of return is determined using the concept of the weighted average cost of capital. Weighted average cost of capital is the weighted average cost of the components of any financing packaged that will allow the project to be undertaken. In case of infrastructure projects, the projects are financed with financing packages which consist of two major financing instruments, debt and equity. Therefore, the weighted cost of capital can be expressed as the weighted average of the required rate of return for equity (or cost of equity) and the required rate of return for debt (or cost of debt).

The required rate of return for debt or cost of equity is the cost incurred by the project on borrowing or issuing debt instruments to raise debt capital. The cost of debt need not be necessarily equal to the interest rate payable at regular intervals. The cost of debt should be determined by discounting the cash debt service requirement payable over the loan period and comparing with the net proceeds to the project on issue of debt. For instance, if NP is the net proceeds from the debt issue, C i represents the cash debt service requirement payable in period i , and r d be the cost of debt. C i includes the interest and principal payable in the time period i . The pre-tax cost of debt can be evaluated by solving the following equation: