Page 148 - DMGT521_PROJECT_MANAGEMENT

Unit 9: Financial Estimates and Projections

n
= A [1(1+r) - 1] /r Notes
Where FVA = future value of an annuity which has a duration of n periods
n
A = constant periodic flow
r = interest rate per period

n = duration of the annuity
When the cash flows occur at the end of each period, the annuity is called an ordinary annuity or
a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is
called an annuity due. Our discussion here will focus on a regular annuity the formulae of course
can be applied, with some modification, to an annuity due.

Self Assessment

Fill in the blanks:
6. Akin to ………………… notes, debentures are instruments for raising debt capital.
7. ………………… margin and pre operative expenses provided in estimating the cost of
project should be added to the fixed assets proportionately to ascertain the value of fixed
assets for determining the depreciation charge.
8. ………………… expenses in excess of 2.5 per cent of the project cost.

9. The liabilities side of the ………………… shows the sources of finance employed by the
business.
10. An ………………… is a stream of constant cash flow (payment or receipt) occurring at
regular intervals of time.

Notes The items on the financing side of the balance sheet are called capital components.
The major capital components are equity, preference, and debt.

9.5 Cost of Capital

Till now we have learnt that the cash flows of a capital investment may be viewed from various
points of view and the discount rate applied to the cash flows must be consistent with the point
of view adopted. We also mentioned that the standard practice in capital budgeting is to look at
the cash flows from the point of view of explicit cost funds (referred to also as investor claims)
and apply the weighted average cost of capital of the firm as the discount rate.

The items on the financing side of the balance sheet are called capital components. The major
capital components are equity, preference, and debt. Capital, like any other factor of production,
has a cost. A company’s cost of capital is the average cost of the various capital components (or
securities) employed by it. Put differently, it is the average rate of return required by the
investors who provide capital to the company.
The cost of capital is a central concept in financial management. It is used for evaluating
investment projects, for determining the capital structure, for assessing leasing proposals, for
setting the rates that regulated organisations like electric utilities can charge to their customers,
so on and so forth.

Now in this unit we will discuss how a company’s cost of capital is calculated.

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