Page 180 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Step 5 – Calculate the Differential after Tax stream: We subtract the existing machine stream
from the new machine stream as follows:
Year New Machine Existing Machine Difference
0 (1,85,000) 0 (1,85,000)
1 1,65,000 1,05,000 60,000
2 1,65,000 1,05,000 60,000
3 1,65,000 1,05,000 60,000
4 2,20,000 1,10,000 1,10,000
This stream shows both the timing and amount of net cash outlay and net cash inflow over the
life of the new machine. All effects are differential – the difference between having the investment
and not having it, and can be evaluated with time-value of money techniques as have been
discussed earlier.
Cost of Capital

As mentioned above, the cost of capital is an important element as basic input information in
capital investment decisions. It provides a yard stick to measure the work of investment proposals
and thus, perform the role of accept reject criterion. It is also referred to a cut-off-rate, target rate,
minimum required rate of return, standard return and so on. In the present value method of
discounted cash flow techniques, the cost of capital is used as the discount rate to calculate the NPV.

Notes The PI Index or benefit cost ratio method similarly employs to determine the
present value of future cash inflows. In case of internal rate of return method, the computed
IRR is compared with the cost of capital, and accept only the cases where they are more
than cost of capital.
In operational terms, cost of capital refers to the discount rate that would be used in determining
the present values of estimated future cash proceeds and eventually deciding whether the project
is worth accepting or not.
The cost of capital is considered as consisting of different sources of funds. The cost of each
source is called as specific cost of capital and these specific costs when combined refer to overall
cost of capital or weighted cost of capital.
Assumptions – Cost of Capital
1. That the firm’s business and financial risk are unaffected by the acceptance and financing
of projects.
2. The firm’s financial structure is assumed to remain fixed. It implies that the additional
funds required to finance the new project are to be raised in the same proportion as the
firm’s existing financing.
Solved Illustrations

Illustraton 1: A project costing 5,60,000 is expected to produce annual net cash benefits of
80,000 over a period of 15 years. Estimate the IRR. Also, find the payback period and obtain the
IRR from it. How do you compare this IRR with the one directly estimated?
Solution:
5,60,000
Payback period = . = 7
80,000

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