Financial Decisions Example for Free

The concept of cost of capital has been used in capital budgeting as the discounted rate or the minimum required rate of return. The cost of capital is the minimum required rate of return; a project must earn in order to cover the cost of raising funds being used by the firm in financing of the proposal. This can be substantiated as These funds can be procured from different types of investors i.e. equity share e funds investors depends upon the risk perception of the investors as well as on the risk-return characteristics of the firm. The determination of the firms cost of capital is important from the point of view of both capital budgeting as planning importance of cost of capital are as follows:

Capital budgeting decisions:

In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the for of new capital expenditure proposals. The decision of the finance manager will be rate which equals to its cost of capital in order to make at least a break even.

Capital structure decisions:

The cost lso an important consideration in capital stricter decisions. The finance manager must raise capital from in a way that it optimizes the risk and cost factors. The sources of funds which have high risk. Rising of loans may, necessary that cost of each source of funds is carefully considered and the risk involved with it.

Basis for evaluating the financial performance:

The be used as a till to cost of capital funds raised to finance the project. If profitability of the project is when compared to the actual, the performance can be evaluated as satisfactory.

Basis for making financial decisions:

The employees as a tool in making other important financial decisions such as dividend policy, , working capital

Factors affecting the cost of capital of a firm

The upon he risk characteristic of the firm, risk internal phenomenon and a mental attitude. If stress is the condiment, strain is the salt and if there is an imbalance in the condiment-salt relationship, the result is impalatable. Stress is generally believed to have a deleterious effect on health and performance. But a minimum level of stress is necessary for effective functioning and peak performance. It is the individual's perception of the investors and a host of other factors. Following are some of the are relevant for the determination of cost of capital of the firm:

Risk free interest rate:

The risk free interest rate, If is the interest rate on the risk free and default free securities. For example, the of India are taken as risk free and default free in respect of payment of periodic interest repayment on maturity. The marketexecutive acts out of hope or success influence, orderliness, relevance, acceptance or growth, this is the approach style. The avoidance style is indicated by an executive acting out of fear of failure, helplessness, chaos, irrelevance, exclusion or inadequacy sources of demand and spply determines the If , which is consisting of two components: Real interest rate: the for the organization, the cost of recruiting, hiring and training new staff to replace burnt out staff is far higher than retaining and rehabilitating burnt-out workers. Often burnt-out individuals are the prime of their lives or peak of their carriers. Hence, it is not always easy to find replacements for them. You can always begin by analyzing your personality. If you move rapidly, are impatient with the speed at which events are taking place and try to do more than one thing at a time, you may be showing signs of burnout. Burnout can be avoided by finding a sense of importance in something besides work. Building relationship with the family and developing surrendering the funds for a particular period. Purchasing power risk premium: when a lender lends money, he infact lends his present acceptance or growth, this is the approach style. The avoidance style is indicated by an executive acting out of fear of failure, helplessness, chaos, irrelevance, exclusion or inadequacyor seeking other's help or jointly working with others for the solutionpurchasing power ayment, he recovers the same face value money. But if the prices ha the same period, then he is not getting back the same purchasing power which he lend.

Business risk:

The business risk is related to the response of the firms earning before interest and taxes (EBIT) to revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal average will probably raise the cost of funds so as to be compensated risk. This premium added for the business risk compensation is also known as business risk premium.

Financial risk:

The financial risk c the trauma of workplace bullying leaves the target feeling powerless, confused, disoriented, helpless and paralyzed. According to a survey, 45% of targeted individuals suffer stress-related health problems. Of those individuals, 80% suffer from debilitating anxiety, 39% suffer from clinical depression and in addition 30% of women and 21% of men suffer from postal stress disorder. In very rare cases, bullying has led to deaths from heart attacks and suicide. Normal well-adjusted members of society can also fall prey to destructive bullying tactics when their positions or authority are questioned. However when bullies' histories are researched, most likely you will not find an affect the, known as the financial plan or the capital structure, can affect the return, etc. the financial risk is often defined as the likely hood that the firm would its fixed financial charges. It is related to the response of the firm's earning per share to a variation in EBIT. The financial risk is a affected by the capital structure plan of the firm. Higher the proportion of the overall capital structure greater would be the financial risk.

Other consideration:

The investors or marketability omay be due to the fact that more women are pursuing carriers and obtaining education. The research is trying to prove that women who have more trouble obtaining balancing their work-life and family duties go on to have fewer additional children. Flexibility in the workplace can be a huge relief to a person struggling to balance their carrier and home life. Until men and women reach a true egalitarian relationship this conflict will remainf the investment. Higher the liquidity available with an investment, the investors. If the investment is not easily marketable, then the investors may add for this also and consequently rate of return. In view of the above, the cost of capital may be defined as, k = If k = of different sources If = risk free interest f = financial risk premium The equation indicates type of funds, the business risk premium and the financial risk premium. If the a firm wants her first job at vacation within a year of qualifying as a chartered accountant. Mala plunged headlong into her new assignment. Her brief was to set up vacations management accounting division and design the information and reporting systems. Her job required her to work long hours late into the night. But Mala didn't mind; the culture at vacation and its working environment help to bring out the best in her. Two years later, Mala got married. But that didn't alter her style or her approach to the job in any way. It didn't take Mala long to realize that while the hotel's industry paid accountants salaries that were higher than in many other industries such jobs lacked a certain depth. There was more to accounting than just departmental profitability, she felt, and a place like Vacation would not be able to provide her with the opportunity to learn and grow as an accountant. "I am losing touch with what I was trained for. At this rate, I will be a misfit in any other industry" she told her husband. Sensing her growing insecurity, he advised her to keep up with the latest developments in finance by regularly reading to raise funds by the issue of security then, it must offer a return in he form of interest or. In other words the investor will be ready to supply the funds only a return which is at least equal to the opportunity cost of the investor. The opportunity cost of the investor may be defined as the return forgone, investment opportunity of the same or comparable r

COST OF BONDS AND DEBENTURES

The is determined by the following variables: The current level of. The level of interest cost of debt of the firm also increase. The default risk of the firm. As the d But she preferred not to dwell on the issues involved. The following week Mala was busy putting together a 200 page report which she had finalized the previous week for a joint venture. A preliminary presentation to the company was scheduled, but Desai insisted that she stick to the administrative aspects of the report even though they could have been delegated and although he knew that Mala was keen on working on the presentation herself. Desai was adamant for the first time and said something that rankled, "lets be clear who the boss is. I am not going to submit in subordination. You may be a chartered efault risk of the firm increases the cost of bonds and debentures will also increase. One way is to se the bond rating for the firm; higher credit rating leads to lower interest rates, and lower rating leads to higher interest rates. The of tax rate. The tax benefit that accrues from paying interest makes the after tax cost of debt lower than the pre-tax cost. The and is subject to the terms and conditions relating to the rate of interest, timings of interest repayment amount etc. the of the firm. In order to find of the cost of capital of debts, the following is required. Net proceeds from the issue: this refers to the net cash inflow at the time of issue of debt. This is calculated as Bo = FV + ndgd Bo = net proceeds FV = face value of debt Pm = owed at the time of issue of debt F = flotation cost Periodic payments of interest: in most of the cases, the firm has to pay interest on debt instruments. To simplify is assumed to be payable annually. Maturity payments: the principle amount of debt instrument or loan will be payable by the firm on the maturity date. This may be paid together with the interest for the lat year.

COST OF EQUITY SHARE CAPITAL

The holders of equity shares are he residual owners of the firm and provide long term funds expecting to be rewarded with an increase in the economic vale of the share. This value comprises the interlocking the market value of the share, which in turn is affected by the risks specific to the industry and to the individual firm. Equity share capital like other sources also has a cost. Just as in the case of debt the investors will invest the funds if they expect a With each passing day she found it increasingly difficult to perform her tasks meaningfully. Subordinates became less communicative and side stepped her preferring to deal with Desai directly. As if that were not enough Desai took to convening departmental meetings after office hours despite knowing that mala had to leave by 6pm in order to pick up her baby from the crèche where he spent his day. Even so Mala often stayed back when the need arose. Desai began holding his meeting without even telling her and then berating her next morning about being absent. Desai became even more difficult in the following weeks. Finally, when it seemed to Mala that the impasse showed no signing of easing she decided to grave the bull by the horns. But Desai was curled and formal with her when she met him. "You showed great promise when you joined. But I can now see how incompetent you are," he said throwing across to her a statement she had submitted to him the previous week. "Even your subordinate who is not chartered accountant has found errors in your calculation and when all he data was right there under your nose." Mala could feel her palms and neck drenched in swept back her desk. Mala looked at the return from the firm, which they will compensate them for surrendering the funds as well as the risk undertaken. The return in case of equity shares is available basically, in the form of dividends from the firm. Therefore, the potential investors of equity share capital from the firm. This stream of dividends may be discounted to get the present value of such stream. The rate of discount at which such streams are discounted to determine their present value is known as the cost of the equity share capital.

WEIGHTED AVERAGE COST OF CAPITAL

After calculating the cost of each component of capital, the average cost of capital is generally as overall cost of capital. The overall cost of capital may be defined as the rate of return that must be earned by the firm in order to satisfy the requirements of different investors. This overall cost of capital should as the weighted average rather than simple average of simple average of different. WACC = ke.w1 + kd.w2 + kp.w3 kd = after tax cost of debt kp = cost of preference shares w2 = proportion of debt in capital structure w3 = proportion of preference shares in capital structure The computation of the weighted average cost of capital involves the following steps:

Calculation of the cost of each specific source of funds:

This involves the determination of the cost of debt, equity capital, preference capital, etc. this can be done either tax basis. This is because the return to the shareholders is an important figure in determining the cost of capital and they can get dividends only after the taxes have been paid.

Assigning weights to specific costs:

This involves. Marginal weights method: weights are assigned to each source of funds, in proportion of financing inputs the firm intends to employ. The method is based on this logic that our average cost of capital so cal and have been appointed only on past experience basis she could have though of Network again. When her immediate boss Desai pointed her mistakes which she never committed and behaved in an occurred manner even after she was appreciated by the owner of Network, instead of ignoring him she could have directly approached the boss and discuss culated may be different from the actual cost of capital. This may lead to wrong capital investment decisions. Historical weights method: the relative proportion of various sources to the existing capital employed by the firm. This is based on the assumption that the firm's present capital structure is optimum and it should be maintained in the future also. Target weights: the target weights refer to the proportion in which he firm plans to raise the funds, the firm n the first instance, decides about the shape of the optimal capital structure and the optimal capital structure, but in, the firm intends to shape it as an optimal capital structure. The weights to be used for calculation of WACC can either be based on the book value or the market value of the funds raised from different sources. Book value weights: the weights are said to be book value weights if the proportions of different sources are ascertained on the basis value weights can be easily calculated by taking the relevant information from the capital structure as given in the balance sheet of the firm. The book value a sound weighing system a firm may design its capital structure in terms of as it appears in the balance sheet. Market value weights: in order to calculate the market value weights the firm has to find out the current market each category. However, a problem may arise if there is no market value available for a particular type of security. The advantages of using the market value weights may be: weights are consistent with the concept of maintaining market value capital of the investor's required rate of return. weights yield good estimate of the cost of capital that would be incurred additional funds from the market. However, the market value weights suffer from some limitations as follows: Not only of equity share is to be segregated into capital and retained earnings. Are subject to change from time to time and so the concept of optimal capital structure in terms of relevant any longer. External factors will, the investment decision process will be influenced by the external factors.

Adding of of all sources of funds to get an overall weighted average cost of capital

isk. So, the cost of be defined of supplier of funds i.e. investors.

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