Business Finance

By : Anurag Mittal (A039139921018)

Dhruv Rishi (A039139921001)
Sarthak Pandey (A039139921030)
Rahul Kumar (A039139921034)
 CONCEPT

•The cost of capital is a very important factor to be considered in

deciding the firm's capital structure. Yet it is a fact that before
determining the capital structure a company is required to compute
the cost of capital of various sources of finance and compare them
on that basis the company decides which source of finance is the
best and in the interest of the owners and even of creditors.
• From the viewpoint of investors, cost of capital is the reward of
postponement of his present needs, so as to get a fair return on his
investment in future. But from the viewpoint of the company, the
cost of capital refers to the financial burden that a company has to
bear in financing its business through various sources.
 SIGNIFICANCE
The significance of the concept of cost of capital are:
• Capital Budgeting Decision
Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. The process
involves analyzing a project’s cash inflows and outflows to determine whether the expected return meets a set benchmark.
• Maintaining market Value of Shares
The lower the cost of capital, the stronger can be the market value of the firm because the price of the share remains high. That is,
they can move towards the goal of wealth maximization. Thus, cost of capital serves as a criterion which helps in optimum utilization
company's financial resources.
• Help in Designing Capital Structure
A proper capital structure can be built with the help of the concept of cost of capital. With a proper mixture of both debt and equity
• Issue of New Securities
If an investment scheme is found profitable, it may be necessary to issue new securities to raise money for this investment scheme.
The concept of cost of capital provides guidance in deciding which type of securities should be used for the investment while taking into
consideration the nature of existing capital structure, different source of finance available and their cost etc.
• Evaluate Performance Of Top Manager
The concept of cost of capital is helpful also in evaluating the financial performance of the top management by assessing the actual
profitability of the new scheme of investment is to be compared with the projected overall cost of capital, and actual cost incurred in
raising required funds.
• Financial Decision
The concept of capital is important in many other areas of financial decision making such as dividend decisions, working capital
policy, capital budgeting decisions etc., the decision about dividends to be taken on the basis of the amount of profit that is to be reserved
in the company.
 • It is to be considered that there are three basic concepts:
• It is not a cost as such. It is merely a hurdle rate.
• It is the minimum rate of return.
• It consist of three important risks such as zero risk level, business risk and
financial risk.

Cost of capital can be measured with the help of the following equation.
ASSUMPTION
K = rj + b + f.
Here,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium
 Inflation Each and every capital provider try to invest in a manner that maximizes their return.
The lowest benchmark for the investment return is the INFLATION. An investment
should beat the inflation then only will prevail some real income(actual return –
inflation).

Dividend A dividend policy of a corporation decides how much percentage of profits it will retain
and how much will be distributed as dividends. If a company retains a higher
Policy percentage of profits in the business, it will increase capital by also increasing cost of
equity. Thus, overall cost of capital will be impacted.

FACTOR Capital The composition of capital structure, that is, debt- equity mix affects the cost of capital
of a firm. As the debt proportion increases, the average cost of capital decreases
Structure
AFFECTING Composition because debt funds are cheaper as they also offer tax advantages. However, this
happens only up to a certain point (called optimum level).

COST OF Market the most fundamental price deciding factor for anything in this world is the law of
demand-supply. The cost of capital is also not away from this fundamental law. When
Opportunity
CAPITAL the demand for capital increases, the cost of capital also increases and vice versa. The
demand is influenced greatly by the available market opportunities.

Tax Corporate taxes is an important factor while determining the cost of capital in a firm. A
higher rate of corporate tax makes the debt funds cheaper because of the tax shield
Implications enjoyed by interest. The tax rates affect the after-tax cost of debt. As tax rates increase,
the cost of debt decreases, thereby causing overall cost of capital to decline.

Risk The “High-risk, high-return” is applicable over here. If the venture where investment is
required has a high level of risk, the return required by the investor would also be very
high to compensate for the risk and vice versa.
 The various different concept of cost are:
• Future Cost and Historical Cost
• Historical cost is the cost of capital raised in the past, while future cost is the cost of capital to
be raised in future. It is the future cost of capital which is significant in making financial
decision. Historical costs are important in that they help in predicting the future costs.
• Specific Cost and Combined Cost
• There are various sources of finance such as equity shares preference shares, debentures and
long-term loans. These are called components of capital. The cost of each of these
components of capital is called specific cost. When the cost of raising funds from all sources is
considered jointly, it is known as composite or combined cost of capital. It is called weighted
average cost of capital also. It is the combined cost of capital which is significant in measuring
the profitability of an investment scheme.
• Average Cost and marginal Cost
VA R I O U S C O N C E P T • Average cost is the weighted average of all specific costs of various components of capital
used. The Weights assigned to different components of capital are according to their
OF COST OF proportions in capital structure. The marginal cost is the average cost of additional funds
C A P I TA L raised for a new investment scheme. For most of the financial decisions and for capital
budgeting purposes, it is the concept of marginal cost which is more important.
• Explicit Cost and Implicit Cost
• The explicit cost of any source of finance is the rate of discount which equates the present
value of its cash inflows with the present value of its cash outflows. Explicit cost is that rate of
discount which equates the present value of all these cash outflows with the present value of
cash inflow. The 162 implicit cost of the chosen investment scheme is the rate of return on
the best alternative that the firm has to sacrifice. Implicit cost arises when funds are invested
in a particular project.
• Spot Cost and Normalized Cost
• Spot cost is the rate which is prevailing in the market at a certain point of time when a
financing decision is to be taken involving appraisal of alternatives. Normalized cost is the cost
which is found out by some averaging process so that cyclical element is removed from it.
 Sources Of Finance
Debt Equity Hybrid Asset Based Financing
Debentures Shares Preference Leasing
Shares
Term Loans ADRs & Hire-Purchase
GDRs Convertible
Floating Rate Securities Instalments
Note (FRNs) Internal
Accruals Warrants Factoring
Foreign Currency
Convertible Bonds
(FCCBs)
 Computation of Cost of
Capital from Various Sources
•Cost of Debt
Numerical
Cost of Debt Numerical
Cost of Equity Numerical
Dividend Yield Method
• Dividend Growth
Method
•Earning Yield
Method
• Cost of Preference
Thank