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Financial Management Decisions COST-VOLUME-PROFIT ANALYSIS 2.2 Cost Of Capital This Section includes : • Cost of Capital-Key Concepts • Importance • Classification • Determination of Cost of Capital • Computation • Weighted Average Cost of Capital INTRODUCTION: It has been discussed in lesson -4 that for evaluating capital investment proposals according to the sophisticated techniques like Net Present Value and Internal Rate of Return, the criterion used to accept or reject a proposal is the cost of capital. The cost of capital plays a significant role in capital budgeting decisions. In the present lesson the concept of cost of capital and the methods for its computation are explained. COST…show more content…
Composite cost, also known as the weighted average cost of capital, should be considered in capital and capital budgeting decisions. iii) Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return and is calculated with the following formula; Fianancial Management & international finance 67 Financial Management Decisions COST-VOLUME-PROFIT ANALYSIS IO = C1 C2 Cn + + ....... + 1 2 (I + K) (I + K) (I + K)n Io = Net cash inflow received at zero of time C = Cash outflows in the period concerned K = Explicit cost of capital N = Duration of time period Implicit cost also known as the opportunity cost is the of the opportunity foregone in order to take up a particular project. For example, the implicit cast of retained earings is the rate of return available to shareholders by investing the funds elsewhere. iv) Average Cost and Marginal Cost: An average cost is the combined cost or weighted average cost of various sources of capital. Marginal cost of refers to the average cost of capital of new or additional funds required by a firm. It is the marginal cost which should be taken into consideration in investment decisions. DETERMINATION OF CAST OF CAPITAL : As stated already, cost of capital plays a very important role in making
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