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Chapter 06 {Final Energy Financial Management}.Doc

Chapter 06 {Final Energy Financial Management}.Doc

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Published by: rathneshkumar on Feb 19, 2009
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Chapter 6Cost of capital
6.1 Introduction
The discussions in last chapter relating to Capital budgeting have shown therelevance of a certain required rate of return as a decision criteria. Such a rate isthe cost of capital of a firm. Apart from its usefulness as an operational criterion toaccept/accept an investment proposal, cost of capital is also an important factor indesigning capital structure.The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). Firms finance their operations by threemechanisms: issuing stock (equity), issuing debt (borrowing from a bank isequivalent for this purpose) (those two are
external financing
), and reinvesting priorearnings (
internal financing
6.2 Important
As mentioned above, the cost of capital is an important element, as inputinformation, in capital investment decisions. In the present value methods of discounted cash flow techniques, the cost of capital is used as the discount rate tocalculate the NPV. The profitability index or benefits cost ratio methods similarlyemployed it to determine the present value of future cash inflows. When the internalrate of return methods is used, the computed IRR is compared with the cost of capital. The cost of capital, thus, constitutes an integral part of investment decisions.It provides a yardstick to measure the worth of investment proposal and, thus,performs the role of accept-reject criterion. This underlines the crucial significanceof cost of capital. It is also referred to as cut-off rate, target rate, burdle rate,minimum required rate of return, standard return and so on.The cost of capital, as an operational criterion, is related to the firm’s objective of wealth maximization. The accept-reject rules require that a firm should avail of only such investment opportunities as promise a rate of return higher than the costof capital. Conversely, the firm would be well advised to reject proposals whoserates of return are less the cost of capital. If the firm accepts a proposal having arate of return higher than the cost of capital, it implies that the proposals yieldsreturns higher than the minimum required by the investors and the prices of shareswill increase and, thus, the shareholders’ wealth. By virtue of the same logic, theshareholders’ wealth will decline on the acceptance of a proposal in which the actualreturn is less than the cost of capital. The cost of capital, thus, provides a rationalmechanism for making optimum investment decisions. In brief, the cost of capital is
important because of its practical utility as an acceptance rejection decisioncriterion.The considerable significance of cost of capital in terms of its practical utilitynotwithstanding, it is probably the most controversial topic in financialmanagement. There are varying opinions as to how this can be computed. In view of the crucial operation signification of this concept, our focus is on the generalframework for the computation of cost of capital. We first define the term cost of capital in general term. This is followed by a details account of the measurement of cost of capital – both specific as well as overall – of different sources of financing.
6.3 Definition
In operational term, cost of capital refers to the discount rate that is used indetermining the present value of the estimated future cash proceeds and eventuallydeciding whether the project is worth undertaking or not. In this sense, it is definedas the minimum rate of return that a firm must earn on its investment for themarket value of the firm to remain unchanged.The cost of capital is visualized as being composed of several elements. Theseelements are the cost of each component of capital. The term component means thedifferent sources from which funds are raised by a firm. Obviously, each sourceseach sources of funds or each component of capital has of cost. For example, equitycapital has a cost, so also preference share capital and so on. The cost of eachsources or component is called specific cost of capital. When these specific costs arecombined to arrive at overall cost of capital, it is referred to as the weighted cost of capital. The terms, cost of capital, weighted cost of capital, composite cost of capitaland combined cost of capital are used interchangeably in this chapter. In otherwords, the term, cost of capital, as the acceptance criterion for investmentproposals, is used in the sense of the combined cost of all sources of financing. Thisis mainly because our focuses on the valuation of the firm as a whole.
6.4 Assumptions
The theory of cost of capital is based on certain assumptions. A basic assumption of traditional cost of capital analysis is that the firm’s business and financial risks areunaffected by the acceptance and financing of projects business risk measures thevariability in operating profits (earnings before interest and taxes – EBIT) due tochange in sales. If a firm accepts a project that is considerably more risky than theaverage, the suppliers of the funds or quite likely to increase the cost of funds asthere is an increased probability of committing default on the part of the firm inmaking payments of their money. A debenture – holder will charge higher rate of in
interest to compensate for increased risk. There is similarly an increaseduncertainty from the point of equity holders of getting dividend from the firm.There fore, they will also require a higher return as a composition for the increasedrisk. In analyzing the cost of capital in this chapter, we assume that there would beno change what so ever in the business risk complexion of the firm as result of acceptance of new investment proposals.The capital budgeting decision determines business risk complexion of the firm. Thefinancing decision determines its financial risk. In general, the greater theproportion of long - term debt in the capital structure of the firm, the greater is thefinancial risk because there is need for a larger amount of periodic interest paymentand principle repayment at the time of maturity. In such a situation, obviously, thefirm requires higher operating profits to cover these charges. If it fails to earnadequate operating profits to cover such financial charges, it may be forced intocash insolvency. Thus, with the increase in the proportion of debt commitments andpreference shares in its capital structure, fixed charges increase. All other thingsbeing the same, the probability that the firm will unable to meet these fixed chargesalso increases. As the firm continues to lever itself, the probability of cashinsolvency, which may lead to legal bankruptcy, increases. Clearly, there fore, asfirm’s financial structure shifts towards a more highly levered position, theincreased financial risk associated with the firm is recognized by the suppliers of funds. They compensate for this increased risk higher by charging higher rate of interest or requiring greater returns. In short, they react in much the same way asthey would in the case of increasing business risks. In the analysis of the cost of capital in this chapter, however, the firm’s financial structure assumed to remainfixed. In the absences of such an assumption, it would be quite difficult to find itscost of capital, as the selection of a particular source financing would the cost of other sources of financing. In operational terms the assumption of a constant capitalstructure implies that the additional funds required to finance the new project areto be raised in the same proposition as the firm exists financing.For the purpose of capital budgeting decisions, benefits from undertaking aproposed project are evaluated on an after-tax basis. In fact, only the cost of capitalof debt requires tax adjustment as interest paid on debt is deductible expanse fromthe point of view determine taxable income whereas dividend paid either topreference shareholders or to equity-holder are not eligible items as a sources of deduction to determine taxable income.To sum up, it may be said that cost of capital (k) consists of the following threecomponents.
The risk cost of the particular type of financing.

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