Cost of Capital

A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the
cost of raising funds through issuing equity shares is different from that of raising funds
through issuing preference shares. The cost of each source is the specific cost of that source,
the average of which gives the overall cost for acquiring capital.

The firm invests the funds in various assets. So it should earn returns that are higher than the
cost of raising the funds. In this sense the minimum return a firm earns must be equal to the
cost of raising the fund. So the cost of capital may be viewed from two viewpoints—
acquisition of funds and application of funds. From the viewpoint of acquisition of funds, it is
the borrowing rate that a firm will try to minimize.

Thus the cost of capital is also referred to as the discounting rate to determine the present
value of return. Cost of capital is also referred to as the breakeven rate, minimum rate, cut-off
rate, target rate, hurdle rate, standard rate, etc. Hence cost of capital may be defined
according to the operational as well as the economic sense.

In the operational sense, cost of capital is the discount rate used to determine the present
value of estimated future cash inflows of a project. Thus, it is the rate of return a firm must
earn on a project to maintain its present market value.

In the economic sense, it is the weighted average cost of capital, i.e. the cost of borrowing
funds. A firm raises funds from different sources. The cost of each source is called specific
cost of capital. The average of each specific source is referred to as weighted average cost of
capital.

Definition of Cost of Capital:

We have seen that cost of capital is the average rate of return required by the investors.

Various authors defined the term cost of capital in different ways some of which are
stated below:
Milton H. Spencer says ‘cost of capital is the minimum required rate of return which a firm
requires as a condition for undertaking an investment’.

According to Ezra Solomon, ‘the cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure’.
L. J. Gitman defines the cost of capital as ‘the rate of return a firm must earn on its
investment so the market value of the firm remains unchanged’.

Cost of Capital—Pricing the Sources of Fund:

The definition given by Keown et al. refers to the cost of capital as ‘the minimum rate of
return necessary to attract an investor to purchase or hold a security’. Analysing the above
definitions we find that cost of capital is the rate of return the investor must forego for the
next best investment. In a general sense, cost of capital is the weighted average cost of fund
used in a firm on a long-term basis.

Significance and Relevance of the Cost of Capital:

Cost of capital is an important area in financial management and is referred to as the
minimum rate, breakeven rate or target rate used for making different investment and financ-
ing decisions. The cost of capital, as an operational criterion, is related to the firm’s objective
of wealth maximization.
The significance and relevance of cost of capital has been discussed below:
Investment Evaluation:
The primary objective of determining the cost of capital is to evaluate a project. Various
methods used in investment decisions require the cost of capital as the cut-off rate. Under net
present value method, profitability index and benefit-cost ratio method the cost of capital is
used as the discounting rate to determine present value of cash flows. Similarly a project is
accepted if its internal rate of return is higher than its cost of capital. Hence cost of capital
provides a rational mechanism for making the optimum investment decision.

Designing Debt Policy:

The cost of capital influences the financing policy decision, i.e. the proportion of debt and
equity in the capital structure. Optimal capital structure of a firm can maximize the share-
holders’ wealth because an optimal capital structure logically follows the objective of
minimization of overall cost of capital of the firm. Thus while designing the appropriate
capital structure of a firm cost of capital is used as the yardstick to determine its optimality.

Project Appraisal:
The cost of capital is also used to evaluate the acceptability of a project. If the internal rate of
return of a project is more than its cost of capital, the project is considered profitable. The
composition of assets, i.e. fixed and current, is also determined by the cost of capital. The
composition of assets, which earns return higher than cost of capital, is accepted.
Weighted Average Cost of Capital

company's weighted average cost of capital (WACC) is the average interest rate it must pay
to finance its assets, growth and working capital. The WACC is also the minimum average
rate of return it must earn on its current assets to satisfy its shareholders or owners, its
investors, and its creditors.

DIVIDEND:

Introduction

The term dividend refers to that profits of a company which is distributed by company among
its shareholders. It is the reward of the shareholders for investments made by them in the
shares of the company. A company may have preference share capital as well as equity share
capital and dividends may be paid on both types of capital. The investors are interested in
earning the maximum return on their investments and to maximize their wealth on the other
hand, a company needs to provide funds to finance its long-term growth. If a company pays
out as dividend most of what it earns, then for Business requirements and further expansion it
will have to depend upon outside resources such as issue of debt or a new shares. Dividend
policy of a firm, thus affects both long-term financing and wealth of shareholders.

Concept and Significance

The dividend decision is one of the three basic decisions which a financial manager may be
required to take, the other two being the investment decisions and the financing decisions. In
each period any earning that remains after satisfying obligations to the creditors, the
government and the preference shareholders can either be retained or paid out as dividends or
bifurcated between retained earnings and dividends. The retained earnings can then be
invested in assets which will help the firm to increase or at least maintain its present rate of
growth.

FINANCIAL MANAGEMENT:

Financial Management

Finance: “Finance” is a broad term that describes two related activities, the study of how
money is managed and the actual process of acquiring needed funds. Because individuals,
businesses and government entities all need funding to operate, the field is often separated
into three sub-categories: personal finance, corporate finance and public finance.
Financial management refers to the efficient and effective management of money (funds)
in such a manner as to accomplish the objectives of the organization. It is the specialized
function directly associated with the top management.

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working
capital decisions.

2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided.

b. Retained profits- Amount of retained profits has to be finalized which will

depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition of

capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

 1. Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has

many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.

5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.

b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Profit Maximization and Wealth Maximization

Financial Management is concerned with the proper utilization of funds in such a manner that
it will increase the value plus earnings of the firm. Wherever funds are involved, financial
management is there. There are two paramount objectives of the Financial Management:
Profit Maximization and Wealth Maximization. Profit Maximization as its name signifies
refers that the profit of the firm should be increased while Wealth Maximization, aims at
accelerating the worth of the entity.

Profit maximization is the primary objective of the concern because of profit act as the
measure of efficiency. On the other hand, wealth maximization aim at increasing the value of
the stakeholders.

Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing maximum output with the
limited input, or it uses minimum input for producing stated output. It is termed as the
foremost objective of the company.

It has been traditionally recommended that the apparent motive of any business organisation
is to earn a profit, it is essential for the success, survival, and growth of the company. Profit is
a long term objective, but it has a short-term perspective i.e. one financial year.

Profit can be calculated by deducting total cost from total revenue. Through profit
maximization, a firm can be able to ascertain the input-output levels, which gives the highest
amount of profit. Therefore, the finance officer of an organisation should take his decision in
the direction of maximizing profit although it is not the only objective of the company.

Definition of Wealth Maximization

Wealth maximizsation is the ability of a company to increase the market value of its common
stock over time. The market value of the firm is based on many factors like their goodwill,
sales, services, quality of products, etc.

It is the versatile goal of the company and highly recommended criterion for evaluating the
performance of a business organisation. This will help the firm to increase their share in the
market, attain leadership, maintain consumer satisfaction and many other benefits are also
there.

It has been universally accepted that the fundamental goal of the business enterprise is to
increase the wealth of its shareholders, as they are the owners of the undertaking, and they
buy the shares of the company with the expectation that it will give some return after a
period. This states that the financial decisions of the firm should be taken in such a manner
that will increase the Net Present Worth of the company’s profit. The value is based on two
factors:

1. Rate of Earning per share

2. Capitalization Rate

Key Differences Between Profit Maximization and Wealth Maximization

The fundamental differences between profit maximization and wealth maximization is

explained in points below:
The process through which the company is capable of increasing earning capacity known as
Profit Maximization. On the other hand, the ability of the company in increasing the value of
its stock in the market is known as wealth maximization.

Profit maximization is a short term objective of the firm while the long-term objective is
Wealth Maximization.

Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which
considers both.

Profit Maximization avoids time value of money, but Wealth Maximization recognises it.

Profit Maximization is necessary for the survival and growth of the enterprise. Conversely,
Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining the
maximum market share of the economy.

Capital budgeting

Definition: Capital Budget consists of capital receipts and payments. It also incorporates
transactions in the Public Account.

Description: Capital receipts are loans raised by the government from the public (which are
called market loans), borrowings by the government from the Reserve Bank and other parties
through sale of treasury bills, loans received from foreign bodies and governments, and
recoveries of loans granted by the Central government to state and Union Territory
governments and other parties.

Capital payments consist of capital expenditure on acquisition of assets like land, buildings,
machinery, and equipment, as also investments in shares, loans and advances granted by the
Central government to state and Union Territory governments, government companies,
corporations and other parties.

LEVERAGE

Leverage, as a business term, refers to debt or to the borrowing of funds to finance the
purchase of a company's assets. Business owners can use either debt or equity to finance or
buy the company's assets. Using debt, or leverage, increases the company's risk of
bankruptcy.

There are three types of leverage:

What is Operating Leverage?

Breakeven analysis shows us that there are essentially two types of costs in a company's cost
structure -- fixed costs and variable costs. Operating leverage refers to the percentage of fixed
costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to
variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then
the firm is said to have high operating leverage. These firms use a lot of fixed costs in their
business and are capital intensive firms.

A good example of capital intensive business firm are the automobile manufacturing
companies. They have a huge amount of equipment that is required to manufacture their
product - automobiles.

What is Financial Leverage?

Financial leverage refers to the amount of debt in the capital structure of the business firm. If
you can envision a balance sheet, financial leverage refers to the right-hand side of the
balance sheet. Operating leverage refers to the left-hand side of the balance sheet - the plant
and equipment side. Operating leverage determines the mix of fixed assets or plant and
equipment used by the business firm. Financial leverage refers to how the firm will pay for it
or how the operation will be financed.

As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's
operations, can really improve the firm's return on equity and earnings per share. This is
because the firm is not diluting the owner's earnings by using equity financing. Too much
financial leverage, however, can lead to the risk of default and bankruptcy.

One of the financial ratios we use in determining the amount of financial leverage we have in
a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in
a business firm to equity.

What is Combined, or Total, Leverage

Combined, or total, leverage is the total amount of risk facing a business firm. It can also be
looked at in another way. It is the total amount of leverage that we can use to magnify the
returns from our business. Operating leverage magnifies the returns from our plant and
equipment or fixed assets. Financial leverage magnifies the returns from our debt
financing. Combined leverage is the total of these two types of leverage or the total
magnification of returns. This is looking at leverage from a balance sheet perspective.

It is also helpful and important to look at leverage from an income statement perspective.
Operating leverage influences the top half of the income statement and operating income,
determining return from operations. Financial leverage influences the bottom half of the
income statement and the earnings per share to the stockholders.

The concept of leverage, in general, is used in breakeven analysis and in the development of
the capital structure of a business firm.
AUDIT

Definition of Auditing

The Institute of Chaartered Accountants of India describes audit as “the independent

examination of financial information of any entity, whether profit oriented or not, and
irrespective of its size or legal form, when such examination is conducted with a view to
expressing an opinion there on”.

Functions of an Auditor

The following are the functions or basic aspects to be covered by the auditor in the
course of audit. They are:

Examination: Auditor should examine the accounting system to ensure about their
appropriateness.

Books: Check the books of accounts to ensure the arithmetical accuracy.

Evidence: The auditor should examine documentary evidence to support the entries in
the books of accounts.

Full Inclusion: Check whether all entries in the books of accounting have been taking
while preparing financial statements.

Properness: Examine whether information contained in financial statements is proper

and it does not contain any fraudulent entry.

Verification of Assets and Liabilities: Check the existence, valuation and disclosure of
all assets and liabilities in financial statements.

Statutory Compliance: Verify the compliance of financial statements with the relevant
statutory authorities.

Disclosure: Examine whether the information in financial statements is disclosed

properly as per accounting principles.

Truth and Fairness: Check whether financial statements represent a true and fair view
of profit or loss and of assets and liabilities of the business concern.

Qualities of an Auditor:- An auditor must have the following qualities:-

1. He/she must have complete knowledge of general accounts, income tax, cost
accounting etc. He/she should be aware of the latest development of the
technique of accounting.

2. He/she should not pass any transaction unless he/she knows that it is correct. It
is possible when sh/she knows thoroughly well the principles of accounting.

3. He/she should be able to grasp quickly the technical detail of the business whose
accounts he/she is auditing.

4. Various types of Auditing used By Companies

5. Review and investigation of financial statements and reports are called auditing. The
reports and statements can be of any nature like revenue reports, expense reports,
management account records etc.

6. The results of audits are shared with external and internal stakeholders. They may also
be shared with government and banks or even public if the need presents itself. The
classification of auditing depends on different types and levels of assurance of the
audit. It depends on the objective, purposes, scope, use etc. While few audits are done
to enhance and improve procedures, others are necessitated by various organizations
as a part of their scrutiny process.

7. 1) Internal audit

8. As the name suggests this type of audit is performed to determine the internal
activities of the company and is carried out by internal or external stakeholders. It is
an independent process which may or may not be reported to the management. The
main function of internal audit is to determine whether or not the internal functions
are working properly.

9. A special investigation, fraud, complaint, or operational review are a few things that
are covered by the internal audit. The general report of internal audit contains an
opinion on feedback along with the list of findings during auditing and its
implications on the working. The final part of internal audit contains
recommendations for the findings that could help benefit the organization. Post-
approval from the management the steps may be applied in the company.

10. 2) External Audit

11. When an external form is employed to perform auditing, it is known as an external

audit. Services like tax, legal, consulting and sales audit may be performed by
external firms. It is one of the most common types of audit found in many firms. To
stay neutral and unbiased, many companies conduct external audits with third party
firms.

12. Deloitte Ernst and young are renowned names of external auditors. Use of external
forms is very common in large multinationals. The firms
follow international standards of auditing very strictly and maintain a professional
code throughout the auditing procedure. It is ensured that the firm works
 independently from the client so that if a conflict of interest of cause proper procedure
and action can be taken to change or withdraw the auditing procedure. External
auditors may not stick to external auditing only but some may offer services for
internal auditing also. External auditing is considered to be more professional when
internal auditing. Also, the chances of biased audits are less in case of external
auditing.

13. 3) Forensic Audit

14. This is a specialized type of audit which is performed by a forensic accountant who is
killed in investigation and accounting both. This is specially used in the cases where
investigations of the report may be used in the court. Forensic auditing acts as proof in
that particular subject matter and hence in this auditing is to be done by specialized
accountant only.

15. The reason for auditing could be anything from fraud to crime or insurance claims or
even a dispute between internal or external stakeholders. Forensic auditing needs to
have a proper planning and execution while following the ethical guidelines of the
finances very strictly. It is not a very popular method of auditing in case of financial
statements are of statutory audit going to the large costs involved. Forensic auditing
may only be used in the cases where it is been made mandatory to perform it.

16. 4) Statutory Audit

17. The auditing that is required by law for local authority about particular financial
statements for a specific type of entities is called statutory audit. The common
examples of statutory auditing are the that all banks’ financial statements are required
to be audited my proper audit firms which are approved by Central Bank. Statutory
audit is conducted only after approval by higher authorities and for the submission to
official authorities.

18. 5) Continuous Audit

19. Continuous audit or a detailed audit is an audit which involves a detailed examination
of books of account at regular intervals i.e. one month or three months. The auditor
visits clients at regular intervals during the financial year and checks each and every
transaction. At the end of the year auditor checks the profit and loss account and the
balance sheet. A continuous audit is not of much use to small firm as its accounts can
be audited at the end of the financial year without much loss of time.

'Risk Analysis'

Risk analysis is the process of assessing the likelihood of an adverse event occurring within
the corporate, government, or environmental sector. Risk analysis is the study of the
underlying uncertainty of a given course of action and refers to the uncertainty of
forecasted cash flow streams, variance of portfolio/stock returns, the probability of a
project's success or failure, and possible future economic states. Risk analysts often work in
tandem with forecasting professionals to minimize future negative unforeseen effects.