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Capital Budgeting decisions depend upon 2 basic factors Cash flows of the projects The discount rate The discount rate is the cut-off rate, the minimum required rate of return. It is also called the target rate or the hurdle rate. It is also used to optimize the capital structure or the financial plan of the firm.

It is the cost of raising funds for the investment proposals of the firm.
It is the minimum rate of return a firm must earn so that it can source the necessary funds. If the actual rate of return exceeds the cost of capital, then it makes a net contribution to the wealth of the shareholders, given that there is no increase in risk. So, to increase the value of the firm, the cost of capital must be minimized. Cost of capital is also known as the opportunity cost for the supplier of funds

Factors affecting the cost of capital of a firm Risk free interest rate If Business risk b (EBITs change to sales) Financial risk f (firm unable to pay financial charges) Other considerations (liquidity or marketability of investments) So, cost of capital k = If + b + f

Investors must be compensated for undertaking any additional risk or else they will not supply the required funds. Government securities do not have any risk and so they have the lowest return to the investor. This rate is called the risk free rate of return . The rate of return on private sector bonds is even higher, since the risk is higher. The rate of dividend on preference shares will be higher than bonds since they are riskier than debts. The rate of return expected on equity shares will be highest, since they bear the highest risk

Business risk remains unchanged. Financial risk remains unchanged Implications of taxes Explicit and implicit cost of capital

This requires details about net proceeds, periodic interest payments and maturity payment Bo = FV + Pm D F Bo = net proceeds at the time of issue of debt FV = Face value of debt Pm = Premium charged on the issue D = Discount allowed on the issue F = Floatation costs

The face value of debenture is Rs 100.It is issued at a discount of 5% and the total floatation cost is estimated at 5%, then the net proceeds is Rs 100- Rs 5- Rs 5 = Rs 90. If the debenture is issued at premium of 10% and floatation cost estimated at 5%, then the net proceeds is Rs 100 + Rs 10 Rs 5.50= Rs 104.50 Floatation cost is calculated at face value or the issue price which ever is higher

Cost of perpetual debt Ki = (I/Bo) Ki = cost of debt before tax I = Annual interest Bo = Net proceeds Kd = Ki(1-t) Cost of redeemable debt Kd = I(1-t) + (RV Bo)/N (RV + Bo)/2

ABC Ltd issues 15% debentures of face value of Rs 100 each, redeemable at the end of 7 years. The debentures are issued at a discount of 5% and the floatation cost is at 1%. Find the cost of capital of the debenture assuming a tax rate of 50%.

Cost of irredeemable preference share Kp = (PD/Po) Kp= cost of preference shares PD= Annual preference dividend Po = Net proceeds on issue of preference shares Cost of redeemable preference shares Kp = PD + (Pn Po)/N (Pn + Po)/2

ABC Ltd issues 15% preference shares of the face value of Rs 100 each at a floatation cost of 4%. Find out the cost of preference share if (i) the preference share is irredeemable and (ii) if the preference shares are redeemable after 10 years at a premium of 10%.

Ke = (D1/Po) is the zero growth model Ke = (E1/Po); Ke = 1/(Po/E1). Therefore Ke is the inverse of the PE ratio. Dn = Do(1+g)n is the constant growth model Ke = (D1/Po) + g WACC = Ke * w1 + Kd * w2 + Kp * w3

Historical weights are exiting weights. The weighing system is in proportions in which the funds have been already raised. It is assumed that the exiting capital structure is optimal and the same proportions would be followed. Marginal weights refer to the proportions in which the firm intends to raise additional funds. So WACC is calculated of the incremental funds.

Target weights refers to the proportions in which the firm plans to raise the funds from various sources in the long run. It reflects the desired capital structure of a firm. If a firm already has an optimal capital structure then the historical weights will be equal to the target weights.