Page 94 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

The financial standard is Cost of Capital. In the Net Present Value (NPV) method, an Notes
investment project is accepted, if the present value of cash inflows are greater than the
present value of cash outflow. The present values of cash inflows are calculated by
discounting the rate known as Cost of Capital. If a firm adopts Internal Rate of Return
(IRR) as the technique for capital budgeting evaluation, investment should be accepted
only when cost of capital is less than the calculated IRR. Hence, the concept of cost of
capital is very much useful in capital budgeting decisions, particularly if a firm is adopting
discounted cash flow methods of project evaluation.
3. Financial Performance Appraisal: Cost of capital framework can be used to evaluate the
financial performance of top management. Financial performance evaluation involves a
comparison of actual profitability of the investment project with the project overall cost of
capital of funds raised to finance the project. If the actual profitability is more than the
projected cost of capital, then the financial performance may said to be satisfactory and
vice-versa.
The above discussion clearly shows the role of cost of capital in financial management
decisions. Apart from the above areas (decisions), cost of capital is also useful in (distribution
of profits), capitalization of profits, making to rights issue and investment in owner
assets.

Self Assessment

Fill in the blanks:
4. The ……………... policy of a firm is significantly influenced by the cost consideration.
5. In the Net Present Value (NPV) method, the present values of cash inflows are calculated
by discounting the rate known as ……………... .
6. If the ……………... is more than the projected cost of capital, then the financial performance
may said to be satisfactory.

5.3 Classification of Cost

Figure 5.1: Classification of Cost

Marginal cost of capital
Average cost
Classification of cost Historic cost
Future cost
Specific cost
Spot cost
Opportunity cost
Explicit cost

Before going to discuss the computation of specific cost of each source of funds and cost of
capital, it is wise to know various relevant costs associated with the problem of measurement of
cost of capital. The relevance costs are:
1. Marginal Cost of Capital: A marginal cost is the additional cost incurred to obtain additional
funds required by a firm. It refers to the change in the total cost of capital resulting from
the use of additional funds. The marginal cost of capital is a very important concept in
investment decisions (capital budgeting decisions).

LOVELY PROFESSIONAL UNIVERSITY 89