Page 95 - DMGT405_FINANCIAL%20MANAGEMENT
P. 95

Unit 6: Cost of Capital



                 present value of  cash outflow.  The present  values of  cash inflows  are  calculated  by  Notes
                 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.

            6.3 Classification of Cost

                                     Figure 6.1:  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).
            2.   Average Cost/Composite/Overall  Cost: It is the average of various specific costs of the
                 different components of equity, preference shares, debentures, retained earnings of capital



                                             LOVELY PROFESSIONAL UNIVERSITY                                   89
   90   91   92   93   94   95   96   97   98   99   100