Application of Fuzzy Logic in Determining Cost of Capital for the Capital Budgeting Process

Abstract

The capital budgeting process is based on the technique of reducing future cash flows of the net present value which implies a process of discounting by using the discount rate. Usually, in capital budgeting process the discount rate is presented through the cost of capital. The determination of the cost of capital primarily depends on the capital structure, but since the process of capital budgeting implies a long time period, it also implies uncertainty and vagueness. Subjective perception, thinking, judgment and decision making, including a large number of predicted vague data is often expressed solely in linguistic variables by the management and this is the main characteristic of the capital budgeting process, especially in the determination of the cost of the capital through a long time period. The main intention of this paper is to present the use of fuzzy logic in the process of determining the cost of capital and providing an alternative approach in the appraisal of the cost of capital in the presence of fuzziness. The integration and implementation of linguistic variables i.e. qualitative information in the determination of the cost of capital using fuzzy numbers in the capital budgeting process will also be discussed. Through the formulation of a fuzzy system and the use of fuzzy numbers we will propose a process and methodology* for the use of fuzzy numbers in the process of the cost of capital determination. We examine the presented methods and suggest new ideas that could improve further research and implementation of fuzzy logic in the capital budgeting process.