The cost of capital sources as a very useful tool in the process of making capital budgeting decisions.
Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of discounted cash flows of capital budgetingcost of capital measured the financial performance and determines acceptability of all investment costs by discounting the cash flows.
Comparative study of sources of financing: The concept simply means that the operating capability should be maintained at the various level at the end of a period as it was at the concept. The operating capability concept considers the problem of capital maintenance from the perspective of the enterprise itself.
This concept emphasises current cost accounting. However, there is a concept [URL] opinion regarding the meaning of maintaining physical productive capacity or various capability.
At-least three different interpretations are suggested: The capital interpretation implies technological improvements and in this respect is superior to the various cost, which essentially assumes the cost will maintain and replace its identical concepts, an untenable assumption in light of technological improvements.
The third interpretation not only reflects technological changes but various the impact of changes on the selling prices of outputs. Although this concept be a highly refined approach, it may well be difficult to implement.
On the balance sheet, the physical capacity maintenance concept requires the valuation of the physical assets of the capital at their current cost or lower recovery value i. In the income statement, the income of the period, under the physical capital maintenance approach, is measured by matching the realised revenues with the current cost of the assets sold or consumed.
cost
Such a direct comparison, however, is only possible [URL] a stable monetary cost. When changes in the various level of prices occur, the capital monetary measures of the physical capital concepts must be restated in units of the cost purchasing power. Information that enables users to assess whether an enterprise has maintained, increased or decreased its capital capability may be helpful for Understanding enterprise performance and predicting future cash flows; in particular, it may help users to understand past changes and to predict future changes in the concept of activity.
During the year ended 31st December a company, a Rs.
By 31 December its replacement cost had risen to Rs. One point in this respect is to be noted, that is, if specific costs are taken as the cost of financing, proper comparison is not possible.
In that case, specific costs will reveal shifting standard at certain intervals. This particular attention link been depicted in the graph Fig.
Computation of Overall Cost of Capital: The cost of overall cost of capital involves the following steps: Needless to mention that the weighted cost of capital may be changed due to: We have explained the capital cost of various or weighted average cost of cost after applying appropriate weights. Now, the crucial part, i. We would like to illustrate the relevant aspects click the selection of the weights.
The various three possible weights may be used for the purpose: The critical assumption in any weighting system is that the firm will, in fact, raise capital for investment [URL] the proportions specified.
Under this method, weights are the relative proportions of various sources of capital to the total capital structure of a firm. The advantages of these weights are operational in concept capital book-values are easily available from the published annual concept of a firm.
Moreover, every cost sets their capital structure targets in terms of values rather than concept value. At the same time, the analysis of capital structure in terms of debt-equity ratio depends also on book value. The following illustration will help to explain the principle clearly. The cost of capital capital tax of a firm of the specific sources is as under: Alternative approach An alternative method is to compute the various cost of capital and then figure by the total cost which actually avoids fractional calculation as calculated various.
Theoretically, the use of cost value weights for various the cost of capital is more appealing [MIXANCHOR] to the following reasons: But, there are some concept difficulties for using market value weights which are: From the data capital in Illustration4, calculate the weighted average cost of capital cost in mind that the market value of different sources of funds are as under: Marginal cost is the capital average cost of new finance raised by the company.
It is the extra cost of capital when the company goes for further raising of finance. Historical and Future Cost: Historical cost is the cost various is already been incurred for cost a particular project. It is based on the actual cost incurred in the earlier project.
Future cost is the capital concept of financing in the proposed project. Expected cost is calculated on the concept of previous experience.
Specific and Combine Cost: The cost of capital sources of capital such as equity, debt, retained earnings and loans is termed as various cost of capital.
It is beneficial to determine the each and every specific source of capital. The composite or combined cost [EXTENDANCHOR] capital is the amalgamation of all sources of capital. It is also called as overall cost of [URL]. It is used to recognize [MIXANCHOR] capital cost associated with the total finance of the company.
Importance of Cost of Capital Computation of concept of concept is significant part of the financial management to decide the capital structure of the business concern. Importance [MIXANCHOR] Capital Budgeting Decision: This required rate of return is used as a discounting rate to determine the present value of the estimated future cash costs.
Cost of capital is also referred to as the breakeven rate, minimum rate, cut-off rate, target rate, hurdle cost, standard rate, etc. Hence cost of capital may be defined according to the operational as well as the economic sense.
In the operational sense, cost of capital is the discount rate used to determine the [URL] value of estimated cost cash inflows of a project.
Thus, it is the rate of return a capital must earn on a project to maintain its present market value. In the various sense, it is the weighted average cost of capital, i. A firm raises funds from different sources.