ABES Business School, Ghaziabad (College Code – 1193)

KMBN204 – UNIT 2 – Financial Management & Corporate Finance

NOTES
Concept of Opportunity Cost
Opportunity cost is a concept in economics that refers to the value of the next best alternative that
must be given up in order to pursue a certain action or decision. In other words, opportunity cost is
the cost of forgoing the benefits of the next best alternative.
Opportunity cost is an important concept because it helps individuals and organizations make better
decisions by taking into account the value of the options that are not chosen. For example, if a
person decides to spend their money on a new car, the opportunity cost would be the value of the
next best alternative, such as investing the money in the stock market or using it to pay off debt.
Opportunity cost can be applied to various decisions, such as investments, business decisions, and
personal choices. For example, a business might choose to invest in new equipment rather than
hiring additional staff. The opportunity cost of this decision would be the potential benefits of hiring
additional staff, such as increased productivity or customer satisfaction.
Opportunity cost can be difficult to measure or quantify, as it depends on the specific context and
individual preferences. However, considering opportunity cost is an important part of decision-
making, as it helps individuals and organizations to make more informed choices that take into
account the full range of available options and their associated costs and benefits.
Cost of Debenture
Debentures are a type of debt instrument issued by companies to raise funds from investors. The
cost of debenture is the rate of interest that the company is required to pay to the debenture holders
for the use of the borrowed funds.
The cost of debenture is determined by various factors, such as the prevailing market interest rates,
credit rating of the issuing company, the term of the debenture, and the type of debenture.
The cost of debenture is usually expressed as a percentage and is calculated by dividing the annual
interest payments by the principal amount of the debenture. For example, if a company issues a
debenture with a face value of $100,000 and an annual interest rate of 8%, the cost of debenture
would be $8,000 per year.
The cost of debenture is an important consideration for companies, as it affects the overall cost of
capital and can impact the profitability of the company. Generally, companies will seek to issue
debentures at the lowest possible cost, while still attracting sufficient investment to meet their
financing needs.
Investors also consider the cost of debenture when making investment decisions, as it affects the
overall return on their investment. Higher interest rates on debentures can provide investors with
higher returns, but may also indicate higher risk or lower creditworthiness of the issuing company.
Overall, the cost of debenture is an important factor to consider for both companies and investors, as
it affects the cost of borrowing and the return on investment.
Preference and Equity Capital
Preference and equity capital are two forms of financing that companies can use to raise capital for
their operations or growth.
Preference capital refers to a type of capital that provides investors with priority over equity
shareholders in terms of dividend payments and in the event of the company’s liquidation.
Preference shares typically pay a fixed dividend, which is agreed upon at the time of issue, and do
not usually carry voting rights. This makes preference capital a hybrid between debt and equity
financing, as it has characteristics of both. The cost of preference capital is typically higher than the
cost of debt but lower than the cost of equity.
Equity capital, on the other hand, refers to the funds that are raised by companies through the sale
of common shares or equity ownership in the company. Equity capital does not require the
repayment of principal or interest like debt and preference capital, but instead provides shareholders
with a share of the company’s profits and voting rights. The cost of equity capital is generally higher
than the cost of debt or preference capital due to the higher risk involved.
Preference and equity capital have different characteristics and advantages. Preference capital
provides companies with a lower cost of capital compared to equity capital, while equity capital
provides companies with the flexibility to raise capital without incurring debt and without having to
make fixed dividend payments. However, preference capital may limit the company’s ability to make
dividend payments to equity shareholders, while equity capital may dilute the ownership and control
of existing shareholders.
Overall, companies need to carefully consider their financing options and the costs and benefits of
each type of capital before deciding which option is best for their specific needs and circumstances.
Composite Cost of Capital
The composite cost of capital is the weighted average cost of all the sources of funding used by a
company to finance its operations and growth. It takes into account the costs of both debt and equity
financing and is calculated based on the proportion of each source of funding in the company’s
capital structure.
To calculate the composite cost of capital, the company first needs to determine the proportion of
each source of funding in its capital structure. This can be done by calculating the percentage of
debt and equity financing in the total capital employed.
Once the proportion of each source of funding is determined, the cost of each source of funding is
calculated separately. The cost of debt is calculated based on the interest rate and any other costs
associated with the debt, such as fees and expenses. The cost of equity is calculated based on the
expected return required by equity investors, which can be estimated using the capital asset pricing
model (CAPM) or other similar methods.
The composite cost of capital is then calculated by multiplying the proportion of each source of
funding by its respective cost and summing the results. The formula for calculating the composite
cost of capital is:
Composite Cost of Capital = (% Debt x Cost of Debt) + (% Equity x Cost of Equity)
The composite cost of capital is an important measure for companies, as it represents the overall
cost of financing and can be used to evaluate the profitability of potential investment projects.
Companies typically seek to minimize their composite cost of capital by optimizing their capital
structure and selecting the most cost-effective sources of financing.
Cash Flow as Profit and Components of Cash Flows
Cash flow and profit are two different concepts in finance. Profit is a measure of a company’s
earnings or net income over a specific period of time, while cash flow refers to the movement of cash
in and out of a company over the same period. A company can have positive profits and negative
cash flow, or vice versa.
Cash flow has three main components:
1. Operating Cash Flow: This is the cash generated from a company’s operations, such as
sales revenue, minus the cost of goods sold, operating expenses, and taxes.
2. Investing Cash Flow: This is the cash used to purchase or sell assets, such as property,
plant, and equipment or investments.
3. Financing Cash Flow: This is the cash used to raise or repay capital, such as issuing or
repurchasing shares, paying dividends, or borrowing or repaying debt.
The net result of these three components is the net cash flow for a given period. Positive cash flow
means that the company has generated more cash than it has used, while negative cash flow means
that the company has used more cash than it has generated.
In some cases, a company may report non-operating cash flows, which are not related to the
company’s core operations. Examples of non-operating cash flows may include proceeds from the
sale of a business or a one-time settlement payment from a legal dispute.
Overall, understanding the components of cash flow is important for investors and analysts to
evaluate a company’s financial health and sustainability. A company with strong operating cash
flows and positive cash flow from investing activities may indicate that the company is investing in
growth opportunities and generating cash from its core business, while a company with negative
cash flow from financing activities may indicate that the company is relying heavily on debt to fund its
operations.
Capital Budgeting Decision
Capital budgeting is the process of making investment decisions in long-term assets or projects that
are expected to generate cash flows over several years. Capital budgeting decisions are critical for
businesses, as they involve large amounts of funds and can significantly impact the future
profitability and growth of the company.
There are several methods used for making capital budgeting decisions, including:
Payback Period: This method determines the length of time it takes to recover the initial investment
in a project. Projects with shorter payback periods are preferred, as they provide a faster return on
investment.
Net Present Value (NPV): This method calculates the present value of future cash flows from a
project, discounted at the company’s cost of capital. Projects with positive NPV are considered
acceptable, as they generate more cash flows than the initial investment.
Internal Rate of Return (IRR): This method calculates the rate of return that a project generates over
its expected life. Projects with higher IRR are preferred, as they generate higher returns on
investment.
Profitability Index (PI): This method compares the present value of future cash inflows to the initial
investment. Projects with higher PI are preferred, as they generate more cash inflows relative to the
initial investment.
When making capital budgeting decisions, companies also consider qualitative factors, such as the
impact on the company’s strategic goals, market competition, and regulatory environment.
Overall, the capital budgeting decision process is a critical aspect of financial management, as it
helps companies evaluate investment opportunities and allocate resources in a way that maximizes
long-term shareholder value.
Capital Budgeting Decision
Capital budgeting is the process of making investment decisions in long-term assets or projects that
are expected to generate cash flows over several years. Capital budgeting decisions are critical for
businesses, as they involve large amounts of funds and can significantly impact the future
profitability and growth of the company.
There are several methods used for making capital budgeting decisions, including:
1. Payback Period: This method determines the length of time it takes to recover the initial
investment in a project. Projects with shorter payback periods are preferred, as they provide
a faster return on investment.
2. Net Present Value (NPV): This method calculates the present value of future cash flows from
a project, discounted at the company’s cost of capital. Projects with positive NPV are
considered acceptable, as they generate more cash flows than the initial investment.
 3. Internal Rate of Return (IRR): This method calculates the rate of return that a project
generates over its expected life. Projects with higher IRR are preferred, as they generate
higher returns on investment.
4. Profitability Index (PI): This method compares the present value of future cash inflows to the
initial investment. Projects with higher PI are preferred, as they generate more cash inflows
relative to the initial investment.
When making capital budgeting decisions, companies also consider qualitative factors, such as the
impact on the company’s strategic goals, market competition, and regulatory environment.
Overall, the capital budgeting decision process is a critical aspect of financial management, as it
helps companies evaluate investment opportunities and allocate resources in a way that maximizes
long-term shareholder value.
Calculation of NPV and IRR
Net Present Value (NPV) and Internal Rate of Return (IRR) are two commonly used methods for
evaluating investment opportunities in capital budgeting.
To calculate NPV, follow these steps:
1. Estimate the cash inflows and outflows for the investment project over its expected life.
2. Determine the discount rate, which is the cost of capital for the company.
3. Calculate the present value of each cash flow, by dividing the cash flow by (1+discount
rate)^number of periods.
4. Subtract the initial investment from the sum of the present values of all future cash flows.
The resulting figure is the NPV.
5. If the NPV is positive, the project is expected to generate more cash flows than the initial
investment, and the project is considered acceptable. If the NPV is negative, the project is
expected to generate fewer cash flows than the initial investment, and the project is
considered unacceptable.
To calculate IRR, follow these steps:
1. Estimate the cash inflows and outflows for the investment project over its expected life.
2. Determine the discount rate that makes the NPV of the project equal to zero.
3. Use trial and error or a financial calculator to find the discount rate that satisfies the equation
NPV=0.
4. The discount rate that satisfies the equation NPV=0 is the IRR. If the IRR is higher than the
company’s cost of capital, the project is considered acceptable, as it generates a higher rate
of return than the cost of capital. If the IRR is lower than the company’s cost of capital, the
project is considered unacceptable, as it generates a lower rate of return than the cost of
capital.
Overall, both NPV and IRR are important methods for evaluating investment opportunities and
making capital budgeting decisions. Companies may use one or both methods to ensure that they
invest in projects that generate positive cash flows and maximize long-term shareholder value.
Excel Application in Analyzing Project
Excel is a powerful tool that can be used to analyze and evaluate investment projects. Some of the
common Excel functions and tools that can be used in capital budgeting analysis include:
1. NPV and IRR functions: Excel has built-in functions to calculate NPV and IRR, which can
help you quickly evaluate the profitability of an investment project.
2. Data tables: Data tables can be used to calculate different scenarios for a project, such as
changes in cash flows or discount rates, and how they affect the NPV and IRR.
3. Goal Seek: Goal Seek can be used to find the discount rate that makes the NPV of a project
equal to zero, which is the IRR.
4. Sensitivity analysis: Sensitivity analysis can be used to assess the impact of changes in
different project variables, such as cash flows or discount rates, on the NPV and IRR.
5. Conditional formatting: Conditional formatting can be used to highlight cells or values that
meet specific criteria, such as cells with negative NPV values.
6. Charts and graphs: Excel can be used to create charts and graphs to visually represent
project data, such as cash flows over time or the impact of changes in different project
variables.
By using Excel to analyze investment projects, you can quickly and easily evaluate different
scenarios and make informed capital budgeting decisions.