Date post: | 20-Jun-2015 |
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Economy & Finance |
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Meaning Of Cost of Capital
Minimum required Rate Of Return
Which A Project MUST earn.
a) The Minimum Earning by a firmb) In order to satisfyc) The Expectations of Those Personsd) Who have invested their funds in the firm.
DEFINITION
Cost Of Capital also known as:
TARGET RATE
HURDLE RATE
CUT-OFF RATE
What If a firm fails to earn returns at expected rate…..
M.V. of shares REDUCE
Overall Wealth of Shareholders REDUCE
Value of The Firm REDUCE
No. of Prospective Investors REDUCE
Moreover,Acceptance Or Rejection
Of an Investment depends onThe Cost Of Capital
ADDITIONAL POINT :-
Importance of Cost Of Capital
For Capital Budgeting Decisions
For Capital Structure Decisions
For Working Capital Policy Decisions
For Comparative Analysis of various sources of Finance
For Evaluation of Fin. Efficiency of TOP MGMT.
Equity share Holders
Pref. share Holders
Debenture Holders
INVESTMENT in the Company
EARNINGS
If Fulfills the Expectations of The Investors
If doesn’t Fulfills the Expectations of The Investors
Value of Firm DecreaseValue of Firm Increase
ADVERSECONDITION
FAVOURABLECONDITION
Cost of RETAINED EARNINGSThe earnings FORGONE by the ShareholdersThe earnings FORGONE by the Shareholders
Part of Profits, Retained for Future Expansion of BusinessPart of Profits, Retained for Future Expansion of Business
NOT FREE of COST i.e. Involve Cost
AsPart of the Shareholders’ Funds which is blocked as Reserves
If it is Invested Anywhere else,
It will produce someExtra Earnings
OpportunityCost
FORMULA-KRE = D1 / MP + g
Or
D / MP
Equity Share Holders
Investment inThe Company
Blocked in Two Ways
SHARE CAPITAL
RETAINED EARNINGS
Weighted Avg. Cost of CapitalAlso Known As :- Combined Cost of Capital
Composite Cost of Capital
Overall Cost of CapitalCombination of
Component Costsi.e.
Kd, Kp, Ke, Kre
According to theWeights of each
Component Capital
Meaning:-
Weights are AssignedAs per
The Proportion of eachComponent capital
In the Capital Structure
Any Fin. DecisionShould be taken with reference to
‘WACC’& Not with reference to
Cost of Component Capital
Main Objective :-
Formula of W.A.C.C.
(D / T.F. * Kd) + (P / T.F. * Kp) + (E / T.F. * Ke)
Kp Ke
Composition according to the respective weights
WACC
Kd
Explicit Cost
The Discount Rate whichEquates
The PV of Cash Inflows&
The PV of Cash Outflows
It ArisesWhen
The FundsAre
Raised
Implicit Cost
The Rate of ReturnWhich will be
ForgoneIf the project presentlyUnder consideration
Is accepted
It ArisesWhen
The FundsAre
Used
AlsoKnown as
OpportunityCost
Assignment of Weights
Book Value Weights
Simple Computations
Wrong Estimates
No Fluctuations
Operationally convenient
Readily Available
Market Value Weights
Difficult To Compute
Good Estimates
Fluctuate Widely
Theoretically consistent
Difficult to calculate
Which Weights Should be used in the calculationof WACC ?
Market Value weightsShould ALWAYS
Be givenPreference
As these provideA Good Estimate of
Cost of Capital
In Case,M.V. Weights
Are not readily avlbl.Then,
Book Value WeightsCan be Used.
Economic Value Added (EVA)Profits Over And Above the Cost of Capital
ROCE > Ko
A Test of Profit Adequacy
A Measure of Corporate Growth
Formula
Actual Earnings – Earnings at Ko
Marginal Cost of CapitalCost of Raising ADDITIONAL Funds
Marginal Weightsare used
i.e. The Proportion of Funds,The firm intends to Employ
The Problem of choosingb/w. B.V. and M.V.
Doesn’t arise inThe case of
WMACC, Why ?
Because WMACC usesMarginal Weights
Which represents theProportion of funds,
The firm intends to employ.
Why should a firm periodically re-examine its Cost of Capital before determining Annual Capital Budget ?
REASONS :-
Firm’s Internal Structure
Capital Market Conditions
Supply and Demand for Funds
Subtle change in Capital Structure