Page 303 - Corporate Finance PDF Final new link

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BRILLIANT’S Cost of Capital 303

the owner as well as manager of a firm. He boVm h¡ VWm BÝdoñQ>‘|Q> àmoOo³Q> Ho$ {bE ’$ÊS²>g ^r gßbm¶
makes investment decision and also supplies H$aVm h¡ Vmo dh BÝdoñQ>‘|Q> àmoOo³Q> Ho$ ‘yë¶m§H$Z Ho$ {bE
funds to finance the investment projects. He AnZo {bE Oê$ar [aQ>Z© H$s aoQ> H$m Cn¶moJ H$aoJm& CgH$m
will use his required rate of return to evaluate
the investment project. His required rate of Oê$ar aoQ> Am°’$ [aQ>Z© ’$‘© Ho$ ~mha CgHo$ {bE CnbãY
return will depend on investment oppor- Bp³ddoboÝQ> [añH$ H$s BÝdoñQ>‘|Q> Am°ßÀ¶y©{ZQ>r na {Z^©a
tunities of equivalent risk outside the firm, hmoJm& A~ ‘mZ br{OE dh AnZo {~OZog H$mo ‘¡ZoO H$aZo Ho$
available to him. Now suppose, he appoints a {bE EH$ ‘¡ZoOa {Z¶w³V H$aVm h¡ Vmo dh ^r BÝdoñQ>‘|Q>
manager to manage his business. He is also {S>grOZ Ho$ {bE {Oå‘oXma hmoJm& ‘¡ZoOa H$mo {H$gH$s
responsible for investment decisions. Whose Am°ßÀ¶y©{ZQ>r H$m°ñQ> H$m Cn¶moJ H$aZm Mm{hE? My§{H$ dh ’$‘©
opportunity cost should the manager use?
Since, he is the supplier of funds to the firm and Ho$ {bE ’$ÊS²>g H$m gßbm¶a hmoVm h¡ VWm CgH$s Amoa go
the manager is acting on his behalf, he will ask ‘¡ZoOa H$m¶© H$aVm h¡ AV: Cgo AnZr [a³dm¶S>© aoQ> Am°’$
to use his required rate of return. [aQ>Z© ~VmZr hmoJr&
Suppose, he converts his firm into a ‘mZ br{OE ¶{X dh AnZr ’$‘© H$mo EH$ H$ånZr Ho$
company where capital is contributed by other ê$n ‘| ~Xb XoVm h¡ Ohm§ ny§Or Aݶ eo¶a hmoëS>g© Ûmam ^r
shareholders also. The firm is now owned by H$m°ÝQ´>rã¶yQ> H$s OmVr h¡& ’$‘© H$m ñdm{‘Ëd A~ ~hþV go
many shareholders. The manager should
eo¶ahmoëS>g© Ho$ nmg hmoVm h¡& ‘¡ZoOa H$mo BÝdoñQ>‘|Q> {S>grOÝg
consider the shareholders required rate of Ho$ ‘yë¶m§H$Z Ho$ Xm¡amZ eo¶ahmoëS>g© Ho$ [a³dm¶S>© aoQ> Am°’$
return in evaluating the investment decisions.
[aQ>Z© H$mo ܶmZ ‘o§ aIZm Mm{hE& ¶{X ‘¡ZoOa [a³dm¶S>© aoQ>
If the manager is unable to earn the required
rate of return, they will have rights to ask for Am°’$ [aQ>Z© AZ© (A{O©V) Zht H$a nmVm h¡ Vmo CÝh| ‘¡ZoOg©
go CZHo$ ’$ÊS> H$mo [aQ>Z© H$aZo H$s ‘m§J H$aZo H$m A{YH$ma
returning their funds. Thus, management acts
hmoVm h¡& Bg àH$ma ‘¡ZoO‘|Q> eo¶ahmoëS>g© Ho$ EH$ EOoÝQ> H$s
as an agent of shareholders. It should evaluate
investment opportunity cost on the basis of the Vah H$m¶© H$aVm h¡& ‘¡ZoO‘|Q> H$mo eo¶ahmoëS>g© Ho$ {bE
rate, which the shareholders would use if they BÝdoñQ>‘|Q> Am°ßÀ¶y©{ZQ>r H$m°ñQ> H$m ‘yë¶m§H$Z Cg aoQ> na
were themselves appraising the investment H$aZm Mm{hE {Og na eo¶ahmoëS>g© ñd¶§ H$aVo ¶{X dh
opportunities. BÝdoñQ>‘|Q> {S>grOZ H$mo ‘¡ZoO H$aVo h¡&
Creditor's Claim: A firm's investment H«o${S>Q>a H$m ³bo‘: ’$‘© Ho$ BÝdoñQ>‘|Q> àmoOo³Q> H$mo
projects are financed by funds supplied by eo¶ahmoëS>g© Bp³dQ>r VWm {à’$aoÝg Ed§ H«o${S>Q>g© Ûmam
shareholders-equity and preference and gßbm¶ {H$E OmZo dmbo ’$ÊS²>g go ’$m¶ZoÝñS> {H$¶m OmVm
creditors. Creditors have priority claim over h¡& H«o${S>Q>g© H$mo ’$‘© Ho$ AgoQ²>g VWm H¡$e âbmo na ³bo‘
the firm's assets and cash flows. The firm is
H$aZo H$mo àm¶mo[aQ>r hmoVr h¡& ’$‘© BÝQ>aoñQ> VWm [aQ>Z©
under a legal obligation to pay interest and qà{gnb Ho$ ^wJVmZ Ho$ {bE brJbr ~mܶ hmoVr h¡& S>oãQ>
return principal. Debt holders are exposed to
the risk of default. Since, the firm's cash flows hmoëS>g© {S>’$m°ëQ> H$s [añH$ na {Z^©a Zht hmoVo h¡& My§{H$,
are uncertain, there is a probability that it may ’$‘© H$m H¡$e âbmo A{ZpíMV hmoVm h¡, BgH$s g§^mdZm
default in its obligation to pay interest and hmoVr h¡ {H$ ’$‘© BÝQ>aoñQ> VWm qà{gnb H$m ^wJVmZ H$aZo
principal. ‘| {S>’$m°ëQ> hmo gH$Vr h¡&
Preference shareholders hold claim prior {à’$aoÝg eo¶ahmoëS>g© gm‘mݶ eo¶ahmoëS>g© go nhbo
to ordinary shareholders but after debt holders. bo{H$Z S>oãQ> hmoëS>g© Ho$ ~mX ³bo‘ H$aVm h¡& {à’$aoÝg