Computation of Overall Cost of Capital

Weighted Average Cost of Capital

Weighted average cost of capital is the expected average future cost of funds over the long run
found by weighting the cost of each specific type of capital by its proportion in the firm’s capital
structure.

Assignment of Weights
The aspects relevant to the selection of appropriate weights are:
1) Historical weights
a) Book value weights or
b) Market value weights
2) Marginal Weights

Historical Weights Historic weights either book or market value weights are based on actual
capital structure proportion to calculate weights.
Market Value Weights Market value weights use market values to measure the proportion of
each type of capital to calculate weighted average cost of capital.
Book Value Weights Book value weights use accounting (book) values to measure the
proportion of each type of capital to calculate the weighted average cost of capital
Marginal Weights Marginal weights use proportion of each type of capital to the total capital to
be raised.

The determination of the market value of retained earnings presents operational difficulties. The
market value of retained earnings can be indirectly estimated. A possible criterion has been
suggested by Gitman according to which, since retained earnings are treated as equity capital for
purpose of calculation of cost of specific source of funds, the market value of the ordinary shares
may be taken to represent the combined market value of equity shares and retained earnings. The
separate market values of retained earnings and ordinary shares may be found by allocating to
each of these a percentage of the total market value equal to their percentage share of the total
based on book values.
 Capital Budgeting Evaluation Techniques
EVALUATION TECHNIQUES
(1)Traditional Techniques
(i) Pay back period method
(ii) Average rate of return method
(2) Discounted Cashflow (DCF)/Time-Adjusted (TA) Techniques
(i) Net present value method
(ii) Internal rate of return method
(iii) Profitability index

Pay Back Method

The pay back method measures the number of years required for the CFAT to pay back the
initial capital investment outlay, ignoring interest
payment. It is determined as follows
(i) In the case of annuity CFAT: Initial investment/Annual CFAT.
(ii) In the case of mixed CFAT: It is obtained by cumulating CFAT till the cumulative CFAT
equal the initial investment.
Original/initial Investment (outlay) is the relevant cash outflow for a proposed project at time
zero (t = 0).
Annuity is a stream of equal cash inflows.
Mixed Stream is a series of cash inflows exhibiting any pattern other than that of an annuity.
Although the pay back method is superior to the ARR method in that it is based on cash flows, it
also ignores time value of money and disregards the total benefits associated with the investment
proposal
Average Rate of Return Method
The ARR is obtained dividing annual average profits after taxes by average investments.
ARR = (Average income/Average investment) × 100.

Average investment = 1/2 (Initial cost of machine – Salvage value) + Salvage value + net
working capital.

Annual average profits after taxes = Total expected after tax profits/Number of years

The ARR is unsatisfactory method as it is based on accounting profits and ignores time value of
money.

Discounted Cashflow (DCF)/Time-Adjusted (TA) Techniques

The DCF methods satisfy all the attributes of a good measure of appraisal as they consider the
total benefits (CFAT) as well as the timing of benefits.
The present value or the discounted cash flow procedure recognises that cash flow streams at
different time periods differ in value and can be compared only when they are expressed in terms
of a common denominator, that is, present values. It, thus, takes into account the time value of
money. In this method, all cash flows are expressed in terms of their present values.

Net Present Value (NPV) Method

The NPV may be described as the summation of the present values of
(i) operating CFAT (CF) in each year and
(ii) salvages value(S) and working capital(W) in the terminal year(n) minus the summation of
present values of the cash outflows(CO) in each year.
The present value is computed using cost of capital (k) as a discount rate.
The decision rule for a project under NPV is to accept the project if the NPV is positive and
reject if it is negative. Symbolically,
(i) NPV > zero, accept, (ii) NPV < zero, reject
Zero NPV implies that the firm is indifferent to accepting or rejecting the project.
 The project will be accepted in case the NPV is positive.
Net Present Value

Internal Rate of Return (IRR) Method

The IRR is defined as the discount rate (r) which equates the aggregate present value of the
operating CFAT received each year and terminal cash flows (working capital recovery and
salvage value) with aggregate present value of cash outflows of an investment proposal.

The project will be accepted when IRR exceeds the required rate of return.

n CFt S n + Wn n COt
Internal Rate
of Return = ∑ (1+r)t + (1+r)n - ∑ (1+r)t
t=1 t=1

IRR for an Annuity

The following steps are taken in determining IRR for an annuity
Determine the pay back period of the proposed investment.
In Table A-4 (present value of an annuity) look for the pay back period that is equal to or closest
to the life of the project.
From the top row of the table, note interest rate (r) corresponding to these PV values (DFr).
Determine actual IRR by interpolation. This can be done either directly using Equation 1 or
indirectly by finding present values of annuity

PB – DFrH
IRR =
Hr - DFrL - DFrH

Where PB = Pay back period

DFr = Discount factor for interest rate r.
DFrL = Discount factor for lower interest rate
DFrH = Discount factor for higher interest rate.
r = Either of the two interest rates used in the formula

PVco -
IRR = PVCFATH
× ∆r
Hr -
∆PV

Where PVCO = Present value of cash outlay

PVCFAT = Present value of cash inflows (DFr x annuity)
r = Either of the two interest rates used in the formula
∆r = Difference in interest rates
∆ PV = Difference in calculated present values of inflows

Profitability Index (PI) or Benefit-Cost Ratio (B/C Ratio)

The profitability index/present value index measures the present value of returns per rupee
invested. It is obtained dividing the present value of future cash inflows (both operating CFAT
and terminal) by the present value of capital cash outflows.
 The proposal will be worth accepting if the PI exceeds one