Page 305 - Corporate Finance PDF Final new link

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BRILLIANT’S Cost of Capital 305

Overall V/s Specific Cost of Capital AmodaAm°b V/s ñno{g{’$H$ H$m°ñQ> Am°’$ H¡${nQ>b
A firm obtains capital from various EH$ ’$‘© {d{^ÝZ gmog}g go H¡${nQ>b àmßV H$aVr h¡&
sources. Because of the risk difference and the
’$‘© VWm BÝdoñQ>g© Ho$ ~rM [añH$ ‘| A§Va VWm H$m°ÝQ´>o³MwAb
contractual agreements between the firm and
EJ«r‘|Q> Ho$ H$maU à˶oH$ gmog© H¡${nQ>b H$s H$m°ñQ> Am°’$
investors, the cost of capital of each source of
capital is known as specific cost of capital. H¡${nQ>b H$mo ñno{g{’$H$ H$m°ñQ> Am°’$ H¡${nQ>b H$hVo h¢&
Suppose, a firm has estimated the cost of ‘mZ br{OE EH$ ’$‘© {H$gr n{Q>©Hw$ba df© ‘| H$m°ñQ>
equity as 11% and cost of debt as 6% in a Am°’$ H¡${nQ>b H$mo 11% VWm H$m°ñQ> Am°’$ S>oãQ> H$mo 6%
particular year. In the beginning of the year,
the firm considers Project A which has an na EpñQ>‘oQ> H$aVr h¡& df© Ho$ àma§^ ‘| ’$‘© àmoOo³Q> A ‘|
expected rate of return 10% and can be financed BÝdoñQ> H$aVr h¡ {OgH$m Ano{jV aoQ> Am°’$ [aQ>Z© 10% h¡
by debt. If the component cost of capital is used VWm {Ogo S>oãQ> Ûmam ’$m¶Z|g {H$¶m Om gH$Vm h¡& ¶{X
to evaluate Project A, the firm will accept it àmoOo³Q> Ho$ ‘yë¶m§H$Z Ho$ {bE H¡${nQ>b H$s H$ånmoZ|Q> H$m°ñQ>
since its IRR (10%) is greater than the
component cost (6%). After sometime, the H$m Cn¶moJ {H$¶m OmVm h¡ My§{H$ BgH$m IRR (10 %) H$ånmoZ|Q>
company considers Project B which has same H$m°ñQ> (6%) go A{YH$ hmoVm h¡ Bg{bE ’$‘© Cgo ñdrH$ma
risk as Project A and also has an expected rate H$aoJr& Hw$N> g‘¶ Ho$ ~mX ’$‘© àmoOo³Q> B ‘| BÝdoñQ> H$aVr
of return of 10%. The firm finds that no h¡ {OgH$s [añH$ ^r àmoOo³Q> A Ho$ g‘mZ h¡ VWm 10%
borrowings are available and it will have to
raise equity funds to finance project B. Using Ano{jV aoQ> Am°’$ [aQ>Z© h¡& G$U CnbãY Zht hmoZo Ho$
the component cost of capital as the cut-off rate, H$maU ’$‘© àmoOo³Q> B H$mo ’$m¶Z|g H$aZo Ho$ {bE Bp³dQ>r
the firm rejects another simply because it ’$ÊS> bJm¶oJr& H$Q>-Am°’$ aoQ> Ho$ ê$n ‘| H$ånmoZoÝQ> H$m°ñQ>
associates the method of financing with the
investment projects. What is wrong with this Am°’$ H¡${nQ>b H$m Cn¶moJ H$aZo go ’$‘© Xÿgao H$mo AmgmZr
policy? It fails to consider the relationship go [aOo³Q> H$aoJr ³¶m|{H$ ¶h BÝdoñQ>‘|Q> àmoOo³Q> ‘| ’$m¶Z|g
between component cost. The various source H$aZo H$s ‘oWS> go Ow‹S>m hmoVm h¡& Bg nm°{bgr ‘| JbV ³¶m
of capital are related to each other. The firm's
h¡? ¶h H$ånmoZ|Q> H$m°ñQ> Ho$ gmW [aboeZ{en H$mo H$pÝgS>a
decision to use debt in a given period reduces
its future debt capacity as well as increases risk H$aZo ‘| Ag’$b ahVr h¡& H¡${nQ>b Ho$ {d{^ÝZ gmog© EH$-
of shareholders. The shareholders will require Xÿgao go Ow‹S>o hmoVo h¢& EH$ hr g‘¶ ‘| S>oãQ> H$m Cn¶moJ H$aZo
a higher rate of return to compensate for the H$m ’$‘© Ho$ {S>grOZ go CgH$s â¶yMa S>oãQ> H¡$no{gQ>r KQ>oJr
borrowing in the future. Over the long-run, the VWm eo¶ahmoëS>g© H$s [añH$ ~‹T>oJr& bå~r Ad[Y ‘| H¡${nQ>b
firm would maintain a balance between debt
and equity. The mix of debt and equity is called ñQ´>³Ma H$mo ~¡boÝg H$aZo ¶m Q>maJoQ> H$aZo H$s ’$‘© H$s
the firm's desire to have a balanced or target BÀN>m H$mo S>oãQ> VWm Bp³dQ>r H$m {‘³g na AmYm[aV hmoVr
capital structure in the long-run, it is generally h¡& AmodaAm°b goÝg ‘| gm‘mݶV: H$m°ñQ> Am°’$ H¡${nQ>b H$mo
agreed that the cost of capital should be used
in the composite, overall sense i.e. in terms of gpå‘{bV {H$¶m OmZm Mm{hE& AWm©V² Bgo doQ>oS> EdaoO
the weighted average cost of capital. H$m°ñQ> Am°’$ H¡${nQ>b H$hm OmVm h¡&
Risk and Cost of Capital [añH$ VWm H$m°ñQ> Am°’$ H¡${nQ>b
If an investor is purchasing a security ¶{X BÝdoñQ>a EH$ Eogr {g³¶y[aQ>r H$mo nM}g H$aVm
where the risk of the investment is significant, h¡ {Og‘| BÝdoñQ>‘|Q> H$s [añH$ {gp½Z{’$Ho$ÝQ> hmo, Vmo