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 CHARLESTHORANGREEN 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.
80,00000
40,00000
40,00000
1) A project requires an initial cash outlay of Rs. 1,00,00000 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
10000
20000
25000
40000
10000
10000
10000
5000
10000
30000
55000
95000 1st year
105000 2nd year
115000
125000
130000
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 =
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
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
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
11,000II year
PBP =
Machine A
25000
7 years
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 =
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
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 investmentscrap 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 investmentscrap 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. 5,00,00000 and has a scrap value
of 20,00000 after 5 years it is expected the yield profit after depreciation
and after tax during the 5 years amounting to Rs. 40,00000, Rs. 60,00000, Rs. 70,00000, Rs. 50,00000 and Rs. 20,00000 respectively.
Calculate ARR on investment.
I.
III.
T.P. = 240000
Average investment = original investment scrap value
2
= 240000 20000 = 480000 = 240000
2
2
= 240000 = 100%
240000
IV.
2) Calculate ARR from the data given below cost of the investment Rs.
630000/, scrap value at the end of 5 years Rs. 30,00000. It is expected to
yield profit after depreciation and taxes during the 5 years.
Year
Profit
I.
1
50000
2
70000
3
80000
4
60000
5
40000
III.
1
50000
2
70000
3
80000
4
60000
5
40000
III.
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
Project A
3000
3000
3000
2000
1000
12000
Project B
6000
6000
5000
3000
2000
1000
23000
1
50000
2
60000
3
70000
4
80000
5
90000
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
.909
.826
0.75
0.683
Calculation of NPV
Year C.I.
1
40000
2
30000
3
50000
4
20000
1,12,350
1,00,000
12350
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
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
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 =
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
Project X
20000
5 years
Project Y
30000
5 years
Cash inflows:
Project X
Project Y
1
5000
20000
2
10000
10000
3
10000
5000
4
3000
3000
5
2000
2000
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. 2,50,00000 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 plant1 has more net present value considering the CI for 5 years (70,100).
It should be accepted as for NPV. But the CI for plant2 are only for 4 years and
when we take the average CI generated by plant1 and plant2 for the minimum
period of 3 years, plant2 generates more profit than plant1. Therefore when we
consider profits the management should select plant2.
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
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
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.
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
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
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. 16,00000, 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
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
Cash inflow
20000
30000
40000
50000
60000
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
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
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
Project X
25000
5 yrs.
Project Y
30000
6 yrs.
2001
600
3800
2002
1000
4500
2003
2500
5000
2004
3000
4500
2005
3500
5500
2006
6000
2001
0.909
2002
0.826
2003
0.751
2004
0.683
2005
0.621
2006
0.564
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
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
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
Iyear
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
IIyear
Less Invt
NPV
P.V. of CI
833
138.8
115.8
120.5
458.4
500.0
41.6
Discount factor at
15%
0.870
0.756
0.658
0.572
Iyear
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
IIyear
Less Invt
NPV
UNITIII
WORKING CAPITAL MANAGEMENT
MEANING:
P.V. of CI
1057.07
599.61
755.59
901.096
900.000
1.096
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.
FINISHED GOODS
WORKINPROGRESS
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
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
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
13000
36000
2250
38250
2000
53250
7500
6000
5000
2600
200
6000
Rs.
27300
25950
2595
28545
Rs.
Rs.
6000
10000
16000
46154
3077
2500
51731
67731
9616
7693
5000
385
7693
30387
37347
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.
2000000
Your are required to prepare a statement showing the WC needed to finance of
activity of 8000000 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
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
Current Assset
Rs.
a) Stock of R.M.
100000 x 50/100 x 2/12 x10
b) Workinprogress
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
Rs.
I
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.
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%
Debentures
10000 x 100
10,00,000
11,00,000
Proportion
AxB
= 11%
of Amount
share
Proportion
1,50,000
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
0.0979
0.1111
= 11%
Amount
Cost of capital
12%
1,00,000
11%
10,00,000
11,00,000
Total Cost
100000 x 12%
= 12,000
1000000 x 11%
= 1100x100
=1,10.000
1,22,000
Amount
Cost of capital
12%
1,50,000
12,00,000
13,50,000
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
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
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%
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
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
Amount
1,00,000
Cost
18%
Reserves
Debentures
Pre share capital
1,00,000
50,000
1,00,000
15%
14%
12%
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
1,00,000
3,50,000
=28.57%
12%
100%
3.4284
14.86%
Amount
15,00,000
6,00,000
3,00,000
6,00,000
Cost
20%
15%
10%
10%
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
6,00,000
30,00,000
10%
60,000
4,80,000
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%
Amount
15,00,000
2,00,000
1,00,000
2,00,000
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
Sources
Amount
Equity
Capital
Share 5,00,000
Retained
earnings
2,00,000
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%
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
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
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
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 (1T)
Principle
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= (1T)R (50%)
= (10.50) 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= (1T) R
= (150/100) 8%
= (10.50) 8/100
= (10.50) 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
= 100020
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
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%
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:
2200000 40000
= 200000
2160000x100 = 9.26%
3) Shares are issued at discount
KP = R/P
= 200000
20000002000000x5/100 2000000x2/100
= 200000
2000000  100000 40000
= 200000
190000040000
= 200000 x 100
1860000
= 10.75%
2) A Company raise pre. Share capital of Rs. 50000000 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+MVP/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+MVP/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+MVP/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+MVP/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. 8000, but its face
value is Rs. 1000. The current dividend per share is Rs. 500, 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. 10000 each at par. The
floatation cost are expected to be 5% of the share price. The Co. pays a dividend
of Rs. 1000 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. 16000 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
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:
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 atleast two
parties
3) Advancing loans:\
Secured and unsecured 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
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 windsup
There are different types of pre shares:1) Cumulative & non cumulative
2) Participating & nonparticipating
3) Convertible & non convertible
4)
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 & nonconvertible 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
LOANS FROM FINANCIAL INSTITUTIONS:The institutions set up by the government to facilitate finance for industrial
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 predetermined period of time.