The cost of capital used in capital budgeting should be calculated as a weighted average, or composite, of the various types of funds a firm generally uses. Cost of capital 2 cost of capital refers to the lowest rate of return that an organization has to earn on its investments to meet the expectations of its investors. Bygrave the portable mba in finance and accounting, third edition,john leslie livingstone and theodore grossman the portable mba in investment,peter l. And the cost of each source reflects the risk of the assets the company invests in. The market value weighted average cost would be overstated if the market value of the share is higher than the book value and viceversa. Most of the business enterprises are run by the corporate sector. Concept based notes financial management mba ii sem. The cost of capital is the average of the cost of each source, weighted by its proportion of the total capital it represents. A realistic appraisal of corporate strengths and weaknesses is essential for identifying investment opportunities which can be profitably exploited. Hence determination of cost of capital would carry greatest. A business enterprise must keep a systematic record of what happens from daytotday events so that it can know its position clearly. The discount rate should be the wacc weighted average cost of capital preferred stock a hybrid security because it has both common stock and bond features. Sep 30, 2010 the capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting. For example, an international bond is valued using the same npv formulas used to value a domestic bond.
Mba faculty bisma biyani institute of science and management, jaipur. Cost of capital weighted average cost of capital taxes and cost of capital weights of the weighted average optimal capital. Hence, it is also referred to as the weighted average cost of capital wacc or the weighted cost of capital wcc. For the love of physics walter lewin may 16, 2011 duration. An explicit cost is one that has occurred and is evidently reported as a separate cost. Initial investment includes capital expenditure and wc 2. Process of analyzing projects and deciding which ones to include in capital budget.
The subtopics for each lecture are related to the chapters in the textbook. The optimal capital structure occurs at a point where the overall cost of capital is minimum since overall cost of capital is the minimum rate of return required by the investors, this rate is used as the discount rate or the cutoff rate for evaluating the. Cost of capital problems solved financial management solved problems solved problems cost of capital problem 1 calculate the cost of capital in the. The objective of the course is to provide the necessary basic tools for the students so as to manage the finance function. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
Pondicherry university a central university directorate of distance education master of business administration. Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Bernstein the portable mba in management, first edition,allan cohen the portable mba in marketdriven management. Conventionally economist use models with two inputs capital, k. Pdf advanced financial management class notes cool manz.
Cost of capital, cost of capital concept, cost of capital. Capital structure detailed notes financial management unit 3 1. Financial management notes on cost of capital and measurement of cost of equity, cost of debt, cost of preference shares and cost of retained. Since, it is the expectation of the investors, it is not a precise exercise. Cost accounting helps the business to ascertain the cost of productionservices offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction. It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation, insure and. Cost of capital is the rate that must be earned in order to satisfy the required rate of return of the firms investors. Mbafinance management accounting unit i management accounting introduction. Risk analysis in capital budget 5 financing decisions. Availability and cost of raw material availability and cost of energy availability and cost of capital fig.
Chapter 7 stocks and stock valuation characteristics of common stock the market price vs. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value npv analysis, or in assessing the value of an asset. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion of the various sources of. A proper capital structure can be built with the help of the concept of cost of capital. The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. Hi guys, i am sharing with you this excellent ebook on financial management in pdf format. Let us make an indepth study of the meaning, importance and measurement of cost of capital.
Financial management notes mba pdf download mba 2nd sem. The cost of capital, lecture notes financial management docsity. Meaning and concept of cost of capital notes for mba. Discuss the term job costing and process costing systems with examples job costing systems.
Financial management has become a vital part of the business concern and they are concentrating more in the field of financial management. Chapter 2 capital budgeting 51 5 financing costs are ignored. Capital is assumed to be the fixed input meaning that the amount of capital used does not vary with the level of production. Find materials for this course in the pages linked along the left. Chapter 14 the cost of capital texas tech university. A firms value will be determined by its project cash flows. The cost of capital is the companys cost of using funds provided by creditors and shareholders. The cost of capital is the minimum rate of return required on the investment projects to keep the market value per share unchanged. Capital structure factors influencing capital structure optimal capital structure dividend and dividend policy. Cost of capital 1 chapter 11 2 cost of capital 3 chapter objectives. Aswath damodaran 16 implications of mm theorem a leverage is irrelevant. There is no way to capture the investor expectation accurately. Particularly, india has undergone a change in its economic ideology from a closedeconomy to openeconomy.
Cost of capital significance of cost of capital calculation of cost of debt cost of preference capital cost of equity capital. Average total cost, average fixed cost, average variable cost, and marginal cost 238 the functional form of the total cost function 241 mathematical relationship between atc and mc 243 learning curve effect 247 longrun cost 250 economies of scale 251. This section provides lecture notes from the course. Money capital needed to run a company comes from either borrowing debt or the owners money equity. The weighted average cost of capital wacc is defined as the weighted average cost of the component costs of debt, preferred stock, and common stock or equity. Meaning, classification sources available for dividends dividend policy general, determinants of dividend policy. In capital structure planning a company strives to achieve the optimal capital structure in order to maximize the value of the firm. Ppt cost of capital powerpoint presentation free to. Feasibility literally means whether some idea will work or not. Sources of capital, component costs, wacc, adjusting for flotation costs, adjusting for risk. Project should not be charged for paintingmachine time 5.
Assumption of cost of capital and taxonomy of cost of capital. Lecture notes, lectures 2 the cost of capital fins3625 studocu. A companys cost of capital is the cost of its longterm sources of funds. Lecture notes principles of microeconomics economics. Cost of capital is expected return by the providers of funds. Here you can download the free lecture notes of mba investment management notes pdf im notes materials with multiple file links mba investment management notes pdf im notes pdf. Capital structure detailed notes financial management unit 3. It can also be defined as the rate of return on investments at which the price of a firms equity share will remain unchanged. Financial management ebook,lecture notes,pdf download for mba. Or it is also the opportunity cost of the funds applied. The cost object is a unit or multiple units of a distinct product or service called a job. It knows beforehand whether there exists a sizeable market for the proposed proposed product service, what would be the investment requirements and where to get the funding from, whether and wherefrom thee necessary technical know how to convert the idea into a tangible product may be available and so on. I will also share the lecture notes on this subject.
These lecture notes were prepared by xingze wang, yinghsuan lin, and frederick jao specifically for mit opencourseware. The market value of the notes payable is equal to the book value. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment. The capital cost of improving working conditions or safety can be obtained through capital expenditure forecasting. Chapter 9 the cost of capital f ortune magazine conducts annual surveys of business. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. This is the standard user cost of capital expression.
Capital components, explicit cost of capital, implicit cost of capital, risk, inflation are also in this note. Optimal debtequity mix for the company is at the point where the composite cost of capital is minimum. The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital. Chapter 5 capital budgeting california institute of. Calculate the aftertax cost of debt, preferred stock, and common equity. Cost of capital problems solved financial management. Weighted average cost of capital formula and calculations. Structure theories capital structure capital structure is the proportion of debt and preference and equity shares on a firms balance sheet optimum capital structure is that at which the weighted average cost of capital is minimum and thereby maximum value of the firm traditional approach the traditional approach argues that moderate degree of debt can lower the firms overall cost. Calculate firms weighted average cost of capital 5. Classification of the cost of capital are as under. Financial management also developed as corporate finance, business finance, financial economics, financial mathematics and financial engineering. Demand analysis and forecasting, profit management, and capital management are also considered under the scope of managerial economics. Classification of the cost of capital notes for mba.
Cost of capital has different connotations in different economic philosophies. Understanding the basic concept about the financial management. The expected return or cost of equity is determined by another financial model, the capm or the capital asset pricing model. Cost the relationship between production and cost 235 shortrun cost 236 key relationships. The scope of managerial economics is a continual process, as it is a developing science. Weighted average cost of capital the weighted average cost of capital wacc is a common topic in the financial management examination. Components of cost of capital the term cost of capital refers to the maximum rate of return a firm must earn on its investment so that the market value of companys equity shares does not fall. Theories of capital structure ppt capital structure. The weighted average flotation cost is the sum of the weight of each source of funds in the capital structure of the company times the flotation costs, so. Lecture notes financial management sloan school of.
Demand and supply between individuals total economic. Management accounting helps the management to conduct the business in a more ef. The total cost of producing a specific level of output is the cost of all the factors of input used. It is the minimum rate of return the firm must earn overall on its existing assets. Evaluate firms capital structure, and determine the relative importance weight of each source of financing. Cost of capital is being considered as discounting factor which has undergone a change over the years. Project should be charged for cannibalization of regular widget sales 6. Definition and concepts, measurement, the weighted average cost of capital.
It facilitates the management in making of the longterm plans an assists in the formulation of general policy. According to khan and jain, finance is the art and science of managing money. If there is a difference between market value and book value weights, the weighted average cost of capital would also differ. The portable mba in entrepreneurship case studies,william d. Unitii capital budgeting nature of investment decisions investment. The cost of capital is a term used in the field of financial investment to refer to the cost of a companys funds both debt and equity, or, from an investors point of view the shareholders required return on a portfolio of all the companys existing securities.
There is no difference between pretax and aftertax equity costs. Explicit cost is the rate that the firm pays to procure financing. Capital budgeting under risk and uncertainties chapter7. Cost of capital refers to the opportunity cost of making a specific investment. Treasury management, receivables management, inventory management, financing of working capital. The weighted average cost of capital wacc is defined as the weighted average cost of the component costs of debt.
Capital budgeting evaluation techniques 112 chapter6. In other words, the cost of capital is simply the rate of return the funds used should produce to justify their use within the firm in the light of the wealth maximisation. Hence, the composite cost of capital is minimum 10. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Cost of capital, cost of capital concept, cost of capital assumptions. The portable mba in finance and accounting, 3rd edition. The cost of capital of the firm will not change with leverage. Chapter iii concepts and theories of capital structure and profitability. Chapter 9 cost of capital capital components cost of debt before and after tax cost of preferred stock cost of retained earnings cost of new common stock weighted average cost of capital wacc factors that affect wacc adjusting the cost of capital for risk capital components debt. The cost of capital is either the interest payment on the debt, or the required profit that the owners want in return for their investment in mba bullshit language. Decisions cost of capital significance of cost of capital calculation of cost of debt cost of preference capital cost of equity capital capm model and gordons model and cost of retained earnings combined cost of capital weightedoverall.
Note that when there are changes in the netoftax price of investment goods from changes in p, c, z, or itc, the user cost becomes rising investment good prices reduce the cost of capital, rising tax subsidies z, itc raise the cost of capital. The lecture notes are from one of the discussion sections for the course. In other words, the cost of capital is simply the rate of return the funds used should produce to justify their use within the firm in the light of the wealth maximisation objective. I evaluation of finance, objectives of the firmprofit max, and wealth max, functions of financial management, organisation of the finance function, cost of capital. This ebook is highly recommended for mba or management students. The term venture capital represents financial investment in a highly risky project with the objective of earning a high rate of return. Mba faculty bisma biyani institute of science and management. Most of the time, analysts want to know the after tax operating cash. Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount.
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