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300 Corporate Finance BRILLIANT’S

two friends (at two different costs), add some {_[Z__ [aQ>Z© àmá hmoJm, AnZo Xmo {_Ìm| go AbJ-AbJ
of your own money with the expectation of a aoQ> na Hw$N> YZ CYma boVo h¢ VWm Hw$N> _Zr ñd`§ BÝdoñQ>
least and certain minimum return, and seek H$aVo h¢ Vmo dh {_{Z__ [aQ>Z© Š`m hmoJm Omo g^r H¡${nQ>b
out an investment. What is the minimum re-
turn you can earn that will just satisfy expec- àmodmBS>g© H$s AnojmAm| H$s ny{V© H$a gHo$Ÿ? Bgo {ZåZ{b{IV
tations of all capital providers? (see below) Q>o~b H$s ghm`Vm go g_Pm Om gH$Vm h¡…

Percentage
Capital Invested Annual cost Proportion of Weighted Annual cost
Provider capital (Investor Return) Total Financing cost (Investor Return)
(1) ($) (2) (3) (2) × (3) (1) × (2) ($)
Rishi 2,000 5% 20% 1.0% 100
Neha 3,000 10% 30% 3.0% 300
You 5,000 15% 50% 7.5% 750
$10,000 100% 11.5% $ 1,150

Assume that your ‘firm’ earns a yearly `{X h_ _mZ b| {H$ h_mar "\$_©" Hw$b $10,000 H$s
11.5 percent (the weighted average cost of capi- BÝdoñQ>_|Q> na 11.5% (Omo {H$ bJmB© JB© H¡${nQ>b H$m
tal employed) on the $10,000 of invested capi- doQ>oS> EdaoO h¡) [aQ>Z© A{O©V H$aVr h¡ Vmo $ 1,150 go
tal. The $ 1,150 so provided will just satisfy g^r H¡${nQ>b àmodmBS>g© Ho$ Ano{jV [aQ>Z© H$s ny{V© hmo
the return requirement of all the capital pro-
gHo$JrŸ& `{X h_ Cnamoº$ CXmhaU _| "F${f", "Zohm" Ed§
viders. Now replace ‘Rishi’ ‘Neha’ and ‘You’ "ñd`§" H$mo H«$_e… "S>oãQ>", "{à\$a|g ñQ>m°H$" Ed§ "H$m°_Z
with the term ‘Debt’, ‘Preference Stock’, and ñQ>m°H$" _mZ b| (`Ú{n Q>¡Šg Ho$ à^md H$mo XoIZm ^r
‘Common Stock’ (and yes, we still need to con-
Amdí`H$ h¡ naÝVw A^r `h _mZ b| {H$ Q>¡Šg Zht h¡) Vmo
sider tax implications; but let's assume no taxes
h_| Amdí`H$ {_{Z__ [aQ>Z© H$m AW© {~ëHw$b ñnï> hmo
for the moment). With these new terms in place
you should begin to understand the direction Om`oJmŸ& BZ Z`r Q>åg© H$s ghm`Vm go h_| `h kmV hmo
that will be taken in finding the firm's required gHo$Jm {H$ h_mar Amdí`H$ [aQ>Z© H$s aoQ> AWm©V² H$m°ñQ>
rate of return- the cost of capital- that will just Am°\$ H¡${nQ>c Š`m h¡ Omo H¡${nQ>b àXmZ H$aZo dmcm| Ûmam
satisfy all capital providers. Ano{úmV [aQ>Z© H$s ny{V© H$a gHo$JrŸ&

Significance of the Cost of Capital H¡${nQ>b H$s H$m°ñQ> H$m _hËd
The concept of cost of capital is of vital H¡${nQ>b H$s H$m°ñQ> H$s AdYmaUm H$m \$m`Z|g {S>grOZ
importance in the finance decision-making. It _oqH$J _| AË`ÝV _hËd h¡Ÿ& `h {ZåZ{b{IV CÔoí`m| H$s
is useful as a standard for: àm{ßV _| _hËd aIVm h¡…
1. Investment evaluation: The primary 1. BÝdoñQ>_|Q> H$m _yë`m§H$Z… H¡${nQ>b H$s H$m°ñQ> H$s
purpose of measuring the cost of capital is its JUZm H$m g~go à_wI CÔoí` BÝdoñQ>_|Q> g§~§Yr àñVmdm| H$m
use as a financial standard for evaluating the _yë`m§H$Z H$aZm h¡Ÿ& ZoQ> àoOoÝQ> d¡ë`y _oWS> _|, {H$gr
investment projects. In the NPV method, an
investment project is accepted if it has a posi- àmoOoŠQ> H$mo V^r ñdrH¥$V {H$`m OmVm h¡ O~ ZoQ> àoOoÝQ>
tive NPV. The project's NPV is calculated by d¡ë`y _oWS> nm°[O{Q>d hmoŸ& Bg ZoQ> àoOoÝQ> d¡ë`y _oWS> H$s