Accounting-Finance

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Friday, July 1, 2011

Significance And Components Of Cost Of Capital

Accounting , Business
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:

A. Cost Of Debt

* Cost of perpetual or irredeemable debt
* Cost of non-perpetual or redeemable debt
* Cost of debt issued on redeemable condition
* Cost of callable debt

 B. Cost Of Preference Share

* Cost of perpetual preference Share
* Cost of redeemable preference Share

 C. Cost of ordinary/equity shares or common stock

 D. Cost of retained earning
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Introduction And Meaning Of Cost Of Capital

Accounting , Business
Introduction Of Cost Of Capital

Investment decision is major decision for an organization. Under investment decision process, the cost and benefit of prospective projects is analyzed and the best alternative is selected on the basis of the result of analysis. The benchmark of computing present value and comparing the profitability of different investment alternatives is cost of capital. Cost of capital is also known as minimum required rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard return etc. Cost of capital is determined on the basis of component cost of financing and proportion of these sources in capital structure.

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Meaning Of Cost Of Capital

Business firms raise the needed fund from internal sources and external sources. Undistributed and retained profit is the main source of internal fund. External fund is raised either by the issue of shares or by issue of debenture (debt) or by both means. The fund collected by any means is not cost free. Interest is to be paid on the fund obtained as debt and dividend is to be paid on the fund collected through the issue of shares. The average cost rate of different sources of fund is known as cost of capital.

From the view point of return, cost of capital is the minimum required rate of return to be earned on investment. In other words, the earning rate of a firm which is just sufficient to satisfy the expectation of the contributors of capital is called cost of capital. Shareholders and debenture holders are the contributors of the capital. 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 $14000 interest(7% of $2,00,000). The required earning $50,000 is 12% of the total fund raised. This 12% rate of return is called cost of capital.

In this way, cost of capital is only minimum required rate of return to earn on investment and it is not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10%. all the earnings will go in the hands of contributors of capital and nothing will be left in the business. Therefore, any business firm should try to maximize the earning rate by investing in the projects that can provide the rate of return which is more than the cost of capital.

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Determination Of Working Capital

Accounting , Business
Determination of working capital requirement is one of the major short-term planning which plays very vital role for operating the business successfully. The determination of working capital is to be done very effectively otherwise there may be over or under estimation of working capital. The amount of working capital should be sufficient. Following two methods can used to determine the amount of working capital:

1. Projected Balance Sheet Method
2. Operating Cycle Method

1. Projected Balance Sheet Method

It is the conventional method of calculating working capital. Total current assets and current liabilities are taken into account to calculating working capital. All the data given in balance sheet regarding current assets and current liabilities are taken into consideration for estimating the working capital. Total current liabilities is deducted from total current assets to obtain the amount of net working capital under this method.
Net Working Capital = Total Current Assets - Total Current Liabilities

2. Operating Cycle Method

Time which is needed to convert raw material into finished goods, finished goods into sales and account receivable into cash is called operating cycle. Under operating cycle method, time needed for different types of current assets and time lag needed for payment of purchase and expenses are considered to compute requirement of working capital. The items of current assets and current liabilities are calculated as follows:

* Raw material inventory
= (Annual output x material cost per unit x inventory holding period)/Total Periods

* Work-in-progress Inventory
= (Annual output x Manufacturing cost per unit x Inventory holding period)/Total periods

* Finished Goods Inventory
= (Annual output x total cost per unit x inventory holding period)/Total periods

* Account Receivable(Debtors)
= ( Annual credit sales units x total cost per unit x credit period allowed)/Total periods

* Prepaid Expenses
= (Annual Expenses x Advance Period)/Total periods

* Account Payable (Creditors)
= (Annual output x raw material cost per unit x credit period)/Total periods

* Outstanding Wages
= (Annual output x labor cost per unit x time lag)/ Total periods

* Outstanding Overhead
= (Annual output x overhead per unit x time lag)/Total periods

* Outstanding Expenses
( Annual expenses x Time lag)/ Total periods

 Notes:
a. Current assets and current liabilities should be estimated on cash cost basis.
b. Non-cash expenses like depreciation should be excluded from overhead.
c. Finished goods and debtors should be valued on total cost basis.
d. Work-in-progress is valued on total cost basis unless percentage completion stage is not mentioned.
e. If the time lag in payment of expenses is not given, there is no need to keep the expenses in the list of current liabilities.
f. If stock holding period is given, there is no need to calculate stock of finished goods, work-in-progress and raw materials.
g. Calculation of debtors should be made on the basis of credit sales.
h. Calculation of creditors should be made on the basis of credit purchase.
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Factors Affecting Working Capital Or Determinants Of Working Capital

Accounting , Business
Requirements Of working capital depend upon various factors such as nature of business, size of business, the flow of business activities. However, small organization relatively needs lesser working capital than the big business organization. Following are the factors which affect the working capital of a firm:

1. Size Of Business

Working capital requirement of a firm is directly influenced by the size of its business operation. Big business organizations require more working capital than the small business organization. Therefore, the size of organization is one of the major determinants of working capital.

2. Nature Of Business

Working capital requirement depends upon the nature of business carried by the firm. Normally, manufacturing industries and trading organizations need more working capital than in the service business organizations. A service sector does not require any amount of stock of goods. In service enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit sales and advance related transactions are in large amount. So, they need more working capital.

3. Storage Time Or Processing Period

Time needed for keeping the stock in store is called storage period. The amount of working capital is influenced by the storage period. If storage period is high, a firm should keep more quantity of goods in store and hence requires more working capital. Similarly, if the processing time is more, then more stock of goods must be held in store as work-in-progress.

4. Credit Period

Credit period allowed to customers is also one of the major factors which influence the requirement of working capital. Longer credit period requires more investment in debtors and hence more working capital is needed.But, the firm which allows less credit period to customers needs less working capital.

 5. Seasonal Requirement

In certain business, raw material is not available throughout the year. Such business organizations have to buy raw material in bulk during the season to ensure an uninterrupted flow and process them during the entire year. Thus, a huge amount is blocked in the form of raw material inventories which gives rise to more working capital requirements.

6. Potential Growth Or Expansion Of Business

If the business is to be extended in future, more working capital is required. More amount of working capital is required to meet the expansion need of business.

7. Changes In Price Level

Change in price level also affects the working capital requirements. Generally, the rise in price will require the firm to maintain large amount of working capital as more funds will be required to maintain the sale level of current assets.

8. Dividend Policy

The dividend policy of the firm is an important determinant of working capital. The need for working capital can be met with the retained earning. If a firm retains more profit and distributes lower amount of dividend, it needs less working capital.

9. Access To Money Market

If a firm has good access to capital market, it can raise loan from bank and financial institutions. It results in minimization of need of working capital.

10. Working Capital Cycle

When the working capital cycle of a firm is long, it will require larger amount of working capital. But, if working capital cycle is short, it will need less working capital.

11. Operating Efficiency

The operating efficiency of a firm also affects the firm's need of working capital. The operating efficiency of the firm results in optimum utilization of assets. The optimum utilization of assets in turn results in more fund release for working capital.
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Wednesday, June 29, 2011

Disadvantages Of Insufficient Working Capital

Accounting , Finance
The amount of working capital should be sufficient. Inadequate amount of working capital may create a lot of financial problems in business. Sometimes, inadequate working capital may be the major causes for closing down the business organization. Due to shortage of working capital, raw materials can not be purchased on time and payment of labor and other expenses can not be made on time. The disadvantages suffered by a firm with insufficient working capital are as follows:

1. The firm is unable to take advantages of new opportunities or adapt to change.

2. Trade discounts are lost. A firm with sufficient working capital is able to finance larger stocks and can therefore place large orders.

3. Cash discounts are lost. Some firms will try to persuade their debtors to pay early by offering cash discounts.

4. The advantages of being able to offer a credit line to customers are forgone.

5. Financial reputation is lost due to non-payment of trade creditors on time.

6. Creditors may apply to the court for winding up if the firm fails to pay their obligations on time.
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Need And Importance Of Working Capital

Accounting , Finance
Working capital is the life blood and nerve center of business. Working capital is very essential to maintain smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages or importance of working capital are as follows:

1. Strengthen The Solvency

Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.

2. Enhance Goodwill

Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.

3. Easy Obtaining Loan

A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.

 4. Regular Supply Of Raw Material

Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production.

5. Smooth Business Operation

Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.

6. Ability To Face Crisis

Adequate working capital enables a firm to face business crisis in emergencies such as depression.
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Classification Of Working Capital

Accounting , Finance
Working capital can be classified into the following types:

1. Permanent Or Fixed Working Capital

Permanent working capital represents the current assets required on continuing basis over the entire year. A fixed amount of current assets are required to operate the business. Every business organization must maintain minimum current assets to ensure effective utilization of fixed facilities and for maintaining the circulating of current assets. Thus, minimum level of current assets is called is called permanent or fixed working capital. Permanent working capital or fixed working capital consists of minimum stock, minimum cash and bank balance and minimum other current assets. Generally, permanent working capital is financed by long-term sources of funds.

 2. Temporary Or Variable Working Capital

Temporary working capital represents additional current assets required during the operation of the year. It is the extra working capital needed to support the changing production and sales activities of the firm. Any excess amount of working capital over the permanent working capital is called temporary working capital. It is required to meet the seasonal demands and contingencies. Temporary working capital is fluctuating, sometimes decreasing and sometimes increasing. Generally, temporary working capital is financed from short term sources of funds.
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