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CAPITAL BUDGETING OR INVESTMENT DECISION

Meaning:It is the process of making investment decision in capital expenditure. The main
characteristics of capital expenditure is that the expenditure which is incurred at
one point of time where as the benefits of the expenditure are realized at all points
of time in future. The following are some of the elements of capital expenditure.
1) Cost of acquisition or purchase in permanent assets such as land and
building plant and machinery etc.
2) Cost of addition, expansion, improvement or alteration in the fixed asset.
3) Research and development product cost etc.
Definition:According to CHARLES-T-HORANGREEN Capital budgeting is long term
planning for making and financing a proposed capital outlay.
According to RICHARD & GREENLAW Capital Budgeting is acquiring
inputs with long run return.
According to LYNCH Capital Budgeting consist in planning &
development of available capital for the purpose of maximizing the long term
profitability of the concern.
NEED & IMPORTANCE OF Capital Budgeting:1) It involves large investment of funds.

2) The large funds are invested more or less on permanent basis.


3) This decision is irreversible in nature.
4) It has long term effect on profitability.
PROCESS OF CAPITAL BUDGETING OR STEPS IN C.B.:1) Identification of investment proposal.
2) Screening the proposal.
3) Evaluation of various proposals.
4) Fixing priorities.
5) Preparation of budget.
6) Implementing proposals.
7) Performance review.
METHODS OR TECHNIQUES OF CAPITAL BUDGETING:Traditional Method:a) Pay Back period
b) Average rate of return method (ARR)
A. PAYBACK PERIOD (PBP)
The term payback period refers to the period in which the product will generate
the necessary cash to recover the initial investment.
Accept or Reject criteria:The selection of the project is based on the earning capacity of the project. A cut
off period for the project is fixed if the payback period is lower than the cut off
period such projects are accepted.
CALCULATIONS OF PAYBACK PERIOD:I.

When cash inflows are uniform.


Cash inflows = Earnings after tax but before depreciation.

Payback period = Cash outflow (original investment)


Cash inflow
MERITS OF PAYBACK PERIOD:1) It is traditional and old method
2) It involves simple calculations
3) Selection or Rejection of the project can be made easily
4) The results attain under this method are more reliable
5) It is the best method for evaluating high risky projects.
DEMERITS OF PAYBACK PERIOD:1) It is based on the principle of rule of thum method
2) It does not recognize the importance of time value of money
3) It does not consider the profitability and economic life of the project
4) It does not recognize the pattern of cash flows and its timings
5) Payback period concept does not reflects all the relevant dimensions of
profitability.
PROBLEMS:1) A project cost Rs. 1,00,000-00 and gives annual cash flow of Rs. 20,00000 for 8 years. Calculate payback period.
PBP= Cash outflow = 1,00,000-00 = 5 years
Cash inflow
20,000-00
2) The project cost Rs. 5,00,000-00 gives annually a profit of Rs. 80,000-00
after depreciation at 12% p.a. But before tax of Rs. 50%, calculate the
PBP.

Calculation of cash inflow


Earnings Rs.
Before (-) tax at 50%

80,000-00
40,000-00
40,000-00

After (+) depreciation


5,00,000 x 12 = 60000
100 100000
PBP = CO = 500000 = 5 years
CI 100000
II.

When cash inflows are not uniform


PBP = 1st year + investment cumulative C.I. of 1st year
Cumulative C.I. 2nd year CCI 1st year

1) A project requires an initial cash outlay of Rs. 1,00,000-00 and generates cash
inflows as under.
Year
1
2
3
4
5
6
7
8

Cash inflows
10000
20000
25000
40000
10000
10000
10000
5000

Calculations of PBP when CI are not uniform


Cumulative cash inflows
1
2
3
4
5
6
7
8

10000
20000
25000
40000
10000
10000
10000
5000

10000
30000
55000
95000 1st year
105000 2nd year
115000
125000
130000

PBP = 1st year + investment CCI of 1st year

CCI of 2nd year CCI of 1st year


= 4 + 100000 95000
105000 95000
= 4 + 5000
10000
= 4 + 0.5 = 4.5
That means 4 years 6 months.
2) MOHAN & Co, is considering the purchase of a machine. 2 machines x and
y each costing Rs. 50,000-00 are available. Cash inflows are expected to be
as under. Calculate PBP.
Year Machine X Rs. Machine Y Rs.
1
15000
5000
2
20000
15000
3
25000
20000
4
15000
30000
5
10000
20000
Calculation of PBP
Year
1
2
3
4
5

Machine X
CI
CCI
15000
15000
20000
35000
25000
60000
15000
75000
10000
85000

Machine Y
CI
CCI
5000
5000
15000
20000
20000
40000
30000
70000
20000
90000

1st year
2nd year

PBP =

1yr + Invt - CCI 1yr


PBP = 1yr + Invt - CCI 1yr
CCI 2yr CCI 1yr
CCI 2yr CCI 1yr
= 2 + 50000 - 35000
= 3 + 50000 - 40000
60000 - 35000
70000 - 40000
= 2 + 15000
= 3 + 10000
25000
30000
= 2 + 0.6 = 2.6
= 3 + 0.33 = 3.33
2 years 7 months
3 years 4 months
Since machine X PBP is less compare to machine Y that means machine X
takes 2 years and seven months to payback 50,000-00 and machine Y takes 3

years and 4 months to payback 50000-00. Therefore as finance the investment on


X to be accepted and machine Y should be rejected.
3) From the following information suggest which project should be selected.
Particulars
Cost of project
Net cash flows
1
2
3
4
5
6

Project A Project B
180000
180000
80000
64000
40000
20000
15000

40000
42000
60000
80000
32000
5000

Calculation of PBP
Year
1
2
3
4
5
6
PBP =

CI
80000
64000
40000
2000
15000

Project A
CCI
80000
144000 1st year
184000 2nd year
184000
204000
219000

1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 2 + 180000 - 144000
184000 - 144000
= 2 + 36000
40000
= 2 + 0.9 = 2.9
2 years 11 months

Year
1
2
3
4
5
6

Project B
CI
CCI
40000 40000
42000 82000
60000 142000
80000 222000
32000 254000
5000 259000

1st year
2nd year

PBP = 1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 3 + 180000 142000
222000 - 142000
= 3 + 38000
80000
= 3 + 0.475 = 3.475
3 years 6 months

According to the PBP method project A should be accepted for investment


because it takes less time (2.0) when compare to project B which takes 3.475.

4) Determine PBP for the following project which requires cash outflow of Rs.
10000/-& generates the cash inflow of Rs. 2000/-, Rs.4000/-, Rs.3000/- & Rs.
2000/- in the 1st, 2nd, 3rd, & 4th, years respectively.
Year
1
2
3
4

Cash inflows
2,000
4,000
3,000
2,000

CCI
2,000
6,000
9,000- 1st year
11,000-II year

PBP =

1yr + Invt CCI 1yr


CCI 2yr CCI 1yr
= 3 + 10000 - 9000
17000 - 9000
= 3 + 1000
2000
= 3 + 0.5 or 3.5
3 years 6 months

5) The following information relating to the machines are available for


consideration. Advice the management which of the 2 machines is preferable.
Particulars
Cost of investment
Estimated life

Machine A
25000
7 years

Net cash benefits or profits


I year
II year
III year
IV year
V year
VI year
VII year

3,000
4,000
5,000
6,000
7,000
7,200
7,500

2,000
5,000
6,000
7,000
8,000
12,000
13,000

Machine B
40000
9 years

VIII year
IX year

7,500
7,500

13,200
13,400

Calculate PBP
Year
1
2
3
4
5
6
7
8
9

CI
3000
4000
5000
6000
7000
7200
7500

Machine A
Year
CCI
3000
1
7000
2
12000
3
18000
4
25000 III year
5
32200
6
39700
7
39700
8
39700
9

PBP =

1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 4 + 25000 16000
25000 - 18000
= 4+1
= 5 years

Machine B
CI
CCI
2000
2000
5000
7000
6000 13000
7000 20000
8000 28000
12000 40000
13000 53000
13200 66200
13400 79600

I year
II year

PBP = 1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 5 + 40000 28000
40000 - 28000
= 5+1
= 6 years

According to this method project A should be selected because if takes


less time to PB the investment compare to machine B
II AVERAGE RATE OF RETURN or ACCOUNTING RATE OF RETURN:This method takes into A/c the earnings expected from the investment
over there whole life. If is known as a/c ing rate of return.
ACCEPT OR REJECT CRITERIA:The expected return is determined & the project which has a higher rate of
return than the minimum rate of return called the cut-off rate is accepted & the
project which gives a lower expected rate of return than the minimum rate is
rejected.
NOTE

Cash inflow or profit here means profit after fax & after dep
METHODS OF ARR:- or RETURN ON INVESTMENT
1) Average rate of return method :ARR= Average annual profit (after dep & after fax) x100
Net investment
a) Where average annual profit= Total profit
No. years
b) Net investment = original investment-scrap value
2) Return per unit of invt method:
RPU= Total profit (AT & D) x100
Net investment
Return on average investment method:RAI = Total profits (AT & D)
Average investment
Where a) Average investment =Total (original) investment
2
3) Average return or average investment method:Average annual profits x100
Average investment
a) Average investment = original investment-scrap value
2
b) Average investment = original investment
2
(DCF=Discounted Cash Flow)
c) Average investment = original investment scrap value + additional WC + SC
2
1) A project requires an investment of Rs. 5,00,000-00 and has a scrap value
of 20,000-00 after 5 years it is expected the yield profit after depreciation
and after tax during the 5 years amounting to Rs. 40,000-00, Rs. 60,00000, Rs. 70,000-00, Rs. 50,000-00 and Rs. 20,000-00 respectively.
Calculate ARR on investment.

I.

ARR = Annual average profit x 100


Average investment

Average Annual profit = Total profit


No. of year
= 40000+60000+70000+50000+20000 = 240000 = 48000
5
5
Net investment = original investment SV
= 500000 20000 = 480000
ARR = 48000 x 100 = 0.1 x 100
480000
= 10
II.

ARR = Total profit x 100 = 240000 x 100 = 50%


Net investment
480000

III.

ARR = Total profits


x 100
Average investment

T.P. = 240000
Average investment = original investment scrap value
2
= 240000 20000 = 480000 = 240000
2
2
= 240000 = 100%
240000
IV.

ARR = Average profit


x 100 = 480000 x 100 = 20%
Average investment
240000

2) Calculate ARR from the data given below cost of the investment Rs.
630000/-, scrap value at the end of 5 years Rs. 30,000-00. It is expected to
yield profit after depreciation and taxes during the 5 years.
Year
Profit
I.

1
50000

2
70000

3
80000

ARR = Annual average profit x 100


Average investment

4
60000

5
40000

Where Average Annual profit = Total profit


No. of year
= 50000+70000+80000+60000+40000 = 300000 = 60000
5
5
Where Net investment = original investment SV
= 630000 30000 = 600000
ARR = 60000 x 100 = 10%
600000
II.

ARR = Total profit x 100 = 300000 x 100 = 50%


Net investment
600000

III.

ARR = Total profits


x 100 = 300000 x 100 = 100%
Average investment
300000

Average investment = original investment scrap value


2
= 630000 30000 = 300000
2
IV.

ARR = Average profit


x 100 = 60000 x 100 = 20%
Average investment
300000

3) Calculate ARR from the following information cost of the project


10,00,000-00, scrap value 4,00,000-00, it is expected to generate the cash
inflows as under.
Year
Profit
I.

1
50000

2
70000

3
80000

4
60000

5
40000

ARR = Annual average profit x 100 = 70000 x 100 = 11.66%


Average investment
600000
Average Annual profit = Total profit
No. of year
= 350000 = 70000
5
Net investment = original investment SV

= 1000000 400000 = 600000


II.

ARR = Total profit x 100 = 350000 x 100 = 58.33%


Net investment
600000

III.

ARR = Total profits


x 100 = 350000 x 100 = 116.66%
Average investment
300000

Average investment = original investment scrap value


2
= 1000000 400000 = 600000 = 300000
2
2
IV.

ARR = Average profit


x 100 = 70000 x 100 = 23%
Average investment
300000

4) Calculate average rate of return for projects A and B from the following
information.
Investment
Expected life

Project A
30000
5 years

Project B
40000
6 years

Projected net income after depreciation and taxes


Years
1
2
3
4
5
6

Project A
3000
3000
3000
2000
1000
12000

Project B
6000
6000
5000
3000
2000
1000
23000

If the required rate of return is 10% which project should be undertaken.


Project A & Project B
AP= Total Profit
No. years

1) ARR= Average of Profit x100


=1200
Net Investment
6
A=2400 x100
=2400
30000
=8%
B= 3833 x100
=23000
40000
6
=9.58%
2) ARR= Total Profit x100
Net Investment
A= 12000x100
30000
= 40%
= 23000x100
4000
= 57.5%
3) ARR= Total Profit x100
Average = Original Investment-scarp value
Average Investment
2
A= 12000 x100
= 30000
15000
2
=80%
= 15000
B= 23000 x100
= 40000
20000
2
=11.5%
3) ARR= Average annual Profit x100
Average investment
A= 2400 x100
15000
=16%
B= 3833 x100
20000
=19.165%
4) Calculate ARR from the following information cost of the project
1000000/-, scrap value 4.00.000/- . It is expected to generate the
cash inflows as under additional 1.00.000/year
C. I

1
50000

2
60000

3
70000

4
80000

5
90000

ARR = Annual Average Profit x100


Average investment
Where Average Profits = Total Profits
No. years
= 350000 = 70000
5
Average Investment = Original Investment Scrap value
2
= 1000000 400000 = 600000
2
2
= 300000
ARR = 70000 x100
300000
= 23.33%
ARR = Average Annual Profit x100
Average Investment
Average Investment = Original Investment scarper value+ additional
2
= 1000000 400000 + 100000+ 400000
2
= 600000 + 500000
2
= 300000 + 500000
= 800000
ARR = 70000 x 100
800000
8.75%

MODERN OR DISCOUNTED CASH FLOW


III

NET PRESENT VALUE METHOD

[IRR] 2) Internal rate of return method


3) Profitability index
Net present value method:-

Net present value value means the disblw the present value of cash
outflows & the present value cash inflows occurring in the future period
over the entire life of the project.
1) The following information is available pertaining to
project A u.r. require to calculate NPV
Cost of the investment Rs. 100000/The cash inflows
1
2
40000
30000

3
50000

4
20000

The discount factors at 10% are


Year
Discount factor
at 10%

.909

.826

0.75

0.683

Calculation of NPV
Year C.I.
1
40000
2
30000
3
50000
4
20000

Discount factor at 10%


0.909
0.826
0.751
0.683

Total pre value of C.I.


Less: original investment
N.P.V.

Pre. Value of CI (AxB)


36360
24780
37550
13660

1,12,350
1,00,000
12350

A firm where cost of capital is 10% is considering to mutually exclusive project X


and Y. The details of which are
Particulars
Capital outlay
Cash inflows

-1
2
3
4
5

Project X
70000
10000
20000
30000
45000
60000

Project Y
70000
50000
40000
20000
10000
10000

Compute NPV at 10%. The present value factors are given below.
Year
1
2
3
4
5
P.V. 10%
0.909
0.826
0.751
0.683
0.621
Calculation of Net Present Value of project X & Y
Year
CI
PV 10%
PV of CI
Year
CI
PV 10%
1
10000
0.909
9090
1
50000
0.909
2
20000
0.826
16520
2
40000
0.826
3
30000
0.751
22530
3
20000
0.751
4
45000
0.683
30735
4
10000
0.683
5
60000
0.621
37260
5
10000
0.621
116135
Less: Investment
70000
Less: Investment
NPV
45135
NPV

PV of CI
45450
33040
15020
6830
6210
106550
70000
36550

Since the NPV of project X is greater than (45135) project Y (36550) it is


advisable to accept project X and reject project Y.
3) From the following information suggest which project should be accepted
under project A PBP

NPV project B

Particulars
Cost of project

Project A
180000

Project B
180000

Dis F
10%

Net C.I.
Year
1
2
3
4
5
6

Project A
8000
64000
40000
20000
15000

Project B
40000
42000
60000
80000
32000
5000

PV
0.564
0.909
0.826
0.751
0.683
0.621

Compute NPV of Project A and Project B


Year
1

CI
80000

PV 10%
0.909

PV of CI
72720

Year
1

CI
40000

PV 10%
0.909

PV of CI
36360

2
3
4
5
6

64000
40000
20000
15000

0.826
0.751
0.683
0.621
0.564

Less:

Investment
NPV

52864
30040

2
3
4
5
6

12420
8460
176504
180000
-3496

42000
60000
80000
32000
5000

0.826
0.751
0.683
0.621
0.564

Less:

Investment
NPV

34692
45060
54640
19872
2820
193444
180000
13444

Calculation of PBP
Year
1
2
3
4
5
6

CI
80000
64000
40000
20000
15000

Project A
CCI
80000
144000 I year
184000 II year
184000
204000
219000

PBP =

1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 2 + 180000 - 144000
184000 - 144000
= 2 + 36000
40000
= 2 + 0.9 = 2.9
2 years 11 months

Year
1
2
3
4
5
6

Project B
CI
CCI
40000 40000
42000 82000
60000 142000
80000 222000
32000 254000
5000 259000

I year
II year

PBP = 1yr + Invt - CCI 1yr


CCI 2yr CCI 1yr
= 3 + 180000 - 142000
222000 - 142000
= 3 + 38000
80000
= 3 + 0.475 = 3.48
3 years 6 months

4) From the following information calculate NPV.


Particulars
Investment
Life of the project

Project X
20000
5 years

Project Y
30000
5 years

Cash inflows:
Project X
Project Y

1
5000
20000

2
10000
10000

Discount factor 10% should be taken

3
10000
5000

4
3000
3000

5
2000
2000

Present value at the rate of PV = (1/1+r)n


Here the discount factors are not provided therefore below calculation is advisable
to calculate discount factor.
I-year = (1/1+r)n = (1/1+10)1 = 0.909
II-year = (1/1+10)2 = 0.909 x 0.909 = 0.826
III-year = (1/1+10)3 = 0.826 x 0.909 = 0.751
IV-year = (1/1+10)4 = 0.751 x 0.909 = 0.683
V-year = (1/1+10)5 = 0.683 x 0.909 = 0.621
Calculation of NPV
Project X
1
2
3
4
5

5000
10000
10000
3000
2000

0.909
0.826
0.751
0.683
0.621

Less:

Investment
NPV

Project Y
4545
8260
7510
2049
1242
23606
20000
3606

1
2
3
4
5

20000
10000
5000
3000
2000

0.909
0.826
0.751
0.683
0.621

Less:

Investment
NPV

18180
8260
3755
2049
1242
33486
30000
3486

5) Raja Ltd. wants to replace its existing plant. It has 3 proposals 1,2,3. The
plants under the 3 proposals are expected to cost Rs. 2,50,000-00 each and has
an estimated life of 5 years, 4 years and 3 years respectively. The companies
required rate of return is 10%. The anticipated net cash inflows after taxes for
the 3 plants are as follows.
Years
1
2
3
4
5

Plant 1
80000
60000
60000
60000
180000

Plant 2
110000
90000
85000
35000
-

Plant 3
130000
110000
20000
-

Which of the above proposals would you recommend to the management for
acceptance? Use NPV technique for evaluation. The present value of Re.1 at 10%
for each of the 5 years is given below.
Year
PV at 10%
Plant 1
Year
CI
PV
10%
1
80000
0.909
2
60000
0.826
3
60000
0.751
4
60000
0.683
5
180000 0.621
Less:

Invest
ment
NPV

1
0.909

2
0.826

Year
72720
49560
45060
40980
111780
320100
250000

1
2
3
4
5

3
0.751

Plant 2
CI
PV
10%
110000
0.909
90000
0.826
85000
0.751
35000
0.683
0.621
Less:

70100

Invest
ment
NPV

4
0.683

Year
99990
74340
63835
23905
262070

1
2
3

250000
12070

5
0.621
Plant 3
CI
PV
10%
130000
0.909
110000
0.826
20000
0.751

224050
Less:

Invest
ment
NPV

Since plant-1 has more net present value considering the CI for 5 years (70,100).
It should be accepted as for NPV. But the CI for plant-2 are only for 4 years and
when we take the average CI generated by plant-1 and plant-2 for the minimum
period of 3 years, plant-2 generates more profit than plant-1. Therefore when we
consider profits the management should select plant-2.
IV. PROFITABILITY INDEX:It is one of the modern techniques of capital budgeting like NPV and IRR
(internal rate of return) it is sound method of appraising investments. Under this
method projects can be ranked on the basis of profitability index. Highest rank
will be assigned to be project with highest profitability index, while the lowest
rank will be given to the project having lowest profitability index.
Profitability Index (PI) = Present value of CI x 100

118170
90860
15020

250000
25950

Initial cash outlay


1) The initial cash outlay of a project is Rs. 1,00,000-00 and it generates CI of
Rs. 40,000-00, 30,000-00, 50,000-00 and Rs. 20,000-00, assume a 10% rate
of discount. Calculate profitability index.
Year
DF at 10%

1
0.909

2
0.826

Computation of PI
Year Cash Inflow
Dis. At 10%
1
40,000
0.909
2
30,000
0.826
3
50,000
0.751
4
20,000
0.683
Total PV of CI

3
0.751

4
0.683

Present value of CI
36360
24780
37550
13660
112350

PI = Present value of CI x 100


Present value of CO
= 112350 x 100
100000
= 11235 x 100
= 112.35

V. INTERNAL RATE OF RETURN (IRR):It is a modern technique of capital budgeting that takes into account the time
value of money. It is also known as time adjusted rate of return, yield method,
trial and error, discounted cash flow etc. Under this method the cash flows of a
project are discounted at suitable rate by trial method which equates the NPV, so
calculated to the amount of investment. The IRR can be defined as that rate of
discount at which the present value of cash inflows is equal to be present value of
cash outflows.

PV Factor = Initial outlay


Annual cash flows
IRR = % 1 yr + 1yr investment x % 1yr % 2 yr
1 yr 2 yr
1) Calculate IRR from the following information initial investment Rs.
60,000-00, life of the asset 4 years, estimated annual cash flows 15,00000, 20,000-00, 30,000-00, 20,000-00. The discount factor at the rate of
10%, 12%, 14% and 15% are as follows.
Year
1
2
3
4

3.169
10%
0.909
0.826
0.751
0.683

3.035
12%
0.892
0.797
0.711
0.635

2.912
14%
0.877
0.769
0.674
0.592

2.853
15%
0.869
0.756
0.657
0.571

PV factor = Initial outflow (investment)


Average annual profit
= 60,000
85,000 = 21250
4
= 60000 = 2.82
21250
Year

C.I.

1
2
3
4

15000
20000
30000
20000

Dis
10%
0.909
0.826
0.751
0.683

P.V.CI
13635
16520
22530
13660
66345

Dis
12%
0.892
0.797
0.711
0.635

P.V.CI
13380
15940
21330
12700
63350

Dis
14%
0.877
0.769
0.674
0.592

IRR = % 1 yr + 1yr investment x % 1yr % 2 yr


1 yr 2 yr
= 14% + 60595 60000 x (14 15)

P.V.CI
13155
15380
20220
11840
60595

Dis
15%
0.869
0.756
0.657
0.571

P.V.CI
13035
15120
19710
11420
59285

60595 - 59285
= 14 + 595 x 1
1310
= 14 + 0.45
IRR = 14.45
2) A project cost Rs. 16,000-00, life is 5 years, the cash flows will be Rs. 4000/for every year. The discount factors are as follows.
Year
7%
8%
9%

1
0.9346
0.9259
0.9174

2
0.8734
0.8593
0.8417

3
0.8163
0.7938
0.7722

4
0.7629
0.7350
0.7084

5
0.7130
0.6809
0.6499

Calculation of IRR
Year
1
2
3
4
5

C.I.
4000
4000
4000
4000
4000

Dis 7%
0.9346
0.9734
0.7938
0.7629
0.7130

P.V.CI
3738.4
3893.6
3265.2
3051.6
2852.0
16800.8

Dis 8%
0.8259
0.8593
0.7938
0.7350
0.6809

P.V.CI
3703.6
3437.2
3175.2
2940.0
2723.6
15979.6

Dis 9%
0.9174
0.8417
0.7722
0.7084
0.6499

P.V.CI
3669.6
3366.8
3088.8
2833.6
2599.6
15558.4

IRR = % 1 yr + 1yr investment x % 1yr % 2 yr


1 yr 2 yr
= 7% + 16800.8 16000 x 7 8
16800.8 15979.6
= 7 + 800.8 x 1
821.2
= 7 + 0.975
IRR = 7.975
3) A firm whose cost of capital is 10% is considering 10% is project X and Y
is details of which
Particulars
Investment

Project X
100000

Project Y
100000

Cash inflow
X
Y

1
20000
45000

2
30000
40000

3
40000
30000

4
50000
10000

5
60000
8000

Compute net present value at 10%, PI and IRR for two project separately, project
X by 20% and 29%, project Y by 9%, 15% use the following discount factors for
calculating IRR.
Project X
20%
0.833
0.694
0.579
0.483
0.402

29%
0.775
0.601
0.466
0.361
0.280

NPV PI
10%
0.909
0.826
0.751
0.683
0.621

Project Y
9%
0.917
0.842
0.772
0.708
0.650

15%
0.870
0.750
0.658
0.572
0.497

Calculation of NPV, PI & IRR of project X


Year
1
2
3
4
5

Cash inflow
20000
30000
40000
50000
60000

Dis. Factor at 10%


0.909
0.826
0.751
0.683
0.621
Less investment
NPV

NPV
18180
24780
30040
34150
37260
144410
100000
44410

PI = Prevalue of CI x 100
Prevalue of CO
= 144410 x 100
100000
= 144.41
Project Y
Year
1
2
3

Cash inflow
45000
40000
30000

Dis. Factor at 10%


0.909
0.826
0.751

NPV
40905
33040
22530

4
5

10000
8000

0.683
0.621
Less investment
NPV

6830
4968
108273
100000
8273

PI = Prevalue of CI x 100
Prevalue of CO
= 108273 x 100
100000
= 108.273
Calculation of IRR - Project X
Year
1
2
3
4
5

Cash inflow
20000
30000
40000
50000
60000

Dis at 20%
0.833
0.694
0.579
0.483
0.402

PV
16660
20820
23160
24150
24120
108910

Dis at 29%
0.775
0.601
0.466
0.361
0.280

PV
15500
18030
18640
18050
16800
87020

Dis at 15%
0.870
0.750
0.658
0.572

PV
39150
30000
19740
5720

IRR = % 1 yr + 1yr investment x % 1yr % 2 yr


1 yr 2 yr
= 20% + 108910 100000 x 20 29
108910 87020
= 20 + 8910 x 9
21890
= 20 + 3.6633
IRR = 23.6633
Calculation of IRR - Project X
Year
1
2
3
4

Cash inflow
45000
40000
30000
10000

Dis at 9%
0.917
0.842
0.772
0.708

PV
41265
33680
23160
7080

8000

0.650

5200
110385

0.497

3976
98586

IRR = % 1 yr + 1yr investment x % 1yr % 2 yr


1 yr 2 yr
= 9% + 110385 100000 x 9 15
110385 98586
= 9 + 10385 x 6
11799
= 9 + 5.2809
IRR = 14.2809
4) Ragini enterprises can make either of two investments at the beginning of
2001 assuming the rate of written of 10% P.A. Evaluate the investment
proposal by using the following methods. PI, discounted cash flow
method.
Particulars
Cash of investment
Life

Project X
25000
5 yrs.

Project Y
30000
6 yrs.

Net income (after dep & tax)


Year
Project X
Project Y

2001
600
3800

2002
1000
4500

2003
2500
5000

2004
3000
4500

2005
3500
5500

2006
6000

It is estimated that each of the alternative project will require an additional WC


Rs. 2000-00 which will be received back in full after the expire of each project
life.
Dep is provided under straight line method. The PV of Rs. 1/- to be
received at the end of each year 10% PA given below.
Year
PV factor

2001
0.909

2002
0.826

2003
0.751

2004
0.683

2005
0.621

2006
0.564

Calculation of NPV/Discounted cash flow method


Year
2001
2002
2003
2004
2005
2006

CI
600
1000
2500
3000
3500
-

Dep. Factor
0.909
0.826
0.751
0.683
0.621
0.564

PV
545.4
826
1877.5
2049
2173.5

Dep
5000
5000
5000
5000
5000

CI+dep
5600
6000
7500
8000
8500

7471.4
Less investment
Dis cash inflow

PV CI
5090.4
4956
5632.5
5464
5278.5
26421.4
25000
1421.4

Cash inflow = 25000 = 5000


No. of years
5
Project X
PI = PV of cash inflow x 100
PV of cash outflow
= 26421.4 x 100
25000
= 105%
Project Y
= 42569.2 x 100 = 1.42 x 100
30000
= 142%
Year
2001
2002
2003
2004
2005
2006

CI
3800
4500
5000
4500
5500
6000

Add dep.
5000
5000
5000
5000
5000
5000

TCI
8800
9500
10000
9500
10500
11000

Dis
0.909
0.826
0.751
0.683
0.621
0.564
Total
Less Invt
NPV

Pre CI
7999.2
7847
7510
6488.5
6520.5
6204
42569.2
30000
12569.2

5) The following are particulars given for two firms.


Particulars
Initial investment
Cash inflows
1
2
3
4
NPV at 25%
NPV at 20%

A
500

B
900

100
2000
200
250
(87.2)
(41.6%)

1269
864
-1305
1098

Evaluate the project by NPV and IRR method using 15% and 20% the discount
factors.
Year
1
2
3
4

15%
0.870
0.856
0.658
0.572

20%
0.833
0.694
0.579
0.482

Note :1) In the above problem the figures in brackets indicate values in negative
news.
2) NPV for project A at 20% already given.
3) You can reject the adequate data.
Calculation of NPV for A
Discount factor at
15%
1
100
0.870
2
200
0.756
3
200
0.658
4
250
0.572
I-year
Less Invt
NPV
Calculation of NPV for B
Year Cash inflow

P.V. of CI
87
151.2
131.6
143.0
512.8
500.0
12.8

Discount at
20%
0.833
0.694
0.579
0.482
II-year
Less Invt
NPV

P.V. of CI
833
138.8
115.8
120.5
458.4
500.0
41.6

Year Cash inflow


1
2
3
4

Discount factor at
15%
0.870
0.756
0.658
0.572
I-year
Less Invt
NPV

1269
364
1305
-

P.V. of CI
1104.03
653.18
-858.69
898.52
900.00
1.48

Discount at
20%
0.833
0.694
0.579
0.482
II-year
Less Invt
NPV

A) IRR = % 1 yr + 1yr investment x % 1yr % 2 yr


1 yr 2 yr
= 15 + 512.8 500 x 20 15
512.8 458.4
= 15 + 12.8 x 5
54.4
= 15 + 1.17
IRR = 16.17
B) IRR = % 1 yr + 1yr investment x % 1yr % 2 yr
1 yr 2 yr
= 20 + 901.096 900 x 15 20
901.096 898.52
= 20 + 1.096 x (-5)
2.57
= 20 + 0.08
IRR = 20.08

UNIT-III
WORKING CAPITAL MANAGEMENT
MEANING:-

P.V. of CI
1057.07
599.61
-755.59
901.096
900.000
1.096

Working Capital to that part of firms capital which is required for


financing short term or current assets such as cash, marketable securities, Dr. and
inventories. In other wards working capital means a capital which is required to
maintain and manage day to day affairs of business in alcing language working
capital means the difference between CA and CL i.e. (CA-CL=WC)
DEFENITION:According to SHUBIN Working Capital is the amount of funds necessary to
cover the cost of operating the en.es.
According to GENESTENBERG Circulating capital means CA of a Co. that are
changed in the ordinary course of business from one form to another as for
example from cash to inventories, inventories to receivables, receivables into
cash.
IMPORTANCE OF ADEQUATE WC OR ADVANTAGES OF ADEQUATE
WC:1) Solvency of the business :It helps in maintaining solvency of business by providing un-interpreted flow of
production.
2) Goodwill :It enables a concern to make prompt payments and hence helps in creating and
maintaining goodwill.
3) Easy loans :A concern having adequate WC can arrange loans from banks.
4) Cash discounts :It enables a concern to avail discounts on the purchases.
5) Regular supply of Raw materials :-

It ensures regular supply of raw materials and continuous production.


6) It enables regular payment of salaries, wages etc.
7) It ensures the exploitation of favourable market conditions.
8) It strengthness of the ability of a concern to face crisis.
9) It helps in quick and regular return on investment.
10) It creates high morale.
EXCESS OR INADEQUATE WC:The WC should neither be excess nor shortage. Both excess as well as shortage
are bad for any business. Out of the two it is the inadequacy of the WC which is
more dangerous from the point of the view of the firm.
DISADVANTAGES OF EXCESSIVE WC:1) It means ideal funds which earn no profit.
2) It may lead to unnecessary purchasing and accumulation of inventories.
3) It implies excessive Dr. and defective Cr. Policy.
4) It may result into overall inefficiency of the organisation.
5) Due to low rate of return the value of shares may also fall.
6) It restricts relations with banks.
7) It gives raise to speculative transactions.
DETERMINANTS OF WC REQUIREMENT or factors determining WC
requirement of factors influencing WC management.
1) NATURE OR CHARACTER OF BUSINESS:Public utility undertakings like electricity, water supply and railways need very
limited WC on the other hand the trading and financial firm require less
investment in fixed assets. But have to invest large amounts in current asset.

2) SIZE OF BUSINESS OR SCALE OF OPERATION:Large industries require more amount of WC where as small industries require
less amount of WC.
3) PRODUCTION POLICY:If the production policy during the slack (dull) season is to curtail then it requires
less WC and if the policy is to have steady production during peak (busy) season
it require large amount of WC.
4) MANUFACTURING PROCESS:In manufacturing business the length of production is longer therefore it requires
high WC than the trading concern.
5) SEASONAL VARIATIONS:Seasonal industries require large WC in busy season to purchase and maintain
inventories for the entire year.
6) WC CAPITAL CYCLE:The speed with which the WC completes one cycle determines the requirements
of WC longer the period of cycle larger is requirement of WC.

WC cycle of Manufacturing Unit


DEBTORS
CASH

FINISHED GOODS

WORK-IN-PROGRESS
RAW MATERIALS
WC cycle of Trading Unit
ACCOUNT RECEIVABLE
CASH
STOCK OF FINISHED GOODS
Service unit of WC cycle
CASH

DEBTORS

7) RATE OF STOCK TURNOVER:If the turnover is high the WC requirement will be low. If the turnover is low the
WC requirement will be high.
8) RECEIVABLES TURNOVER:A prompt collection of receivables and god facilities for settling payables result
into low WC requirement.
9) PRODUCTION SCHEDULE:Availability of WC can solve the problem of stoppage of production.

10) TERMS OF PURCHASES AND SALES:If the Cr. terms with respect to purchases are more favourable and those of sales
less liberal, less cash will be invested in inventory. With more favourable Cr.
terms WC requirements can be reduced.

11) BUSINESS CYCLE:Business expands during period of prosperity and declaims during the period of
depression. Consequently more WC is required during period of prosperity and
less during the periods of depression.
12) VALUE OF CR.:A decrease in the real value of Cr. reduces the size of WC. If the real value of Cr.
increases there is an increase in the WC.
13) VARIATIONS IN SALES:A seasonal business requires the maximum amount of WC for a relatively short
period of time.
14) Credit control
15) Liquidity and profitability
16) Inflation
17) Seasonal fluctuations.
18) Profit planning and control
19) Repayment ability
20) Cash reserves
21) Operational and financial efficiency
22) Changes in technology
23) Firms policies
24) Activities of the firm
25) Attitude of risk
PROFORMA FOR CALCULATING WC

Requirements
Particulars
1) Current assets
* Opening inventories (Stock)
Raw materials
Finished goods
Work in progress
* Dr. based on Cr. sales
In land and foreign sales
* Advance paid or prepaid expenses

Rs.
Xxx
Xxx
Xxx
Xxx

Xxx
Xxx
Xxx
Xxx

Cash Balance
2) Current liability
* Cr. based on Cr. purchases
* Advance received from Dr.
* Wages
* Manufacturing expenses

Rs.

Xxx
Xxx
Xxx
Xxx

Add contingencies
Required WC

Xxx
Xxx
Xxx
Xxx

1) Te board of directors of SHIVA Engineering Ltd. request you to advice


them the average amount of WC required in the first years working. You
are given the following estimates and instructed to add 10% to your
computed figure to allow for contingencies.
1) Amount blocked up for stocks
a) Stock of finished product Rs. 7000-00
b) Stock of stores materials Rs. 10000-00
2) Average Cr. given Dr.
a) Inland sales 6 week Cr. Rs. 208000-00
b) Export sales 1 weeks Cr. Rs. 78000-00
3) Lag in payment of wages and other out going
a) Wages 2 weeks Rs. 260000-00
b) Stock of materials etc. 1 month amount Rs. 48000-00

c) Rent, royalties etc 6 months 10000-00


d) Clerical staff month (i.e.1.5months) Rs. 62400-00
e) Manager salary month (i.e. 0.5month) 4800-00
f) Miscellaneous expenses 1 month 48000-00
4) Payment in advance:
Sundry expenses paid quarterly in advance 8000-00
5) Undrawn profit on the average throughout the year 18000-00
Statement showing WC requirement for Shiva Engineering Ltd.
Particulars
Current assets
1) Stock
a) Finished product
b) Stores materials
2) Credit sales or DV
a) Inland sales
(208000 x 6/52)
b) Export sales
(1=3/2)=1.5 78000/52 x 3/2
3) Payment in advance (8000x1/4)
Less Current liability
1) Lag in payment
a) Wages 2 weeks 260000x2/52
b) Stock of materials 1 month (48000/52 x 3/2)
48000/12 x 3/2
c) Rent and royalties
10000x6/2
d) Clerical staff (1/2 month)
(62400/12) 62400/12 x
e) Manager salary (1/2 month) (4800/12)
f) Miscellaneous expenses (1 month) 48000/12 x 3/2
Net WC
Add 10% for emergency
WC requirement

Rs.

Rs.

7000
10000

17000

24000
2250

26250
2000
45250

10000
6000
5000
2600
2400
6000

NOTE:- The undrawn profit is not considered due to the following reasons.

29800
15450
1545
16995

1) Profit may be or may not be included in the WC.


2) If it is included in WC it should be balanced with income tax, dividends,
drawings.
2) X & Co. is interested in purchasing a business and it has consulted you and you
are asked to advice them in determining average amount of WC which will be
required in the first year.
You are given the following estimate and instructed to add 10% to your computed
figure to allow for emergencies.
1) Average amount of Stock:
a) Stock of finished products 5000-00
b) Stock of stores and materials 8000-00
2) Average debit given:
a) Inland sales 6 (weeks) credit 312000-00
b) Export sales 1 (weeks) credit 78000-00
Lag in payments:
a) Wages 1 (week) 260000-00
b) Stock & materials 1 (month) 48000-00
c) Rent & Royalties 6 (month) 10,000-00
d) Clerical staff salary (month) 62400-00
e) Manager salary (month) 4800-00
f) Miscellaneous expenses 1 (month) 48000-00
3) Payment in advance:
Sundry expenses paid quarterly in advance Rs. 8000-00
4) Undrawn profit on the average throughout the year Rs. 11000-00
Estimate the amount of WC.
Statement showing WC requirement for the X & Co. Ltd.

Particulars
Current assets
1) Average amount of Stock
a) Stock of Finished product
b) Stock of Stores & materials
2) Debit sales or DV
a) Inland sales
312000 x 6/52)
b) Export sales
78000/52 x 3/2
3) Payment in advance (8000x1/4)
Sundry expenses quarterly (8000 x )
Less Current liability
1) Lag in payment
a) Wages (1 weeks) 260000/52 x 3/2
b) Stock of materials 1 month 48000/52 x 3/2
c) Rent and royalties (6 months)
10000x6/12
d) Clerical staff (1/2 month)
(62400/12) 62400/12 x
e) Manager salary ( month) 4800/12 x
f) Miscellaneous expenses (1 month) 48000/12 x 3/2
Net WC
Add 10% for emergency
WC requirement

Rs.
5000
8000

1) Stock of finished goods 6000-00


2) Stock of stores of materials 10000-00
II. Average credit given & to Drs.
1) Inland sales 8 weeks Cr. 300000
2) Export sales 2 weeks Cr. 80000
III. Lag in payment of wages & other outgoing
1) Wages (2 weeks) 250000

13000

36000
2250

38250
2000
53250

7500
6000
5000
2600
200
6000

From the following information estimate the WC requirements of a Co.


I. Amount blacked up for stocks

Rs.

27300
25950
2595
28545

2) Stock of materials (8 weeks) 50000-00


3) Rent (26 weeks) 10000-00
4) Clerical staff (4 weeks) 5000-00
5) Miscellaneous expenses (8 weeks) 50000-00
IV. Payment in advance and general expenses (period quarterly) 10000-00
Statement showing WC requirement for the Co.
Particulars
I. Current assets
a) Stock of Finished product
b) Stock of Stores of materials
II. Average Credit given
1) Inland sales (8 weeks) 800000 x 8/52 (46153.846)
b) Export sales (2 weeks) 80000 x 2/52 (3076.923)
III. Payment in advance and general expenses (quarterly)
(10000x1/4)

Rs.

Rs.

6000
10000

16000

46154
3077
2500

51731
67731

Less Current liability


1) Wages (2 weeks) 250000 x 2/52 (9615.3846)
b) Stock of materials (8 weeks) 50000 x 8/52 (7692.3076)
3) Rent (26 weeks)
10000 x 26/52
4) Clerical staff (4 weeks)
(5000 x 4/52) (384.61538)
5) Miscellaneous expenses (8 weeks) 50000 x 8/52
(7692.3076)
WC requirement

9616
7693
5000
385
7693

30387
37347

4) Following is the cost structure of product M, your are required to findout WC


required.
Elements of Cost
Raw materials
Direct labour
Overheads
Total cost
Add profit
Selling price

Amount per unit


70
40
60
170
30
200

The following further particulars are available:Raw materials or in stoke are an average for (1 month), materials o in process on
an average for ( a month), finished goods are in stoke on an average for (1
month)
Credit allowed by suppliers is (1 month)
Credit allowed to customers is (2 months)
Lag in payment of wages is (1 weeks)
Lag in payment of overhead expenses is (1 month)
of the output is sold against cash, cash in hand & at bank is expected to be Rs.
20000-00
Your are required to prepare a statement showing the WC needed to finance of
activity of 80000-00 units of production. You may assume that production is
carried on evenly throughout the year. Wages and overheads accrue similarly and
a time period of 4 weeks is equivalent to a month.
Statement showing WC requirement
I Current asset:a) stock Total unit 80000x70x4
52
(1 month __ 4 weeks)
b) work___ in progress
( a month = 2 week)
Raw material 80000x70 = 5600000
( 5600000x2/52
Direct labour 80000x40 = (3200000x2/52)
Overheads 80000x60 = (4800000x2/52)
c) Finished goods
(1 month = 4 weeks)
Raw material 5600000x4/52
Direct labour 3200000x4/52
Overheads 4800000x 4/52

4,30,769

2,15,385
1,23,077
1,84,615

5,23,077

4,30,769
2,46,154
3,69,231

10,46,154

d) Debit or Credit sales


Is because is on cash
& ( 2 months = 8 weeks)
R.M. 5600000x8/52x3/4
D.L 3200000x 8/52 x
O.H. 4800000 x 8/52 x
e) Cash in hand & at bank
Total Current Asset (A)
Less Current Liability:a) Purchase of Raw Materials (
( 1 month = 4 weeks)
5600000 x 4/52
b) Wages outstanding (Lag)
3200000 /52 x 3/2
c) Lag in payment of overhead
4800000 x 4/52 Total (B)
Required account [A-B]
[ CA-CL]

6,46,154
3,69,230
5,53,846

15,69,230
20,000
35, 89,230

4,30,769
92,308
3,69,231

9,92,308
25, 96,922

4) A proform cost sheet of a company provides the following particulars


Elements of Cost
Amount per unit
Materials
50%
Direct labour
10%
Overheads
10%
The following further particulars are available:1) It is prepare to maintain a level of activity of 100000/- units.
2) Selling price is Rs. 10 per unit
3) Raw materials are expected to be in stores for an average of 2 months
4) Materials will be in process on an average of 1 month
5) Finished goods are required to be in stock for an average 2 months
6) Current allowed to debit is 3 months
7) Current allowed by suppliers is 2 months
Statement showing account requirement
Rs.
I

Current Assset

Rs.

a) Stock of R.M.
100000 x 50/100 x 2/12 x10
b) Work-in-progress
R.M. 100000 x 50/100 x 1/12 x 10
D.L. 100000 x 10/100 x 1/12 x 10
O.H. 100000 x 10/100 x 1/12 x 10
c) Finished goods:R.M. 100000 x 50/100 x 2/12 x 10
D.L. 100000 x 10/100 x 2/12 x 10
O.H. 100000 x 10/100 x 2/12 x 10
d) Current allowed to debit (3 month)
R.M. 100000 x 50/100 x 3/12 x 10
D.L. 100000 x 10/100 x 3/12 x 10
O.H. 100000 x 10/100 x 3/12 x 10
Total A C.A.
Less Current Liability
R.M. 100000 x 50/100 x 2/12 x 10
WC requirement

83,333
41,667
8,333
8,333

83,333
41,667
8,333
8,333
83,333
16,667
16,667
1,25,000
25,000
25,000
4,33,333
8,33,333
3,50,000

5) Proform cost sheet of a company provides the following particulars


Elements of Cost
Materials
D.L.
O.H.

Amount per unit


50%
15%
15%

The following further particulars are available


a) It is proposed to maintain a level of activity of 300000 units
b) Selling price is Rs. 20 per unit
c) R.M. are expected to be in the store for an average of 2 months
d) Materials will be in the process are an average of 1 month
e) Finished goods are required to be in stock for an average of 2 months
f) Current allowed to debit is 2 months
g) Current allowed by supplier is 2 months
Statement showing W/c requirements

Rs.
I

Current Asset:a) Stock of R.M.


300000 x 50/100 x 2/12 x 20
b) Work- in- progress
R.M. 300000 x 50/100 x 1/12 x 20
D.L. 300000 x 15/100 x 1/12 x 20
O.H. 300000 x 15/100 x 1/12 x 20
c) Finished goods
R.M. 300000 x 50/100 x 2/12 x 20
D.L. 300000 x 15/100 x 2/12 x 20
O.H. 300000 x 15/100 x 2/12 x 20
d) Debit or Credit sale
R.M. 300000 x 50/100 x 2/12 x 20
D.L. 300000 x 15/100 x 2/12 x 20
O.H. 300000 x 15/100 x 2/12 x 20
Current Asset Total A
Less
Current Liability
R.M. 300000 x 50/100 x 2/12 x 20
Total B
Net WC requirement

Rs.
5,00,000

2,50,000
75,000
75,000

4,00,000

5,00,000
1,50,000
1,50,000

8,00,000

5,00,000
1,50,000
1,50,000

8,00,000
25,00,000
5,00,000
20,00,000

COST OF CAPITAL
INTRODUCTION:Cost means the amount spent on the form of money, material, & labour for
production of goods & services. Capital as a cost because interest is to be
paid an capital. Capital is an important invested on both fixed as well as
current asset of a firm.
Cost of capital is one of the basic Karnal Stone of the theory of financial
mgt. While deciding capital structure of a com. It is very essential to consider
the cost of each capital & compare then so as to decide which source of
capital is in the interest of the owners as well as the creditors.

Meaning of cost of capital:It is a rate of returns expected by the investors that is K = ro +b+f. That
means the cost of capital includes the rate of return at O risk + premium for
business risk + premium for financial risk.
It is the minimum rate of return the firm earns as its investment on order to
satisfies the expectations of the investors who provide funds to the form.
Cost of capital is the measurement of the sacrifice made by the investors
on due to the capital formation with a view to get a fair return on investment
CALCULATION OF COST OF CAPITAL:The cost of capital can be calculated as follows
1) Computation of weighted average cost of capital
2) Computation of cost of capital for various sources of finance separately
like equity share capital, pre share capital, debenture share capital &
retained earnings
Computation of weighted average cost of capital [WACC] or Over all cost
of capital = KO
Weighted average cost of capital is the average cost of the costs of
various sources of financing. It is also known as composite cost of capital
or over all cost of capital or average cost of capital.

Weighted average cost is the average of the cost of specific sources


of capital employed in a business, properly weighted by the proportion
they hold in the firms capital structure.
DEFINITION:According ICMA (Institute of charted Mgt Accountant) in Landon
weighted average cost of capital is the average cost of companies finance
weighted according to the proportion each element bears to the total pool
of capital, weighing is usually based on market valuations current yield &
costs after tax
Computation of weighted average cost of capital
1) Calculation of the cost of each specific source of funds:The cost of each source of capital i.e equity capital, pre-capital, debt
capital, etc is ascertained either on the basis of before tax, after tax.
However it will be appropriate to measure the cost of capital after taxes.
2) Assigning weights to specific costs:This involves determination of the proportion of each source of
funds in the total capital structure of the company.
BOOK VALUE:Value shown in the books is called book value. Weightage to each
source of finance is given on the basis of book value as recorded in the books.
MARKET VALUE:It represents the prices of sources of finance prevailing in the stock
market. So current market price are applied in ascertaining the weightage.

I From the following inforn calculate weighted average cost of capital using
book value & market value
1) Equity shares: 10000/- of Rs. 10 each Market price Rs. 15 each
Cost of equity (Ke) 12%
2) Debentures 10000/- of Rs. 100 each.
Market value Rs. 120 each
Cost of debt (KD) (after tax) 11%

1) Calculation of cost of capital based on weights & book value


Source
of Amount
capital
Equity Capital
10000 x 10
1,00,000

Debentures
10000 x 100

10,00,000
11,00,000

Proportion

Cost of capital Weighted


A
cost
1,00,000
0.12 (12%)
0.0108
Converted Cost
11,00,000
=0.0 of capital
9
10,00,000
0.11 (11%)
0.1001
11,00,000
=0.91
1.0
0.1109
0

0.1109 or 0.1109 x 100

AxB

= 11%

2) Using Market value:- (based on weights)


Source
capital
Equity

of Amount
share

Proportion
1,50,000

Cost of capital Weighted


B
cost
0.12
0.0132

AxB

Capital
10000 x 15

1,50,000

Debentures
10000 x 120

12,00,000
13,50,000

13,50,000
=0.1
1
12,00,000
0.11
13,50,000
=0.89
1.0
0

0.1111 or 0.1111 x 100

0.0979
0.1111

= 11%

3) Calculation of weighted average cost of capital based on (Total Cost)


Source of capital
Equity Capital
10000 x 10
Debentures
10000 x 100

Amount

Cost of capital
12%

1,00,000
11%
10,00,000
11,00,000

Weighted average cost capital

Total Cost
100000 x 12%
= 12,000
1000000 x 11%
= 1100x100
=1,10.000
1,22,000

= Total Cost x 100


Total Amount
= 1,22,000
11,00,000
= 11.0909

3) Calculation of weighted average cost using market value


Source of capital
Equity Capital
10000 x 15
Debentures
10000 x 120

Amount

Cost of capital
12%

1,50,000
12,00,000
13,50,000

Weighted average cost of


Capital = Total Cost x 100
Total Amount
= 1,50,000 x 100

Total Cost
150000 x 12/100
= 18,000
1200000 x 11/100
=1,32,000
1,50,000

13,50,000
= 11,1111
2) Anand Limited has the following capital structure equity expected dividend
12% Rs. 20,00,000/10% Pre shares Rs. 10,00,000
8% Debenture Rs. 30,00,000
Credit require to calculated weighted average cost of capital assuming 50% as
the rate of tax before & after tax
Calculation of Weighted average cost of capital based on total cost before tax
Source of capital
Equity Capital

Amount
20,00,000

Cost of capital
12%

Pre Shares

10,00,000

10%

Debenture

30,00,000

8%

60,00,000

Total Cost
2000000 x 12/100
= 2,40,000
1000000 x 10/100
=1,00,000
3000000 x 8/100
= 2,40,000
5,80,000

Weighted Average cost of capital = Total Cost x 100


Total Amount
= 5,80,000 x 100
60,00,000
= 9.6666 or 9.67
II Weighted Average cost of capital based on weights (before tax)
Source of capital
Equity Capital

Amount
20,00,000

Cost of Capital
12%

Pre Capital
Debenture

10,00,000
30,00,000
60,00,000

10%

Proportion
33.33
20,00,000 x100
60,00,000
10,00,000 x100
60,00,000
16.67
30,00,000 x100
60,00,00
50%
100.00

Weighted cost
4
1.67
4.00
9.67

Calculation of proportion :Equity share Capital = 20,00,000 x 100


60,00,000
= 33.33
Pre capital
= 10,00,000 x 100
60,00,000
= 16.67
Debenture
= 30,00,000 x100
60,00,000
= 50%
III

Weighted average cost of capital based on weights ( after tax)

Source of capital
Equity Share
Pre Shares
Debenture
at
50% tax it means
of 8%

Amount
20,00,000
10,00,000

Cost of capital
12%
10%

30,00,000

4%

Total Cost AxB


2,40,000
1,00,000
1,20,000

60,00,000
Weighted Average cost of capital

4,60,000
= Total Cost x 100
Total Amount
= 4,60,000 x 100
60,00,000
= 7.6

Calculation of weighted average cost using market value


Source of capital
Equity Share
Pre Share
Debenture

Amount
20,00,000
10,00,000
30,00,000
60,00,000

Proportion
33.33
16.67
50.00
100.00

Cost of Capital
12%
10%
4%

Weighted cost
4.00
1.67
2.00
7.67

3) Mallikarjun Company Limited desires to finance to the following process


Sources
Equity Capital

Amount
1,00,000

Cost
18%

Reserves
Debentures
Pre share capital

1,00,000
50,000
1,00,000

15%
14%
12%

Calculate the weighted average cost of capital


SOLUTION:Calculation of weighted average cost of capital based on Total Cost
Source of capital
Equity Capital
Reserves

Amount
1,00,000
1,00,000

Cost
18%
15%

Total Cost
18,000
15,000
1,00,000x 15/100
Debentures
50,000
14%
50,000 x 14/100
= 7000
Pre Share Capital 1,00,000
12%
12,000
3,50,000
52,000
Weighted Average cost of Capital = Total Cost x100
Total Amount
= 52,000 x100
3,50,000
= 14.86%
Based on weighted Cost
AXB
100
Source of capital
Equity Capital

Amount
1,00,000

Reserves

1,00,000

Debentures

50,000

A
Proportion
1,00,000 x 100
3,50,000
= 28.57%
1,00,000 x100
3,50,000
= 28.57%
50,000 x 100
3,50,000
=14.29%
=1,00,000 x100
3,50,000

B
Cost
18%
15%

Weighted cost
5.1426
28.57 x18
100
4.2855

14%

2.0006

Pre share capital

1,00,000
3,50,000

=28.57%

12%
100%

3.4284
14.86%

4) weighted average cost of capital of Hubli Company Limited from the


following
Sources
Equity Shares
Pre Shares
Retained Earnings
Long term debt

Amount
15,00,000
6,00,000
3,00,000
6,00,000

Cost
20%
15%
10%
10%

Calculation of weighted average cost of capital based on Total Cost


Sources
Equity Shares

Amount
15,00,000

Cost
20%

Pre Share

6,00,000

15%

Total Cost
3,00,000
15,00,000 x 20/100
90,000

Retained earnings

3,00,000

10%

30,000

Long term debt

6,00,000
30,00,000

10%

60,000
4,80,000

Weighted Average cost of Capital

= Total Cost x 100


Total Amount
= 4,80,000 x100
30,00,000
= 16%

Based on weighted cost


Equity Capital

15,00,000

15,00,000

x100

20%

5%

30,00,000
Pre shares

6,00,000

= 50%
6,00,000
30,00,000

10%
x 100
15%

3%

Retained earning

3,00,000

= 20%
8,00,000

x100

30,00,000
Long term debt

6,00,000

= 10%
6,00,000

10%

1%

10%

2%
16%

x 100

30,00,000
30,00,000

= 20%
100%

5) Compute weighted average cost of capital of Babu company from the


following
Inforn sources
Equity share capital
Retained earnings
Pre share capital
Debentures

Amount
15,00,000
2,00,000
1,00,000
2,00,000

Specific Cost, After tax


15%
12%
12%
6%

Calculation of weighted average cost of capital based on


Sources
Equity share capital
Retained earnings
Pre share capital
Debentures

Amount
5,00,000
2,00,000
1,00,000
2,00,000
10,00,000

Cost
15%
12%
12%
6%

Total Cost
75,000
24,000
12,000
12,000
1,23,000

Weighted average cost of capital = TC x 100 = 123000 x 100


TA
1000000
= 12.3%
Based on weighted average cost

Sources

Amount

Equity
Capital

Share 5,00,000

Retained
earnings

2,00,000

Pre Share Capital 1,00,000

Debentures

2,00,000

10,00,000

Proportion

Cost

5,00,000 x 100
10,00,000
= 50%
2,00,000 x100
10,00,000
= 20%
1,00,000 x100
10,00,000
=10%
2,00,000 x100
10,00,000
=20%
100%

15%
12%
12%

6%

Weighted
AxB/100
15x50
100
7.5%
12x20
100
2.4%
12x10
100
6x20
100
=1.2%
12.3%

6) Following are the details regarding the capital structure of


a company.
Source of capital
Debentures
Pre Shares

Book Value
80,000
20,000

Market value
76,000
22,000

Specific cost
10%
15%

Equity Shares

1,20,000

1,80,000

30%

Retained earnings

40,000

60,000

15%

You are require to determine the weighted average cost of capital using
1) Book value as weights
2) Market value as weights
Based on Book value calculation of weighted average cost of capital

Debentures
Pre Shares

Based on Total Cost


Book Value
Cost
Total Rs.
Capital
80,000
10%
20,000
15%

Equity Shares

1,20,000

Sources

30%

of Total cost
8,000
3,000
36,000

cost

Retained earnings

40,000
2,60,000

15%

6,000
53,000

Weighted Average cost of capital = Total Cost x100


Total Amount
= 53,000 x 100
2,60,000
= 20.38%
Based on weighted average cost, based on market value
Sources
Market Value Cost
of Total Cost
Amount
capital
Debentures
76,000
10%
76,000
Pre Shares
22,000
15%
3300
Equity Shares
1,80,000
30%
54,000
Retained earning 60,000
15%
9,000
3,38,000
73,900
Weighted Average cost of capital

= Total Cost x 100


Total Amount
= 73,900 x 100
3,38,000
= 21.87%
Calculation of Weighted Average cost of capital based on weighted cost
Sources

Amount

Proportion

Cost

Debentures
Pre shares
Equity Shares

80,000
20,000
1,20,000

30.76
7.69
46.16

10%
15%
30%

Retained Earnings

40,000
2,60,000

15.39
100.00

15%

Weighted
cost
AxB/100
3.076 or 154
1.1535.16
13.848
2.3085
20.386

Calculation of weighted average cost of capital based on market value


Sources
Debentures

Market
value
76,000

Pre shares

22,000

Proportion

Cost

76,000x100
3,38,00 =22.49
22,000 x 100

10%
15%

Weighted
AxB/100
224.9
= 2.249
97.65

cost

Equity Shares

1,80,000

Retained Earnings

60,000

3,38,000

3,38,000 = 6.51
1,80,000x 100
30%
3,38,000 =53.25
60,000 x100
15%
3,38,000
=
17.75
100.00

=0.9765
1.597.5
=15.97
266.25
=2.6625
21.858

The Vinayaka Company Limited cost of capital along with the indicated
book value & market value weighted
Types of capital

Cost

Equity Capital
Pre Shares
Long term debt

0.20
0.15
0.10

Book value
weight
0.50
0.25
0.25
1.00

Market Value
weight
0.60
0.15
0.25
1.00

Calculate weighted average cost of capital using book value & market
value weights
Calculation of weighted average cost of capital
Type
of Cost of Book value Market
Book value Market value
capital
capital
weight
value weight W.A Cost
W.A. Cost
Equity
0.20
0.50
0.60
0.10
0.12
capital
Pre shares 0.15
0.25
0.15
0.0375
0.0225
Long term 0.10
0.25
0.25
0.0250
0.025
debt
1.00
1.00
0.1625
0.1675
Or 16.25% or 16.75%
Computation of cost of capital for different sources of capital:Computation varies from one source of capital to the another source. The
company may raise the capital with the help of long term liabilities to purchase
the fixed asset in different forms. They are:1) Debentures

2) Equity shares
3) Preference shares
4) Long term loans
5) Retained earnings
1) Debentures:Debenture is a piece of paper acknowledging the ownership to the holder. The
return to the debenture holder is a cost to the company. They return may be in
the form of interest or tax.
The computation of cost of debenture is as follows:1) Before Tax:Cost of debenture [kd] = I/P
Kd = Cost of debenture
I

= Interest

P= principle

2) After Tax:Kd = (1 T) R
Kd = cost of debenture
1

= Re 1

T = Tax rate
R= Rate of interest
2) Cost of debenture on paper
When the debentures are issued on the basis of face value it is called
debentures on issued on paper
Kd= (1- T) R or

Interest x (1-T)
Principle

Where Kd = cost of debenture


I = Interest
T = Tax ratem

P = Net Proceeds [issue price]


4) Cost of debenture issued on discount:When the cost of debentures are issued less than the face value it is
called debentures issued on
Kd = I/P ( 1-T) Kd= cost of debentures
I = Interest
T= Tax
P = Face value discount
5) Cost of debenture issued on premium:When the cost of debentures are issued more than the face value it is
called debentures issued on premium.
Kd = I/P (1-T)

Kd = cost of debenture
I = Interest
T = Tax
P = face value + Premium

PROBLEMS
1) A company issues 12% debentures its marginal tax rate is 50%
calculate cost of debenture.
After
Kd= (1-T)R (50%)
= (1-0.50) 12%
= 0.50 x 12/100 = 0.06
(convert into percentage. Because
= 0.06x 100 = 6% the answer shows x 100
2) A company issues Rs. 50,000/- 8% debentures at paper, what is
the cost of debt
Before tax * (there is not given tax. So it is before tax)
Kd = I/P x 100
= 50,000 x 8/100 x 100
50,000
= 4,000 x 100

50,000
= 8%
3) A company issues Rs. 50,000 8% debentures at paper. The tax rate
is 50% what is the cost of debentures.
Kd= (1-T) R
= (1-50/100) 8%
= (1-0.50) 8/100
= (1-0.50) 0.08
= 0.50 x 0.08
= 0.40 x 100
= 40%
4) Calculate the cost of debenture when they are issued at paper from
the following inforn
1) Face value of debenture Rs. 1000/2) Floatation Cost 2%
3) Net proceeds?
4) Kd = face value discount
= 1000 -1000 x 2/100
= 1000-20
Net proceeds 980
5) Calculate the cost of debentures when they are issued at discount
from the following inforn
1) Issue price of debentures Rs. 1000
2) Floatation cost 2%
3) Discount 5%
4) Net proceeds
Kd or Net proceeds = Face value discount floatation cost
= 1000 (1000x 5/100) 2%
= 1000 50 = 2/100
= 950 950 x 2/100
NP = 931
5) Face value of debentures Rs. 1000 premium 10%
Floatation cost 2%
Net proceeds ?
Net proceeds or kd= face value + premium floatationcost
= 1000 + 1000 x 10/100 2/100
= 1000 + 100 2/100

= 1100 1100 x 2/100


= 1100 22
Rs. = 1078
6) Company issues Rs. 80,000, 9% debentures at paper. The tax rate
applicable to the company is 50% , compute the cost of debenture.

Kd = cost of capital
I = Interest = 7200
T= Tax = 0.50
P = Issue price = 80,000

Kd= I/P (1 T)
= 80,000 x 9/100 x (1 - 50/100)
80,000
= 7,200 x (1 0.50)
80,000
= 0.09 x 0.50
= 0.045 x 100
= 4.5%

8) Nagu company issues Rs. 80,000/-, 9% debentures at a premium of


10% the tax rate applicable to the company is compute the cost of
debenture capital.
Kd = I/P (1 T)
= 80,000x 9/100 x (1 60/100)
80,000 + 80,000x 10/100 = 8,000
= 7,200 (1 0.60)
88,000
= 0.081 (0.40)
= 0.0324 x 100 = 3.24%
9) Ashok company issues 80,000, 9% debentures at discount of 5%.
The tax rate is 50% compute the cost of debenture capital
Kd = I/P (1 T)
Face value= face value discount
= 80,000 x 9/100
x ( 1 50/100)
80,000 80,000 x 5/100
=
7,200
x (1 0.50)
80,000 4,000
= 7,200 (0.50)
76,000
= 0.095 x 0.50
= 0.0475 x 100 = 4.75

10) Ashok company issues 12% debentures of Rs. 6,00,000. The company is
in 50% tax bracket. The cost of debenture if the debenture at 1) paper 2) 10%
discount 3) 10% premium
1) Paper
Kd = I/P (1 T )
= 6,00,000 x 12/100
x (1 50/100)
6,00,000
= 72,000 x (1 0.50)
6,00,000
= 0.12 x 0.50 = 0.06 x 100
= 6%
2} If issued at 10% discount:Kd = I/P (1 T)
= 6,00,000 x 12/100
x (1 0.50)
6,00,000 6,00,000 x 10/100
= 72,000
x 0.50
6,00,000 60,000
= 72,000
x 0.50
5,40,000
= 0.133 x 0.50
= 0.0665 x 100 = 6.65%
3} If issued at 10% premium:Kd = I/P (1 T)
= 6,00,000 x 12/100
x( 1 0.50)
6,00,000 + 6,00,000x 10/100
= 72,000
x0.50
6,00,000+60,000
= 72,000 x0.50
6,60,000
= 0.109 x 0.50
= 0.0545 x 100
= 5.45%
11) Arun Limited issues Rs. 1,00,00/-, 8% debentures at paper compute the cost of
debenture capital if tax rate is 50%
On paper kd = I/P (1 T )
= 1,00,000 x 8/100 x (1 50/100)
1,00,000
= 8,000 x(1 0.50)

1,00,000
= 0.08 x 1.50
= 0.04 x 100 = 4%
12) Vikas company Limited issues Rs. 1,00,000, 8% debentures at a premium of
10% the tax rate applicable to the company is 50% compute the cost of debenture
capital
= I/P (1 T)
= 1,00,000 x 8/100
x(1 50/100)
1,00,000+1,00,000x 10/100
=
8,000
x(1 0.50)
1,00,000+10,000
= 8,000 x 0.50
11,000
= 0.0727 x 0.50
= 0.03635 x 100
= 3.635%
13) Leela Ltd issues Rs. 1,00,000/-, 8% debentures at a discount of 5% . The
tax rate is 50% compute the cost of debenture capital
Kd = I/P (1 T)
= 1,00,000 x 8/100
x (1 T)
1,00,000 1,00,000x 5/100
=
8,000
(1 50/100)
1,00,000 5000
= 0.0842 x 0.50
= 0.0421 x 100 = 4.21%
14) Basu Ltd issues Rs. 1,00,000/-, 10% debentures at a premium of 10% the
brokerage charges 2% the tax rate applicable is 60% compute the cost of
debenture capital
Kd at premium
Kd = I/P (1 T)
=
1,00,000x 10/100
x(1 60/100)
1,00,000 + 1,00,000x 10/100 1,00,000x 2/100
=
10,000
x (1 60/100)
1,00,000 + 10,000 2000
=
10,000
x(1 0.60)
1,10,000 2000

= 10,000 x 0.40
1,08,000
= 0.0925 x 0.40
= 0.037 x 100
= 3.7%
COST OF PREFERENCE CAPITAL:A fixed rate of dividends is payable on pre shares, but payment of
dividend is not a legal binding it is generally paid whenever the company
makes sufficient profit.
If the dividend is not paid to preference share holders. It will affect
the fund raising capacity of the company. Hence dividends are regularly paid
on pre shares except when there is no profits to pay dividends. The cost of pre
share capital can be calculated as
KP = R/P where Kp = cost of pre capital
R = Rate of dividend
P = Proceeds of Net
1) If shares are issued at Par:Kp = R/P
2) If shares are issued at discount:Kp = R/P = (P = Face value discount)
3) If the share are issued at premium:Kp = R/P = ( P= Face value + Premium)
NOTE:-

1) If any expenses incurred in the form of brokerage or cost of floatation. Such


expenses is deducted from the Face value in order to find out P (Net
Proceeds) of shares.
2) Dividends are deducted in computation of tax
3) Pre shares may be issued at par, at a premium & discount
1) A Co. issue 20,000-00 10% Pre. Share of Rs. 100-00 each. Cost of issue is Rs.
2% per share. Calculate cost of Pre. Cap if there shares are issued (a) at par (b) at
a premium of 10% (c) at a discount of 5%
1) When pre. Shares are issued at par KP = R/P
Where R= Rate of dividend
20000x100=2000000
2000000x10/100 = 200000
P= Net proceeds = FV-cost of floation
= 2000000-2000000x2/100
= 2000000-40000
= 1960000
So KP = 200000 x 100
1960000
= 10.20%
2) Shares issued at premium
KP = R/p
= 200000
FV+premium-floatation cost
= 200000
2000000+2000000x10/100 40000
= 200000
2000000+200000 40000
= 200000

2200000 40000
= 200000
2160000x100 = 9.26%
3) Shares are issued at discount
KP = R/P
= 200000
2000000-2000000x5/100 2000000x2/100
= 200000
2000000 - 100000 40000
= 200000
1900000-40000
= 200000 x 100
1860000
= 10.75%
2) A Company raise pre. Share capital of Rs. 500000-00 by issue of 10% pre
shares of Rs. 10 each, calculate the cost of pre. Capital when they are issued (a)
par (b) at dis. 10% (c) at 10%
1) Shares issued at par:KP = R/P
= 500000 x 10/100 = 50000 x 100
500000
500000
= 0.1x100 = 10%
2) Shares issued at discount:KP = R/P
= 500000 x 10/100
500000 - 500000 x 10/100
= 50000
5000000 50000
= 50000 x 100
450000

= 11.11%
KP = R+MV-P/N
(MV+P)
3) Shares issued at premium:KP = R/P
= 500000 x 10/100
500000 - 500000 x 10/100
= 50000
500000 + 50000
= 50000 x 100
550000
= 9.09%
Calculation of cost of redeemable premium shares.
Redeemable premium shares are issued which can be redeemed or cancelled on
maturity date. The cost of redeemable preference share capital can be calculated
as
KP = R+MV-P/N
(MV+P)
Where KP = cost of redeemable premium, R = Rate of dividend, MV = Maturity
Value (FV+Premium)
P = Net Proceeds
N = No. of years to maturity
(1) Redeemable premium shares at premium:1) A company issues 20000, 10% premium shares of Rs. 100 each redeemable
after 10 years at a premium of 5%. The cost of issue is Rs. 2 per share. Calculate
the cost of premium cap.
KP = R+MV-P/N
(MV+P)
R = 2000000 x 10/100 = 200000

MV = 2000000+2000000 x 5/100
= 2000000+100000 = 2100000
P = FV cost
= 2000000 40000 (20000 x 2/100)
= 1960000
KP = 200000+2100000 1960000/10
(2100000+1960000)
= 200000 + 140000/10
(4060000)
= 200000 + 14000
2030000
= 214000 x 100
2030000
= 10.54%
Issued at premium repayable at par:A Company issues 20000, 7% premium share of Rs. 10 each at a premium of 10%
redeemable after 5 years at par. Compute the cost of premium capital.
KP = R+MV-P/N
(MV+P)
Cost = 20000 x 10 = 200000
R = 200000 x 7/100 = 14000
MV = 200000
P = FV + cost
= 200000 + 200000 x 10/100
= 200000 + 20000
= 220000
N = 5 years

KP = 14000+200000 220000/5
(200000+220000)
= 14000 - 20000/5
(420000)
= 14000 - 4000
210000
= 10000
210000
= 4.8% or 4.77%
Cost of equity share capital:The cost of equity share is the minimum rate of return co. has to earn.
Equity share holders are not paid dividend at a fixed rate every year. The
distribution of dividend depends upon the profitability of the co.
More over the payment of dividend depends upon the retained earnings as well as
the present profits but it is not a legal binding. It may or may not be paid.
The cost of equity capital is calculated based on the following approaches.
a) Dividend price ratio
b) Earning price ratio
c) Dividend price + growth of earnings (P+G)
d) Realised yield approach
Dividend Price + Growth of Earnings:This approach emphasises what the investors actually received as dividend + the
rate of growth in dividend
Ke = D + G

P
D = expected dividend per share
Ke = cost of equity share capital
P = Net proceed per share
G = Growth rate in dividend
Ke = D + G
MP
Ke = cost of equity
D = Dividend rate per share
MP = Market price of shares
G = Growth rate in earnings per share
1) The current market price of equity share of the Co. is Rs. 80-00, but its face
value is Rs. 10-00. The current dividend per share is Rs. 5-00, in case of dividends
are expected to grow at the rate of 9%, calculate the cost of equity capital.
Ke = D + G
MP
= 5 + 9%
80
= 5 + 0.09
80
= 0.0625 + 0.09
= 0.1525 x 100
= 15.25%
2) A Co. plans to issue 2000 new equity shares of Rs. 100-00 each at par. The
floatation cost are expected to be 5% of the share price. The Co. pays a dividend
of Rs. 10-00 per share initially and the growth in dividend is expected to be 5%.
Compute the cost of new issues equity shares.

If the current market price of equity share is Rs. 160-00 calculate the cost of
existing equity share capital.
1) Cost of equity at par
Ke = D + G
P
=

10
+ 5%
FV flotation cost

10
100 5

+ 0.05

= 10 + 0.05
95
= 0.1552 x 100
= 15.52%
2) Cost of equity at Market Price
Ke = D + G
MP
= 10 + 5%
160
= 10 + 0.05
160
= 0.1125 x 100
= 11.25%
SOURCES OF FINANCE:INTRODUCTION:Finance is essential for all organs in order to carry out his day activity &
to achieve the target of the enes. The business cannot run without adequate
finance, that is why finance is called life blood of business

MEANING:It means the agencies or services from which the funds are obtained or
collected, method of raising finance & period for which funds are required.
The financial requirements can be classified into 2 groups
1) Fixed capital / long term financial requirements:The capital is required to meet the capital expenditure as purchase of L/B,
P/M, F/F.etc
2) working capital / short term financial requirements:This capital is required to meet day to day expenses such as purchase of
materials, payment of salaries & wagesetc
CLASSIFICATION OF SOURCES OF FINANCE:I On the basis of period:1) Long term sources:Ex:- equity & preference shaves, debentures, retained earnings, long term
loansetc
2) Short term sources:Ex:- Public deposits, trade credit, short term loansetc
II On the basis of ownership:1) Own capital:Ex:- Share capital, reserves & scirples, retained earnings
2) Barrowed capital:Ex:- Debentures, public deposits, loans..etc
III On the basis of source of generation:1) Internal sources:Ex:-Retained earnings, depreciation.etc
2) External sources:Ex:- Shaves, debentures, loansetc

However the most popular form to classify sources of finance is


1) Long term & medium term sources of finance
2) Short term sources of finance
SOURCES OF FINANCE:SHORT TERM
MEDIUM TERM
LONG TERM
1 yr or less than 1 yr
1 yr to 5 yr
5 years above
1 Indigeneous bankers
1 Issue of debentures
1 Issue of shares
2 Customers
advance 2 Issue of preference 2 Ploughing bank of profits
debentures
3 Trade Credit

shaves
3 Bank loans

3 Loans

from

specialised

financial institutions
4 Bank Credit
5 Factoring
6 Accruals

4 Public deposits
5 Fixed deposits
6 Loans
from

the

financial institutions
7 Deferred incomes
8 Commercial papers

8 Instalment Credit

SHORT TERM FINANCE:It is a fund required to meet the working capital for a period of 12 months
or less than 12 months. It is used for office equipment, furniture, loose tools,
payment of salaries & wages, purchase of raw materials.etc
Advantages of short term Finance:1) Easy to obtain:It is easy to secure short term funds because creditors advance the funds
for a few weeks or months generally assume less risk as compared to
longer period
2) Low cost:Cost means interest charged an annual basis for the funds raised
3) Flexibility:-

As & when they are required


Disadvantages of short term financing:1) Frequent maturities:Liability on the maturity should be otherwise more cost incurred
2) High cost:In rate of interest is very high because it is for short term & there by
increases the cost of capital
SOURCES OF SHORT TERM FINANCE:
1) Indigeneous Bankers:Private money lenders are called indigeneous bankers. They charges high
rate of interest.
2) Customers advance:Companies may take advance from their customers for meeting out their
short term financial requirement, some times ene may take some advance
money from customers @ the time of receiving orders for supply of goods
to them.
Advantages of customers advance:1) It is an easy source of finance
2) It is free from the interest
3) It is an un-secured loan i.e. no security is required
4) It is refunded without interest
Dis-advantages:1) Its duration is short
2) It is a loss to customer
3) TRADE CREDIT:It is a credit granted by a seller to the buyer for a short period. It is made
available to companies who have sufficient financial reputation &
goodwill. Trade is granted on an open account basis.

ADVANTAGES:
1) It is simple & easy method of finance
2) It is flexible
3) It doesnt require any agreement
4) It is unsecured loan i.e. no security is required
Disadvantages:1) It is a short period
2) High price is charged by the seller
3) It is loss of cash discount
4) Too much depend upon reputation & credit wothiness
5) BANK CREDIT:Bank provides financial accommodation to the business firms in the
following ways
1) Over draft:
It is a temporary financial accommodation provided by a bank to its
customer, where a customer is allowed to draw money over & above
their credit balance.
2) Cash credit:It is also a temporary financial accommodation granted by a bank
against tangible security or promissory note signed by at-least two
parties
3) Advancing loans:-\
Secured and un-secured loans.
4) Discounting & purchase of bills of exchange, promissory notes,
5) Factoring:It is a method by which a businessmen obtains cash for invoice that he
sends to his customers in respect of foods & services to them. It is
also called as invoice discounting. It is a method of financing under

which a business ene obtains cash by selling accounts receivables.


The financial institution which undertake factoring is called factor
the business is called client
ADVANTAGES:1) It provides specified services in credit mgt
2) It helps in reduction in the cost of maintainance & collection of book
debts
3) It helps in increasing the sales by purchasing the customers
receivables
4) It saves in time man power..etc received for collection
DISADVANTAGES:1) High cost of factoring as compared to other short-term sources
2) Shows the financial weakness of the ene
3) It is a short period
LONG TERM & MEDIUM TERM SOURCES OF FINANCE:1) Equity Share:These are the shares which do not carry preferential rights in respect
of payment of dividend or repayment of capital. They are also called as ordinary
or common shares. Equity shareholders are called the owners of the joint stock
company. Equity shares has the following characteristics
a) voting right
b) Right to income
c) Limited liability
ADVANTAGES
1) No charge on assets:The company is liable to collect the required funds without any charge on
its assets
2) It is a permanent & long term source of finance

3) Dividends are payable only when profits are earned.


4) WIDE MARKET:These shares are of nominal value & hence attract large number of
investors
5) Owners of the company:The share holders of equity shares has the voting right
DISADVANTAGES:1) No trading on equity:Company will not get the benefit of trading on equity if is has only equity
shares
2) Over capitalization:As they cannot be redeemed during the life time of the company, a slight
miscalculation in estimating the financial needs may lead to over
capitalization
3) Speculation in prices:Increase in the value of shares causes for a lot of speculation
4) Manipulation of control:Shareholders can put obstacles in mgt by organizing themselves
II

Preference shares:These shares are those who enjoy two preferential right over equity shares
a) preference as to payment of dividend @ a fixed rate
b) preference as to the return of capital when the company winds-up
There are different types of pre shares:1) Cumulative & non- cumulative
2) Participating & non-participating
3) Convertible & non- convertible
4)

Redeemable & non-redeemable


ADVANTAGES:-

1) Facilitates trading on equity in the capital structure of company


2) No control over companies mgt as the shareholders do not carry voting
rights
3) Since they can be redeemed whenever company does not service them
they eliminate over capitalization
4) Lesser financial burden because dividends are payable only when
company makes sufficient profits
5) It is an unsecured source of finance no charge on asset
DISADVANTAGES:1) It is costly source of finance because high rate of dividend will be paid
than interest on debentures
2) No voting right
3) Permanent burden on company
4) No scope for participation in prosperity
III

DEBENTURES:- (Medium term of finance)


It is a long term borrowed capital. A debenture is an acknowledgement in

writing of debt taken by a company. The debenture holders are entitled to get the
fixed rate of interest. These are different types of debentures. They are
1) Simple & mortgage debentures
2) Bearer debentures & registered debentures
3) Redeemable debentures & non redeemable debentures
4) Convertible debentures & non-convertible debentures
5) First debentures & Second debentures
6) Guaranteed debentures
7) Collateral debentures
8) Zero interest debentures
9) Zero coupon bonds (ZCB)
10) Deep discount bonds

ADANTAGES:1) Lower rate of interest when compared to the dividends of pre


shares
2) Trading on equity is allowed with fixed interest security
3) Freedom in mgt as the holders do not have voting rights
4) Reduction in tax liability hence exemption of tax is availed
5) Surety of finance
6) Capital from ordinary investors can be attracted
7) Finance during boom is possible with debentures
8) Control on over capitalization
9) Finance during depression is also possible
10) Consolidation of debt
11) Fixed & stable income ( investors)
12) Safe investment ( investors)
13) Liquid investment
14) Convention of loan
DIS-ADAVANTAGES
1) Fixed charge on assets:- (interest)
As debenture carry fixed interest charge on all assets further
money can not be raised if needed
2) Fixed burden:- (liable)
Interest is payable even if company does not earn profit
3) Risk of winding up:If the interest on debentures is not paid by the company, the
debenture holders can demand the winding up company
particularly when there are no profit
4) Debenture holder do not have voting right
5) Share in profits is fixed even of company earns more profit

6) There is always uncertainty of redemption of debentures


IV PUBLIC DEPOSITS:Company may invite general public to deposit their savings with the
company @ specified rate of interest for a specified period which may range from
1 year to 6 years. The total amount of such deposits should not exceed 25% of
paid-up capital & free reserves of the company
ADAVANTAGES:1) It is simple
2) It is a cheap source of finance
3) It is reduces the cost of finance
4) It helps companies to pay higher rate of dividend
5) There is no interference
DISADVANTAGES:1) It is un-reliable source of finance
2) Loss of money may be due to miss-mgt
3) Maturity period is very short
V PLOUGHING BACK & PROFIT (Self financing/ Internal financing/ Retained
earnings/ Re-investment of earnings):
Under this method, companies re-invest a part of the profits in the business
& only a part of the earnings is distributed in the form of dividends. In other
words a part of profit is retained or re-invested in the company
ADVANTAGES TO THE COMPANY:1) It is a cushion to absorb the shocks of the company.
2) It is a economical method of financing
3) It helps to maintain stable dividend policy
4) It helps in making good the defeliencies of depreciation
5) It helps to redeem long term debt

ADVANTAGES TO THE SHAREHOLDERS:1) It increase in the value of shares


2) It is a safe investment
3) It increase the earning capacity.
4) It provides an opportunity for evasion of super tax
ADVANTAGES TO THE SOCIETY:1) It increases productivity
2) It leads to higher standard of living
3) It leads to rapid industrialization
DISADVANTAGES:1) Danger of over capitalization due to excessive earnings
2) It may lead to the creation of monopoly power to few
3) It is subject to minimize of retained earnings
4) Evasion of taxes reduces the revenue of the government
VI

LOANS FROM FINANCIAL INSTITUTIONS:The institutions set up by the government to facilitate finance for industrial

purpose. There are 2 entities with respect to this work


1) Financial institutions like ICICI, IDBI, ICFC, SFC
2) Financial intermediaries like venture capital, credit rating
SHORT TERM SOURCES
1) ACCRUALS- Accrued expenses:Companies postpone the accrued expenses in respect of which payments
are due. This delay in payments of accrued expenses helps the company to

use such amount for meeting their short term financial requirements of
expenses like accrued expenses, wages, salaries, interest & tax.etc
2) DEFERED INCOMES:These are the incomes received in advances before supplying
goods or services. These funds increases the liquidity of a firm
3) COMMERCIAL PAPER:It represents unsecured promissory notes issued by firms to raise
the short term funds. It may be issued even @ discount. The maturity period
of commercial paper in India ranges from 91 to 180 days.
4) INSTALMENT CREDIT:Purchase of any durable goods or capital goods like plant &
machineries, furniture etc paying the cash price by way of instalment
including interest over a pre-determined period of time.