When evaluating the feasibility of a purchase, such as an oven, the appropriate cost of capital to use is the company's weighted average cost of capital (WACC). The WACC is the average rate of return a company needs to generate to satisfy all of its stakeholders, including shareholders, debt holders, and other capital providers.
WACC takes into account the proportion of equity, debt, and other financing sources in a company's capital structure and the respective costs associated with each source. Here's the formula to calculate the WACC:
WACC = (E/V * Re) + (D/V * Rd * (1 - Tc))
Where: E = Market value of equity V = Total market value of equity + market value of debt Re = Cost of equity D = Market value of debt Rd = Cost of debt Tc = Corporate tax rate
The cost of equity (Re) is the return required by the company's shareholders, often calculated using the Capital Asset Pricing Model (CAPM) or other equity valuation models. The cost of debt (Rd) is the interest rate the company pays on its debt, adjusted for taxes (Tc) since interest payments are tax-deductible.
Using the WACC as the discount rate for evaluating the feasibility of the oven purchase accounts for the overall cost of all the capital invested in the company and reflects the opportunity cost of using those funds for the new investment. The decision to proceed with the oven purchase would depend on comparing the potential cash flows generated by the oven (e.g., cost savings, increased efficiency, revenue generation) with the initial investment and using the WACC as the discount rate to determine the net present value (NPV) or internal rate of return (IRR) of the investment. If the NPV is positive or the IRR exceeds the WACC, the investment may be considered feasible.