Understanding Cost of Capital, Working Capital, and Funding Sources

Posted on Mar 20, 2025 in Economy

Cost of Capital: An Introduction

Cost of capital is a cut-off rate for allocating capital to investment projects. It represents the rate of return a project must achieve to maintain the market price of the stock.

Importance of Cost of Capital

The cost of capital is crucial in financial management and plays a vital role in several areas:

  1. Capital Budgeting Decisions: Used for discounting cash flows under the Net Present Value (NPV) method for investment proposals.
  2. Capital Structure Decisions: Helps in designing an optimal capital structure where the firm’s value is maximized and the cost of capital is minimized.
  3. Evaluation of Financial Performance: Used to assess top management’s performance by comparing actual profitability to the expected cost of capital.
  4. Other Financial Decisions: Influences dividend policy, capitalization of profits, and rights issues.

Components of Cost of Capital

The components considered when calculating the cost of capital include:

  1. Long-term debt (including debentures)
  2. Preference capital
  3. Equity capital
  4. Retained earnings
  5. Weighted Average Cost of Capital (WACC)
  6. Marginal Cost of Capital

Working Capital: Definition and Types

Working capital refers to the circulating capital required for a business firm’s day-to-day operations. It represents a firm’s investment in short-term assets, such as cash, accounts receivable, and inventories. Working capital essentially means current assets.

Types of Working Capital

  • Gross Working Capital
  • Net Working Capital
  • Permanent Working Capital

Factors Influencing Working Capital Needs

Working capital is needed until a firm receives cash from the sale of finished products. It depends on factors like manufacturing working capital and the credit cycle.

Internal and External Factors Affecting Working Capital Decisions

The factors influencing a firm’s working capital decisions can be classified into two groups: internal and external factors.

Internal Factors

  • Nature and size of the business
  • Firm’s production policy
  • Availability of credit
  • Operating efficiency of the firm

External Factors

  • Business fluctuations
  • Changes in technology
  • Import policy
  • Infrastructure facilities
  • Taxation policy

Sources of Funds

Internal Sources

  • Profit After Tax
  • Depreciation

External Sources

Shareholder Funds

  • Preference Shares (Cumulative, Non-Cumulative, Redeemable, Participating, Non-Participative)
  • Equity Shares

Borrowed Funds

  • Debentures
  • Long-term borrowings
  • Public deposits
  • Loans from financial institutions
  • Short-term borrowings

Convertible Funds

  • Convertible debentures
  • Convertible cumulative preference shares

International Finance

  • Term loans
  • Depository receipts
  • Foreign currency convertible bonds
  • Other sources