Contribution margin is the excess of sales revenue over variable costs. Thus, contribution margin is the balance of the sales revenue left after recovering variable expenses and thus is available to recover fixed expenses and to realize profits for the period. Therefore contribution margin is used first to cover the fixed expenses, and then whatever remains after the fixed expenses recovery goes towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period.

Contribution Margin = Net Sales Revenue - Variable Costs
Total contribution margin is the total sales revenue less total variable costs. It is called contribution margin because whatever is left after covering the variable costs contributes to pay for fixed costs and to earn profit. If the contribution margin is not sufficient to cover the fixed costs, then the firm suffers from a loss.
Contribution margin per unit (CMPU) is the selling price per unit less(SPPU) less variable costs per unit(VCPU) Therefore, CMPU= SPPU- VCPU Related Topics Meaning Of Cost Volume Profit Analysis Concept Of Contribution Margin Ratio Concept Of Break Even Analysis And Break Even Ratio

Meaning Of Cost-Volume-Profit Analysis(CVP Analysis)

Every firm has a prime motive of not only earning profit but also maximizing it. A profit does not happen by chance. It has to be managed. Cost-volume-profit analysis (CVP Analysis) is a tool of planning for profit. CVP analysis is helpful for developing alternative strategies in sales planning and cost estimation. Certain relationship exists among the variables like selling price, sales volume and taxes. Cost-volu-profit analysis (CVP analysis) is an accounting technique showing the relationship among these variables. CVP analysis, though most often illustrates business cases, is equally applicable for not profit making organizations to allocate scarce economic resources most effectively among the competing alternatives. Allocation of scarce resources among the various demanding sectors is the most important issue of national planning. CVP analysis is the analysis of the relationship between cost and volume of activities and the effect of the relationship on profit. Managers can use the concept of cost-volume-profit analysis to forecast volume of activity at which the firm will break-even or attain target profits. CVP analysis is therefore, a useful tool that helps managers, business owners and entrepreneurs to determine the profit potential of a new firm or the impact on profit due to changes in selling price, cost or level of activities of current business.

Costs-Volume Relationship

Costs show important behavior in relation to the volume of activity such as:
* Total variable costs change in the same proportion and in the same direction as the volume by output change.
* Per unit variable costs remain fixed.
* Total fixed costs remain unchanged for the same period of time whatever is the level of output within the relevant range.
* Per unit fixed costs are variable.

Stage I
In the first stage, major activities of a form for manufacturing finished products are required to be noted. Like material procurements, material handling, production runs, customers' order execution etc. needed by every product line.
Following are the few examples of the activities:

* Material procurement
* Customers' order execution
* Inspections
* Production scheduling
* Employee's related activity
* Material handling
* Dispatch of goods
* Machine operation
* Production runs
* Set-ups

Stage II
In the second stage, cost indicators, also called cost drivers, influence overheads needed to be listed in accordance with the major activities required by products. Nature of activity or transaction decides a suitable cost driver
Activity-based costing system uses an appropriate cost driver that differs with the nature of activities that create costs. A few examples of the activities and appropriate cost drivers are stated below:

Activities or transactions...............Cost drivers
Material procurement.................................Number of materials procured
Material handling.........................................Quantity of input material
Customers' order execution........................Number of orders executed
Dispatch of goods..........................................Number of dispatches
Inspections.....................................................Number of inspections
Machine operation.........................................Machine hours
Production scheduling...................................Number of production scheduling
Production runs..............................................Number of production run
Employees' related activity...........................Number of employees
Set-ups.............................................................Number of set-ups

Stage III
Analysis and collection of cost incurred for each cost pool are essential for determining driver rate. A cost pool is like a center.

illustration:
If inspection cost is $ 140,000 for assembling 100 ordinary and 100 automatic cameras. If one ordinary camera needs 2 inspections and one automatic camera needs 5 inspection, then find the inspection cost per inspection.

Solution,
Calculation of number of inspection:
Number of inspections of ordinary cameras = 100 cameras x 2 = 200
Number of inspections of automatic camera = 100 cameras x 5 = 500
Therefore, total number of inspections = 200+500 = 700

Now, inspection cost per inspection = total inspection costs/No. of inspections
= $ 140000/700 inspections = $ 200 per inspection.

Stage IV Trace or allocate the cost of the activities or operations to the final products.
Trace refers to the distribution of overheads to different product lines produced by using a cost driver rate. Overheads are recovered by different product lines based on the number of the activities required by each product by using a driver rate. Tracing refers to the recovery of inspection cost by the product lines by using relevant cost driver.

In the above illustration, $ 100000 and $ 40000 shared by automatic and ordinary cameras respectively i.e the ordinary camera required 200 inspection at the rate of $ 200 per inspection and automatic cameras required 500 inspection at the rate of $200 per inspection.
Thus, overheads are assigned to prevailing products lines by recognizing the relevant cost drivers for ascertaining product cost under activity-based costing.

1. Product cost determination under activity-based costing is more accurate and reliable because it focuses on the cause and effect linkage of costs and activities in the context of producing goods.

2. Fixation of selling price for multi-products under activity-based costing is fair and correct because overheads are allocated on the basis of relevant cost drivers.

3. Control of overheads consisting of fixed and variable becomes possible by controlling and monitoring activities. Linkage between cost and activities are clearly identified in activity-based costing and thus provides opportunities to control overhead costs.

4. Sufficient information can be obtained to make decisions about the profitability of different product lines.

5. Fair allocation of overheads occupy a considerable portion in the total cost components.

Disadvantages Or Limitations Of Activity-Based Costing(ABC)

1. Difficult to identify the overall activities that influence costs.

2. Not easy to select the most suitable cost drive.

3. Difficult to evaluate cost on the basis of activities.

The traditional system of costing suffers from certain limitations. It fails to precisely assign the overhead costs into product units. Therefore activity-based costing system has recently been developed to overcome the limitations of traditional costing system. The activity costing system is based on premise that activities make a product.

Activity- based costing (ABC) is the determination of product cost based on the activity needed for producing a product. The activities required to produce a product or render service consume a cost. Therefore, an insight into the expenses consumed by all those activities performed for the manufacturing of finished products and sale is very important. A number of researched studies have shown the increasing utility of activity-based costing on overheads allocation and apportionment for product cost determination.

Product cost determination under activity-based costing is made on the basis of cost driver required for producing goods or delivering services. Activity-based costing is becoming more effective in costing of multi-products produced by industries and executing customers' orders.
Activity-based costing (ABC) is an effective management approach for distributing and controlling the overhead costs. Overhead analysis can be made more accurate by using ABC techniques for a wide range of products, for product costing and profitability analysis and for distribution and control of the overheads appropriately.

The IRR is used when the cost of the investment and the annual cash flows are known and the unknown rate of earnings to be determined.The IRR is described as that rate which equates the present value of the future cash flows with the cost of the investment which produce them. IRR method is also called yield on investments, marginal efficiency of capital, time adjusted rate of return, rate of return and so on.

The IRR is the discounted rate that equals the aggregate present value of CFAT (cash flow after tax) with the aggregate present value of cash outflows required for a new investment. The project will be accepted only if IRR is higher than cost of capital.

Advantages Of IRR

1. IRR method considers the time value of money.

2. IRR method discloses the maximum rate of return the project can give.

3. IRR method considers and analysis all cash flows of entire project.

4. IRR method ascertains the exact rate of return the project earns.

Disadvantages Of IRR

1. IRR method is difficult to understand, complications due to trial and error method.

2. The important drawback of IRR is that it recognizes the cash inflows generated by project is reinvested to internal rate of project, but NPV recognizes such cash inflows are reinvested to cost of capital of the organization.

3. Single discount rate ignores the varying future interpret rate.

Calculation Of IRR

For even case

First, find out factor

Factor = Net Cash Outlay(NCO)/Cash flow after tax(CFAT)

Factor is also known as payback period.

After finding out the factor, locate the factor in the line of annuity table at given year from row side, if the factor lies exactly in any percentage then that percentage is known as IRR.If the factor does not lie exactly then take two percentage corresponding one higher and another lower and interpolate it.

By interpolation,

IRR= LR + (Factor at LR- Required rate)/(Factor at LR- Factor at HR) x (HR-LR)

where, LR = lower rate and HR = higher rate.

For uneven case

First find out factor

Factor = NCO/Average CFAT

where, average CFAT= Total sum of CFAT/Total life of the project

After finding the factor, locate the factor in the line of annuity table at given year from row side, if the factor lies exactly in any percentage then that percentage is known as IRR. If the factor does not lie exactly then take two percentages corresponding one higher and another lower and interpolate it.

By interpolation,

IRR= LR +(TPV at LR - NCO)/(TPV at LR- TPV at HR)x (HR-LR)

Note: For even case one TPV must be higher than NCO whereas another should be lower than NCO.

Decision Rules Of IRR

If projects are independent

* Accept the project which has higher IRR than cost of capital(IRR> k).

* Reject the project which has lower IRR than cost of capital(IRR

If projects are mutually exclusive

* Accept the project which has higher IRR

* Reject other projects

For the acceptance of the project, IRR must be greater than cost of capital. Higher IRR is accepted among different alternatives.

Concept And Meaning Of Profitability Index (PI)
The profitability index is known as benefit cost ratio. PI is similar to the NPV approach. The profitability index approach measures the present value of return per dollar invested, while the NPV is based on the difference between the present value of the future cash inflow and present value of cash outlay. PI is calculated by dividing the present value of future cash inflow by present value of cash outlay.

Profitability Index (PI) = Total present value/Net cash outlay

Calculation Of Profitability Index (PI)

Illustration
The cash flow of two projects are as under:
Years.......................0................1...................2......................3...................4
Project A..........-25000..........8000..........8000................8000............8000
Project B..........-25000..........10000........11000...............8000............5000
The cost of capital is 10%
Required:
Calculate PI Of each project Solution, Project A.
Total present value = Annual cash flow x 10% annuity factor = 8000 x 3.170 = $ 25,360
Profitability Index (PI) = TPV/NCO = 25,360/25,000 = 1.01

Profitability Index (PI) = TPV/NCO = 27599/25000 = 1.10

Decision Rules Of Profitability Index(PI) A. If projects are independent
Accept the project when PI is higher than 1.
Reject the project when PI is less than 1. B. If projects are mutually exclusive
Accept the project which has higher PI.(PI must be greater than one)
Reject other project.

In above calculation, project B should be selected because it has higher PI.

Net Present Value (NPV)
Net present value (NPV) is a discounted technique, which considers the time value of money. NPV consider different period cash flow value differ in their values. So, estimated cash flow must be converted into present value. It can be defined as the difference between total present value and net cash outlay. It is determined as following.

Net present value (NPV) - Total present value - Net cash outlay

Calculation Of Net Present Value (NPV) Illustration,
Suppose,
The net investment = $ 50,000
Cash flow per year = $ 16,000
Period(No. of years)= 5 years
minimum required rate of return = 10% Required:Net present value (NPV)

Solution,
Net present value (NPV) = Total present value - Net investment
= (16000 x 3.972) - 50000 = $ 10,656

Decision Rules Of Net Present Value A. If projects are independent
Accept the project with positive NPV.
Reject the project with negative NPV.

B. If projects are mutually exclusive
Accept the project with high NPV.
Reject other projects.

Concept And Meaning Of Accounting Rate Of Return (ARR)

Accounting rate of return (ARR) is also known as average rate of return. ARR is based upon accounting information rather than on cash flow. In other words, Accounting rate of return (ARR) refers to the rate of earning or rate of net profit after tax on investment.
ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book income is divided by the average book investment in the project.

ARR = (Average net income/Average investment) x 100
Where,
Average net income= Total net income/No. of years
Average investment= Net investment/2

Calculation Of Accounting Rate Of Return (ARR)
Illustration:
The initial investment of the project is $30,000. The net profit after tax is as follows:
Year............................Net profit after tax($)
1....................................25000
2....................................30000
3.....................................20000
4......................................25000
5......................................40000

Required: Accounting rate of return. Solution
Calculation of ARR:
ARR = (Average net income/Average investment) x 100
= (28000/15000) x 100 = 18.67%.
Where,
Average net income = Total net income/No, of years
= 25000+30000+20000+25000+40000/5 = 28000
Average Investment = Net investment/2 = 30000/2 = 15000

Decision Rules Of Accounting Rate Of Return (ARR)

A. If projects are independent
Accept the project which has higher ARR than standard.
Reject the project which has lower ARR than standard. B. If projects are mutually exclusive
Accept the project which has highest ARR
Reject other projects.

Concept And Meaning Of Pay Back Period (PBP)
The pay back period is the traditional method of evaluating investment proposals under capital budgeting. It is the simplest and perhaps the most widely employed quantitative method for appraising capital expenditure decisions. It is also called payout or pay off period. It calculates the period of return back of investment. Pay back period is the time period required to recover the investment made in a project. Thus, PBP measures the number of years to pay back the original outlay from cash inflows generated by an investment proposal.

Calculation Of Pay Back Period (PBP) There are two ways of calculating PBP:

1. Even Cash Flow
Even cash flow is also known as equal amount of cash flow during the life period of project. The following formula is use to calculate PBP if cash flow is equal: PBP = Investment/Constant annual cash flow after tax(CFAT)

2. Uneven Cash Flow
If the amount of cash flow are different, it is known as uneven cash flow. In such a situation, PBP is calculated by process of cumulating cash flow still the time when cumulative cash flow become equal to the original investment outlay. The following formula is used to calculate PBP when cash flow is not equal: PBP = Minimum year + Amount to be recovered investment/CFAT of next year.

Decision Rules Of Pay Back Period (PBP)

A. If projects are independent:
Accept the project whose pay back period is less than the life or standard pay back period.
Reject the project whose pay back period is more than the life or standard pay back period.

B. If projects are mutually exclusive:
Accept the project with lowest pay back period.
Reject other projects.

Capital budgeting is making long-run planning decisions for investment in project. Evaluation techniques of capital budgeting can be classified into two categories.

1. Traditional Methods
2. Discounted Cash Flow Methods

1. Traditional Method
Traditional method does not consider the time value of money. It assumes that present value is equal to future value. Traditional method is also known as on discounted or unsophisticated method. There are two methods of evaluation:
i) Pay Back Period (PBP)
ii) Accounting Rate Of Return (ARR).

2. Discounted Cash Flow Method
Discounted cash flow method is based on the concept of the time value of money. It is more practicable concept of decision making. The discounted cash flow method assumes that present value of any amount is not equal to future value. The present value is much more worth than future value. So, before evaluating any project, first of all the estimated cash flows must be converted into present value. To convert into present value from the future value is known as discounted value. On the basis of discounted value, it makes decision. So, it is known as discounted cash flow method. The following methods are used under discounted cash flow method:
i) Net Present Value (NPV)
ii) Profitability Index (PI)
iii) Internal Rate Of Return (IRR)

Cash flow indicates a cash outflow and cash inflows. It is necessary to estimate the cash flow in the process of analyzing investment proposal. While analyzing the cash flow, it is also necessary to estimate the cash outflow as well as cash inflow. Estimation of the net cash flow in an investment project should cover the following procedures:

Step 1: Determination Of Net Investment or Net Cash Outlay Or Initial Cash Outlay.

Initial investment or start-up costs are net cash outflows at present cost. It refers to the sum of all cash outflows and cash inflows occurring at zero time periods. Net investment refers to the amount of which will be required for the acquisition of fixed assets. Thus initial investment of a new fixed assets or project comprises cost, freight, installation charges, custom duty etc.

Determination of net investment in replacement case is different than investment of new proposal. The following factors also effect on the determination of net investment of a replacement proposal. The various factors are as follows:

Salvage Value

Salvage value means the value which is estimated to be realized on account of the sales of assets at the end of its useful life. To calculate the amount of depreciation, it is deducted from the cost of assets. Salvage value is also known as residual value.

Salvage value can be divided as follows:

i. Book Salvage value: Remaining value of the fixed assets after charging depreciation is known as book salvage value. It is determined as follows:

Book salvage value = Cost of assets - Accumulated depreciation

ii Cash Salvage Value: Actual sales value of remaining assets is known as cash salvage value. The book salvage value may be equal or more or less than cash salvage value. The existing asset's cash salvage value effect the net investment when an asset is replaced.

Tax Adjustment

When cash and book salvage value of asset is differentiate in this situation we have to adjust the tax. Cash salvage value affects on an estimation of initial cash outlay.

i. If book salvage value is equal to cash salvage value:

If existent assets are sold at their book value there is no tax adjustment because tax is adjusted in profit or loss.

ii. If cash salvage value is more than book salvage value but less than original cost:

When company sells fixed assets more than book salvage value less than original cost this more value is known as normal gain. In normal gain company has to pay tax. For example, the assets which is purchased at $ 500,000 five years before. The book value today is $ 250,000 and cash salvage value today is $ 300,000. In this case, the profit will be $ 50,000, which is known as normal gain. If there is the provision of 40% normal tax $ 20,000 ( 40% of $ 50,000) must be paid as tax.

If the company desired to purchased the new assets of $ 600,000, the net investment can be determined as follows:

Purchase price of new assets.....................................= - 600,000

Cash salvage value of old assets................................= + 300,000

Note: cash outflow is indicated my minus(-) and cash inflow is indicated by plus (+).

iii. If cash salvage value is more than book salvage value as well as original value:

The difference between cash salvage value and original value of assets is known as capital gain and different between original value and book value is known as normal gain. It should be cleared as follows:

Normal gain = Original value - Book salvage value

Capital gain = Cash salvage value - Original value

Both capital and normal gain have to pay tax but capital gain tax may be low than normal gain tax. For example,

Original value of assets = $ 300,000

Book salvage value of assets = $ 200,000

Cash salvage value of assets = $ 330,000

Then, capital gain = cash salvage value - original value = 330,000 - 300,000 = $ 30,000.

Normal gain = Original value - Book salvage value = 300,000 - 200,000 = $ 100,000.

Let capital gain tax rate 25% and normal tax rate is 40% in that case tax paid will be:

Normal tax(40% of 100,000) = $ 40,000

Capital gain tax (25% of $ 30,000) = $ 7,500

If company desired to purchase the new assets of $ 600,000, the new investment can be determined as follows:

Purchase price of new assets ...................= -600,000

cash salvage value of old assets..............= + 330,000

Tax paid on capital gain.............................= -7,500

Tax paid on normal gain..........................= -40,000

Net investment........................................= -317,500

iv. If cash salvage value is less than book salvage value:

Sometimes company sells fixed assets less than book salvage value. Company suffer from loss. In this situation, it can save tax. In other words, when company faces loss, the tax need not to be paid. As a result, the taxable amount comes to be surplus at a certain percentage. For example:

Book salvage value of assets = $ 300,000

Cash salvage value of assets = $ 250,000

Loss = 300,000- 250,000 = $ 50,000

Tax saving:

Let tax rate = 40%

Tax saving = 40% of $ 50,000 = $ 20,000.

If the company desired to purchase the new assets of $ 600,000, the new investment can be determined as follows:

Purchase price of new assets ...............= - 600,000

Cash salvage value of old assets..........= + 250,000

Tax save on loss on sale of assets........= + 20,000

New investment.....................................= -330,000

Working Capital

Working capital may be defined as the funds required within a business for supporting day to day business activities. Working capital may increase in case of new proposal. These increases working capital increase cash outflow. Some times working capital may decrease and these decrease working capital increase cash inflow. In other words, reduction refer

s to the returning investing, It should be cleared as follows:

Increase in working capital = cash outflow(-)

Decrease in working capital = cash inflow (+)

Investment Tax Credit

In order to encourage the industry, sometime government may provide facilities of tax credit. It reduces initial cash outlay. There are many methods of determining the investment tax credit allowance, however, following method is considered more appropriate:

Investment tax credit = Original cost of assets X ITC rate/100

Where, ITC = Investment tax credit.

On the basis of the above noted points, the net cash outlay of the replacement proposal can be estimated. To estimate the net cash outlay or net investment

Net cash outlay..........................................................(-) XXX

Step 2: Determination of annual net cash inflow or cash inflow after tax:

It is second step of capital budgeting which is determined after the determination of net cash outflow of investment proposal. In this step, net cash inflow is determined during the life of the project. It is called net cash inflow or cash flow after tax. It is determined on the basis of accounting for cash flow concept. To determine the net cash inflow, interest amount is not included. To determine net cash flow following table is taken:

Step 3: Determination of net cash inflow for the final year:

Final year net cash flow may be different due to course of working capital and salvage value of assets. If working capital is invested in initial stage, less in net cash outflow and plus in final year net cash inflow. it is called release of working capital. If working capital is reduced in initial year, Plus in net cash outflow and less is final year net cash inflow. Similarly, final year net cash inflow is affected by salvage value of assets. If salvage value of assets is not given, CFAT is effected only by working capital. The tax is adjusted on profit or loss on sales of assets. To determine the final year's CFAT following table is taken:

The extent to which the capital budgeting process needs to be formalized and systematic procedures established depends on the size of the organization, number of projects to be considered, direct financial benefit of each project considered by itself, the composition of the firm's existing assets and management's desire to change that composition, timing of expenditures associated with the that are finally accepted.

1. Planning
The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm's fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.

2. Evaluation
This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple pay back method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.

3. Selection
Considering the returns and risk associated with the individual project as well as the cost of capital to the organization, the organization will choose among projects so as to maximize shareholders wealth.

4. Implementation
When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.

5. Control
The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.

6. Review
When a project terminates, or even before, the organization should review the entire project to explain its success or failure. This phase may have implication for forms planning and evaluation procedures. Further, the review may produce ideas for new proposal to be undertaken in the future.

In brief, capital budgeting processes include:
A. Estimation of initial investment
B. Estimation of cash inflows
C. Evaluation of projects
D. Selection of projects

1. Mutually Exclusive Project
The project, under which the selection of any project eliminates the possibility of selecting another project, is called mutually exclusive project. For example, if project X, Y and Z are mutually exclusive and suppose a firm selects project Y. The selection project Y means that projects X and Z are automatically rejected. All replacement projects(replacement of existing project by purchasing new project) are mutually exclusive.

2. Mutually Related Projects
The project under which the selection of any project does not affect the possibility of selecting another project is called mutually related or independent projects. Independent projects are evaluated on the basis of cost and benefit of the related project rather than comparing with other projects.

3. New Project
The investment in a new alternative is called new project. The establishment of a new sugar factory is an example of new project.

4. Replacement Projects
The projects in which the existing assets are replaced by new assets are known as replacement projects. Generally, manual based and outdated projects are replaced by new and automatic assets. Such projects help to increase the efficiency and reduction cost. The replacement of manual machine by automatic machine is an example of replacement project.

5. Expansion Projects
When the capacity of existing project is expanded for the purpose of increasing the revenue generating capacity, such project is called expansion project. In other words, it refers to increasing the present capacity of a project according to the demand of the product.

6. Diversification Projects
Diversification projects are those projects where investment is made in such alternative which is not identical with existing project. Investment in pharmaceutical sector by computer manufacturer is an example of diversification project. The purpose of such project is to minimize the risk.

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of the firm. The need and importance of capital budgeting has been explained as follows:

1. Long-term Implication
Capital expenditure decision affects the company's future cost structure over a long time span. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or give less profit than expected, the company will have to bear the extra burden of fixed cost. Such risk can be minimized through the systematic analysis of projects which is the integral part of investment decision.

2. Irreversible Decision
Capital investment decision are not easily reversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital investment decisions are to be carried out and performed carefully and effectively in order to save the company from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavorable projects.

3. Long-term Commitments Of Funds
Capital budgeting decision involves the funds for the long-term. So, it is long-term investment decision. The long-term commitment of funds leads to the financial risk. Hence, careful and effective planning is must to reduce the financial risk as much as possible.

The resources of a business firm is invested in current and fixed assets. Current assets are acquired for the smooth running of business whereas fixed assets are purchased for generating revenue. The profitability of a firm depends upon the productive capacity of the fixed assets. Furthermore, the decision of investing in fixed assets has far-reaching impact because it requires huge capital for long period. The failure of any project may lead the firm in the door of liquidation. Therefore, the cost, benefit and probable risk of the proposed project should be analyzed systematically before making the investment.

Capital budgeting decision comprises of three words 'Capital', 'Budgeting' and 'Decision'. Capital means the fund or resource available for investing. Budgeting is the numerical aspect of planning. Decision or decision making is the process of deciding whether alternative action is to be undertaken or not. In this way, capital budgeting decision is the process under which different investment alternatives are evaluated and the best alternative is selected. In other words, capital budgeting decision is concerned with the long-term investment decision i.e. making capital expenditure. The expenditure on fixed asset such as land and building, furniture and fixtures, plant and machinery etc. is called capital expenditure. The life of these fixed assets is more than one year. So, capital budgeting decision is concerned with long-term planning. Capital budgeting is also decision making process for an investment which includes the process of investment, evaluating, planning and financing major investment project of an organization.

Therefore, it can be said that capital budgeting is concerned with the allocation of the firm's financial resources among the available investment alternatives. It is a part of long-term planning and comprises the evaluation and selection of investment projects.

Generally, projects are evaluated on the basis of overall cost of capital, not on the basis of specific cot of capital. The product of component of cost of capital and weight respective source of capital is known as weighted average cost of capital. In other words, weighted average cost of capital is the minimum required rate of return to be earned on investment. Therefore, it is computed on the basis of the proportion of the funds from which the fund has been raised and their respective proportion.

For example, a firm needs $ 5,00,000 for investing in a new project. The firm can collect $ 3,00,000 from shares on which it must pay 12% dividend and $ 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least $ 50,000 which becomes sufficient to pay $ 36,000 dividend(12% of 3,00,000) and $ 14,000 interest (7% of 2,00,000) . The required earning ($ 50,000) is 10% of the total fund raised. This 10% rate of return is called weighted average cost of capital.

Calculation Process Of Weighted Average Cost Of Capital (WACC)

Step I: calculation of component or specific cost of capital:

* After tax cost of debt (kdt)

* Cost of preference share (kp)

* Cost of equity share (ke)

* Cost of retained earnings( kr)

Step II: Calculation of proportion or weight of source of capital:

* Proportion or weight of debt (Wd) = Amount of debt/Total Capital

* Weight of preference share (Wp) = Amount of preference share/Total capital

* Weight of equity share (We)= Amount of equity share/Total capital

* Weight of retained earnings (Wr)= Amount of retained earnings/ Total capital

Step III: Calculation of Weighted average cost of capital (WACC):

The portion of net profit distributed to shareholders is called dividend and the remaining portion of the profit is called retained earning. In other word, the amount of undistributed profit which is available for investment is called retained earning. Retained earning is considered as internal source of long-term financing and it is a part of shareholders equity.

Generally, retained earning is considered as cost free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. Shareholders of the company that retains more profit expect more income in future than the shareholders of the company that pay more dividend and retains less profit. Therefore, there is an opportunity cost of retained earning. In other words, retained earning is not a cost free source of financing. The cost of retained earning must be at least equal to shareholders rate of return on re-investment of dividend paid by the company.

Determination Of Cost Of Retained Earning
In the absence of any information relating to addition of cost of re-investment and extra burden of personal tax, the cost of retained earning is considered to be equal to the cost of equity. However, the cost of retained earnings differs from the cost of equity when there is flotation cost to be paid by the shareholders on re-investment and personal tax rate of shareholders exists. i)Cost of retained earnings when there is no flotation cost and personal tax rateapplicable for shareholders: Cost of retained earnings(kr) = Cost of equity(ke) = (D1/NP)+g where,
D1= expected dividend per share
NP= current selling price or net proceed ii)Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders:
Cost of retained earnings(kr) = Cost of equity(ke) x 1-fp) (1-tp) where, fp = flotation cost on re-investment(in fraction) by shareholders tp = Shareholders' personal tax rate.

Illustration
A company's share are currently selling for $ 120. The expected dividend and the growth rate are $5.20 and 6% respectively. Then calculate the cost of retained earning.

Solution,
Cost of retained earning(kr) = (D1/NP)+ g
= (5.20/120) +0.60 = 0.1033 or 10.33%

Preference shares are those shares which have the prior right on the dividend and refund of capital in case of liquidation of company. Like debentures, preference shares have the following features:

Face Value Or Par Value: The value or price stated on the share certificate is called face value. The dividend is computed on the basis of face value. The share's market price may be different from the face value depending upon the financial condition of the issuing company.

Dividend Rate: The rate of dividend payable on preference share is predetermined. On the basis of such dividend rate and face value of share, the amount of dividend is determined as below:

Dividend per share (DPS) = Face value X Dividend rate

Total Dividend = Face value X Dividend rate X No. of preference share.

Maturity Period: Maturity period is mentioned on the preference shares if such shares are redeemable after some years in future. Generally, maturity period is not mentioned on the preference share and such shares are called irredeemable.

Net Proceed: The amount received by the company issuing the preference hares after deducting all issuing expenses is called net proceed. Net proceed is computed on the basis of face value of the share, discount on premium and issuing cost or flotation cost.

Concept Of Cost Of Ordinary Shares/Equity Shares Or Common Stock

The shares on which dividend rate is not predetermined and maturity period is not stated is called ordinary shares. Ordinary shareholders are the real owners of the company and they have the voting right. Ordinary shareholders receive the residual income i.e the income left after paying the interest to debt-holders and dividend to preference shareholders. Thus, the amount of dividend payable to ordinary shareholders is pre-determinable.

Since, the amount of dividend payable to ordinary shareholders is pre-determinable, the cost of ordinary share is calculated either on the basis of earning per share or by estimating the expected dividend on the basis of growth rate of past dividend.

Approaches Of Calculating Cost Of Ordinary Shares/Common Stock Or Equity Shares

Different approaches of calculating cost of ordinary shares or common stock or equity shares are as follows:

1. Earning Yield Approach

When the earning per share or net income after tax is given and there is no information regarding the dividend of ordinary share, the cost of ordinary share can be calculated on the basis of earning and market price of shares as shown below:

Ke = Earning per share/Market price per share or, EPS/MPS or, EPS/NP

2. Dividend Yield Approach

When the dividend per share or total equity dividend is given and there is no information regarding the growth rate, the cost of equity share can be calculated on the basis of dividend and market price of shares as below:

Ke = Dividend per share/Market price per share or, DPS/MPS or, D/NP

3. Dividend Yield Plus Growth Rate Approach

This is the most popular method of calculating the cost of equity shares. Under this method, the cost of equity share is determined on the basis of the following information:

i. Current Dividend(Do): The dividend which has been recently paid and referred as last year's dividend, previous dividend, past dividend etc.

ii. Growth Rate In Dividend (g): The rate at which the annual earning or dividend is increasing. When the growth rate is not given, it can be computed on the basis of past dividend or earning.

iii. Expected Dividend (D1): The dividend which will be paid to the shareholders in the recent future is called expected dividend. It is also referred as next dividend, coming dividend, future dividend, subsequent dividend etc. On the basis of current dividend and past growth rate, the expected dividend can be determined as below:

iv. Net proceed Or Net Market Price (NP): The net selling price of share after deducting all kinds of issuing expense is known as net proceed. The expenses incurred in the process of issuing the shares is called flotation cost. Flotation cost includes brokerage fee, commission and other publicity and administrative expenses. Net proceed is determined as follows:

Net proceed (NP) = Gross selling price - Flotation cost

= Gross selling price(1-Flotation cost) = Po(1-f)

On the basis of the above information, the cost of equity shares can be calculated as given below by using dividend yield plus growth rate approach:

The cost of obtaining and using interest paying liabilities is known as cost of debt. Generally, companies borrow debt through the issuance of debenture and bonds. Thus, the cost of debt is the cost associated with the interest payment and other cost of issuing the debenture and bonds.

It is important to note that the cost of debt is computed on after tax basis because interest is a tax deductible expense. In other words, the company can deduct the interest from income while calculating tax. Payment of interest saves tax which is called tax shield or tax benefit. The amount of such tax is equal to interest X tax rate. Thus the net cost of debt is computed on the basis of interest X (1- tax rate. This rule does not apply in case of ordinary and preference shares.

Essential Features Of Debt

Before computing the cost of debt, it is essential to understand the essential features of debt which are as follows:

1. Face Value/Par Value (FV)

The value mentioned in the debenture certificate is known as par value or face value of the debenture. The debenture can be issued at any price, however, the amount of interest is calculated on the basis of face value. In brief, the principal per debenture is called face value or par value.

2.Coupon Rate (R)

The interest rate stated in the debenture certificate is known as coupon rate. Coupon rate is the simple interest rate and the amount of interest is determined on the basis of the coupon rate not on the basis of the prevailing market interest rate.

3.Maturity Period (M)

The time period of the loan or life of the debenture is known as maturity period of the debt. For example, if a company issued debentures on Jan. 1, 2011 and these debentures are repayable on Dec. 31, 2021, then the total time period from the date of issue to final due date is called maturity period which is 10 years.

4. Call Provision

Call provision is the clause stated in the debt contract under which the company can refund the amount of debt before the maturity period. The time at which the amount is refunded is called call period and the amount refunded is called call price.

5. Net Proceed (NP)

The amount received by the company issuing a debenture after deducting all issuing expenses (except interest) is called net proceed. Net proceed is computed on the basis of the following factors:

i. Face value of the debenture (total or per debenture)

ii. Discount or premium on issue

iii. Issuing cost or flotation cost

On the basis of above information, net proceed can be computed as follows:

Net proceed (NP) = Gross selling price - Flotation cost

= Face value + Premium (or - discount) - Flotation cost

Types Of Cost Of Debts

1. Cost Of Perpetual Debt

The debt on which maturity period is not given is called perpetual debt. The cost of such bond is computed as below:

Condition 1: when the bond is selling at face value:

Cost of debt (Kdt) = Interest rate X ( 1- Tax rate) = Kb(1-t)

Condition 2: when the bond is selling below or above the face value:

Kdt = 1/NP X (1-t)

2. Cost Of Non-perpetual Debt Or Debt With Maturity Period

When the life or maturity period of debt is given, such debt is known as Non-perpetual debt or debt with maturity period.

3. Cost Of Debt Issued On Redeemable Condition

In most cases, the face value of debt is refunded at the end of maturity period. However some bonds and debentures are repayable at premium or discount. In such condition, the amount of interest is computed on the basis of face value and the cost is computed on the basis of redemption. Redemption value is computed as below:

i. When bonds/debentures are repayable at premium:

Repayable value = Face value + premium on redemption

ii. When bonds/debentures are repayable or redeemable at discount:

Repayable value = Face value - Discount on redemption

4. Cost Of Callable Debt

The debt, which is refunded by the company before the maturity period is called callable debt. The time at which the amount is refunded is called call period (NC) and the amount refunded is called call price (CP).

Significance Of Cost Of Capital
Cost of capital is considered as a standard of comparison for making different business decisions. Such importance of cost of capital has been presented below.

1. Making Investment Decision
Cost of capital is used as discount factor in determining the net present value. Similarly, the actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a significant role in making investment decisions.

2. Designing Capital structure
The proportion of debt and equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to design the capital structure considering the cost of each sources of financing, investor's expectation, effect of tax and potentiality of growth.

3. Evaluating The Performance
Cost of capital is the benchmark of evaluating the performance of different departments. The department is considered the best which can provide the highest positive net present value to the firm. The activities of different departments are expanded or dropped out on the basis of their performance.

4. Formulating Dividend Policy
Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such projects which can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

Components Of Cost Of Capital
The individual cost of each source of financing is called component of cost of capital. The component of cost of capital is also known as the specific cost of capital which includes the individual cost of debt, preference shares, ordinary shares and retained earning. Such components of cost of capital have been presented below: