9FINANCIAL MANAGEMENT 1

GROUP ASSIGNMENT

GROUP MEMBERS

1. Lornah Momanyi – BBIT/2020/89631

2. Kelvin Kibet - BCOM/2022/51551
3. Anita Mumbe – BBM/2020/92597
4. Michael Mbithi – BBM/2019/88202
5. Flovian Buret - BCOM/2022/30197
6. Stacy Wambui - BCOM/2022/50886
7. Steve Ager – BCOM/2020/91722
8. Kelvin Kirimi – BCOM/2022/32431

Define: Implicit & explicit costs; Cost of obtaining funds & equity

Implicit and Explicit costs

Implicit costs refer to the opportunity costs of using resources in a certain way. These costs are not
explicitly stated or recorded in financial statements but they represent the value of the best
alternative foregone. For example if a business owner decides to use their personal savings to finance
their business instead of investing it in the stock market the implicit cost would be the potential
return they could have earned from the stock market.

On the other hand explicit costs are the actual out-of-pocket expenses that are recorded in financial
statements. These costs are easily identifiable and quantifiable. For example rent, wages, utilities and
materials are considered explicit costs because they represent actual payments made by the business.

Cost of obtaining funds and cost of equity

The cost of obtaining funds refers to the cost associated with obtaining external financing such as
bank loans or issuing bonds. This cost includes the interest payments and any fees or charges
associated with the financing. It is essentially the cost of borrowing money or raising capital from
external sources.

On the other hand the cost of equity refers to the return that is expected by investors who provide
capital to a company in exchange for ownership or shares in the company. This return is based on the
potential dividends or capital appreciation that the investor expects to receive from their investment.
The cost of equity is often estimated using methods such as the dividend discount model or the capital
asset pricing model.
Factors influencing cost of finance

Interest rates: Interest rates set by central banks and market forces can significantly impact the cost
of borrowing funds. Higher interest rates generally increase the cost of finance while lower interest
rates can make financing more affordable.

Creditworthiness and risk profile: Lenders assess the creditworthiness and risk profile of a borrower
before extending finance. Those with a higher credit rating and lower perceived risk may receive loans
at lower interest rates while those with lower credit ratings or higher risk profiles may have to pay
higher rates to offset the increased risk.

Inflation: Inflation erodes the purchasing power of money over time. When inflation is high lenders
may charge higher interest rates to compensate for the loss in value of the money they lend.

Market conditions: Supply and demand dynamics in the financial markets can impact the cost of
finance. If there is a high demand for funds and a limited supply lenders may increase interest rates to
attract borrowers. Conversely when there is excess liquidity in the market lenders may lower interest
rates to stimulate borrowing and investment.

Type of financing: The type of financing chosen such as debt or equity can also impact the cost of
finance. Debt financing typically involves interest payments while equity financing may involve
dividend payments or a share of company ownership. The cost of equity financing can be higher as
investors expect a higher return to compensate for the increased risk compared to debt financing.

Market conditions: The overall state of the economy may influence the cost of finance. During
periods of economic growth interest rates tend to be higher as demand for financing increases. In
contrast during economic downturns interest rates may be lower to stimulate borrowing and
investment.

Collateral and security: Lenders often require collateral or security for loans. The presence of
collateral or security can reduce the risk for lenders leading to lower interest rates.
Loan term and repayment period: The length of the loan term and repayment period can also impact
the cost of finance. Longer terms or repayment periods may incur higher interest rates as there is a
greater risk associated with longer timeframes.

Classification of cost:

Weighted average cost of capital (WACC) – WACC is a financial metric used to calculate the average
cost of financing a company’s operations. It takes into account the cost of debt and equity capital and
is typically expressed as a percentage. WACC is used to assess the feasibility of investment projects
and to make decisions regarding the optimal capital structure for a company.

Marginal cost of capital – The marginal cost of capital refers to the cost associated with raising an
additional unit of capital. It is the cost of obtaining additional funds to finance new investments or
projects. By comparing the expected return on an investment with the marginal cost of capital
companies can determine whether the investment is financially viable.

Explicit costs – Explicit costs are direct out-of-pocket expenses that a company incurs as a result of its
operations. These costs are tangible and easily measurable such as wages rent materials utilities and
marketing expenses. Explicit costs are deducted from the company’s revenues to determine its net
income.

Implicit costs – Implicit costs are indirect costs that are not easily measurable or quantifiable. These
costs represent the opportunity cost of utilizing resources in a particular way rather than in their next
best alternative use. For example if a business owner decides to invest their own funds into the
business instead of pursuing an alternative investment opportunity the implicit cost would be the
potential return they would have earned from that alternative investment.

Components of cost:

Cost of new equity: The cost of new equity refers to the cost incurred by a company to raise funds by
issuing new shares of common stock to equity investors. This cost is typically calculated as the
expected return demanded by investors in exchange for purchasing newly issued equity shares.

PO= ke – g /po

= D1/po

D1=(1 + g)Do

When account Is taken of the floatation costs, the cost of equity (ke) would be calculated as follows ;
Ke=(D1 / Po – f ) +E

Where ke, cost of equity capital

D1, expected dividend

G, growth rate in dividend

Do, current dividend

Po, current market price of ordinary

Shares

F, floatation cost

Cost of retained earnings: The cost of retained earnings is the opportunity cost of using the company’s
profits to fund new investments instead of distributing them to shareholders as dividends. It is the
return that shareholders could have earned by investing their dividend payments in alternative
investment opportunities of similar risk.

Cost of preference capital: The cost of preference capital is the cost incurred by a company when it
raises funds by issuing preference shares to investors. It represents the return that investors demand
in exchange for owning preference shares which typically have preferred rights over common
shareholders regarding dividend payments and liquidation proceeds.

Cost of long-term debts: The cost of long-term debts refers to the interest expense a company incurs
when it borrows funds from lenders or issues long-term bonds. It is the interest rate that reflects the
cost of borrowing and represents the return required by debt holders.
Cost of debentures: The cost of debentures is similar to the cost of long-term debts and refers to the
interest expense incurred by a company when it issues debentures as a form of long-term borrowing.
Debentures are a type of debt instrument that is not backed by specific collateral and relies on the
general creditworthiness of the issuing company. The cost of debentures is the interest rate that
reflects the required return by