Question

Explain the cost of:

 Capital

 Capital structure

 Working capital Answer in 250-300 words for each item

Answer 1

COST OF CAPITAL :-

Cost of capital refers to the weighted average cost of various capital components,that is sources of finance, employed by the firm such as equity, preference or debt. It is the rate of return, that must be received by the firm on its investment projects, to attract investment projects, to attract investing capital in the firm and to maintain its market value.

The factors which determine the cost of capital are:

1. Source of finance

2. Corresponding payment for using finance.

On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is nothing but the cost of using the capital, that is cost of capital which is either paid in lump sum or at periodic intervals.

Importance of cost of capital

1. It helps in evaluating the investment options by converting the future cash flows of the investment avenues into   present values by discounting it.

2. It is helpful in capital budgeting decisions regarding the sources of finance used by the company.

3. It is vittal in designing the optimal capital structure of the firm,where in the firm's value is maximum, and the cost of capital is minimum.

4. It can also be used to appraise the performance of specific projects by comparing the performance against the cost of capital.

It is future classificated into Explicit cost of capital and implicit cost of capital.

Explicit cost of capital:- It is the cost of capital in which firm's cash outflow is oriented towards utilisation of capital which is evident,such as payment of dividend  to the shareholder, interest to the debenture holders,etc..

Implicit cost of capital:- It does not involve any cash outflow, but it denotes the opportunity foregone while opting for another alternative opportunity.

COST OF CAPITAL STRUCTURE:-

Capital structure refers to a company's outstanding debt and equity. It allows a firm to understand what kind of funding the company uses to finance its overall activities and growth. In other words, it shows the proportions of senior debt subordinated debt and equity in the funding. the purpose of capital structure is to provide an overview of the level of the company's risk. as a rule of thumb, the higher the proportion of debt financing a company has the higher its exposure to risk.

Debt and equity capital are used to fund a business's operation, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and managers will balance the two to find the optimal capital structure.

Every company has to chart out its financing strategy at an early stage. The cost of capital becomes a critical factor in deciding which financing track to follow- debt,equity,or a combination of two. Early- stage companies have sizable assets to pledge as collateral for debt financing, so equity financing becomes the default mode of funding for most of them. Less established companies with limited operating histories will play a higher cost for capital than older companies with solid track records .

The cost of debt is merely the interest rate paid by the company on its debt. However, since interest expenses is tax-deductible, the debt is calculated on an after-tax basis as follows

  
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A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both cost of debt and equity must be forward looking and reflect the expectations of risk and return in the future. It means that the past cost of debt is not a good indicator of the actual forward looking cost of debt.

COST OF WORKING CAPITAL:-

Working capital represents a company's ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company's ability to pay off its debts within a year.

working capital represents the difference between a firm's current assets and current liabilities. The challenge can be determining the proper category for the vast array of assets and liabilities on a corporate balance sheet and analysing the overall health of a firm in meeting its short-term commitments.

Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and generally the higher the ratio, the better.

Working capital funds do not expire, the working capital figure does change over time. That's because a company's current liabilities and current assets are based on 12 month period. The exact working capital figure can change everyday, depending on the nature of a company's debt. What was once a long-term liability, such as a 10 year loan, becomes a current liability in the ninth year when the repayment deadline is less than a year away. similarly, what was once a long-term asset, such as real estate or equipment, suddenly becomes a current asset when a buyer is lined up.

Working capital as current assets cannot be depreciated the way long- term , fixed assets are. Certain working capital,such as inventory and accounts receivable, may lose value or even be written off sometimes, but how that is recorded does not follow depreciation rules. working capital as current assets can only be expensed immediately as one time costs to match the revenue they help generate in the period. While it can't lose its value to depreciation over time, working capital may be devalued when some assets have to be marked, That happens when an asset's price is below its original cost, and others are not salvageable. two common examples involve inventory and accounts receivable.