SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate

different projects in terms of their viability to be taken up for investments

 It helps in exposing the risk and uncertainty of different projects

 It helps in keeping a check on over or under investments

 The management is provided with an effective control on cost of capital

expenditure projects

 Ultimately the fate of a business is decided on how optimally the available

resources are used

In our last article, we talked about the Basics of Capital Budgeting, which covered
the meaning, features and Capital Budgeting Decisions. In this article let us talk
about the important techniques adopted for capital budgeting along with its
importance and example.

CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional methods
or non discount methods include: Payback period and Accounting rate of return
method. The discounted cash flow method includes the NPV method, profitability
index method and IRR.

 Payback period method:

As the name suggests, this method refers to the period in which the proposal will
generate cash to recover the initial investment made. It purely emphasizes on the
cash inflows, economic life of the project and the investment made in the project,
with no consideration to time value of money. Through this method selection of a
proposal is based on the earning capacity of the project. With simple calculations,
selection or rejection of the project can be done, with results that will help gauge the
risks involved. However, as the method is based on thumb rule, it does not consider
the importance of time value of money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example
Project Project
A B

Cost 1,00,000 1,00,000

Expected future cash

flow

Year 1 50,000 1,00,000

Year 2 50,000 5,000

Year 3 1,10,000 5,000

Year 4 None None

TOTAL 2,10,000 1,10,000

Payback 2 years 1 year

Payback period of project B is shorter than A, but project A provides higher

returns. Hence, project A is superior to B.

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 Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method.
The rate of return is expressed as a percentage of the earnings of the investment in
a particular project. It works on the criteria that any project having ARR higher than
the minimum rate established by the management will be considered and those
below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a
better means of comparison. It also ensures compensation of expected profitability of
projects through the concept of net earnings. However, this method also ignores time
value of money and doesn’t consider the length of life of the projects. Also it is not
consistent with the firm’s objective of maximizing the market value of shares.

ARR= Average income/Average Investment

  Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through
the life of an asset. These are then discounted through a discounting factor. The
discounted cash inflows and outflows are then compared. This technique takes into
account the interest factor and the return after the payback period.

 Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals.
In this technique the cash inflow that is expected at different periods of time is
discounted at a particular rate. The present values of the cash inflow are compared
to the original investment. If the difference between them is positive (+) then it is
accepted or otherwise rejected. This method considers the time value of money and
is consistent with the objective of maximizing profits for the owners. However,
understanding the concept of cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in
the initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal. It should be
noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

 Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow is equal to the discounted cash outflow. This method
also considers time value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash inflows. However,
computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment. It may be gross or net, net being
simply gross minus one. The formula to calculate profitability index (PI) or benefit
cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper planning through
capital budgeting is needed.

2) Huge investments and irreversible ones: As the investments are huge but the
funds are limited, proper planning through capital expenditure is a pre-requisite.
Also, the capital investment decisions are irreversible in nature, i.e. once a
permanent asset is purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate

different projects in terms of their viability to be taken up for investments

 It helps in exposing the risk and uncertainty of different projects

 It helps in keeping a check on over or under investments

 The management is provided with an effective control on cost of capital

expenditure projects

 Ultimately the fate of a business is decided on how optimally the available

resources are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the
investment’s cost, projecting the investment’s cash flows and comparing the
projected earnings with inflation rates and the time value of the investment.

For example, equipment that costs $15,000 and generates a $5,000 annual return
would appear to "pay back" on the investment in 3 years. However, if economists
expect inflation to rise 30 percent annually, then the estimated return value at the
end of the first year ($20,000) is actually worth $15,385 when you account for
inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only
$385 in real value after the first year.
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Conclusion:
According to the definition of Charles T. Hrongreen, “Capital Budgeting is a long-
term planning for making and financing proposed capital outlays.”

CAPITAL BUDGETING DECISIONS:

The crux of capital budgeting is profit maximization. There are two ways to it; either
increase the revenues or reduce the costs. The increase in revenues can be
achieved by expansion of operations by adding a new product line. Reducing costs
means representing obsolete return on assets.
Accept / Reject decision – If a proposal is accepted, the firm invests in it and if
rejected the firm does not invest. Generally, proposals that yield a rate of return
greater than a certain required rate of return or cost of capital are accepted and the
others are rejected. All independent projects are accepted. Independent projects are
projects that do not compete with one another in such a way that acceptance gives a
fair possibility of acceptance of another.
Mutually exclusive project decision – Mutually exclusive projects compete with
other projects in such a way that the acceptance of one will exclude the acceptance
of the other projects. Only one may be chosen. Mutually exclusive investment
decisions gain importance when more than one proposal is acceptable under the
accept / reject decision. The acceptance of the best alternative eliminates the other
alternatives.
Capital rationing decision – In a situation where the firm has unlimited funds,
capital budgeting becomes a very simple process. In that, independent investment
proposals yielding a return greater than some predetermined level are accepted. But
actual business has a different picture. They have fixed capital budget with large
number of investment proposals competing for it. Capital rationing refers to the
situation where the firm has more acceptable investments requiring a greater amount
of finance than that is available with the firm. Ranking of the investment project is
employed on the basis of some predetermined criterion such as the rate of return.
The project with highest return is ranked first and the acceptable projects are ranked
thereafter
Factors influencing capital expenditure decisions
1. Availability of Funds
All the projects are not requiring the same level of investments. Some
projects require huge amount and having high profitability. If the company
does not have adequate funds, such projects may be given up.

2. Minimum Rate of Return on Investment

Every management expects a minimum rate of return or cut-off rate on
capital investment. It refers to the point of below which a project would not
be accepted.

3. Future Earnings
The future earnings may be uniform or fluctuating. Even though, the
company expects guaranteed future earnings in total which affects the
choice of a project.

4. Quantum of Profit Expected

It is necessary to assess the quantum of profit expected on implementation
of selected project. Here, the term profit refers to realized amount of
projects as per the accounting records.

5. Cash Inflows
The term cash inflows refers to profit after tax but before depreciation. The
reason is that recording of depreciation is a book entry and there is no
actual cash outflow. Hence, depreciation amount is included in the cash
inflow.

6. Legal Compulsions
The management should consider the legal provisions while-selecting a
project. In the case of leather and chemical industries, there are number of
legal provisions created to protect environment pollution. Now, the
management gives much importance to legal provisions rather than cost
and profit.

7. Ranking of the Capital Investment Proposal

Sometimes, a company has two or more profitable projects in hand. If there
is only one profitable project out of many and huge amount is available in
the hands of management, there is no need of ranking of capital investment
proposal. Ranking is necessary if there is many profitable projects in hand
and limited funds is available in the hands of management.
8. Degree of Risk and Uncertainty
Every proposal involves certain risk and uncertainty due to economic
conditions, competition, demand and supply conditions, consumer
preferences etc. The degree of risk and uncertainty affects the profitability
of the project. Hence, degree of risk and uncertainty of the project is taken
into consideration for selection.

9. Urgency
A project may be selected immediately due to emergency or urgency. The
reason is that such immediate selection saves the life of the company i.e.
survival of a company is the primary importance than other factors.

10. Research and Development Projects

Research and Development project is highly required for technology based
industries. The reason is that there is a lot of changes made within short
period in technology. The research and development project gives more
benefits in the long run. Hence, profitability is getting less importance and
survival of business is getting much importance in the case of research and
development project.

11. Obsolescence
The replacement of existing fixed assets is compulsory since there is an
obsolescence of plant and machinery.

12. Competitors Activities

Every company should watch the activities of the competitors. The
company should take a decision by considering the activities of the
competitors. If so, the company can withstand in competition by
implementing new projects.

13. Intangible Factors

Goodwill of the company, industries relations, safety and welfare of the
employees are considered while selecting a project instead of considering
profit alone. These factors are also high responsible for selection of any
project.

Ezra Solomon defines “Cost of capital is the minimum

required rate of earnings or cutoff rate of capital
expenditure”.
According to Mittal and Agarwal “the cost of capital is the
minimum rate of return which a company is expected to
earn from a proposed project so as to make no reduction
in the earning per share to equity shareholders and its
market price”.
According to Khan and Jain, cost of capital means “the minimum
rate of return that a firm must earn on its investment for
the market value of the firm to remain unchanged”.
Cost of capital depends upon:
(a) Demand and supply of capital,

(b) Expected rate of inflation,

(c) Various risk involved, and

(d) Debt-equity ratio of the firm etc.

Significance of Cost of Capital:

The concept of cost of capital plays a vital role in decision-making
process of financial management. The financial leverage, capital
structure, dividend policy, working capital management, financial
decision, appraisal of financial performance of top management etc.
are greatly influenced by the cost of capital.

ADVERTISEMENTS:

The significance or importance of cost of capital may be

stated in the following ways:
1. Maximisation of the Value of the Firm:
For the purpose of maximisation of value of the firm, a firm tries to
minimise the average cost of capital. There should be judicious mix
of debt and equity in the capital structure of a firm so that the
business does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking
capital budgeting decisions. Generally cost of capital is the discount
rate used in evaluating the desirability of the investment project. In
the internal rate of return method, the project will be accepted if it
has a rate of return greater than the cost of capital.

In calculating the net present value of the expected future cash

flows from the project, the cost of capital is used as the rate of
discounting. Therefore, cost of capital acts as a standard for
allocating the firm’s investible funds in the most optimum manner.
For this reason, cost of capital is also referred to as cut-off rate,
target rate, hurdle rate, minimum required rate of return etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions
of business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to
calculate the cost of carrying investment in receivables and to
evaluate alternative policies regarding receivables. It is also used in
inventory management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The
dividend policy of a firm should be formulated according to the
nature of the firm— whether it is a growth firm, normal firm or
declining firm. However, the nature of the firm is determined by
comparing the internal rate of return (r) and the cost of capital (k)
i.e., r > k, r = k, or r < k which indicate growth firm, normal firm
and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In
designing optimum capital structure that is the proportion of debt
and equity, due importance is given to the overall or weighted
average cost of capital of the firm. The objective of the firm should
be to choose such a mix of debt and equity so that the overall cost of
capital is minimised.

7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial
performance of top management. This can be done by comparing
the actual profitability of the investment project undertaken by the
firm with the overall cost of capital.

Measurement of Cost of Capital:

Cost of capital is measured for different sources of capital structure
of a firm. It includes cost of debenture, cost of loan capital, cost of
equity share capital, cost of preference share capital, cost of retained
earnings etc.

The measurement of cost of capital of different sources of

capital structure is discussed:
A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital.
Debt may be in the form of debentures bonds, term loans from
financial institutions and banks etc. The amount of interest payable
for issuing debenture is considered to be the cost of debenture or
debt capital (Kd). Cost of debt capital is much cheaper than the cost
of capital raised from other sources, because interest paid on debt
capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1
– t)
where Kd = Cost of debenture
r = Fixed interest rate

t = Tax rate

(ii) When the debentures are issued at a premium or discount but

redeemable at par

Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment

t = Tax rate

Np = Net proceeds from the issue of debenture.

(iii) When the debentures are redeemable at a premium or discount

and are redeemable after ‘n’ period:

Kd
I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
where Kd = Cost of debenture .
I = Annual interest payment

t = Tax rate
NP = Net proceeds from the issue of debentures

Ry = Redeemable value of debenture at the time of maturity

Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each.
The company is in 40% tax bracket. You are required to compute
the cost of debt after tax, if debentures are issued at (i) Par, (ii) 10%
discount, and (iii) 10% premium.

(b) If brokerage is paid at 5%, what will be the cost of debentures if

issue is at par?

Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs.
60 lakh. The floating charge of the issue is 5% on face value. The
interest is payable annually and the debentures are redeemable at a
premium of 10% after 10 years.

What will be the cost of debentures if the tax is 50%?

B. Cost of Preference Share Capital:
For preference shares, the dividend rate can be considered as its
cost, since it is this amount which the company wants to pay against
the preference shares. Like debentures, the issue expenses or the
discount/premium on issue/redemption are also to be taken into
account.

(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.

(ii) If the preference shares are redeemable after a period of ‘n’, the
cost of preference shares (KP) will be:

where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares

DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its
dividend is not allowed deduction from income for income tax
purposes. The students should note that both in the case of debt and
preference shares, the cost of capital is computed with reference to
the obligations incurred and proceeds received. The net proceeds
received must be taken into account while computing cost of capital.

Example 3:
A company issues 10% Preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price.

What will be the cost of preference share capital (KP), if preference

shares are issued (i) at par, (ii) at 10% premium and (iii) at 5%
discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital (KP) = DP/P

Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par
redeemable after 10 years at 10% premium.

What will be the cost of preference share capital?

Example 5:
A company issues 12% redeemable preference shares of Rs. 100
each at 5% premium redeemable after 15 years at 10% premium. If
the floatation cost of each share is Rs. 2, what is the value of
KP (Cost of preference share) to the company?

C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity
shares which are of permanent nature. These funds need not be
repayable during the lifetime of the organisation. Calculation of the
cost of equity shares is complicated because, unlike debt and
preference shares, there is no fixed rate of interest or dividend
payment.

Cost of equity share is calculated by considering the earnings of the

company, market value of the shares, dividend per share and the
growth rate of dividend or earnings.

(i) Dividend/Price Ratio Method:

An investors buys equity shares of a particular company as he
expects a certain return (i.e. dividend). The expected rate of
dividend per share on the current market price per share is the cost
of equity share capital. Thus the cost of equity share capital is
computed on the basis of the present value of the expected future
stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share
P = Current market price per share.

If dividends are expected to grow at a constant rate of ‘g’ then cost

of equity share capital

(Ke) will be Ke = D/P + g.

This method is suitable for those entities where growth rate in
dividend is relatively stable. But this method ignores the capital
appreciation in the value of shares. A company which declares a
higher amount of dividend out of given quantum of earnings will be
placed at a premium as compared to a company which earns the
same amount of profits but utilizes a major part of it in financing its
expansion programme.

Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays
a dividend of Rs. 3 per share and investors expect a growth rate of
10% per year.

You are required to calculate:

(i) The company’s cost of equity capital.

(ii) The indicated market price per share, if anticipated growth rate
is 12%.

(iii) The market price, if the company’s cost of equity capital is 12%,
anticipated growth rate is 10% p.a., and dividend of Rs. 3 per share
is to be maintained.
Example 7:
The current market price of a share is Rs. 100. The firm needs Rs.
1,00,000 for expansion and the new shares can be sold at only Rs.
95. The expected dividend at the end of the current year is Rs. 4.75
per share with a growth rate of 6%.

Calculate the cost of capital of new equity.

Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100

K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.

(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or,
11%.

Example 8:
A company’s share is currently quoted in the market at Rs. 20. The
company pays a dividend of Rs. 2 per share and the investors expect
a growth rate of 5% per year.

You are required to calculate (a) Cost of equity capital of the

company, and (b) the market price per share, if the anticipated
growth rate of dividend is 7%.
Solution:
(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% =
15%
(b) Ke = D/P + g
or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.

Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a
stock exchange at a market price of Rs. 28. A constant expected
annual growth rate of 6% and a dividend of Rs. 1.80 per share has
been paid for the current year.

Calculate the cost of equity share capital.

Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%

(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS)
and the market price of share. Thus, the cost of equity share capital
will be based upon the expected rate of earnings of a company. The
argument is that each investor expects a certain amount of earnings
whether distributed or not, from the company in whose shares he
invests.

If the earnings are not distributed as dividends, it is kept in the

retained earnings and it causes future growth in the earnings of the
company as well as the increase in market price of the share.

Thus, the cost of equity capital (Ke) is measured by:

Ke = E/P where E = Current earnings per share
P = Market price per share.

If the future earnings per share will grow at a constant rate ‘g’ then
cost of equity share capital (Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the
factor of capital appreciation or depreciation in the market value of
shares. Adjustment of Floatation Cost There are costs of floating
shares in market and include brokerage, underwriting commission
etc. paid to brokers, underwriters etc.

These costs are to be adjusted with the current market price of the
share at the time of computing cost of equity share capital since the
full market value per share cannot be realised. So the market price
per share will be adjusted by (1 – f) where ‘f’ stands for the rate of
floatation cost.

Thus, using the Earnings growth model the cost of equity

share capital will be:
Ke = E / P (1 – f) + g
Example 10:
The share capital of a company is represented by 10,000 Equity
Shares of Rs. 10 each, fully paid. The current market price of the
share is Rs. 40. Earnings available to the equity shareholders
amount to Rs. 60,000 at the end of a period.

Calculate the cost of equity share capital using Earning/Price ratio.

Example 11:
A company plans to issue 10,000 new Equity Shares of Rs. 10 each
to raise additional capital. The cost of floatation is expected to be
5%. Its current market price per share is Rs. 40.

If the earnings per share is Rs. 7.25, find out the cost of new equity.

D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the
business also entail cost. When earnings are retained in the
business, shareholders are forced to forego dividends. The
dividends forgone by the equity shareholders are, in fact, an
opportunity cost. Thus retained earnings involve opportunity cost.

If earnings are not retained they are passed on to the equity

shareholders who, in turn, invest the same in new equity shares and
earn a return on it. In such a case, the cost of retained earnings (Kr)
would be adjusted by the personal tax rate and applicable
brokerage, commission etc. if any.
Many accountants consider the cost of retained earnings as the
same as that of the cost of equity share capital. However, if the cost
of equity share capital i9 computed on the basis of dividend growth
model (i.e., D/P + g), a separate cost of retained earnings need not
be computed since the cost of retained earnings is automatically
included in the cost of equity share capital.

Therefore, Kr = Ke = D/P + g.
Example 12:
It is given that the cost of equity of a company is 20%, marginal tax
rate of the shareholders is 30% and the Broker’s Commission is 2%
of the investment in share. The company proposes to utilise its
retained earnings to the extent of Rs. 6,00,000.

Find out the cost of retained earnings.

E. Overall or Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like
equity share capital, preference share capital, debentures, term
loans, retained earnings etc. at different costs depending on the risk
perceived by the investors.

When all these costs of different forms of long-term funds are

weighted by their relative proportions to get overall cost of capital it
is termed as weighted average cost of capital. It is also known as
composite cost of capital. While taking financial decisions, the
weighted or composite cost of capital is considered.

The weighted average cost of capital is used by an

enterprise because of the following reasons:
(i) It is useful in taking capital budgeting/investment decisions.

(ii) It recognises the various sources of finance from which the

investment proposal derives its life-blood (i.e., finance).

(iii) It indicates an optimum combination of various sources of

finance for the enhancement of the market value of the firm.

(iv) It provides a basis for comparison among projects as a standard

or cut-off rate.

I. Computation of Weighted Average Cost of Capital:

Computation of Weighted Average cost of capital is made
in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity,
preference shares, debts, retained earnings etc.) is to be calculated.

(ii) Weights (i.e., proportion of each, source of fund in the capital

structure) are to be computed and assigned to each type of funds.
This implies multiplication of each source of capital by appropriate
weights.

Generally, the-following weights are assigned:

(a) Book values of various sources of funds

(b) Market values of various sources of capital

(c) Marginal book values of various sources of capital.

Book values of weights are based on the values reflected by the

balance sheet of a concern, prepared under historical basis and
ignoring price level changes. Most of the financial analysts prefer to
use market value as the weights to calculate the weighted average
cost of capital as it reflects the current cost of capital.

But the determination of market value involves some difficulties for

which the measurement of cost of capital becomes very difficult.

(iii) Add all the weighted component costs to obtain the firm’s
weighted average cost of capital.

Therefore, weighted average cost of capital (Ko) is to be calculated

by using the following formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ………….. are
weights.
Example 13:
Jamuna Ltd has the following capital structure and, after
tax, costs for the different sources of fund used:
Example 14:
Excel Ltd. has assets of Rs. 1,60,000 which have been financed with
Rs. 52,000 of debt and Rs. 90,000 of equity and a general reserve of
Rs. 18,000. The firm’s total profits after interest and taxes for the
year ended 31st March 2006 were Rs. 13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900 equity
shares of Rs. 100 each selling at a market price of Rs. 120 per share.

What is the Weighted Average Cost of Capital?

Example 15:
RIL Ltd. opts for the following capital structure:

Example 16:
In considering the most desirable capital structure for a
company, the following estimates of the cost Debt and
Equity Capital (after tax) have been made at various levels
of debt-equity mix:
You are required to determine the optimum debt-equity mix for the
company by calculating composite cost of capital.

Optimal debt-equity mix for the company is at the point where the
composite cost of capital is minimum. Hence, the composite cost of
capital is minimum (10.75%) at the debt-equity mix of 3: 7 (i.e., 30%
debt and 70% equity). Therefore, 30% of debt and 70% equity mix
would be an optimal debt-equity mix for the company.
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Cost of capital
Cost of capital is vital part of investment decision as it is used to measure the value of investment
proposal provided by the business concern. It is used as a discount rate to determine the present
value of future cash flows related with capital projects. Cost of capital is also termed as cut-off
rate, target rate, hurdle rate and required rate of return. When the companies are using different
sources of finance, the finance manager must take vigilant decision with regard to the cost of
capital; because it is closely associated with the value of the firm and the earning capacity of the
firm.

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Concept of Cost of Capital

There is bulk of finance literature to describe this concept. Numerous studies have shown that
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its
market value and attract funds. It is the required rate of return on its investments which belongs
to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the decrease of overall prosperity of the
shareholders. Famous theorist, John J. Hampton described cost of capital as "the rate of return
the firm required from investment in order to increase the value of the firm in the market place".
Solomon Ezra stated that "Cost of capital is the minimum required rate of earnings or the cut-off
rate of capital expenditure" According to James C. Van Horne, Cost of capital is "A cut-off rate for
the allocation of capital to investment of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock". Another theorist, William and Donaldson explained
that "Cost of capital may be defined as the rate that must be earned on the net proceeds to
provide the cost elements of the burden at the time they are due".

Assumption of Cost of Capital

It is documented in theoretical studies that cost of capital is based on some assumptions which
are directly related while calculating and measuring the cost of capital. There are three basic
concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and financial risk.

Cost of capital can be measured with the following equation:

Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.

Taxonomy of Cost of Capital

Cost of capital may be categorized into the following types on the basis of nature and usage:
 1. Explicit and Implicit Cost.
2. Average and Marginal Cost.
3. Historical and Future Cost.
4. Specific and Combined Cost.

1. Explicit and Implicit Cost:

The cost of capital may be explicit or implicit cost on the basis of the computation of cost of
capital. Explicit cost is the rate that the firm pays to procure financing. An explicit cost is one that
has occurred and is evidently reported as a separate cost. It is defined as direct payment to
others in doing business such as wage, rent and materials.
This may be calculated with the following equation;

Where,
CIo = initial cash inflow
C = outflow in the period concerned
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return linked with the best investment opportunity for the firm and its
shareholders that will be inevitable if the projects presently under consideration by the firm were
accepted. It is the opportunity cost equal to what a firm must give up in order to use factor of
production which it already owns and thus does not pay rent for.
Both implicit and explicit costs are actual business cost of firms (Barthwal, 2007).

2. Average and Marginal Cost:

Average cost of capital is the weighted average cost of each element of capital employed by the
company. It reflects weighted average cost of all kinds of financing such as equity, debt, retained
earnings.
Marginal cost is the weighted average cost of new finance raised by the company. It is the extra
cost of capital when the company goes for further raising of finance.

3. Historical and Future Cost:

Historical cost is the cost which is already been incurred for financing a particular project. It is
based on the actual cost incurred in the earlier project. Future cost is the expected cost of
financing in the proposed project. Expected cost is calculated on the basis of previous
experience.

4. Specific and Combine Cost:

The cost of each sources of capital such as equity, debt, retained earnings and loans is termed
as specific cost of capital. It is beneficial to determine the each and every specific source of
capital. The composite or combined cost of capital is the amalgamation of all sources of capital. It
is also called as overall cost of capital. It is used to recognize the total cost associated with the
total finance of the company.

Importance of Cost of Capital

Computation of cost of capital is significant part of the financial management to decide the capital
structure of the business concern.
Importance to Capital Budgeting Decision: Capital budget decision mainly depends on the cost of
capital of each source. According to net present value method, present value of cash inflow must
be more than the present value of cash outflow. Therefore, cost of capital is used for capital
budgeting decision.
Importance to Structure Decision: Capital structure is the mix or proportion of the different types
of long term securities. Company uses particular type of sources if the cost of capital is suitable.
Therefore, cost of capital supports to take decision regarding structure.
Importance to Evolution of Financial Performance: Cost of capital is imperative to determine
which affects the capital budgeting, capital structure and value of the firm. It helps to estimate the
financial performance of the firm.
Importance to Other Financial Decisions: Cost of capital is also used in some other areas such
as, market value of share, earning capacity of securities etc. hence, it plays a major part in the
financial management.

Computation of cost of capital:

Computation of cost of capital has two important parts:

1. Measurement of specific costs

2. Measurement of overall cost of capital

Measurement of Cost of Capital:

It refers to the cost of each specific sources of finance such as:

o Cost of equity
o Cost of debt
o Cost of preference share
o Cost of retained earnings

Cost of Equity: Cost of equity capital is the rate at which investors discount the expected
dividends of the firm to determine its share value. Theoretically, the cost of equity capital is
described as the "Minimum rate of return that a firm must earn on the equity financed portion of
an investment project in order to leave unchanged the market price of the shares".
Cost of equity can be calculated from the following approach:

o Dividend price (D/P) approach.

o Dividend price plus growth (D/P + g) approach.
o Earning price (E/P) approach.
o Realized yield approach.

Dividend Price Approach: The cost of equity capital will be that rate of expected dividend which
will maintain the present market price of equity shares.
Dividend price approach can be measured with the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach: The cost of equity is calculated on the basis of the
expected dividend rate per share plus growth in dividend (R M Srivastava, 2008).
It can be measured by the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach: Cost of equity regulates the market price of the shares. It is based on
the future earnings forecasts of the equity (R M Srivastava, 2008). The formula for calculating the
cost of equity according to this approach is as follows.

Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Realized Yield Approach: It is simple method to compute cost of equity capital (R M Srivastava,
2008). Under this method, cost of equity is calculated by

Where,
Ke = Cost of equity capital.
PVf = Present value of discount factor.
D = Dividend per share.
II. Cost of Debt: Cost of debt is the after tax cost of long-term funds through borrowing. Debt may
be issued at par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of the debt. It may
be calculated with the following formula

Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount: If the debt is issued at premium or discount, the cost of
debt is calculated with the following formula.

Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt: It is the rate of return which the lenders expect.
The debt carries a certain rate of interest.

Where,
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax
Cost of debt after tax can be calculated with the following formula:

Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
III. Cost of Preference Share Capital: Cost of preference share capital is the annual preference
share dividend by the net proceeds from the sale of preference share. There are two types of
preference shares irredeemable and redeemable.
Following formula is used to calculate the cost of redeemable preference share capital:

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the following formula:

Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.
IV. Cost of Retained Earnings: Retained earnings is one of the sources of finance for investment
proposal. It is dissimilar from other sources like debt, equity and preference shares. Cost of
retained earnings is the same as the cost of an equivalent fully subscripted issue of additional
shares, which is measured by the cost of equity capital.
Cost of retained earnings can be calculated with the following formula:

Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost

Measurement of Overall Cost of Capital:

It is also known as weighted average cost of capital and composite cost of capital. Weighted
average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firm's capital structure.

The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the following formula;

Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
To, summarize, cost of return is defined as the return the firm's investors could expect to earn if
they invested in securities with comparable degrees of risk. The cost of capital signifies the
overall cost of financing to the firm. It is normally the relevant discount rate to use in evaluating
an investment. Cost of capital is important because it is used to assess new project of company
and permits the calculations to be easy so that it has minimum return that investor expect for
providing investment to the company.

Concept of cost of capital

July 1, 2006admin Finance Management

CONCEPTS OF COST OF CAPITAL

The cost of capital of a company is the average rate of return required by investors who
provide long term funds (equity, preference, and long term debt). A central concept in
financing decisions, the cost of capital is important for two reasons:

1. For evaluating capital investment proposals an estimate of the cost of capital is required.
As we have seen, the cost of capital is the discount rate in NPV calculation and also the
financial benchmark against which the internal rate of return is compared

2. To maximize the value of the firm, costs of all inputs (including the capital input) must be
minimized. In the context the firm should what its cost of capital is and what are its key
determinants.
Basic Concepts:

A firm’s cost of capital is the weighted arithmetic average of the cost of various sources
of long term finance employed by it. Suppose that a firm uses equity costing 18%, preference
costing 15%, and debt costing 11%. If the proportions in which equity, preference, and debt
are used are respectively 40%, 10%, and 50%, the cost of capital of the firm will be:

Cost of Capital = {Proportion of equity}{Cost of equity} + {Proportion of preference}{Cost

of preference} + {Proportion of debt}{Cost of debt)

From the above example, it is clear that three basic steps are involved in calculation a
firm’s cost of capital:

1. Determine the cost of different components of capital.

2. Establish a set of weights (proportions).
3. Calculate the weighted average cost of capital.

Conditions for using the Cost of capital:

Two key conditions should be satisfied for using a firm’s cost of capital for evaluating
new investments:

* The risk of new investment is the same as the average risk of existing investment. In other
words, the adoption of new investment will not change the risk complexion of the firm.

* The capital structure of the firm will not be affected by the new investments. Put
differently, the firm will continue to pursue the same financing policy.

Thus, strictly speaking the cost of capital is an appropriate discount rate for a project that is a
carbon copy of the firm’s existing business. However, in practice, the cost of capital is
used as a benchmark hurdle rate that is adjusted for variations in risk and financing patterns

Determination of the Component Costs:

Before you calculate the average cost of capital for a company, you should know the cost of
specific sources of finances used by the company. How is the cost of a specific source of
finance calculated? It is measured as the rate of discount that equates the present value of the
expected post tax payments to that source of finance with the net funds received from that
source of finance. In symbols, it is the value of k in the following equation:

P = Ct / (1+k)t

Where P= net funds received from the source

Ct= expected payment to the source at the end of year t
We measure costs at the margin since we are interested in using costs for analyzing
investment decisions to be undertaken. Further, the explicit costs are measured on a post-tax
basis because the cost of capital is used to evaluate post tax cash flows. Remember that the
relevant cash flows for investment analysis are defined in post-tax terms.