Cost Of Capital, Concept Of Wealth Maximisation, Long Term Vs Short Term Finance, Capital Structure
Cost of capital:
According to I M Pandy, Cost of capital is the discount rate used in evaluating the desirability of the investment project. The cost of capital is the minimum rate of return which will maintain the market value per share at its current. If the firm earns more than the cost of capital, the market value per share is expected to increase.
Importance of cost of capital:
- Capital budgeting decision: The cost of capital is used for discounting cash flows under net present value method for investment purpose.
- To decided the capital structure of the firm.
- Evaluation of financial performance of top management. The actual profitability is compared with the actual cost of capital of funds and if profit is greater than the cost of capital the performance may said to be satisfactory.
- Cost of capital is also used in the making other financial decision related to dividend payment, capitalisation of profit and making the rights issue.
Concept of wealth maximisation:
The primary aim of financial management is to maximise shareholder wealth , which is referred to as wealth maximisation concept. In all decision whether financial, investment or dividend value addition should be there or increase in the price of equity share . It can be achieved by an efficient decision making.
Decision taken at following level for wealth maximisation:
- Investment decision
- Financing decision
- Dividend decision
Objective of wealth maximisation:
- Maximising shareholders utility.
- Increasing the market value of shares.
- It takes care of the quality of cash flow.
- The risk that are associated with cash flows are adequately reflected when present values are taken to arrive at the net present value of any project.
Difference between long term finance and short term finance.
| Short term finance | Long term finance |
| Time period:One year or less | Greater than 3 to 5 years |
| Funds raised are less costly as flotation cost is less | Funds raised are costly as flotation cost is high.
|
| Flexibility is more | Flexibility is less |
| Less restrictive as less provisions or covenants attached with it are less | More restrictive |
| May not require collateral or security | Specific assets as collateral or security |
| More riskier as interest rates are volatile and temporary recession may render to non payment of debt and may lead to bankruptcy | Interest rate are stable , temporary recession do not affect it much. |
| Used for financing upkeep of fixed assets and working capital | Can be used for finance 0any type of assets like fixed or current. |
| Companies can raised limited amount of money using this provision | Can raised large amount of money |
Capital structure :
Capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised.Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business.
Importance of capital structure:
- A sound capital structure helps to increase the market value of the firm.
- Helps is better utilisation of available funds.
- Maximisation of return.
- Helps to achieve minimisation of cost of capital.
- Helps to maintain healthy solvency or liquidity position.
Expected questions:
- Concept of wealth maximisation
- Objective of wealth maximisation
- Cost of capital define
- Importance of cost of capital
- Differentiate between long term finance and short term finance.
- Definition of capital structure.
- Importance of capital structure.
