5. Define the Cost of Capital.

Cost of capital refers to the opportunity cost of making a specific investment. It is

the rate of return that could have been earned by putting the same money into a
different investment with equal risk. Thus, the cost of capital is the rate of return
required to persuade the investor to make a given investment. Cost of capital consists
of both the cost of debt and the cost of equity used for financing a business. A company’s cost of
capital depends to a large extent on the type of financing the company chooses to rely on. The
company may rely solely on equity or debt, or use a combination of the two.

The choice of financing makes the cost of capital a crucial variable for every company, as it will
determine the company’s capital structure. Companies look for the optimal mix of financing that
provides adequate funding and that minimizes the cost of capital.

6. State the Importance of Cost of Capital.

The cost of capital is very important concept in the financial decision making. Cost of capital
is the measurement of the sacrifice made by investors in order to invest with a view to get a fair
return in future on his investments as a reward for the postponement of his present needs. On the
other hand from the point of view of the firm using the capital, cost of capital is the price paid to
the investor for the use of capital provided by him. Thus, cost of capital is reward for the use of
capital. The management always likes to consider the importance cost of capital while taking
financial decisions as it’s very relevant in the following spheres:

1. Designing the capital structure: The cost of capital is the significant factor in designing a balanced
and optimal capital structure of a firm. While designing it, the management has to consider the
objective of maximizing the value of the firm and minimizing cost of capital. Comparing the
various specific costs of different sources of capital, the financial manager can select the best and
the most economical source of finance and can designed a sound and balanced capital structure.
2. Capital budgeting decisions: The cost of capital sources as a very useful tool in the process of
making capital budgeting decisions. Acceptance or rejection of any investment proposal depends
upon the cost of capital. A proposal shall not be accepted till its rate of return is greater than the
cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital
measured the financial performance and determines acceptability of all investment proposals by
discounting the cash flows.
3. Comparative study of sources of financing: There are various sources of financing a project. Out
of these, which source should be used at a particular point of time is to be decided by comparing
costs of different sources of financing. The source which bears the minimum cost of capital would
be selected. Although cost of capital is an important factor in such decisions, but equally
important are the considerations of retaining control and of avoiding risks.
4. Evaluations of financial performance: Cost of capital can be used to evaluate the financial
performance of the capital projects. Such as evaluations can be done by comparing actual
profitability of the project undertaken with the actual cost of capital of funds raise to finance the
 project. If the actual profitability of the project is more than the actual cost of capital, the
performance can be evaluated as satisfactory.
5. Knowledge of firms expected income and inherent risks: Investors can know the firms expected
income and risks inherent there in by cost of capital. If a firms cost of capital is high, it means the
firms present rate of earnings is less, risk is more and capital structure is imbalanced, in such
situations, investors expect higher rate of return.
6. Financing and Dividend Decisions: The concept of capital can be conveniently employed as a tool
in making other important financial decisions. On the basis, decisions can be taken regarding
dividend policy, capitalization of profits and selections of sources of working capital.

In sum, the importance of cost of capital is that it is used to evaluate new project of company and
allows the calculations to be easy so that it has minimum return that investor expect for providing
investment to the company.

2. Profit maximization is not ultimate goal of finance- explain.

In old times, the traditional approach of companies was to maximize the owner’s profit. Modern
approach puts more emphasis on Shareholder Wealth Maximization rather than owner profit
maximization. This includes increasing the earnings per share (EPS) of every shareholder so that
their net worth is maximized. Wealth increase is equal to what gross present worth in needed for
raising profits in the future. This value needs to be discounted as per the time frame to find out the
annualized rate of return for the shareholder. In Shareholder Wealth Maximization, it places
priority before any other objective for the organization. Any action which has positive effective
on Shareholder Wealth Maximization needs to be given priority.

In any capitalistic society, the goal of business should be Shareholder Wealth Maximization as
mostly the ownership of goods and services is by individuals, since, they own all the means so that
they can make money. Shareholder Wealth Maximization at the end leads to rise in value of the
shares which at end maximizes wealth of the shareholder. Warren Buffet, who has been the
advocate of Shareholder wealth, says that long term economic goal of any organization should be
increasing the average annual gain of the intrinsic business value in their firm for their
shareholders. Economic progress isn’t shown by size of firm but by per share progress.

7. Explain the concept of Weighted average cost of capital(WACC)

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is commonly referred to as the
firm's cost of capital. Importantly, it is dictated by the external market and not by management.
The WACC represents the minimum return that a company must earn on an existing asset base to
satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

Companies raise money from a number of sources: common stock, preferred stock, straight debt,
convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock
options, governmental subsidies, and so on. Different securities, which represent different
sources of finance, are expected to generate different returns. The WACC is calculated taking
into account the relative weights of each component of the capital structure.
Companies can use WACC to see if the investment projects available to them are worthwhile to
undertake.

8. What is capital structure? Briefly explain the main organs of capital structure.

Capital Structure: The capital structure is a process by which a firm finances its overall
operations and growth by using different sources of fund. Simply, capital structure makes up of
firm’s capitalization. In other words, capital structure is the combination of equity capital and debt
capital. A company procures its fund by issuing various types of securities, i.e, ordinary shares,
preference shares, bonds and debentures.
Before issuing any of these securities, a company should think about the kind of securities to be
issued and in what proportion of the various kinds of securities will be issued. So, in broader sense,
capital structure of goods are all the long-term capital resources. components of capital resources
are like as loans, bonds, share issues, reserve etc.
A hypothetical capital structure is shown below:
Capital structure
Sources of fund Amount in taka (Crore)
Ordinary share capital 10
8% preference share 5
12% Bonds 2
Reserve 3
Total capital employed Total 20 crore taka

Organs of capital structure:

Organs of capital structure are given in the diagram below:

Shareholder's Funds (Owned Capital)

In components of capital structure, shareholder's funds (owned capital) means funds provided or
contributed by the owners. It is also known as owned capital or ownership capital. Various
constituents of owned capital are:

1. Equity Capital

In components of Capital structure, equity share capital represents the ownership capital of the
company. It is the permanent capital and cannot be withdrawn during the lifetime of the
company. They are the real risk bearers, but they also enjoy rewards. Their liability is restricted
to their capital contributed. Equity shares are popular among the investing class. “Equity Capital
is also known as 'Owned Capital' or 'Risk Capital' or 'Venture Capital.'”

2. Preference Capital

In components of capital structure, preference shareholders are also owners of the firm, and they
get preference regarding payment of dividends and repayment of Capital. They are cautious
investors. Preference Shares carry a stipulated dividend. Preference Shares are of different types
such as:

 Redeemable and Non-Redeemable,

 Convertible and Non-Convertible,
 Cumulative and Non-Cumulative preference shares.

3. Retained Earnings

In components of capital structure, instead of distributing all the profits to shareholders by way
of a dividend, the firm retains / keeps / saves a part of the profit for self-financing. Retained
earnings constitute the sum total of those profits which have been realized over the years and
have been reinvested in the business. Thus, it is also known as self-financing or ploughing back
of profits. Thus, it is also known as self-financing or working back of profits.

Borrowed Capital

Borrowed capital is the amount raised by way of loans or credit. Various parts of borrowed
capital are:

1. Debentures

In components of capital structure, debenture capital is a part of borrowed capital. The creditors
of the company are the debenture holders. Different types of debentures are issued for the
convenience of investors.

2. Term Loan
In components of capital structure, organizations can obtain long-term and medium term loans
from banks and financial institutions. Further, banks advance loans in US dollar. Term loans are
repayable by installments. For obtaining term loans, collateral security has to be offered by the
organization.

3. Public Deposits

Public deposit means any money received by a non-banking company by way of deposit or loan
from the public, including employees, customers and shareholders of the company other than in
the form of shares and debentures. Companies prefer this method as such deposits are unsecured.
A company can accept public deposits for a period of up to 3 years.

9. Explain the concept of Time Value of Money.

The time value of money (TVM) is the concept that money available at the present time is worth
more than the identical sum in the future due to its potential earning capacity. This core principle
of finance holds that, provided money can earn interest, any amount of money is worth more the
sooner it is received. TVM is also sometimes referred to as present discounted value.

The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money's potential to grow
in value over a given period of time. For example, money deposited into a savings account earns
a certain interest rate and is therefore said to be compounding in value.

As for example, you have the option to choose between receiving $10,000 now versus $10,000 in
two years. It's reasonable to assume most people would choose the first option. Despite the equal
value at time of disbursement, receiving the $10,000 today has more value and utility to the
beneficiary than receiving it in the future due to the opportunity costs associated with the
wait. Such opportunity costs could include the potential gain on interest were that money
received today and held in a savings account for two years.

10. State the limitations of time value of money

The major disadvantage to the time value of money is that it requires some guesswork about the
firm's cost of capital. Assuming a cost of capital that is too low will result in making suboptimal
investments. Assuming a cost of capital that is too high will result in forgoing too many good
investments. As a matter of fact, It is impossible to forecast accurate inflation rates.

In addition, the time value of money is not useful for comparing two projects of different size.
Because the NPV method results in an answer in dollars, the size of the net present value output
3. Explain the concept of ‘’Agency Problem’’.

The agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, the agency problem usually refers
to a conflict of interest between a company's management and the company's stockholders. The
manager, acting as the agent for the shareholders, or principals, is supposed to make decisions
that will maximize shareholder wealth even though it is in the manager’s best interest to
maximize his own wealth.

The agency problem does not exist without a relationship between a principal and an agent. In
this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged
by principals due to different skill levels, different employment positions or restrictions on time
and access. For example, a principal will hire a plumber — the agent — to fix plumbing issues.
Although the plumber‘s best interest is to collect as much income as he can, he is given the
responsibility to perform in whatever situation results in the most benefit to the principal.

1. Discuss the role of Finance.

Finance plays an important role in an economy of a country.The functioning of an economy
depends on the financial system of a country. The financial system includes banks as a central
entity along with other financial services providers. The financial system of a country is deeply
entrenched in the society and provides employment to a large population. According to Baily and
Elliott, there are three major functions of the financial system:

Credit Provision – Credit supports economic activity. Governments can invest in infrastructure
projects by reducing the cycles of tax revenues and correcting spends, businesses can invest
more than the cash they have and individuals can purchase homes and other utilities without
having to save the entire amount in advance. Banks and other financial service providers give
this credit facility to all stakeholders.

Liquidity provision – Banks and other financial providers protect businesses and individuals
against sudden cash needs. Banks provide the facility of demand deposits which the business or
individual can withdraw at any time. Similarly, they provide credit and overdraft facility to
businesses. Moreover, banks and financial institutions offer to buy or sell securities as per need
and often in large volumes to fulfil sudden cash requirements of the stakeholders.

Risk management services – Finance provides risk management from the risks of financial
markets and commodity prices by pooling risks. Derivative transactions enable banks to provide
this risk management. These services are extremely valuable even though they receive a lot of
flak due to excesses during financial crisis.

The above three major functions are important for the running and development activities of any
economy. Apart from these functions, an economy’s growth is boosted by the following
functionalities of finance:

Savings-investment relationship
When there are sufficient savings, only then can there be sizeable investment and production
activity. This savings facility is provided by financial institutions through attractive interest
schemes. The money saved by the public is used by the financial institutions for lending to
businesses at substantial interest rates. These funds allow businesses to increase their production
and distribution activities.

Growth of capital markets

Another important work of finance is to boost growth of capital markets.. The financial system
helps in raising capital in the following ways:

Fixed capital – Businesses issue shares and debentures to raise fixed capital. Financial service
providers, both public and private, invest in these shares and debentures to make profits with
minimal risk.

Working capital – Businesses issue bills, promissory notes etc. to raise short term loans. These
credit instruments are valid in the money markets that exist for this purpose.

Foreign exchange markets

In order to support the export and import businessmen, there are foreign exchange markets
whereby businesses can receive and transmit funds to other countries and in other currencies.
These foreign exchange markets also enable banks and other financial institutions to borrow or
lend sums in other currencies. Moreover, financial institutions can invest and reap profits from
their short term idle money by investing in foreign exchange markets. Governments also meet
their foreign exchange requirements through these markets. Hence, foreign exchange markets
impact the growth and goodwill of an economy in the international markets.

Government securities

Governments use the financial system to raise funds for both short term and long term fund
requirements. Governments issue bonds and bills at attractive interest rates and also provide tax
concessions. Budget gaps are taken care of by government securities. Thus, capital markets,
foreign exchange markets and government securities markets are essential for helping
businesses, industries and governments to carry out development and growth activities of the
economy.

Infrastructure and growth

The economic growth depends on the growth of infrastructural facilities of the country. Key
industries such as power, coal, oil determine the growth of other industries. These infrastructure
industries are funded by the finance system of the country. The capital requirement for
infrastructure industries is huge. Raising such a huge amount is difficult for private players and
hence, traditionally, governments have taken care of infrastructure projects solely. However, the
economic liberalization policy led to the private sector participation in infrastructure industries.
Development and Merchant banks such as IDBI in India help fund these activities for the private
sector.

Trade development

Trade is the most important economic activity. Both, domestic and international trade are
supported by the financial system. Traders need finance which is provided by the financial
institutions. Financial markets on the other hand help discount financial instruments such as
promissory notes and bills. Commercial banks finance international trade through pre and post-
shipment funding. Letters of credit are issued for importers, thereby helping the country to earn
important foreign exchange.

Employment growth

Financial system plays a key role in employment growth in an economy. Businesses and
industries are financed by the financial systems which lead to growth in employment and in turn
increases economic activity and domestic trade. Increase in trade leads to increase in competition
which leads to activities such as sales and marketing which further increases employment in
these sectors.

Venture capital

Increase in venture capital or investment in ventures will boost growth in economy. Currently,
the extent of venture capital in India is less. It is difficult for individual companies to invest in
ventures directly due to the risk involved. It is mostly the financial institutions that fund
ventures. An increase in the number of financial institutions supporting ventures will boost this
segment.

Balances economic growth

The growth of different sectors of an economy is balanced through the financial system. There
are primary, secondary and tertiary sector industries and all need sufficient funds for growth. The
financial system of the country funds these sectors and provides sufficient funds for each sector –
industrial, agricultural and services.

Thus, finance plays a key role in the development of any economy and no economy can run
successfully without a sound financial system.