FM 3 2024

FINANCIAL MANAGEMENT II SEM VTU 22MBA22 - 2024
Module-3
COST OF CAPITAL
The term cost of capital is a concept having different meanings. Cost of capital from the three
viewpoints is given below. From:
1. The Investor’s viewpoint - it may be defined as “The measurement of the sacrifice made by
him/her in order to capital formation.”
Ex- Mr.A an investor invested in a company’s equity shares, an amount of Rs.1,00,000 instead of
investing in a bank deposit which pays 7% interest. Here investor had sacrificed 7% interest for
not having invested in the bank.
2. The Firm’s viewpoint- “it is the minimum required rate of return needed to justify the use of
capital.
Ex- A firm raised Rs. 50 lakhs through the issues of 10% debentures, for justifying this issue it
has to earn a 10% minimum rate of return on investment.
3. Capital expenditures viewpoint- The cost of capital is the minimum required rate of return or
the hurdle rate or target rate or cut off rate used to value cash flows.
Ex. Firm A is planning to invest in a project, that requires Rs.20 lakhs as an initial investment
and it provides cash flows for 5 years period, here for conversion of the future 5 year cash
inflows into present values we need coat of capital.
Cost of capital is the weighted average cost of various sources of finance used by the firm in
capital formation. The sources are equity shares, preference shares, long-term debt and short-
term debt.
Thus, from the above, we can say that cost of capital is that minimum rate of return, which a firm
must and is expected to earn on its investment so as to maintain the market value of its shares.
BASIC ASPECTS OF COST OF CAPITAL
1.Rates of Return- Cost of capital is not a cost, it is the rate of return that a firm requires to earn
from its investment projects.
2. Minimum rate of return- Cost of capital of any firm is that minimum rate of return that will at
least maintain the market value of the shares.
3. Cost of capital(Ko) comprises 3 components
a. The risk less cost of the particular type of financing(rj)
b. The business risk premium(b)
c. The financial risk premium(f)
Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 1
Symbolically represented as: K=rj+b+f
IMPORTANCE OF COST OF CAPITAL
The cost of capital is very important and is useful in the following financial management
decisions.
1. Desigining Optimal Capital Structure
Cost of capital is helpful in formulating a sound and economical capital structure for a firm.
Capital structure involves determination of proportion of debt and equity in capital structure
where cost of capital is minimum.
While designing a firm’s capital structure, financial executives always keep in mind
minimization of the overall cost of capital and to maximize value of the firm. The measurement
of specific cost of each source of fund and calculation of WACC helps to come to a balanced
capital structure. By comparing various sources of finance, he/she can choose the best and most
economical source of finance and can succeed in designing a sound and viable capital structure.
2. Investment (Capital budgeting) evaluation
Capital budgeting decisions require a financial standard(Cost of capital) for evaluation. In the
NPV method, an investment project is accepted, if the PV of cash inflows is greater than the
present value of cash outflows.
The present values of cash inflows are calculated by discounting with a discount rate known as
cost of capital. If a firm has adopted IRR as the technique for capital budgeting evaluation,
investment proposal should be accepted only when cost of capital is less than the calculated IRR.
Hence, the cost of capital is very much useful in capital budgeting decisions, particularly if a
firm is adopting discounted cash flow methods of project evaluation.
Cost of capital framework can be used to evaluate the financial performance of top management.
Financial performance evaluation involves a comparison of actual profitability of the project
with the project’s overall cost of capital. If the actual profitability rate is more than the projected
cost of capital, then the financial performance may be said to be satisfactory and vice versa.
CLASSIFICATION OF COST
1.Marginal cost of capital: Marginal cost of capital is the additional cost incurred to obtain
additional funds required by a firm. It refers to the change in total cost of capital resulting from
the use of additional funds.
2. Average cost/overall cost: It is the average cost of various specific costs of the different
components(equity, preference shares, debentures, retained earnings) of capital structure and is
used as acceptance criteria for investment proposals.
3. Historic Cost (Book Cost): The book cost has its origin in the accounting system. They are
related to the past. It is in common use for computation of cost of capital. Historical cost set as a
guide for future cost estimation.
4. Future Cost: It is the cost of capital that is expected to raise funds to finance a capital budget.
5. Specific Cost: It is the cost associated with a particular with a particular source of finance. It
is also known as component cost of capital. For example, cost of equity (Ke) or cost of
preference share (Kp), or cost of debt (Kd), etc.
6. Spot Costs: These are the costs that are prevailing in the market at a certain time.
7. Opportunity Cost: The opportunity cost is the benefit that the shareholder foregoes by not
putting his/her funds elsewhere because they have been retained by the management.
8. Explicit Cost: An explicit cost of any source of capital is the discount rate that equates the
present value of the cash inflows that are incremental to the taking of the financing opportunity
with present value of its incremental cash outflow. In other words, the discount rate that equates
the present value of cash inflows with present value of cash outflow
9. Implicit Cost: It is defined as “the rate of return associated with the best investment
opportunity for the firm and its shareholders that would be foregone, it the projects presently
under consideration by the firm were accepted”.
COMPUTATION OF OVERALL COST OF CAPITAL (WACC)

DEFINITION: weighted average of the cost of each specific type of fund. It is also known as
composite cost or WACC. In order to compute WACC ,a finance manager has to follow certain
steps.
1. Determination of the total funds required and share of individual source of finance in the
firm’s capitalization.
2. Computation of cost of specific source of funds.
3. Assignment of weights to specific source of funds.
4. Multiply the cost of each source of funds by appropriate assigned weights.
5. Add individual source weight cost to get cost of capital.

COMPUTATION OF SPECIFIC SOURCE OF FUND COST

Financial manager has to compute the specific cost of each source of funds needed in the
capitalization of a company. Company may resort to many financial sources. It may prefer
internal source (retained earnings) or external source(equity, preference and public deposits).
Investors required rate of return is interest, and discount on debt; dividend, capital appreciation,
and earnings per share on equity share holders, dividend and share of profit on preference share
holders funds.
COST OF EQUITY
Firms may obtain equity capital in two ways
1. Retention of earnings.
2. Issue of (additional) equity shares to public.
In both the cases shareholders are providing funds to the firm to finance firm’s investment
proposals. Retention of earnings involves opportunity cost. Shareholders could receive the
earnings as dividends and invest the same in alternative investments of comparable risk to earn
returns.
Issue of additional equity shares to the public involves a flotation cost whereas there is no
flotation cost for retained earnings. Hence, issue of additional equity shares to the public for
raising equity finance involves a bigger cost when compared to retained earnings.
I. Cost of retained earnings (Kr)

Retained earnings is one of the internal sources of funds to raise equity funds. The opportunity
cost of retained earnings is the rate of return the shareholder forgoes by not putting his/her funds
elsewhere, because the management has retained the funds.
II. Cost of issue of equity shares (Ke)
The rate at which investors discount the expected dividend over a future period to value stock .
In contrast, the return on equity shareholders solely depends on the discretion of the company
management.

APPROACHES TO CALCULATE COST OF EQUITY

There are five approaches namely
1. Dividends Capitalization Approach
According to this approach, the cost of equity capital is calculated on the basis of the required
rate of return in terms of the future dividends to be paid on the shares. It means investor arrives
at a market price for a share by capitalizing dividends at a normal rate of return.
This method assumes that investor gives prime importance to dividends and risk in the firm
remains unchanged and it does not consider the growth in dividend.
LIMITATIONS OF APPROACH
 It does not consider future earnings .
 It ignores the earnings on retained earnings.
 It ignores the fact that market price rise may be due to retained earnings and not on
account of high dividends.
 It does not take into account the capital gains.
2. Earnings Capitalization Approach

According to this approach , cost of equity (Ke) is the discount rate that equates the present value
of expected future earnings per share with the net proceeds of a share. It is more useful than the
dividend capitalization approach, due to 2 reasons
One, the earnings capitalization acknowledges that all earnings of the company after payment of
fixed dividend to preference shareholders, the remaining amount legally belongs to equity
shareholders whether they are paid as dividends or retained for investment.
secondly ,determining the marketprice of equity shares is based on earnings and not dividends.
This approach is employed under the following conditions
a) constant earnings per share over the future period
b) there should be either 100 % retention or 100 % dividend payout ratio
c) company satisfies the requirements with the equity share a and does not employ debt

LIMITATIONS OF APPROACH
 All earnings are not distributed to the equity shareholders as dividends.
 Earnings per share may not be constant.
 Share price also does not remain constant.
3. Dividend Capitalization Plus Growth Rate Approach

Computation of cost of equity capital based on a fixed dividend rate may not be appropriate,
because dividend may grow. The growth in dividends may be constant perpetually or may vary
over a period of time.
4. Bond Yield Plus Risk Premium (BYRP) Approach

Considers bond yield plus some premium for considering risk for calculating Ke .according to
this approach the rate of return required by the equity shareholder of a company is equal to
Ke= yield on long term bonds + risk premium
5. Capital Asset Pricing Model Approach (CAPM)

Describes the relationship between risk and return for efficient and inefficient portfolios
Capital asset pricing model (CAPM) was developed by William F. Sharpe. This is another
approach that can be used to calculate cost of equity.
Basic Assumption of CAPM Model

 Individual are risk averse
 Individuals seek to maximize the expected utility of their portfolio over a single period
planning horizon
 Individuals have homogeneous expectations they have identical subjective estimates
planning horizon
 Individual can borrow and lend freely at a riskless rate of interest

 The market is perfect: there are no taxes, there are no transactions costs: securities are
completely divisible, the market is competitive
 The quantity of risky securities In the market is given
MARGINAL COST OF CAPITAL

Companies may raise additional funds for expansion. Here a financial manager may be
required to calculate the cost of additional funds to be raised. The cost of additional funds is
called marginal cost of capital. For example, a firm at present has Rs 1, 00, 00,000 Capital with
WACC 12 percent, but it is planned to raise Rs 5, 00,000 for expansion, such as additional funds,
the cost that is related to this is marginal cost of capital.
COST OF PREFERENCE SHARE
Preference share (PS) is one of the types of shares issued by the companies to raise funds from
the public. PS has two preferential rights over equity shares, (i) preference in payment of
dividend, from distributable profits, (ii) preference in the payment of capital at the time of
liquidation of the company.
The cost of preference share capital is a function of the dividend expected by the investors.
Generally PS capital is issued with an intention (a fixed rate) to pay dividends.
There are different types of PS, cumulative and non-cumulative, redeemable and irredeemable,
participating and non-participating and convertible and non-convertible.
(a) Cost of Irredeemable (Perpetual) Preference Share:
The share that cannot be paid till the liquidation of the company is called as
irredeemable PS.
Flotation cost: It is the cost involved in issuing and selling securities.
Cost of Preferred Stock: The rate at which investors expect dividends of a firm to determine its
preferred stock.
(b) Cost of Redeemable Preference Share:
Shares that are issued for a specific maturity period or redeemable after a specific period
are known as redeemable PS. The explicit cost of redeemable PS is the discount rate that equals
the net proceeds of the sale of PS with the present value of the future dividend and principal
repayments.
Cost of Debt:
Companies may raise debt capital through issue of debenture or raise loans from financial
institutions or deposits from the public. All these resources involve a specific rate of interest. The
interest paid on these sources of funds is a charge on the profit and loss account of the company.
Computation of cost of debenture or debt is relatively easy, because the interest rate that is
payable on debt is fixed by the agreement between the firm and the creditors. Computation of
cost of debenture or debt capital depends on their nature. The debt/debenture can be perpetual or
irredeemable and redeemable, cost of debt capital is equal to the interest paid on that debt.
(a) Cost of Irredeemable Debt :
Perpetual debt provides permanent funds to the firm, because the funds will remain in the
firm till liquidation. The market yield on debt can be said to represent an approximation
of cost of debt. Bonds/debenture can be issued at (i) par/face value, (ii) discount and (iii)
premium. The following formulae as used to compute cost of debenture or debt of bond.
(b) Cost of Redeemable Debt :
Redeemable debenture are those having a maturity period or repayable after ascertain given
period of time. In other words, these types of debentures are under legal obligation to repay the
principal amount to its holders either at a certain agreed intervals during the duration of loan or a
lump sum amount at the end of maturity period.
WEIGHTED AVERAGE COST OF CAPITAL
It is also called as overall cost of capital or composite cost of capital. The weighted average cost
of capital is calculated by multiplying the weights of the various sources of capital with the cost
of capital of that particular source. Weight is the proportion of each source of fund in the capital
structure.
Steps involved in calculation of Weighted Average Cost of Capital
a. Calculate the cost of specific sources of funds

b. Multiply the cost of specific sources by its proportion in the capital structure (weight)
c. Add the weighted component costs to get the firm’s weighted average cost of capital
MARGINAL COST OF CAPITAL

 The weighted average cost of new or incremental capital is known as the marginal cost of
capital.
 The marginal cost of capital is the weighted average cost of new capital using the marginal
weights.
The marginal weights represent the portion of various funds the firm intends to employ
Sources of Financing

ISSUE OF SHARES
A company has an option to issue shares to raise the long-term finance for its operations.
Shares:

A unit of ownership that represents an equal proportion of a company's capital. It entitles its
holder (the shareholder) to an equal claim on the company's profits and an equal obligation for
the company's debts and losses.
Two major types of shares are (1) ordinary shares (common stock), which entitle the shareholder
to share in the earnings of the company as and when they occur, and to vote at the company's
annual general meetings and other official meetings, and (2) preference shares (preferred stock)
which entitle the shareholder to a fixed periodic income (interest) but generally do not give him
or her voting rights.
EQUITY SHARES: These are also termed as ordinary shares or common stock. The owners of
these shares are the real owners of the company. They have a control over the working of the
company. Equity share holders are paid dividends after paying it to the preference shareholders.
These shareholders take more risk when compared to preference shareholders.
Equity share is one of the main sources of finance for any company. Normally, a company is
started with equity shares as its first source of capital from the owners or promoters of that
company. After a certain level of growth, more capital is required for further growth. The
company then finds investor in the form of friends, relatives, venture capitalists, mutual funds, or
any such small group of investors and issue fresh equity shares to these investors.
A point comes where the company reaches a very big level and requires huge capital investment
for business growth. It then offers its equity share to general public. This is called Initial Public
Offer (IPO). More such issues in future are called Follow on Public Offer (FPO).
They are categorized under long term sources of finance because legally they are irredeemable in
nature. For an investor, these shares are a certificate of ownership in the company by virtue of
which investors are entitled to share the net profits and have a residual claim over the assets of

the company in the event of liquidation. Investors have voting rights in the company and their
liability to company is limited to the amount of investment.
Types of Equity Shares:
Equity share is a main source of finance for any company giving investors rights to vote, share
profits and claim on assets. Various types of equity capital are authorized, issued, subscribed,
paid up, rights, bonus, sweat equity etc. The value of equity shares are expressed in terms of face
value or par value, issue price, book value, market value etc.
There are various types of equity shares classified based on various things.In the financial
statements of a company, equity shares are placed in the liability side of the balance sheet. They
are classified into various categories which are as follows:
 Authorized Share Capital: It is the maximum amount of capital which can be issued by a
company. It can be increased from time to time. Some fee is required to be paid to legal
bodies accompanied with some formalities.
 Issued Share Capital: It is that part of authorized capital which is offered to investors.
 Subscribed Share Capital: It is that part of Issued capital which is accepted and agreed by
the investor.
 Paid Up Capital: It is the part of subscribed capital, the amount for which is paid by the
investor. Normally, all companies accept complete money in one shot and therefore
issued, subscribed and paid capital becomes one and the same. Conceptually, paid up
capital is the amount of money which is actually invested in the business.
There are other types of equity shares discussed below:
 Rights Share: These are the shares issued to the existing shareholders of a company.
Such kind of shares is issued to protect the ownership rights of the investors.
 Bonus Share: These are the type of shares given by the company to its shareholders as
a dividend.
 Sweat Equity Share: These shares are issued to exceptional employees or directors of
the company for their exceptional job in terms of providing know-how or intellectual
property rights to the company.
Various Prices of Equity Shares

 Par or Face Value: It is the value of a share at which it is accounted in books of

accounts.
 Issue Price: It is the price at which the equity share is actually offered to the investor.
Normally, the issue price and face value of share is same in case of new companies.
 Share Premium and Share at Discount: When share is issued at a price higher than
face value, the excess amount is called premium. Contrary to it, if the share is issued at
a price lower than face value, it is said to be issued at a discount.
 Book Value: It is the ratio of total of paid up capital and reserves and surplus divided
by total no. of shares. This is the balance sheet value of shares.
 Market Value: In case of companies listed on stock exchanges, the market value of
the share is the price at which they are sold currently sold in the market.
Characteristic Features
Equity shares have a number of special features which distinguish it from other securities.
These features relate to the rights and claims of ordinary shareholders.
1. Risk Capital
2. Fluctuating Dividend
3. Changing market value
4. Growth prospectus
5. Protection against inflation
6. Voting rights
7. Claim assets
8. Right to control
9. Pre-emptive rights
10. Limited liability
Advantages of equity shares
1. No compulsion for the company to pay dividends
2. Equity capital has no maturity and hence the firm has no obligation to redeem.
3. Dividends are tax-exempt in the hands of investors.
4. Enhances the creditworthiness of the company.
Disadvantages of equity shares

1. Sale of equity shares to outsiders dilutes the control of the existing owners
2. The cost of equity share capital is the highest and hence the expectation the equity share is
also very high.
3. Equity dividend is paid out of profit after tax while interest is a deductible expenditure. This
makes the cost of equity relative more.
4. The cost of issuing equity shares is higher than the cost of issuing other securities.
PREFERENCE SHARES:
Capital stock which provides a specific dividend that is paid before any dividends are paid to
common stock holders, and which takes precedence over common stock in the event of
liquidation. Like common stock, preference shares represent partial ownership in a company,
although preferred stock shareholders do not enjoy any of the voting rights of common
stockholders. Also unlike common stock, preference shares pay a fixed dividend that does not
fluctuate, although the company does not have to pay this dividend if it lacks the financial ability
to do so. The main benefit to owning preference shares are that the investor has a greater claim
on the company's assets than common stockholders. Preferred shareholders always receive their
dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off
before common stockholders. In general, there are four different types of preferred stock:
cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and
convertible preferred stock. also called preferred stock.
Characteristic features
1. Return of income
2. Return of capital
3. Fixed dividend
4. Non participation in prosperity
5. Non participation in management
6. No voting rights
Different types of Preference Shares
 Cumulative preference shares
 Non-cumulative preference shares
 Redeemable preference shares
 Irredeemable preference shares

 Participating preference shares
Cumulative preference shares

In case the company has not been able to pay part or all of the annual dividends because of
insufficient profit, the unpaid amount is carried forward to future years and made good when the
company has sufficient profit to pay the dividends.
Non-Cumulative preference shares

In case the company has not been able to pay part or all of the annual dividends because of
insufficient profit, preference shareholders lose the unpaid amount.
Redeemable preference shares

These are preference shares that the company will buy back at an agreed date in the future. They
are classified as non-current liabilities in the statement of financial position of a company.
Irredeemable preference shares

These are preference shares that will not be bought back by the company. Shareholders will
continue to earn dividends as long as profit is earned. They are listed under heading equity in the
statement of financial position of a company.
Participating preference shares

In addition to a fixed rate of dividend, holders of participating preference shares are also entitled
to participate in the distribution of dividends with ordinary shareholders.
Advantages of preference share capital

1. There is no legal obligation to pay dividend
2. These shares are particularly useful if its assets are not acceptable as collateral security for
creditor ship securities like debentures and bonds.

3. These shares save the company from payment of high interest if debentures were to be
borrowed.
4. The property need not be mortgaged as in case of debentures if these shares are issued.
5. Preference shares since they bear fixed yield and enable the company to declare higher rates
of dividend for the equity shareholders
6. The promoters can retain control over the company
Disadvantages of preference share capital

1. Though there is no compulsion on the part of the company to declare dividend, but frequent
delays and non-payment adversely affects the creditworthiness of the firm.
2. Preference share dividend is not a deductible expense like debenture interest.
3. Since the holders of these shares do not carry any voting right, they remain at the mercy of
the management for the payment of dividend and redemption of their capital.
4. The rate of dividend on preference shares is less than compared to the equity shares.
5. The share holders of do not have any charge on the assets
DEBENTURES
Debenture (Greek word) means you owe something and is derived from Latin word “debere”
meaning “to borrow”. It is a written certificate/instrument signed by the company under its
common seal acknowledging debt due by it to its holders. In simple words, through this
document:
 Company promises to pay a specific amount of money as stated
 At a fixed date in future
 Along with periodic interest payment
 To compensate holders for using their funds.
A debenture is a debt instrument similar to a bond. But bonds are secured while debentures
are not. However, many people use both the terms interchangeably.

The debenture is an acknowledgement of debt issued by a company for the amount of loan taken
from them and carrying a definite time period of maturity and also a certain rate of interest. A
debenture holder is a creditor of the company.
Features of debentures
1. They have a fixed maturity period
2. They carry a fixed rate of interest
3. The debentures have a claim on the company’s income
4. They have a claim on the assets of the company
5. They do not have any control over the company and
6. The debenture holders are the creditors of the company.
7. The debentures have call feature.
Debentures differ on the basis on terms and conditions on which they are issued.
Security:
Secured/Mortgage Debentures: Debentures secured against assets of the company .i.e. if the
company is winding up, assets will be sold and debenture holders will be paid back. The
charge/mortgage may be fixed or a floating charge. If it is fixed, charge is on a specific asset say
plant, machinery etc. If it is floating charge, it means it is on general assets of the company.
Which assets are charged: The ones available with the company presently and also assets in
future

Mortgage deed: Includes nature/value of the security, date of interest payment, and rate of
interest, repayment terms, and rights of the debenture holders if the company defaults. In the
event of default of company to pay interest or principal installment, they can recover their money
via the assets mortgaged.
Unsecured/Naked Debentures: Debentures not secured against assets of the company .i.e. if the
company is winding up, assets will be not be sold in order to pay the debenture holders. In other
words, no charge is created on the assets of the company which means that there is no security of
interest and principal payment. The creditworthiness and soundness of the company serves as a
security.
Tenure:
Redeemable Debentures: Debentures which have to be repaid within a certain specified period.
Eg: 5% 2 years Rs. 1000 debenture means redeemable period is 2 years(5%:interest/coupon
payment). After redemption, they can be reissued.
Irredeemable/Perpetual Debentures: These can be paid back at any time during the life of the
company .i.e. there is no specified period for redemption. Hence they are also called Perpetual
Debentures. Nonetheless if the company has to wind up, then they have to repay the debenture
holders.
Registration:
Registered Debentures: As the name suggested, these are debentures that are registered with the
company. It records all details of debenture holdings such as name, address, particulars of
holding etc. Interest shall be paid only to the registered holder (treated as a non-negotiable
instrument). They can be transferred by a transfer deed.
Bearer Debentures: These can be transferred by mere delivery. Company does not hold records
for the debenture holder. Interest will be paid to the one who displays the interest coupon
attached to the debenture.

Coupon:
Zero Coupon Debentures: Does not have a specified interest rate, there by to compensate, they
are issued at a substantial discount. Interest: Difference in face value and issue price.
Specific Coupon rate Debentures: Debentures are normally issued with an interest rate which
is nothing but the coupon rate. It can be fixed or floating. Floating is associated with the bank
rates.
Convertibility:
Convertible Debentures (Fully/ Partly convertible): Debentures which can be converted to
either equity shares or preference shares by the company or debenture holders at a specified rate
after a certain period. A company can also issue Partly Convertible Debentures whereby only a
part of the amount can be converted to equity/preference shares.
Non Convertible Debentures (NCDs): These can’t be converted into equity/preference shares.
Advantages/Merits of Debenture Issue:

 It enables a company to raise funds for a specific period.
 No dilution of control as debenture holders don’t possess voting rights
 Debenture (debt) enables the company to Trade on equity. It can pay dividend to equity
shareholders at a rate higher than overall ROI.
 Debenture holders entitled to a fixed rate of interest. Eg: 10% debenture
 They enjoy priority over other unsecured creditors with respect to debt repayment.
 Suitable for conservative investors who seek steady ROI with little or no risk.
 Interest on debentures is treated as expense and is tax deductible.
 Company can adjust its gearing in accordance to its financial plan.
 Debenture holders are regarded as creditors of the company and they receive preference
over equity shareholders and preference share holders.
Disadvantages/Demerits of Debenture issue:
 They have a fixed maturity; hence provision has to be made for repayment.
 There is a limit to which funds can be raised through debentures.

 It is risky if the company fails to pay interest or principal installment on time, as
debenture holders can file petition for winding up the company.
 It is not suitable for a company with fluctuating earnings as it may also lead to
fluctuations in payment of dividend payable to equity shareholders.
 With more risk, you get more return. Debentures being secure investments, returns are
less.
 Like ordinary shares, debenture holders will not be regarded as owners of the company
and have no voting rights.
Venture capital Firms:-

A financial service that is concerned with the provision of financial and other assistance to high
technology, high-risk and high-return ventures are called ‘venture capital’. Venture capital is
designed to suit the high expectation of entrepreneurs for high gains.
Venture capital institution is a financial intermediary between investors looking for high
potential returns & entrepreneurs who need institutional capital as they are yet not ready to go to
the public.
It is a source of financing for new businesses. Venture capital funds pool investors' cash and loan
it to startup firms and small businesses with perceived, long-term growth potential. This is a very
important source of funding startups that do not have access to other capital and it typically
entails high risk (and potentially high returns) for the investor.
Most venture capital comes from groups of wealthy investors, investment banks and other
financial institutions that pool such investments or partnerships. This form of raising capital is
popular among new companies, or ventures, with a limited operating history that cannot raise
capital though a debt issue or equity offering. Often, venture firms will also provide start-ups
with managerial or technical expertise. For entrepreneurs, venture capitalists are a vital source of
financing, but the cash infusion often comes at a high price. Venture firms often take large equity
positions in exchange for funding and may also require representation on the start-up's board.

Leasing:-
An arrangement whereby a person called ‘the lessee’ commands the use of an asset without
owing the same, in consideration of a periodic rental payment called ‘the lease charges’ to the
‘the lessor’ is known as leasing.
According to the Institute of chartered Accountants of India “a lease is an agreement whereby
the lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of
time. Lessor is a person who conveys to another person (lessee) the right to use an asset in
consideration of a payment of periodical rental, under a lease agreement. Lessee is a person who
obtains from the lessor, the right to use the asset for a periodical rental payment for an agreed
period of time.
Characteristics:-
1) The parties:-
There are two parties to a lease agreement. They are – lessor and lessee.
2) The Asset:-
Leasing is used for financing the use of fixed assets of high value. The asset is the
property to be leased out . It may include an automobile, an aircraft, plant & machinery,
a building etc.
3) The Term:-
The term of the lease is called the lease period. It is the period for which the lease
agreement is in operation. It is illegal to have a lease without a specified term.
4) The Lease Rentals:-
Lease rentals constitute the consideration payable by the lessee as specified in the lease
transaction.
Types:-
1) Financial Lease:-
 A financial lease is also known as capital lease, long term lease, Net lease and close
lease.
 The lessee selects the equipments, settles the price and terms of sale and arranges with
the leasing company to buy it.
 Lessee enters into a irrevocable and non-cancellable contractual agreement with a leasing
company to buy it.
 The lessee uses the equipment exclusively, maintains it, insures and avails of the after
sales service and warranty backing it.
 Lessee also bears the risk of obsolescence as it stands committed to pay the rental for the
entire lease period.
 The financial lease could be with purchase option, where at the end of the predetermined
period, the lessee has the option to buy the equipment at a predetermined value or at a
nominal value or at fair market price.
2) Operating Lease:-
 An operating lease is also known as service lease, short term lease or True lease.
 The contractual period between lessor and lessee is less than the expected economic life
of equipment.
 The lease is terminable by giving stipulated notice as per the agreement.
 Leasing
 The lease rentals will be higher as compared to other leases on account of short period of
primary lease.
 The risk of obsolescence is enforced on the lessor who will also bear the cost of
maintenance and other relevant expenditure.
3) Leverage Lease:-
 A leverage lease is used for financing those assets which require huge capital outlay. The
outlay for purchase cost of the asset generally varies from Rs.50 lakhs to Rs.2 crores and
has economic life of 10 years or more.
 The leverage lease agreement involves three parties, the lessee, the lessor and lender
 The lessor acquires the assets as per the terms of lease agreement but finances only a part
of the total investment say 20% to 50%. The balance is provided by a person or a group
of persons in the form of loan to the lessor.

 The loan is generally secured by mortgage of the asset besides assignment of the leased
rental payments.
Hire purchasing firms:-

Hire purchase finance refers to a transaction of finance, whereby goods are bought and sold
under certain terms and conditions such as payment of periodic instalments, immediate
possession of goods to the buyer, etc.
Hire purchase is a method of selling goods. In a hire purchase transaction the goods are let out on
hire by a finance company (creditor) to the hire purchase customer (hirer). The buyer is required
to pay an agreed amount in periodical installments during a given period. The ownership of the
property remains with creditor and passes on to hirer on the payment of the last instalment.
Characteristics:-
1) Payment to be made in instalments over a specified period.
2) The possession is delivered to the hirer at the time of entering into the contract.
3) The property in the goods passes to the hirer on payment of the last instalment.
4) Each instalment is treated as hire charges so that if default is made in payment of any
instalment, the seller becomes entitled to take away the goods and
5) The hirer/purchaser is free to return the goods without being required to pay any further
instalments falling due after the return.
Lease Financing Vs Hire purchase Financing

Characteristics Lease Financing Hire purchase Financing
1) Ownership Ownership of the property lies with Ownership of property is transferred to
the finance company, the lessor and the hirer on the payment of the last
it is never transferred to the lessee, instalment
the user
2)Depreciation Lessor, and not the lessee, is The hirer (owner) is entitled to claim
entitled to claim depreciation tax depreciation tax shield
shield
3) Capitalization Capitalization of the asset is done Capitalization of the asset is done in
in the books of the lessor, the the books of hirer
leasing company
4) Payments The entire lease payments are Only the hire-interest is eligible for tax
eligible for tax computation in the computation in the books of the hirer
books of the lessee
5) Salvage value The lessor and not the lessee, has The hirer can claim benefit of salvage
the right to claim the benefit of value as the prospective owner of the
salvage value asset.
6) Magnitude Leasing is used as a source of Hire purchase is used as a source of
finance, usually for acquiring high finance usually for acquiring relatively
cost assets such as machinery, low cost assets such as automobiles,
ships, airplanes office equipments etc.
7) Down payment No down payment is required for Down payment is required to be made
acquiring the use of the leased for acquiring the asset and there is a
assets margin maintained to the extent of 20-
25 percent
8) Reporting In the books of the lessee, leased The asset bought on hire purchase will
assets are disclosed by way of a be shown as an asset, and the amount
note only of instalments payable to the lessor as
a liability
9) Maintenance of Where as the lessee has to maintain It is the hirer’s responsibility to ensure
Asset the leased asset in the case of the maintenance of the asset bought
financial lease, upkeep is the
responsibility of the lessor in the
case of operating lease
10) Suitability It is not suitable for the low-capital It is highly suitable for the low-capital
enterprises which desire to show a enterprises which need to show a
strong asset position in their strong asset position in their balance
balance sheets sheets
11) Nature of Asset An asset given on lease by a leasing The hire vendor normally shows the
company is considered as the fixed asset let under hp either a stock in
asset of the lessor trade, or as receivables
12) Receipts All receipts from the lessee is taken Only the interest portion is taken into
into lessor’s profit and loss account the hire vendor’s profit and loss
account
13) Income Lessor’s income declines as the In the case of HP transactions, finance
investment outstanding in the lease charges are allocated to the HP period
declines equally
Term Loans Market:-

In India many industrial financing institutions have been created by the Government both at the
national and regional levels to supply long term and medium term loans to corporate customers
directly as well as indirectly. These development banks dominate the industrial finance in India.
Institutions like IDBI, IFCI, ICICI and other state meet the growing and varied long term
financial requirement These institutions meet the growing and varied long term financial
requirements of industries by supplying long term loan.
Term loans are also known as project finance. The primary source of such loans are financial
institutions. Commercial banks also provide term finance in a limited way. The financial
institutions provide project finance for new projects as also for expansion & modernisation
whereas the bulk of term loans extended by banks is in the form of working capital term loan to
finance the working capital gap. Though they are permitted to finance infrastructure projects on a
long term basis, the quantum of such financing is marginal.
Features:
Maturity:
The maturity period of term loans is typically longer in case of sanctions by financial institutions
in the range of 6-10 years in comparison to 3-5 years of bank advances. However, they are
rescheduled to enable corporates tide of temporary financial exigencies.
Negotiated: The term loans are negotiated loans between the borrowers & the lenders. They are
akin to private placement of debentures in contrast to their public offering to investors.
Security:
All term loans are secured. While the assets financed by term loans serve as primary security, all
the other present & future assets of the company provide collateral security for the term loan.
Hybrid Financing:
Equity & debt lie at the two ends of the spectrum of financing. In between lie hybrid sources of
financing which partake some characteristics of equity & some characteristics of debt. The
important forms of hybrid financing are preference capital, warrants, convertible debentures, &
innovative hybrids.

Preference capital ordinarily carries a fixed rate of dividend which is payable at the discretion of
directors when the company has distributable surplus.
A warrant gives its holder the right to subscribe to the equity shares of a company during a
certain period at a specified price.
A convertible debenture is a debenture that is convertible, partially or fully, into equity shares.
The conversion may be compulsory or optional.
An innovative hybrid is a hybrid security whose payoff is linked to some general economic
variable like the interest rate, exchange rate or commodity index.
Angel Investing:
An angel investor or angel (also known as a business angel or informal investor) is an affluent
individual who provides capital for a business start-up, usually in exchange for convertible debt
or ownership equity. A small but increasing number of angel investors organize themselves into
angel groups or angel networks to share research and pool their investment capital, as well as to
provide advice to their portfolio companies.
An investor who provides financial backing for small startups or entrepreneurs. Angel investors
are usually found among an entrepreneur's family and friends. The capital they provide can be a
one-time injection of seed money or ongoing support to carry the company through difficult
times.
Angel investors give more favorable terms than other lenders, as they are usually investing in the
person rather than the viability of the business. They are focused on helping the business succeed,
rather than reaping a huge profit from their investment. Angel investors are essentially the exact
opposite of a venture capitalist.
Private Equity:
Equity capital that is not quoted on a public exchange. Private equity consists of investors and
funds that make investments directly into private companies or conduct buyouts of public
companies that result in a delisting of public equity. Capital for private equity is raised from
retail and institutional investors, and can be used to fund new technologies, expand working
capital within an owned company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors who can
commit large sums of money for long periods of time. Private equity investments often demand
long holding periods to allow for a turnaround of a distressed company or a liquidity event such
as an IPO or sale to a public company.
The size of the private equity market has grown steadily since the 1970s. Private equity firms
will sometimes pool funds together to take very large public companies private. Many private
equity firms conduct what are known as leveraged buyouts (LBOs), where large amounts of debt
are issued to fund a large purchase. Private equity firms will then try to improve the financial
results and prospects of the company in the hope of reselling the company to another firm or
cashing out via an IPO.
Private equity refers to a type of investment aimed at gaining significant, or even complete,
control of a company in the hopes of earning a high return. As the name implies, private equity
funds invest in assets that either are not owned publicly or that are publicly owned but the private
equity buyer plans to take private. Though the money used to fund these investments comes from
private markets, private equity firms invest in both privately and publicly held companies. The
private equity industry has evolved substantially over the past decade or so. The basic principle
has remained constant: a group of investors buy out a company and use that company's earnings
to pay themselves back. What has changed are the sheer numbers of recent private equity deals.
In the past ten years, the record for the most expensive buyout has been broken and re-broken
several times. Private equity firms have been acquiring companies left and right, paying
sometimes shockingly high premiums over these companies' market values.
Warrants:
Warrants are a type of security that gives the holder the right to purchase (or sell) another
security from (or to) the company that issued the warrant at a set strike price on or before the
expiration of the warrant. The most common type of warrant is a stock warrant, which gives the
holder the right to purchase or sell a set number of shares of the company.
A warrant is similar to an option in that both give the holder the right (but not an obligation) to
purchase/sell a given security at a given strike price before its expiration. Like options, there are
different exercise types associated with warrants such as American style (holder can exercise
anytime before expiration) or European style (holder can only exercise on expiration date).
Warrants are also broken down into call warrants, which give the holder the right to purchase an
underlying security, and put warrants, which give the holder the right to sell the underlying
security.
Convertibles:
Securities, usually bonds or preferred shares, that can be converted into common stock.
Convertibles are most often associated with convertible bonds, which allow bond holders to
convert their creditor position to that of an equity holder at an agreed upon price. Other
convertible securities can include notes and preferred shares, which can possess many different
traits.
Convertibles are ideal for investors demanding greater potential for appreciation than bonds
provide, and higher income than common stocks offer. Convertible bonds, for instance, will
typically offer a lower coupon than a standard bond. However, the optionality of the bond to
convert it to common stock adds value for the bond holder.
*********

FM 3 2024

Uploaded by

Copyright:

Available Formats

FM 3 2024

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FM 3 2024

Uploaded by

Copyright:

Available Formats

FINANCIAL MANAGEMENT II SEM VTU 22MBA22 - 2024

Symbolically represented as: K=rj+b+f

IMPORTANCE OF COST OF CAPITAL

1. Desigining Optimal Capital Structure

2. Investment (Capital budgeting) evaluation

COMPUTATION OF OVERALL COST OF CAPITAL (WACC)

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 3

COMPUTATION OF SPECIFIC SOURCE OF FUND COST

I. Cost of retained earnings (Kr)

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 4

APPROACHES TO CALCULATE COST OF EQUITY

2. Earnings Capitalization Approach

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 5

3. Dividend Capitalization Plus Growth Rate Approach

4. Bond Yield Plus Risk Premium (BYRP) Approach

5. Capital Asset Pricing Model Approach (CAPM)

Basic Assumption of CAPM Model

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 6

MARGINAL COST OF CAPITAL

COST OF PREFERENCE SHARE

(a) Cost of Irredeemable (Perpetual) Preference Share:

Flotation cost: It is the cost involved in issuing and selling securities.

(b) Cost of Redeemable Preference Share:

(a) Cost of Irredeemable Debt :

(b) Cost of Redeemable Debt :

WEIGHTED AVERAGE COST OF CAPITAL

Steps involved in calculation of Weighted Average Cost of Capital

a. Calculate the cost of specific sources of funds

MARGINAL COST OF CAPITAL

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 9

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 10

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 11

Types of Equity Shares:

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 12

 Par or Face Value: It is the value of a share at which it is accounted in books of

Disadvantages of equity shares

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 14

 Participating preference shares

Cumulative preference shares

Non-Cumulative preference shares

Redeemable preference shares

Irredeemable preference shares

Participating preference shares

Advantages of preference share capital

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 15

Disadvantages of preference share capital

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 16

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 17

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 18

Advantages/Merits of Debenture Issue:

 There is a limit to which funds can be raised through debentures.

Venture capital Firms:-

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 20

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 22

Hire purchasing firms:-

Lease Financing Vs Hire purchase Financing

Term Loans Market:-

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 24

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 25

Dr. Deepak D, MBA, RNSIT, Bangalore | Ph : 9538321088 26