COST OF CAPITAL

The main objective of a business firm is to maximize the wealth of its

shareholders in the long-run, the Management Should only invest in those projects

which give a return in excess of cost of fund invested in the project of the business.

The difficulty will arise in determination of cost of funds, if is raised from different

sources and different quantum. The various sources of funds to the company are in the

form of equity and debt. The cost of capital is the rate of return the company has to

pay to various suppliers of fund in the company. There are main two sources of

capital for a company – shareholder and lender. The cost of equity and cost of debt

are the rate of return that need to be offered to those two groups of suppliers of the

capital in order to attract funds from them.

The primary function of every financial manager is to arrange adequate capital

for the firm. A business firm can raise capital from various sources such as equity and

or preference shares, debentures, retain earning etc. This capital is invested in

different projects of the firm for generating revenue. On the other hand, it is necessary

for the firm to pay a minimum return to each source of capital. Therefore, each project

must earn so much of the income that a minimum return can be paid to these sources

or supplier of capital. What should be this minimum return? The concept used to

determine this minimum return is called Cost of Capital. On the basis of it the

management evaluates alternative sources of finance and select the optimal one. In

this chapter, concepts and implications of firms cast of capital, determination of cast

of difference sources of capital and overall cost of capital are being discussed.

CONCEPT OF COST OF CAPITAL

Cost of capital is the measurement of the sacrifice made by investors in order to

invest with a view to get a fair return in future on his investments as a reward for the

postponement of his present needs. On the other hand form the point of view of the

firm using the capital, cost of capital is the price paid to the investor for the use of

capital provided by him. Thus, cost of capital is reward for the use of capital. Author

Lutz has called it” BORROWING AND LANDING RATES”. The borrowing rates

means the rate of interest which must be paid to obtained and use the capital.

Similarly, landing rate is the rate at which the firn discounts its profits. It may also the

1

opportunity cost of the funds to the firm i.e. what the firm would earn by investing

these funds elsewhere. In practice the borrowing rates used indicate the cost of capital

in preference to landing rates.

Technically and Operationally, the cost of capital define as the minimum rate

of return a firm must earn on its investment in order to satisfy investors and to

maintain its market value. I.e. it is the investors required rate of return. Cost of capital

also refers to the discount rate which is used while determining the present value of

estimated future cash flows. In the other word of John J. Hampton, “The cost of

capital is the rate of return in the firm requires from investment in order to

increase the value of firm in the market place”. For example if a firm borrows Rs.

5 crore at an interest of 11% P.A., then the cost of capital is 11%. Hear it’s the

essential for the firm to invest these Rs. 5 Crore in such a way that it earn at least Rs.

55 lacks i.e. rate of return at 11%. If the return less then this, then the rate of dividend

which the share holder are receiving till now will go down resulting in a decline in its

market value thus the cost of capital is the reward for the use capital. Solomon Ezra,

has called “It the minimum required rate of return or the cut of rate for capital

expenditure.”

FEATURES OF COST OF CAPITAL

It is not a cost in reality the cost of capital is not a cost as such, but its rate of

return which it requires on the projects.

MINIMUM RATE OF RETURN:

Cost of capital is the minimum rate of return a firm is required in order to

maintain the market value of its equity shares.

2

REWARDS FOR RISKS

Cost of capital is the reward for the business and financial risk. Business risks

is the measurement of variability in profits due to changes in sales, while financial

risks depends on the capital structure i.e. that equity mix of the firm.

SIGNIFICANCE OF CONCEPT OF COST OF CAPITAL

The cost of capital is very important concept in the financial decision making. The

progressive management always likes to consider the cost of capital while taking

financial decisions as it’s very relevant in the following spheres...

1. Designing the capital structure: the cost of capital is the significant factor in

designing a balanced an optimal capital structure of a firm. While designing it,

the management has to consider the objective of maximizing the value of the

firm and minimizing cost of capita. I comparing the various specific costs of

different sources of capital, the financial manager can select the best and the

most economical source of finance and can designed a sound and balanced

capital structure.

2. Capital budgeting decisions: the cost of capital sources as a very useful tool in

the process of making capital budgeting decisions. Acceptance or rejection of

any investment proposal depends upon the cost of capital. A proposal shall not

be accepted till its rate of return is greater then the cost of capital. In various

methods of discounted cash flows of capital budgeting, cost of capital

measured the financial performance and determines acceptability of all

investment proposals by discounting the cash flows.

3. Comparative study of sources of financing: there are various sources of

financing a project. Out of these, which source should be used at a particular

point of time is to be decided by comparing cost of different sources of

financing. The source which bears the minimum cost of capital would be

selected. Although cost of capital is an important factor in such decisions, but

equally important are the considerations of retaining control and of avoiding

risks.

3

4. Evaluations of financial performance of top management: cost of capital can

be used to evaluate the financial performance of the top executives. Such as

evaluations can be done by comparing actual profitability of the project

undertaken with the actual cost of capital of funds raise o finance the project.

If the actual profitability of the project is more then the actual cost of capital,

the performance can be evaluated as satisfactory.

5. Knowledge of firms expected income and inherent risks: investors can know

the firms expected income and risks inherent there in by cost of capital. If a

firms cost of capital is high, it means the firms present rate of earnings is less,

risk is more and capital structure is imbalanced, in such situations, investors

expect higher rate of return.

6. Financing and Dividend Decisions: the concept of capital can be conveniently

employed as a tool in making other important financial decisions. On the

basis, decisions can be taken regarding dividend policy, capitalization of

profits and selections of sources of working capital.

CLASSIFICATION OF COST OF CAPITAL

1. Historical Cost and future Cost

Historical Cost represents the cost which has already been incurred for

financing a project. It is calculated on the basis of the past data. Future cost

refers to the expected cost of funds to be raised for financing a project.

Historical costs help in predicting the future costs and provide an evaluation of

the past performance when compared with standard costs. In financial

decisions future costs are more relevant than historical costs.

2. Specific Costs and Composite Cost

Specific costs refer to the cost of a specific source of capital such as equity

share. Preference share, debenture, retain earnings etc. Composite cost of

capital refers to the combined cost of various sources of finance. In other

words, it is a weighted average cost of capita. It is also termed as ‘overall costs

of capital’. While evaluating a capital expenditure proposal, the composite

cost of capital should be as an acceptance/ rejection criterion. When capital

from more than one source is employed in the business, it is the composite

4

cost which should be considered for decision-making and not the specific cost.

But where capital from only one source is employed in the business, the

specific cost of those sources of capital alone must be considered.

3. Average Cost and Marginal Cost

Average cost of capital refers to the weighted average cost of capital

calculated on the basis of cost of each source of capital and weights are

assigned to the ratio of their share to total capital funds. Marginal cost of

capital may be defined as the ‘Cost of obtaining another rupee of new capital.’

When a firm rises additional capital from only one sources (not different

sources), than marginal cost is the specific or explicit cost. Marginal cost is

considered more important in capital budgeting and financing decisions.

Marginal cost tends to increase proportionately as the amount of debt increase.

4. Explicit Cost and Implicit Cost

Explicit cost refers to the discount rate which equates the present value of cash

outflows or value of investment. Thus, the explicit cost of capital is the

internal rate of return which a firm pays for procuring the finances. If a firm

takes interest free loan, its explicit cost will be zero percent as no cash outflow

in the form of interest are involved. On the other hand, the implicit cost

represents the rate of return which can be earned by investing the funds in the

alternative investments. In other words, the opportunity cost of the funds is the

implicit cost. Port field has defined the implicit cost as “the rate of return with

the best investment opportunity for the firm and its shareholders that will be

forgone if the project presently under consideration by the firm were

accepted.” Thus implicit cost arises only when funds are invested somewhere,

otherwise not. For example, the implicit cost of retained earnings is the rate of

return which the shareholder could have earn by investing these funds, if the

company would have distributed these earning to them as dividends.

Therefore, explicit cost will arise only when funds are raised whereas implicit

cost arises when they are used.

5

Assumption of Cost of Capital

While computing the cost of capital, the following assumptions are made:

The cost can be either explicit or implicit.

The financial and business risks are not affected by investing in

new investment proposals.

The firm’s capital structure remains unchanged.

Cost of each source of capital is determined on an after tax

basis.

Costs of previously obtained capital are not relevant for

computing the cost of capital to be raised from specific source.

Computation of specific costs

A firm can raise funds from different sources such as loan, equity shares, preference

shares, retained earnings etc. All these sources are called components of capital. The

cost of capital of these different sources is called specific cost of capital. Computation

of specific cost of capital helps in determining the overall cost of capital for the firm

and in evaluating the decision to raise funds from a particular source. The

computation procedure of specific costs is explained in the pages that follow –

COST OF DEBT CAPITAL

Cost of Debt is the effective rate that a company pays on its current debt. This

can be measured in either before- or after-tax returns; however, because interest

expense is deductible, the after-tax cost is seen most often. This is one part of the

company's capital structure, which also includes the cost of equity.

 

Much theoretical work characterizes the choice between debt and equity, in a

trade-off context: Firms choose their optimal debt ratio by balancing the benefits and

6

costs. Traditionally, tax savings that occur because interest is deductible while equity

payout is not have been modelled as a primary benefit of debt. Large firms with

tangible assets and few growth options tend to use a relatively large amount of debt.

Firms with high corporate tax rates also tend to have higher debt ratios and use more

debt incrementally. A company will use various bonds, loans and other forms of debt,

so this measure is useful for giving an idea as to the overall rate being paid by the

company to use debt financing. The measure can also give investors an idea as to the

riskiness of the company compared to others, because riskier companies generally

have a higher cost of debt.

Example-: If a company issues 12% debentures worth Rs. 5 lacs of Rs. 100 each at

par, then it must be earn at least Rs.60000(12% of Rs. 5 lacs) per year on this

investment to maintain the income available to the shareholders unchanged. If the

company earns less than this interest rate (12%) than the income available to the

shareholders will be reduced and the market value of the share will go down.

Therefore, the cost of debt capital is the contractual interest rate adjusted further for

the tax liability of the firm. But, to know the real cost of debt, the relation of the

interest rate is to be established with the actual amount realised or net proceeds from

the issue of debentures.

To get the after-tax rate, you simply multiply the before-tax rate by one minus the

marginal tax rate.

Cost of Debt = (before-tax rate x (1-marginal tax))

The before tax rate of interest can be calculated as below:

= Interest Expense of the company

---------------------------------------- X 100

Total Debt

7

Net Proceeds:

1. At par = Par value – Floatation cost

2. At premium = Par value + Premium – Floatation cost

3. At Discount = Par value – Discount – Floatation cost

COST OF PREFERENCE SHARE CAPITAL

Preference share is another source of Capital for a company. Preference Shares are the

shares that have a preferential right over the dividends of the company over the

common shares. A preference shareholder enjoys priority in terms of repayment vis-à-

vis equity shares in case a company goes into liquidation. Preference shareholders,

however, do not have ownership rights in the company. In the companies under

observation only India Cement has preference shares issued.

Cost of Preference Capital = Preference Dividend/Market Value of Preference

Shree Cement has not paid any dividend to the Preference Shareholders. Thus the

Cost of Preference Capital is 0 (Zero).

COST OF EQUITY SHARE CAPITAL

The computation of cost of equity share capital is relatively difficult because

nether the rate of dividend is predetermined nor the payment of dividend is legally

binding, therefore, some financial experts hold the opinion the p.s capital does not

carry any cost but this is not true. When additional equity shares are issued, the new

equity share holders get propranate share in future dividend and undistributed profits

of the company. If reduces the earning per shares of existing share holders resulting in

a fall in marker price of shares. Therefore, at the time of issue of new equity shares, it

is the duty of the management to see that the company must earn at least so much

income that the market price of its existing share remains unchanged. This expected

8

minimum rate of return is the cast o equity share capital. Thus, cost of equity share

capital may be define as the minimum rate of return that a firm must earn on the

equity financed portion of a investment- project in order to leave unchanged the

market price of its shares. The cost of equity can be computed by any of the following

method:

1. Dividend yield method:

Ke = DPS\mP*100

Ke= cost of equity capital

Dps= current cash dividend per share

Mp=current market price per share

2. Earning yield method:

Ke= EPS\mp*100

Eps= earning per share

3. Dividing yield plus growth in dividend method:

While computing cost of capital under dividend yield(d\p

ratio)method, it had been assumed that present rate of dividend will

remain the same in future also. But, if the management estimates that

companies present dividend will increased continuously for the year to

come, then adjustment for this increase is essential to compute the cost

of capital.

The growth rate in dividend is assumed to be equal to the growth rate

in earning per share. For example if the EPS increase at the rate of

10% per year, the DPS and market price per share would show an

increase at the rate of 10%. Therefore, under this method, cost of

equity capital is computed by adjusting the present rate of dividend on

the basis of expected future increase in company’s earning.

Ke= DPS\MP*100+G

G= Growth rate in dividend.

9

4. Realised yield method:

In case where future dividend and market price are uncertain, it is very difficult to

estimate the rate of return on investment. In order to overcome this difficulty, the

average rate of return actually realise in the past few year by the investors is used to

determine the cost of capital. Under this method, the realised yield is discounted at the

present value factor, and then compare with value of investment this method is based

on these assumptions.

The company’s risk doe not change i.e. dividend and growth rate are stable.

The alternative investment opportunities, elsewhere for the investor, yield the return

which is equal to realised yields in the company, and

The market of equity share of the company does not fluctuate widely.

Cost of newly issued equity shares

when new equity share are issued by a company, it is not possible to realise the

market price per share, because the company has to incur some expenses on new

issue, including underwriting commission, brokerage etc. so, the amount of net

proceeds is calculated by deducting the issue expenses form the expected market

value or issue price. To ascertain the cost of capital, dividend per share or EPS is

divided by the amount of net proceeds. Any of the following formulae may be used

for this purpose:

Ke= DPS\NP*100

Or

Ke= EPS\NP*100

Or

Ke=DPS\NP*100+G

10

COST OF RETAIN EARNINGS OR INTERNAL EQUITY

Generally, company’s do not distribute the entire profits by way of dividend

among their share holders. A part of such profit is retained for future expansion and

development. Thus year by year, companies create sufficient fund for the financing

through internal sources. But , nether the company pays any cost nor incur any

expenditure for such funds. Therefore, it is assumed to cost free capital that is not

true. Though retain earnings like retained earnings like equity funds have no explicit

cost but do have opportunity cost. The opportunity cost of retained earnings is the

income forgone by the share holders. It is equal to the income what a share holders

could have earns otherwise by investing the same in an alternative investment, if the

company would have distributed the earnings by way of dividend instead of retaining

in the business. Therefore , every share holders expects from the company that much

of income on retained earnings for which he is deprived of the income arising o its

alternative investment. Thus, income forgone or sacrificed is the cost of retain

earnings which the share holders expects from the company.

WEIGHTED AVERAGE COST OF CAPITAL

Once the specific cost of capital of the long-term sources i.e. the debt, the

preference share capital, the equity share capital and the retained earnings have been

ascertained, the next step is to calculate the overall cost of capital of the firm. The

capital raised from various sources is invested in different projects. The profitability

of these projects is evaluated by comparing the expected rate of return with overall

cost of capital of the firm. The overall cost of capital is the weighted average of the

costs of the various sources of the funds, weights being the proportion of each source

of funds in the total capital structure. Thus, weighted average as the name implies,

is an average of the cost of specific sources of capital employed in the business

properly weighted by the proportion they held in firm’s capital structure. It is

also termed as ‘Composite Cost of Capital’ or ‘Overall Cost of Capital’ or ‘Average

Cost of Capital’.

11

WEIGHTED AVERAGE, How to calculate?

Though, the concept of weighted average cost of capital is very simple. Yet there are

many problems in its calculation. Its computation requires:

1. Assignment of Weights: First of all, weights have to be assigned to each

source of capital for calculating the weighted average cost of capital. Weight

can be either ‘book value weight’ or ‘market value weight’. Book value

weights are the relative proportion of various sources of capital to the total

capital structure of a firm. The book value weight can be easily calculated by

taking the relevant information from the capital structure as given in the

balance sheet of the firm. Market value weights may be calculated on the basic

on the market value of different sources of capital i.e. the proportion of each

source at its market value. In order to calculate the market value weights, the

firm has to find out the current market price of each security in each category.

Theoretically, the use of market value weights for calculating the weighted

average cost of capital is more appealing due to the following reasons:

The market values of securities are closely approximate to the actual

amount to be received from the proceeds of such securities.

The cost of each specific source of finance is calculated according to

the prevailing market price.

But, the assignment of the weight on the basic of market value is operationally

inconvenient as the market value of securities may frequently fluctuate.

Moreover, sometimes, no market value is available for the particular type of

security, specially in case of retained earnings can indirectly be estimated by

Gitman’s method. According to him, retained earnings are treated as equity

capital for calculating cost of specific sources of funds. The market value of

equity share may be considered as the combined market value of both equity

shares and retained earnings or individual market value (equity shares and

retained earnings) may also be determined by allocating each of percentage

share of the total market value to their respective percentage share of the total

values.

12

For example:- the capital structure of a company consists of 40,000 equity

shares of Rs. 10 each ad retained earning of Rs. 1,00,000. if the market price

of company’s equity share is Rs. 18, than total market value of equity shares

and retained earnings would be Rs. 7,20,000 (40,000* 18) which can be

allocated between equity capital and retained earnings as follows-

Market Value of Equity Capital = 7,20,000*4,00,000/5,00,000

=Rs. 5,76,000.

Market Value of Retained Earnings= 7,20,000*1,00,000/5,00,000

=Rs. 1,44,000.

2. Computation of Specific Cost of Each Source :

After assigning the weight; specific costs of each source of capital, as

explained earlier, are to be calculated. In financial decisions, all costs are

‘after tax’ costs. Therefore, if any source has ‘before tax’ cost, it has to be

converted in to ‘after tax’ cost.

3. Computation of Weighted Cost of Capital :

After ascertaining the weights and cost of each source of capital, the weighted

average cost is calculated by multiplying the cost of each source by its

appropriate weights and weighted cost of all the sources is added. This total of

weighted costs is the weighted average cost of capital. The following formula

may be used for this purpose :

Kw = ∑XW/∑W

Here; Kw = Weighted average cost of capital

X = After tax cost of different sources of capital

W = Weights assigned to a particular source of capital

13

Example : Following information is available with regard to the capital structure of

ABC Limited :

Sources of Funds Amount(Rs.) After tax cost of Capital

E.S. Capital 3,50,000 .12

Retained Earning 2,00,000 .10

P.S. Capital 1,50,000 .13

Debentures 3,00,000 .09

You are required to calculate the weighted average cost of capital.

Computation of Weighted Average Cost of Capital

Source

(1)

Amount

Rs.

(2)

Weights

(3)

After tax

Cost

(4)

Weighted

Cost

(5)= (3) * (4)

E.S. Capital 3,50,000 .35 .12 .0420

Retained Earning 2,00,000 .20 .10 .0200

P.S. Capital 1,50,000 .10 .13 .0195

Debentures 3,00,000 .09 .09 .0270

Total 10,00,000 1.00 .1085

Weighted Average Cost of Capital (WACC) .10850 or 10.85%

14

CALCULATION OF COST OF CAPITAL OF SHREE CEMENT LTD.

Cost of Debt Capital:

For the year 2009-10:

Total Debt Capital = Term loan from Banks + Debts

= 131570.37+30000 = 161570.37 lacs

Total Interest Paid = 13065.36 lacs

Tax Rate = 30%

Interest Expense of the company

Kd (before tax) = -------------------------------------------- X 100

Total Debt

Kd (before tax) = 13065.36

................................................. X 100

161570.37

= 8.08 %

Kd (after tax) = Interest Rate Before Tax – Tax Rate ( 30%.)

Kd (after tax) = 8.08% - 30% = 5.65 %

15

For the year 2008-09:

Total Debt Capital = Term loan from Banks + Debts

= 105716.94+000 = 105716.94 lacs

Total Interest Paid = 9355.94

Tax Rate = 30%

Interest Expense of the company

Kd (before tax) = -------------------------------------------- X 100

Total Debt

9355.94

Kd (before tax) = ---------------------- X 100

105716.94

= 8.85 %

Kd (after tax) = Interest Rate Before Tax – Tax Rate ( 30%.)

Kd (after tax) = 8.85% - 30% = 6.20 %

16

For the year 2007-08

Total Debt Capital = Term loan from Banks + Debts

= 112573.18+800 = 113373.18 lacs

Total Interest Paid = 9636.72 lacs

Tax Rate = 30%

9636.72

Kd (before tax) = ---------------------- X 100

113373.18

= 8.50%

Kd (after tax) = 8.50% - 30% = 5.95%

17

For the year 2006-07

Total Debt Capital = Term loan from Banks + Debts

= 83427.02+1400= 84827.02lacs

Total Interest Paid = 6573.02lacs

Tax Rate = 30%

6573.02

Kd (before tax) = ---------------------- X 100

84827.02

= 7.25%

Kd (after tax) = 7.25% - 30% = 5.42%

18

COMPARATIVE CALCULATION OF Kd FOR FOUR YEAR

Particular 2009-10 2008-09 2007-08 2006-07

Total Debts (Term loan from

Bank+ Debts)

131570.37+

30000

=161570.37

105716.94+

000

=105716.94

112573.18+

800

=113373.18

83427.02+

1400

=84824.02

Total Interest paid 13065.36 9355.94 9636.72 6573.86

Interest Rate (Before Tax) 8.08% 8.85% 8.50% 7.75%

Interest Rate (After Tax)= Interest

Rate Before Tax – Tax Rate 30%.

5.65% 6.20% 5.95% 5.42%

19

COST OF EQUITY CAPITAL:

EQUITY SHARE CAPITAL

Particular 2009-10 2008-09 2007-08 2006-07

No. of Shares (In lacs) 348.37 348.37 348.37 348.73

DPS Given 13 10 8 6

Market Price (at the end of

March)

2300.05 710.50 1079.40 921.85

Earning per equity share

of rs. 10(in Rs.)

194.07 165.91 74.74 50.81

Final dividend on equity

share (in lacs)

4528.84 3483.72 2786.98 Not given

Market Capitalisation (in

Lacs)

801268.41 247516.88 376033.01 321146.96

1. Dividend yield plus growth in dividend method:-

Ke = DPS\mP*100 + G

Dps = Current cash dividend per share = 13Rs.

Mp = Current market price per share = 2300.05 Rs.

G = Growth rate = 10%

20

13

Ke = -------------------- X 100 + 10%

2300.05

= 10.56%

2. Earning yield method:-

Ke= EPS\mp*100

Eps = earning per share = 194.07 Rs.

Mp = Market prise = 2300.05 Rs.

194.07

Ke = -------------------- X 100

2300.05

= 8.43%

3. Dividend per share method:-

Ke = Proposed final dividend on Equity Share / No. of

Equity Share

Final dividend on Equity Share = 4528.84 Lacs

No. of Equity Share = 348.37 Lacs

21

4528.84

Ke = -------------------- = 13

348.37

COST OF EQUITY SHARE CAPITAL (KE)

Particular 2008-09

Dividend Per share method 13

Earning Yeild Method 8.43

Dividend yield plus growth method 10.56

22

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

WACC = (We * Ke) + (Wd * Kd)

Where………... We = Weight of equity

Wd = Weight of Debt.

Ke = Cost of Equity Share capital

Kd = Cost of Debt. capital

WACC = ( 0.8322 * 10.56) +( 0.1678 *05.65 ) = 9.74%

WACC OF SHREE CEMENT LIMITED (2008-2009)

23

Source

(1)

Amount

Rs.

(2)

Weights

(3)

After tax

Cost

(4)

Weighted

Cost

(5)= (3) * (4)

E.S. Capital 801268.41 .8322 10.56 8.79

Debentures 161570.37 .1678 05.65 0.95

Total 962838.78 1.00 9.74

Weighted Average Cost of Capital (WACC) 9.74%

MERITS OF WEIGHTED AVERAGE COST OF CAPITAL

The WACC is widely used approach in determining the required return on a

firm’s investments. It offers a number of advantages including the followings-

1. Straight forward and logical : It is the straightforward and logical approach

to a difficult problem. It depicts the overall cost of capital as the some of the

cost of the individual components of the capital structure. It employs a direct

and reasonable methodology and is easily calculated and understood.

2. Responsiveness to Changing Condition : Since, it is based upon individual

debt and equity components, the weighted average cost of capital reflects each

element in the capital structure. Small changes in the capital structure of the

firm will be noted by small changes in overall cost of capital of the firm.

3. Accurate when Profits are Normal : During the period of normal profits, the

weighted average cost of capital is more accurate as a cut-off rate in selecting

the capital budgeting proposals. It is because the weighted average cost

recognises the relatively low debt cost and the need to continue to achieve the

higher return on the equity financed assets.

4. Ideal Creation for Capital Expenditure Proposals : With the help of

weighted average cost of capital, the finance manager decides the cut-off rate

for taking decisions relating to capital expenditure proposals. This cut-off rate

determines the miimum limit for accepting an investment proposal. If an

investment proposal is accepted below this limit, the firm incur a loss.

Therefore, this cut-off rate is always decided above the weighted average cost

of capital.

24

LIMITATION OF WEIGHTED AVERAGE COST OF CAPITAL

The weighted Average cost approach also has some weaknesses, important among

them are as follows :

1. Unsuitable in case of Excessive Low-cost Debts : Short term loan can

represent an important sources of fund for firm experiencing financial

difficulties. When a firm relies on Zero cost (in the form of payables) or low

cost short term debt, the inclusion of such debts in the calculation of cost of

capital will result in a low WACC. If the firm accepts low-return projects on

the basic of this low WACC, the firm will be in a high financing risk.

2. Unsuitable in Case of Low Profits : If a firm is experiencing a period of low

profits, not earning profit as compared to other firms in the industry, WACC

will be inaccurate and of limited value.

3. Difficulty in Assigning Weights : The main difficulty in calculating the

WACC is to assign weight to different components of capital structure.

Normally, there are two type of weights- (i) book value weights and (ii)

market value weight. These two type of weights give different results. Hence,

the problem is which type of weight should be assigned. Though, market value

is more appropriate than book value, but the market value of each component

of capital of a company is not readily available. When the securities of the

company are unlisted, the problem becomes more intricate.

4. Selection of Capital Structure : The selection of capital structure to be used

for determining the WACC is also not easy job. Three types of capital

structure are there i.e. current capital structure, marginal capital structure and

optimal capital structure. Which of these capital structure be selected.

Generally, current capital structure is regarded as the optimal structure, but it

is not always correct.

Research Methodology

25

The research methodology was subdivided and performed in the following method-

Analyzing relevant figures and date for the last financial years.

Analyzing the future outlook of the companies and its expansion plan.

Study of the complete process of the uses of Cost of Capital using

literature and discussing with the organizational guide.

Connection of the data regarding the use of Cost of Capital and

financial policies for Shree Cement.

On the basis of the data collected, necessary suggestions regarding the

financial structure are given.

Preparing a questionnaire for the customers to know the image of the

company in the market.

On the basis of the questionnaire necessary suggestion are given.

DATA SOURCNG

While performing this project both Primary as well as Secondary Data sources

were use.

1. Primary Data:-

Major source of data for the project were the pass years’ financial

statement and information gather from my guide questionnaire also played a

vital role.

2. Secondary Data:-

It included information provided by the company workers. I adopted a

holistic approach and toiled to collect the information about the company

other than Shree Cement through secondary sources such as internet,

newspaper, magazines, research papers , online data basis ect..

QUESTIONNAIRE

26

The information provided by you (customer) is for the research work and will be kept confidential.

With your help we will be able to improve customer service level.

1.Name:-

2. Occupation: -

3. Income Group : -

a. Up to Rs.50,000 [ ] b. Rs. 50,000-1, 50,000 [ ]

c. Rs. 1,50,000-3,00,000 [ ] d. Above Rs. 3, 00,000 [ ]

4. Which cement brand do you prefer?

a. Shree Cement [ ] b. Ambuja cement [ ] c.ACC Ltd. [ ]

d. J.K. Laxmi Cement [ ] e. Birla White Cement [ ]

5. What influenced you to buy this particular brand?

a. Durability [ ] b. Sustainability [ ] c. Low price [ ]

d. Strength ness [ ] e. Advertising [ ]

6. What is your opinion about the quality of Shree Cement?

a. Excellent [ ] b.Very good [ ] c.Good [ ] d. Average [ ] e. Poor [ ]

7. How would you rank Shree Cement the basis of its brand image?

a. Excellent [ ] b.Very good [ ] c.Good [ ] d. Average [ ] e. Poor [ ]

8. What is the status of availability of the grand in you area?

a. Always [ ] b. Mostly [ ] c.Sometimes [ ]

d. Rarely [ ] e. Never [ ]

9. What promotional tools should company adopt to promote their product?

27

a. Banners [ ] b. News Paper [ ] c. Holdings [ ]

d. Wall painting [ ] e. Promotional offers [ ]

10. Brief recommends your views for the improvement of the brand?

Ans: - ………………………………………………………………………………………………………………………………………………………………………………………………………………

28