Financial Management
UNIT – II FINANCIAL MANAGEMENT
Financing Decision: Cost of Capital – Meaning – Definition – Classification of Cost –
Factors Affecting Cost of Capital – Importance – Cost of Specific Sources of Capital –
Equity Capital – Preferred Share Capital – Debentures – Reserves – Weighted
Average Cost of Capital.
COST OF CAPITAL
The term cost of capital refers to the minimum rate of return a firm must earn on its
investment so that the market value of the company’s equity shares does not fall. This
is in consonance with the overall firm’s objective of wealth maximization.
Meaning and Definition of Cost of Capital
Cost of Capital of a firm is the minimum rate of return expected by its investors. It is
the weighted average cost of various sources of finance by a firm. It is also referred to
as cut-off rate, target cost, hurdle cost, minimum rate of return and standard cost.
According to Solomon Ezra, “Cost of Capital is the minimum required rate of earning
of the cut-off rate of capital expenditures”.
CLASSIFICATION OF COST
Classification of Cost
Future Cost and Historical Cost
Specific Cost and Composite Cost
Average Cost and Marginal Cost
Implicit Cost and Explicit Cost
Future Cost and Historical Cost: Financial decisions are based on the future costs
and not on the historical costs. Historical costs act simply as guides to estimate the
future costs.
Specific Cost and Composite Cost: The cost of individual source of capital is referred
to as the specific cost and the cost of capital of all the sources combined is termed
as composite cost or overall cost.
Average Cost and Marginal Cost: The average cost of capital is the weighted
average of the costs of each component of funds employed by the firm. Marginal
cost of capital is the weighted average cost of new funds raised by the firm.
Implicit Cost and Explicit Cost: The implicit cost of retained earnings is the rate of
return available to the shareholders had the funds been distributed to them. The
explicit cost of any source of capital is the discount rate that equates the present
value of the cash inflows.
Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 1
, Financial Management
FACTORS AFFECTING COST OF CAPITAL
1) General Economic Conditions: General Economic Conditions determine the
demand for and supply of capital within the economy as well as the level of
expected inflation.
2) Market Conditions: If an investor is purchasing a security where the risk of the
investment is significant, the opportunity for additional returns is necessary to
make the investment attractive.
3) Firm’s Operation and Financing Decisions: Risks or the variability of return also
results from decision made within the company. Risk resulting from these
decisions is generally divided into two types – (1) Business risk and (2)
Financial risk.
4) Amount of Financing: As the financing requirements of the firm become larger,
the weighted cost of capital increases for several reasons. For instance, as more
securities are issued, additional floatation cost (cost of selling securities) will
affect the percentage cost of the funds of the firm.
IMPORTANCE OF COST OF CAPITAL
Importance of Cost of Capital
Capital Budgeting Decisions
Capital Structure Decisions
Other Decisions
Evaluating Financial Performance
Capital Budgeting Decisions: Cost of capital is used as a rate for discounting cash
flows to determine the profitability of a project.
Capital Structure Decisions: While designing an optimal capital structure, the firm
has to bear in mind the objective of minimizing the cost of capital so that the
market value of the firm is minimized.
Other Decisions: Decisions such as dividend decisions, working capital decisions,
etc. are influenced by the cost of capital.
Evaluating Financial performance:. If the actual profitability of the project is more
than the projected and the actual cost of capital, the performance may be said to be
satisfactory.
COST OF SPECIFIC SOURCES OF CAPITAL
For calculating the cost of capital of the firm, it is essential to consider the different
sources from which the funds are received by the firm. It includes Equity share
capital, Preference share capital, Debt capital, and Retained earnings.
Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 2
UNIT – II FINANCIAL MANAGEMENT
Financing Decision: Cost of Capital – Meaning – Definition – Classification of Cost –
Factors Affecting Cost of Capital – Importance – Cost of Specific Sources of Capital –
Equity Capital – Preferred Share Capital – Debentures – Reserves – Weighted
Average Cost of Capital.
COST OF CAPITAL
The term cost of capital refers to the minimum rate of return a firm must earn on its
investment so that the market value of the company’s equity shares does not fall. This
is in consonance with the overall firm’s objective of wealth maximization.
Meaning and Definition of Cost of Capital
Cost of Capital of a firm is the minimum rate of return expected by its investors. It is
the weighted average cost of various sources of finance by a firm. It is also referred to
as cut-off rate, target cost, hurdle cost, minimum rate of return and standard cost.
According to Solomon Ezra, “Cost of Capital is the minimum required rate of earning
of the cut-off rate of capital expenditures”.
CLASSIFICATION OF COST
Classification of Cost
Future Cost and Historical Cost
Specific Cost and Composite Cost
Average Cost and Marginal Cost
Implicit Cost and Explicit Cost
Future Cost and Historical Cost: Financial decisions are based on the future costs
and not on the historical costs. Historical costs act simply as guides to estimate the
future costs.
Specific Cost and Composite Cost: The cost of individual source of capital is referred
to as the specific cost and the cost of capital of all the sources combined is termed
as composite cost or overall cost.
Average Cost and Marginal Cost: The average cost of capital is the weighted
average of the costs of each component of funds employed by the firm. Marginal
cost of capital is the weighted average cost of new funds raised by the firm.
Implicit Cost and Explicit Cost: The implicit cost of retained earnings is the rate of
return available to the shareholders had the funds been distributed to them. The
explicit cost of any source of capital is the discount rate that equates the present
value of the cash inflows.
Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 1
, Financial Management
FACTORS AFFECTING COST OF CAPITAL
1) General Economic Conditions: General Economic Conditions determine the
demand for and supply of capital within the economy as well as the level of
expected inflation.
2) Market Conditions: If an investor is purchasing a security where the risk of the
investment is significant, the opportunity for additional returns is necessary to
make the investment attractive.
3) Firm’s Operation and Financing Decisions: Risks or the variability of return also
results from decision made within the company. Risk resulting from these
decisions is generally divided into two types – (1) Business risk and (2)
Financial risk.
4) Amount of Financing: As the financing requirements of the firm become larger,
the weighted cost of capital increases for several reasons. For instance, as more
securities are issued, additional floatation cost (cost of selling securities) will
affect the percentage cost of the funds of the firm.
IMPORTANCE OF COST OF CAPITAL
Importance of Cost of Capital
Capital Budgeting Decisions
Capital Structure Decisions
Other Decisions
Evaluating Financial Performance
Capital Budgeting Decisions: Cost of capital is used as a rate for discounting cash
flows to determine the profitability of a project.
Capital Structure Decisions: While designing an optimal capital structure, the firm
has to bear in mind the objective of minimizing the cost of capital so that the
market value of the firm is minimized.
Other Decisions: Decisions such as dividend decisions, working capital decisions,
etc. are influenced by the cost of capital.
Evaluating Financial performance:. If the actual profitability of the project is more
than the projected and the actual cost of capital, the performance may be said to be
satisfactory.
COST OF SPECIFIC SOURCES OF CAPITAL
For calculating the cost of capital of the firm, it is essential to consider the different
sources from which the funds are received by the firm. It includes Equity share
capital, Preference share capital, Debt capital, and Retained earnings.
Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 2
