Cost of Capital, Concept Of Wealth Maximisation, Long Term Vs Short Term Finance, Capital Structure
Cost of capital:
According to I M Pandy, Cost of capital is the DISCOUNT rate used in evaluating the desirability of the Investment project. The cost of capital is the minimum rate of return which will maintain the market value per share at its current. If the firm earns more than the cost of capital, the market value per share is expected to increase.
Importance of cost of capital:
- Capital BUDGETING decision: The cost of capital is used for discounting cash flows under net present value method for investment purpose.
- To decided the capital structure of the firm.
- Evaluation of financial performance of top management. The actual profitability is compared with the actual cost of capital of funds and if profit is greater than the cost of capital the performance may said to be satisfactory.
- Cost of capital is also used in the making other financial decision related to dividend payment, capitalisation of profit and making the rights issue.
Concept of wealth maximisation:
The primary aim of financial management is to maximise shareholder wealth , which is referred to as wealth maximisation concept. In all decision whether financial, investment or dividend value addition should be there or increase in the price of Equity share . It can be achieved by an efficient DECISION MAKING.
Decision taken at following level for wealth maximisation:
- Investment decision
- Financing decision
- Dividend decision
Objective of wealth maximisation:
- Maximising shareholders utility.
- Increasing the market value of Shares.
- It takes care of the quality of cash flow.
- The risk that are associated with cash flows are adequately reflected when present values are taken to arrive at the net present value of any project.
Difference between long term finance and short term finance.
| Short term finance | Long term finance |
| Time period:One year or less | Greater than 3 to 5 years |
| Funds raised are less costly as flotation cost is less | Funds raised are costly as flotation cost is high.
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| Flexibility is more | Flexibility is less |
| Less restrictive as less provisions or covenants attached with it are less | More restrictive |
| May not require collateral or security | Specific assets as collateral or security |
| More riskier as interest rates are volatile and temporary Recession may render to non payment of debt and may lead to bankruptcy | Interest rate are stable , temporary recession do not affect it much. |
| Used for financing upkeep of fixed assets and WORKING CAPITAL | Can be used for finance 0any type of assets like fixed or current. |
| Companies can raised limited amount of Money using this provision | Can raised large amount of money |
Capital structure :
Capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised.Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, Debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business.
Importance of capital structure:
- A Sound capital structure helps to increase the market value of the firm.
- Helps is better utilisation of available funds.
- Maximisation of return.
- Helps to achieve minimisation of cost of capital.
- Helps to maintain healthy solvency or liquidity position.
Expected questions:
- Concept of wealth maximisation
- Objective of wealth maximisation
- Cost of capital define
- Importance of cost of capital
- Differentiate between long term finance and short term finance.
- Definition of capital structure.
- Importance of capital structure.
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Cost of Capital
The cost of capital is the rate of return a company must earn on its investments in order to satisfy its investors. It is a key concept in financial management, as it is used to determine the value of a company’s assets and to make investment decisions.
There are three main components of a company’s cost of capital: the cost of debt, the cost of equity, and the cost of preferred stock.
The cost of debt is the interest rate a company pays on its loans. The cost of equity is the rate of return that investors expect to earn on their investment in the company. The cost of preferred stock is the dividend rate a company pays on its preferred stock.
The weighted Average cost of capital (WACC) is a measure of a company’s overall cost of capital. It is calculated by taking a weighted average of the cost of debt, the cost of equity, and the cost of preferred stock, where the weights are determined by the relative proportions of each type of financing in the company’s capital structure.
The WACC is an important concept in financial management, as it is used to determine the value of a company’s assets and to make investment decisions.
Concept of Wealth Maximisation
WEALTH MAXIMIZATION is the goal of a company’s management. It is the process of maximizing the value of the company’s stock for its shareholders.
There are two main approaches to wealth maximization: shareholder wealth maximization and stakeholder wealth maximization.
Shareholder wealth maximization is the traditional approach to wealth maximization. It focuses on maximizing the return on investment for shareholders.
Stakeholder wealth maximization is a more recent approach to wealth maximization. It focuses on maximizing the return on investment for all stakeholders, including shareholders, employees, customers, and suppliers.
Long Term Vs Short Term Finance
Long-term finance is the financing of assets that will be used for more than one year. Short-term finance is the financing of assets that will be used for less than one year.
Long-term finance is typically used to finance the purchase of fixed assets, such as land, buildings, and equipment. Short-term finance is typically used to finance the purchase of current assets, such as inventory and accounts receivable.
There are a number of different sources of long-term finance, including debt, equity, and hybrid financing. Debt financing involves borrowing money from a lender, such as a bank. Equity financing involves selling shares of ownership in the company to investors. Hybrid financing involves a combination of debt and equity financing.
There are a number of different sources of short-term finance, including trade credit, bank loans, and Commercial Paper. Trade credit involves extending credit to customers who purchase goods or Services from the company. Bank loans involve borrowing money from a bank. Commercial paper involves selling short-term debt securities to investors.
Capital Structure
Capital structure is the mix of debt and equity financing that a company uses to finance its operations. The optimal capital structure is the mix of debt and equity financing that minimizes the company’s cost of capital and maximizes its value.
There are a number of factors that affect a company’s optimal capital structure, including the company’s tax rate, the cost of debt, the cost of equity, and the risk of the company’s business.
The tax rate affects the optimal capital structure because interest payments on debt are tax-deductible, while dividends on equity are not. This means that debt financing is cheaper than equity financing from a tax perspective.
The cost of debt is the interest rate that a company pays on its loans. The cost of equity is the rate of return that investors expect to earn on their investment in the company. The risk of the company’s business affects the cost of equity, as investors demand a higher return for riskier investments.
The optimal capital structure is a complex issue that should be determined on a case-by-case basis. There is no one-size-fits-all answer to the question of what the optimal capital structure is for a particular company.
Cost of Capital
- What is the cost of capital?
The cost of capital is the rate of return that a company must earn on its investments in order to satisfy its investors. - What are the different types of costs of capital?
The different types of costs of capital include the cost of debt, the cost of equity, and the weighted average cost of capital (WACC). - How is the cost of capital used?
The cost of capital is used to calculate the value of a company, to make investment decisions, and to set prices.
Concept of Wealth Maximisation
- What is the concept of wealth maximisation?
The concept of wealth maximisation is the idea that a company should make decisions that will increase the wealth of its shareholders. - How is the concept of wealth maximisation used?
The concept of wealth maximisation is used to make investment decisions, to set prices, and to evaluate the performance of a company.
Long Term Vs Short Term Finance
- What is the difference between long term finance and short term finance?
Long term finance is financing that is used to fund assets that will be used for more than one year. Short term finance is financing that is used to fund assets that will be used for less than one year. - When should a company use long term finance?
A company should use long term finance when it needs to fund assets that will be used for more than one year. - When should a company use short term finance?
A company should use short term finance when it needs to fund assets that will be used for less than one year.
Capital Structure
- What is capital structure?
Capital structure is the mix of debt and equity that a company uses to finance its assets. - What are the different types of capital structures?
The different types of capital structures include a levered capital structure, an unlevered capital structure, and an optimal capital structure. - How is capital structure determined?
Capital structure is determined by the company’s investment opportunities, its risk Tolerance, and its tax situation.
Cost of Capital
- The cost of capital is the rate of return that a company must earn on its investments in order to satisfy its investors.
- The cost of capital is a weighted average of the costs of debt and equity financing.
- The cost of debt is the interest rate that a company pays on its loans.
- The cost of equity is the rate of return that investors expect to earn on their investment in a company.
- The cost of capital is used to calculate the value of a company and to make investment decisions.
Concept of Wealth Maximisation
- The concept of wealth maximisation is the idea that a company should make decisions that will increase the wealth of its shareholders.
- The concept of wealth maximisation is based on the idea that shareholders are the owners of a company and that they should be the primary beneficiaries of the company’s success.
- The concept of wealth maximisation is often used to justify decisions that increase the short-term profits of a company, even if these decisions have negative consequences for the company’s long-term Health.
- The concept of wealth maximisation has been criticized for being too focused on the short-term and for ignoring the interests of other stakeholders, such as employees, customers, and the Environment.
Long Term Vs Short Term Finance
- Long-term finance is the financing of assets that will be used for more than one year.
- Short-term finance is the financing of assets that will be used for less than one year.
- Long-term finance is typically more expensive than short-term finance.
- Long-term finance is often used to finance the purchase of fixed assets, such as buildings and equipment.
- Short-term finance is often used to finance the purchase of inventory and accounts receivable.
Capital Structure
- Capital structure is the mix of debt and equity financing that a company uses.
- The optimal capital structure is the mix of debt and equity financing that minimizes the company’s cost of capital.
- The optimal capital structure is affected by a number of factors, including the company’s tax rate, the risk of its business, and the availability of debt financing.
- A company’s capital structure can be changed by issuing new debt or equity, or by repurchasing debt or equity.
- A company’s capital structure can have a significant impact on its financial performance.
MCQs
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The cost of capital is:
(a) The rate of return that a company must earn on its investments in order to satisfy its investors.
(b) The interest rate that a company pays on its loans.
(c) The rate of return that investors expect to earn on their investment in a company.
(d) All of the above. -
The concept of wealth maximisation is based on the idea that:
(a) Shareholders are the owners of a company and that they should be the primary beneficiaries of the company’s success.
(b) Decisions should be made that increase the short-term profits of a company, even if these decisions have negative consequences for the company’s long-term health.
(c) Both (a) and (b).
(d) Neither (a) nor (b). -
Long-term finance is typically:
(a) More expensive than short-term finance.
(b) Less expensive than short-term finance.
(c) The same price as short-term finance.
(d) Not related to the price of short-term finance. -
Capital structure is the mix of:
(a) Debt and equity financing that a company uses.
(b) Assets and liabilities that a company uses.
(c) Revenue and expenses that a company uses.
(d) None of the above. -
The optimal capital structure is the mix of debt and equity financing that:
(a) Minimizes the company’s cost of capital.
(b) Maximizes the company’s profits.
(c) Maximizes the company’s value.
(d) All of the above.