In our last article, we talked about the Basics of Capital Budgeting, which covered
the meaning, features and Capital Budgeting Decisions. In this article let us talk
about the important techniques adopted for capital budgeting along with its
importance and example.
As the name suggests, this method refers to the period in which the proposal will
generate cash to recover the initial investment made. It purely emphasizes on the
cash inflows, economic life of the project and the investment made in the project,
with no consideration to time value of money. Through this method selection of a
proposal is based on the earning capacity of the project. With simple calculations,
selection or rejection of the project can be done, with results that will help gauge the
risks involved. However, as the method is based on thumb rule, it does not consider
the importance of time value of money and so the relevant dimensions of profitability.
This method takes into account the entire economic life of a project providing a
better means of comparison. It also ensures compensation of expected profitability of
projects through the concept of net earnings. However, this method also ignores time
value of money and doesn’t consider the length of life of the projects. Also it is not
consistent with the firm’s objective of maximizing the market value of shares.
The discounted cash flow technique calculates the cash inflow and outflow through
the life of an asset. These are then discounted through a discounting factor. The
discounted cash inflows and outflows are then compared. This technique takes into
account the interest factor and the return after the payback period.
This is one of the widely used methods for evaluating capital investment proposals.
In this technique the cash inflow that is expected at different periods of time is
discounted at a particular rate. The present values of the cash inflow are compared
to the original investment. If the difference between them is positive (+) then it is
accepted or otherwise rejected. This method considers the time value of money and
is consistent with the objective of maximizing profits for the owners. However,
understanding the concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in
the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal. It should be
noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
where,
It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.
If IR < k = reject
It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment. It may be gross or net, net being
simply gross minus one. The formula to calculate profitability index (PI) or benefit
cost (BC) ratio is as follows.
2) Huge investments and irreversible ones: As the investments are huge but the
funds are limited, proper planning through capital expenditure is a pre-requisite.
Also, the capital investment decisions are irreversible in nature, i.e. once a
permanent asset is purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.
For example, equipment that costs $15,000 and generates a $5,000 annual return
would appear to "pay back" on the investment in 3 years. However, if economists
expect inflation to rise 30 percent annually, then the estimated return value at the
end of the first year ($20,000) is actually worth $15,385 when you account for
inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only
$385 in real value after the first year.
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Conclusion:
According to the definition of Charles T. Hrongreen, “Capital Budgeting is a long-
term planning for making and financing proposed capital outlays.”
3. Future Earnings
The future earnings may be uniform or fluctuating. Even though, the
company expects guaranteed future earnings in total which affects the
choice of a project.
5. Cash Inflows
The term cash inflows refers to profit after tax but before depreciation. The
reason is that recording of depreciation is a book entry and there is no
actual cash outflow. Hence, depreciation amount is included in the cash
inflow.
6. Legal Compulsions
The management should consider the legal provisions while-selecting a
project. In the case of leather and chemical industries, there are number of
legal provisions created to protect environment pollution. Now, the
management gives much importance to legal provisions rather than cost
and profit.
9. Urgency
A project may be selected immediately due to emergency or urgency. The
reason is that such immediate selection saves the life of the company i.e.
survival of a company is the primary importance than other factors.
11. Obsolescence
The replacement of existing fixed assets is compulsory since there is an
obsolescence of plant and machinery.
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5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The
dividend policy of a firm should be formulated according to the
nature of the firm— whether it is a growth firm, normal firm or
declining firm. However, the nature of the firm is determined by
comparing the internal rate of return (r) and the cost of capital (k)
i.e., r > k, r = k, or r < k which indicate growth firm, normal firm
and decline firm, respectively.
t = Tax rate
Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Kd
I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
where Kd = Cost of debenture .
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each.
The company is in 40% tax bracket. You are required to compute
the cost of debt after tax, if debentures are issued at (i) Par, (ii) 10%
discount, and (iii) 10% premium.
Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs.
60 lakh. The floating charge of the issue is 5% on face value. The
interest is payable annually and the debentures are redeemable at a
premium of 10% after 10 years.
(ii) If the preference shares are redeemable after a period of ‘n’, the
cost of preference shares (KP) will be:
Example 3:
A company issues 10% Preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price.
Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par
redeemable after 10 years at 10% premium.
Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays
a dividend of Rs. 3 per share and investors expect a growth rate of
10% per year.
(ii) The indicated market price per share, if anticipated growth rate
is 12%.
(iii) The market price, if the company’s cost of equity capital is 12%,
anticipated growth rate is 10% p.a., and dividend of Rs. 3 per share
is to be maintained.
Example 7:
The current market price of a share is Rs. 100. The firm needs Rs.
1,00,000 for expansion and the new shares can be sold at only Rs.
95. The expected dividend at the end of the current year is Rs. 4.75
per share with a growth rate of 6%.
Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100
(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or,
11%.
Example 8:
A company’s share is currently quoted in the market at Rs. 20. The
company pays a dividend of Rs. 2 per share and the investors expect
a growth rate of 5% per year.
Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a
stock exchange at a market price of Rs. 28. A constant expected
annual growth rate of 6% and a dividend of Rs. 1.80 per share has
been paid for the current year.
Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%
If the future earnings per share will grow at a constant rate ‘g’ then
cost of equity share capital (Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the
factor of capital appreciation or depreciation in the market value of
shares. Adjustment of Floatation Cost There are costs of floating
shares in market and include brokerage, underwriting commission
etc. paid to brokers, underwriters etc.
These costs are to be adjusted with the current market price of the
share at the time of computing cost of equity share capital since the
full market value per share cannot be realised. So the market price
per share will be adjusted by (1 – f) where ‘f’ stands for the rate of
floatation cost.
If the earnings per share is Rs. 7.25, find out the cost of new equity.
Therefore, Kr = Ke = D/P + g.
Example 12:
It is given that the cost of equity of a company is 20%, marginal tax
rate of the shareholders is 30% and the Broker’s Commission is 2%
of the investment in share. The company proposes to utilise its
retained earnings to the extent of Rs. 6,00,000.
(iii) Add all the weighted component costs to obtain the firm’s
weighted average cost of capital.
Example 16:
In considering the most desirable capital structure for a
company, the following estimates of the cost Debt and
Equity Capital (after tax) have been made at various levels
of debt-equity mix:
You are required to determine the optimum debt-equity mix for the
company by calculating composite cost of capital.
Optimal debt-equity mix for the company is at the point where the
composite cost of capital is minimum. Hence, the composite cost of
capital is minimum (10.75%) at the debt-equity mix of 3: 7 (i.e., 30%
debt and 70% equity). Therefore, 30% of debt and 70% equity mix
would be an optimal debt-equity mix for the company.
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Cost of capital
Cost of capital is vital part of investment decision as it is used to measure the value of investment
proposal provided by the business concern. It is used as a discount rate to determine the present
value of future cash flows related with capital projects. Cost of capital is also termed as cut-off
rate, target rate, hurdle rate and required rate of return. When the companies are using different
sources of finance, the finance manager must take vigilant decision with regard to the cost of
capital; because it is closely associated with the value of the firm and the earning capacity of the
firm.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance.
b = The business risk premium.
f = The financial risk premium.
Where,
CIo = initial cash inflow
C = outflow in the period concerned
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return linked with the best investment opportunity for the firm and its
shareholders that will be inevitable if the projects presently under consideration by the firm were
accepted. It is the opportunity cost equal to what a firm must give up in order to use factor of
production which it already owns and thus does not pay rent for.
Both implicit and explicit costs are actual business cost of firms (Barthwal, 2007).
o Cost of equity
o Cost of debt
o Cost of preference share
o Cost of retained earnings
Cost of Equity: Cost of equity capital is the rate at which investors discount the expected
dividends of the firm to determine its share value. Theoretically, the cost of equity capital is
described as the "Minimum rate of return that a firm must earn on the equity financed portion of
an investment project in order to leave unchanged the market price of the shares".
Cost of equity can be calculated from the following approach:
Dividend Price Approach: The cost of equity capital will be that rate of expected dividend which
will maintain the present market price of equity shares.
Dividend price approach can be measured with the following formula:
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach: The cost of equity is calculated on the basis of the
expected dividend rate per share plus growth in dividend (R M Srivastava, 2008).
It can be measured by the following formula:
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach: Cost of equity regulates the market price of the shares. It is based on
the future earnings forecasts of the equity (R M Srivastava, 2008). The formula for calculating the
cost of equity according to this approach is as follows.
Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Realized Yield Approach: It is simple method to compute cost of equity capital (R M Srivastava,
2008). Under this method, cost of equity is calculated by
Where,
Ke = Cost of equity capital.
PVf = Present value of discount factor.
D = Dividend per share.
II. Cost of Debt: Cost of debt is the after tax cost of long-term funds through borrowing. Debt may
be issued at par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of the debt. It may
be calculated with the following formula
Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount: If the debt is issued at premium or discount, the cost of
debt is calculated with the following formula.
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt: It is the rate of return which the lenders expect.
The debt carries a certain rate of interest.
Where,
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax
Cost of debt after tax can be calculated with the following formula:
Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
III. Cost of Preference Share Capital: Cost of preference share capital is the annual preference
share dividend by the net proceeds from the sale of preference share. There are two types of
preference shares irredeemable and redeemable.
Following formula is used to calculate the cost of redeemable preference share capital:
Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the following formula:
Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.
IV. Cost of Retained Earnings: Retained earnings is one of the sources of finance for investment
proposal. It is dissimilar from other sources like debt, equity and preference shares. Cost of
retained earnings is the same as the cost of an equivalent fully subscripted issue of additional
shares, which is measured by the cost of equity capital.
Cost of retained earnings can be calculated with the following formula:
Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost
The computation of the overall cost of capital (Ko) involves the following steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the following formula;
Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:
Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
To, summarize, cost of return is defined as the return the firm's investors could expect to earn if
they invested in securities with comparable degrees of risk. The cost of capital signifies the
overall cost of financing to the firm. It is normally the relevant discount rate to use in evaluating
an investment. Cost of capital is important because it is used to assess new project of company
and permits the calculations to be easy so that it has minimum return that investor expect for
providing investment to the company.
The cost of capital of a company is the average rate of return required by investors who
provide long term funds (equity, preference, and long term debt). A central concept in
financing decisions, the cost of capital is important for two reasons:
1. For evaluating capital investment proposals an estimate of the cost of capital is required.
As we have seen, the cost of capital is the discount rate in NPV calculation and also the
financial benchmark against which the internal rate of return is compared
2. To maximize the value of the firm, costs of all inputs (including the capital input) must be
minimized. In the context the firm should what its cost of capital is and what are its key
determinants.
Basic Concepts:
A firm’s cost of capital is the weighted arithmetic average of the cost of various sources
of long term finance employed by it. Suppose that a firm uses equity costing 18%, preference
costing 15%, and debt costing 11%. If the proportions in which equity, preference, and debt
are used are respectively 40%, 10%, and 50%, the cost of capital of the firm will be:
From the above example, it is clear that three basic steps are involved in calculation a
firm’s cost of capital:
Two key conditions should be satisfied for using a firm’s cost of capital for evaluating
new investments:
* The risk of new investment is the same as the average risk of existing investment. In other
words, the adoption of new investment will not change the risk complexion of the firm.
* The capital structure of the firm will not be affected by the new investments. Put
differently, the firm will continue to pursue the same financing policy.
Thus, strictly speaking the cost of capital is an appropriate discount rate for a project that is a
carbon copy of the firm’s existing business. However, in practice, the cost of capital is
used as a benchmark hurdle rate that is adjusted for variations in risk and financing patterns
Before you calculate the average cost of capital for a company, you should know the cost of
specific sources of finances used by the company. How is the cost of a specific source of
finance calculated? It is measured as the rate of discount that equates the present value of the
expected post tax payments to that source of finance with the net funds received from that
source of finance. In symbols, it is the value of k in the following equation:
P = Ct / (1+k)t