Tag: Capital

  • Meaning, Definition, and Importance of Capital Expenditure

    Meaning, Definition, and Importance of Capital Expenditure

    What is Capital Expenditure? Capital expenditures (CAPEX) refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve the efficiency or capacity of the company. Capital expenditure can be tangible, such as a copy machine, or it can be intangible, such as a patent. In many tax codes, both tangible and intangible capital expenditures are counted as assets because they have the potential to be sold if necessary. So, what is the discussion? Meaning, Definition, and Importance of Capital Expenditure.

    The Concept of Capital Expenditure explanation of Meaning, Definition, and Importance of Capital Expenditure.

    Also known as CAPEX or capital expenses, capital expenditures include the purchase of items such as new equipment, machinery, land, plant, buildings or warehouses, furniture and fixtures, business vehicles, software and intangible assets such as a patent or license. Long-term assets are a company’s land, buildings, machinery, vehicles, furniture, computers, office equipment, software as well as patents, trademarks, and licenses. Companies report CAPEX on the cash flow statement and are amortized over the life of the related asset because, usually, the asset’s useful life is longer than the taxable year and, therefore, CAPEX cannot be reported as an expense.

    Meaning and Definition of Capital Expenditure:

    An expenditure which results in the acquisition of the permanent asset which is intended to be permanently used in the business for the purpose of earning revenue is known as capital expenditure. These expenditures are ‘non-recurring’ by nature. Assets acquired by incurring these expenditures are utilized by the business for a long time and thereby they earn revenue.

    For example, money spent on the purchase of building, machinery, furniture etc. Take the case of machinery-machinery is permanently used for, producing goods and profit is earned by selling those goods. This is not an expenditure for one accounting period, machinery has a long life and its benefit will be enjoyed over a long period of time. By a long period of time, we mean a period exceeding one accounting period. Moreover, any expenditure which is incurred for the purpose of increasing profit earning capacity or reducing the cost of production is a capital expenditure.

    Sometimes the expenditure even not resulting in an increase of profit earning capacity but acquires an asset comparatively permanent in nature will also be a capital expenditure. It should be remembered that when an asset is purchased, all amounts spent up to the point until the asset is ready for use should be treated as capital expenditure.

    Examples are, A) A machinery was purchased for $50,000 from Karachi. We paid carriage $1,000, octroi duty $500 to bring the machinery from Karachi to Lahore. Then we paid wages $1,000 for its installation in the factory. For all these expenditures, we should debit machinery account instead of debiting carriage A/c, octroi A/c and wages A/c. B) Fees paid to a lawyer for drawing up the purchase deed of land, C) Overhaul expenses of second-hand machinery etc. D) Interest paid on loans raised to acquire a fixed asset etc.

    Rules and Items for Determining Capital Expenditure.

    Capital Expenditure is that expenditure which results in the acquisition of the permanent asset or fixed asset which is used continuously in the business for the purpose of earning revenue any amount spent on the asset which will result in increasing the production or reducing the cost of production may also be treated as Capital Expenditure.

    The following Rules for Determining Capital Expenditure are:
    • Expenditure incurred for acquiring Land, Building, Machinery, Investments, Patents or Furniture etc. are permanent or fixed assets. The fixed asset is used in the business for earning the profit and not for resale, is called a Capital Expenditure. For instance, when we purchase furniture it is a capital expenditure and at the same time to the Furniture Shop, who is engaged in buying and selling of furniture, it is not capital expenditure.
    • Expenditure incurred for putting an old asset in working condition or for putting a new asset to use is capital expenditure. For instance, an old machine is purchased for Rs. 10,000 and Rs 2,000 is spent for its repairs and installation and the total expenditures are capital expenditure.
    • Which increases the earning capacity in any way of a fixed asset can be called capital expenditure. For instance, the amount spent on cinema theatre for air conditioning.
    • Spent on raising the capital required for earning the profit is called capital expenditure. For instance, underwriting commission, brokerage etc.
    • On an existing asset which results in the improvement or extension of the business by increasing the earning capacity of the asset or by reducing the cost of production is also called capital expenditure. For instance, installations of machine or additions to buildings or plant etc. are capital expenditure.
    • When the benefit of expenditure is not fully consumed in one period but spread over several periods, is called capita, expenditure. For instance, expenditure met for massive advertisements.
    The following Items of Capital Expenditure are:
    • Land, Building, Plant, and Machinery.
    • Leasehold Land and Building.
    • Manufacture or purchase of furniture and fixtures.
    • Office Cars, Vans, Lorries or Vehicles.
    • Installation of lights, fans etc.
    • The erection of Plant and Machinery.
    • Trade Mark, Patents, Copyrights, Patterns, and Designs.
    • Preliminary Expenses.
    • Goodwill.
    • Addition to an extension of existing fixed assets.
    • Development in case of Mines and Plantations.
    • The invention.
    • Increasing capacity of the fixed asset, and.
    • Administration in industrial enterprises incurred during the period of construction.

    Importance of Capital Expenditure:

    Decisions how much to invest in capital expenditures can often be extremely vital decisions made by an organization.

    They are important because of the following reasons:

    Long-term Effects: 

    The effect of capital expenditure decisions usually extends into the future. The range of current production or manufacturing activities is mainly as a result of past capital expenditures. 

    Similarly, the current decisions on capital expenditure will have a major influence on the future activities of the company. Capital investment decisions usually have a huge impact on the basic character of the organization. 

    The long-term strategic goals, as well as the budgeting process of a company, need to be in place before authorization of capital expenditures.

    Irreversibility: 

    Capital expenditures can hardly be undone without the company incurring losses. Since most forms of capital equipment are customized to meet specific company requirements and needs, the market for capital equipment that has been used is generally very poor.

    Once the capital equipment is purchased, there is little room to reverse the decision since the cost can often not be recouped. For this reason, wrong capital investment decisions are often irreversible, and poor ones lead to substantial losses being incurred. Once acquired, they need to be employed for use.

    High Initial Costs: 

    Capital expenditures are characteristically very expensive, especially for companies in industries such as production, manufacturing, telecom, utilities, and oil exploration.

    The Capital investments in physical assets like buildings, equipment, or property offer the potential of providing benefits in the long run but will need a huge monetary outlay initially, much greater than even operating outlays. Capital costs often tend to rise with advanced technology.

    Depreciation: 

    Capital expenditures lead to an increase in the asset accounts of an organization. However, once capital assets start being put in service, their depreciation begins, and they continue to decrease in value throughout their useful lives.

    “A capital expenditure (CAPEX) is an expense that a company makes towards. The purchase of new equipment or the improvement of its long-term assets, namely property, plant, and equipment”. Capital expenditures normally have a substantial effect on the short-term and long-term financial standing of an organization.

    Therefore, making wise capital expenditure decisions is of critical importance to the financial health of a company. Many companies usually try to maintain the levels of their historical capital expenditure to show investors. That the managers of the company are investing effectively in the business. The expenditure amounts for an accounting period are usually stated in the cash flow statement.

    Meaning Definition and Importance of Capital Expenditure
    Meaning, Definition, and Importance of Capital Expenditure. Image credit from #Pixabay.
  • Meaning, Nature, and Importance of Capital Expenditure Decisions

    Meaning, Nature, and Importance of Capital Expenditure Decisions

    It is the planning, evaluation, and selection of capital expenditure proposals, the benefits of which are expected to accrue over more than one accounting year. Capital expenditure decisions are just the opposite of operating expenditure decisions. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. So, what is discusses are: Meaning, Nature, and Importance of Capital Expenditure Decisions.

    The Concept of Capital Expenditure Decisions is explaining in Meaning, Definition, Nature, Objectives, Difficulty, and Importance.

    What is Capital Expenditure? A capital expenditure is the use of funds by a company to acquire physical assets to improve its value or increase its long-term productivity. Also known as capital expenses, capital expenditures include purchases such as buildings or warehouses, new equipment such as machinery or computers, and business vehicles. Many companies strive to maintain their historical capital expenditure levels in order to show investors that managers are investing adequately in the business.

    Much of the discussion has focused on decisions relating to near-term operations and activities. But, managers must also ponder occasional big-ticket expenditures that will impact many years to come. The decision on long-term investments is quite pivotal due to many reasons. It is a part of the duties of an entity’s key management to affect most accurate the decision with respect to the long-term investments. The question of decisions is: What is the concept of financial decisions?

    Such capital expenditure decisions relate to the construction of new facilities, large outlays for vehicles and machinery, embarking upon new product research and development, and similar items where the upfront cost is huge and the payback period will span years to come. A number of business factors combine to make business investment perhaps the most important financial management decision.

    Meaning of Capital Expenditure Decisions:

    The capital expenditure decision is the process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, plant & machinery, etc. Thus it refers to long-term planning for proposed capital expenditures and includes raising of long-term funds and their utilization. The key function of the finance manager is the selection of the most profitable project for invest­ment. This task is very crucial because any action taken by the manager in this area affects the working and profitability of the firm for many years to come.

    Definition of Capital Expenditure Decisions:

    Former is generally termed as ‘current’ expenditure and is ex­pected to result in benefits in a short period of less than a year. The latter is termed as ‘capital’ expenditure, and is expected to result in benefits in the future period of one or more years and is also known as capital budgeting decisions. Capital Expenditure Decisions Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions.

    Although the tendency is to focus on the financial dimensions, such decisions are made even more complex because they usually involve a number of nonfinancial components as well. Thus, the final decision may involve consideration of architectural, engineering, marketing, regulatory, and numerous other variables.

    These types of decisions involve considerable risk because they usually involve large amounts of money and extended durations of time. In addition, capital expenditure decisions (also called capital budgeting) are usually accompanied by a number of alternatives from which to choose. Sometimes, an option that is best in the long term may be the least desirable in the near term and vice versa.

    Nature of Capital Expenditure Decisions:

    Capital expenditure decisions involve the acquisition of assets that have a long life span and which provide benefits spread over a long period of time.

    The nature of capital expenditure decisions can be explained in brief as under:

    • Irreversible Decision: Capital expenditure decisions once approved represent long-term invest­ments that cannot be reversed or withdrawn at any time. Withdrawal or reversal of such decisions may lead to considerable financial losses to the firm.
    • Maximization of Shareholder’s Wealth: It helps protect the interest of the shareholders as well as of the firm because it avoids over-investment and under-investment in fixed assets.
    • Substantial Investments: Capital expenditure decisions involve large amounts of funds. Such decisions have its effect over a long span of time.
    • Estimation of Future Cash Inflows: Preparation of capital expenditure budget involves forecast­ing of cash inflows over several years for evaluating the profitability of projects.

    Objectives of Capital Expenditure Decisions:

    Financing decisions are one of the most crucial and critical decisions of a firm as they have a significant impact on the profitability of the firm.

    There is the number of objectives of capital expenditure decisions, some of which are:

    • Cost Reduction: The existence of a firm depends on profitability, which in turn depends on the production of goods or services at a reasonable price. This is possible if over/under-investment in fixed assets is avoided.
    • Providing Contemporary Goods: Consumer tastes change every day. To satisfy the new demands from customers, either proper utilization of existing facility or installation of the latest machinery is necessary—which is not possible without proper capital expenditure decision.
    • Increasing Output: An output may be increased by utilizing the existing facility or through expansion by installing new plant and machinery.

    The Importance of Capital Expenditure Decisions:

    Here are understand about the importance of Capital expenditure and also know their Difficulty.

    The following importance is:
    • Effects in the Long Run: the consequences of capital expenditure decisions extend into the feature. The scope of current manufacture activities of a company governed largely by capital expenditures in the past. Likewise, current capital expenditure decisions provide the framework for future activities. Capital investment decisions have an enormous bearing on the basic character of a company.
    • Irreversibility: The market for used capital equipment, in general, is ill-organized. Further, for some types of capital equipment, custom-made to meet the specific requirement, the market virtually be non-existent. Once such equipment is acquired, reversal of decision may mean scrapping the capital equipment. Thus, a wrong capital investment decision cannot be reversed without incurring a substantial loss.
    • Substantial outlays: Capital expenditures usually involve substantial outlays. An integrated steel plant, for example, involves an outlay of several thousand million. Capital costs tend to increase with advanced technology.
    The following difficulty is:
    • Measurement problems: Identifying and measuring the costs and benefits of a capital expenditure proposal tends to be difficult. This is more so when a capital expenditure has a bearing o some other activities of the company like cutting into sales of some existing product or has some intangible consequences like improving the morale of workers.
    • Uncertainty: A capital expenditure decision involves costs and benefits that extend far into the future. It is impossible to predict exactly what will happen in the future. Hence, there is usually a great deal of uncertainty characterizing the costs and benefits of a capital expenditure decision.
    • Temporal Spread: The costs and benefits associated with a capital expenditure decision are spread out over a long period of time, usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. Such a temporal spread creates some problems in estimating discount rates and establishing equivalence.

    Capital Expenditure Decisions Managers in all organizations periodically face major decisions that involve cash flows over several years. Decisions involving the acquisition of machinery, vehicles, buildings, or land are examples of such decisions. Other examples include decisions involving significant changes in a production process or adding a major new line of products or services to the organization’s activities.

    Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting decisions. Managers encounter two types of capital-budgeting decisions. Acceptance-or-Rejection Decisions In acceptance-or-rejection decisions, managers must decide whether they should undertake a particular capital investment project. In such a decision, the required funds are available or readily obtainable, and management must decide whether the project is worthwhile.

    Meaning Nature and Importance of Capital Expenditure Decisions
    Meaning, Nature, and Importance of Capital Expenditure Decisions. Image credit from #Pixabay.
  • Classification of Cost of Capital, and explain their Types

    Classification of Cost of Capital, and explain their Types

    Cost of capital refers to the opportunity cost of making a specific investment. Classification of Cost of Capital, and explain their Types. Cost of capital consists of both the cost of debt and the cost of equity used for financing a business. It is the rate of return that could have earn by putting the same money into a different investment with equal risk. Cost of Capital, and explain their Types (With Calculations), PDF Download Full Explanations.

    Financial Management in Classification of Cost of Capital and how to explain their Types.

    The following points highlight the five types of costs including in the list of the cost of capital. They are 1. Explicit Cost and Implicit Cost, 2. Future Cost and Historical Cost, 3. Specific Cost, 4. Average Cost and Marginal Cost, and 5. Overall Cost or Composite or Combined Cost.

    1. Explicit Cost and Implicit Cost:

    The explicit cost of any sources of capital may define as the discount rate that equates the present value of the cash inflows. That is incremental to the taking of the financing opportunity with the present value of its incremental cash outflow. When a firm raises funds from different sources, it involves a series of cash flows. At its first stage, there is only a cash inflow by the amount raised which is followed by a series of cash outflows in the form of interest payments, repayment of principal or repayment of dividends.

    2. Future Cost and Historical Cost:

    Future Costs are the expected costs of funds for financing a particular project. They are very significant while making financial decisions. For instance, at the time of taking financial decisions about capital expenditure. A comparison is to make between the expected IRR and the expected cost of funds for financing the same, i.e. the relevant costs here are future costs.

    3. Specific Cost:

    The cost of each component of capital, viz., equity shares, preference shares, debentures, loans etc. are termed specific or component cost of capital which is the most appealing concept. While determining the average cost of capital. It requires consideration of the cost of specific methods for financing the projects.

    4. Average Cost and Marginal Cost:

    Average Cost:

    The average cost of capital is the weighted average cost of each component of the funds invested by the firm for a particular project, i.e. percentage or proportionate cost of each element in the total investment. The weights are in proportion to the shares of each component of capital in the total capital structure or investment.

    Marginal Cost:

    According to the Terminology of Cost Accountancy, Marginal Cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is increasing or decreasing by one unit. The same principle is being followed by the cost of capital. That is, the marginal cost of capital may define as the cost of obtaining another rupee of new capital, and last.

    5. Overall Cost or Composite or Combined Cost:

    It may recall that the term ‘cost of capital’ has used to denote the overall composite cost of capital or weighted average of the cost of each specific type of fund, i.e., weighted average cost. In other words, when specific costs are combined in order to find out the overall cost of capital. It may define as the composite or weighted average cost of capital.

    Classification of Cost of Capital, and explain their Types (With Calculations).
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  • What is the Cost of Capital? Meaning and Definition

    What is the Cost of Capital? Meaning and Definition

    Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. Keep Reading What is the Cost of Capital? Meaning and Definition. It can also define as the rate of return on investments at which the price of a firm’s equity share will remain unchanged.

    Cost of Capital – Meaning and Definition, define each one, Read this article to learn about the Cost of Capital.

    Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn the return at the expected rate, the market value of the shares will fall and it will result in the reduction of the overall wealth of the shareholders.

    Meaning of Cost of Capital:

    An investor provides long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and quite naturally he expects a good return on his investment. In order to satisfy the investor’s expectations, the company should be able to earn enough revenue. Thus, to the company, the COC is the minimum rate of return that the company must earn on its investments to fulfill the expectations of the investors.

    If a company can raise long-term funds from the market at 10%, then 10% can use as the cut-off rate as the management gains only when the project gives return higher than 10%. Hence 10% is the discount rate or cut-off rate. In other words, it is the minimum rate of return required on the investment project to keep the market value per share unchanged.

    In order to maximize the shareholders’ wealth through increase price of shares, a company has to earn more than the COC. The firm’s cost of capital can determine by working out the weighted average of the different costs of raising different sources of capital.

    Definition of Cost of Capital:

    We have seen that the 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. Some definitions of financial experts are given below for the clear conception of the COC:

    Ezra Solomon defines:

    “Cost of capital is the minimum required rate of earnings or cut­off rate of capital expenditure”.

    According to Mittal and Agarwal:

    “The cost of capital is the minimum rate of return which a company is expected to earn from a proposed project so as to make no reduction in the earning per share to equity shareholders and its market price”.

    According to Khan and Jain, cost of capital means:

    “The minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged”.

    According to the definition of John J. Hampton:

    “Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the marketplace”.

    Each type of capital used by the firm (debt, preference shares, and equity) should incorporate into the COC, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using the cost a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems.

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  • Cost of Capital: Meaning, Classification, and Importance!

    Cost of Capital: Meaning, Classification, and Importance!

    Investment in capital projects needs funds. The Concept of the study Explains – Cost of Capital: Meaning, What is the Cost of Capital? Components of Cost of Capital, Significance of the Cost of Capital, Classification of Cost of Capital, and the Importance of Cost of Capital. These funds are provided by the investors like equity shareholders, preference shareholders, debenture holders, etc in expectation of a minimum return from the firm. The minimum return expected by the investors depends upon the risk perception of the investor as well as on the risk-return characteristics of the firm. Also learn, Cost of Capital: Meaning, Classification, and Importance!

    Understand and Learn, Cost of Capital: Meaning, Classification, and Importance! 

    This minimum return expected by the investors, which in turn, is the cost of procuring funds for the firm, is termed as the cost of capital of the firm. Thus, the cost of capital of a firm is the minimum rate of return that it must earn on its investments in order to satisfy the expectation of the various categories of investors who have invested in the firm.

    What is the Cost of Capital?

    Meaning By accounting coach: The cost of capital is the weighted-average, after-tax cost of a corporation’s long-term debt, preferred stock, and the stockholders’ equity associated with common stock. The cost of capital is a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.

    By Wikipedia: In economics and accounting, the cost of capital is the cost of a company’s funds (both debt and equity), or, from an investor’s point of view “the required rate of return on a portfolio company’s existing securities”. It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

    A firm procures funds from various sources by issuing different securities to finance its projects. Each of these sources of finance entails the cost to the firm. Since the minimum rate of return expected by various investors – equity investor and debt investor – will be different depending upon their risk perception of the firm, the cost of each source of finance will be different. Thus the overall cost of capital of a firm will be the weighted average of the cost of different sources of finance, with the proportion of each source of finance as the weight. Unless the firm earns this minimum rate of return, the investors will be tempted to pull out of the company, let alone, to participate in any further capital issue.

    We have seen that the cost of capital of a firm is the minimum required rates of return of various investors – shareholders and debt investors- who supply funds to the firm. How does a firm determine the required rates of return of each investor? The required rates of return are market determined and are reflected in the market price of each security. An investor, before investing in a security, evaluates the risk-return profile of investment and assigns a risk premium to the security. This risk premium and the expected return of an investor is incorporated in the market price of the security. Thus the market price of a security is a function of the return expected by the investors.

    Basic three Components of Cost of Capital: 

    There are various sources of finance that are used by the firm for financing its investment activities. The major sources are equity capital and debt. Equity capital represents ownership capital. Equity shares are financial instruments to raise equity capital. A debt may be in the form of secured/unsecured loans, debentures, bonds, etc. The debt carries a fixed rate of interest and the payment of interest is mandatory irrespective of the profit earned or loss incurred by the firm.

    Since interest payable on debt is tax deductible, the usage of debt provides a tax shield to the company. Basic three components as follows:

    1. Cost of Equity Share Capital: Theoretically, the cost of equity share capital is the minimum return expected by the equity investors. The minimum return expected by the equity investors depends upon the risk perception of the investor as well as on the risk-return complexion of the firm.
    2. Cost of Preference Share Capital: The cost of preference share capital is the discount rate which equates the net proceeds from the issue of preference shares to the present value of the expected cash outflows in the form of dividend and principal repayment on redemption.
    3. Cost of Debentures or Bonds: The cost of debentures or bonds is defined as the discount rate which equates the net proceeds from the issue of debentures to the present value of the expected cash outflows in the form of interest and principal repayment.

    Basic Significance of Cost of Capital: 

    The basic objective of financial management is to maximize the wealth of the shareholders or the value of the firm. The value of a firm is inversely related to the cost of capital of the firm. So in order to maximize the value of a firm, the overall cost of capital of the firm should be minimized.

    The cost of capital is of utmost importance in capital structure planning and in capital budgeting decisions.

    • In capital structure planning a company strives to achieve the optimal capital structure in order to maximize the value of the firm. The optimal capital structure occurs at a point where the overall cost of capital is minimum.
    • Since the overall cost of capital is the minimum rate of return required by the investors, this rate is used as the discount rate or the cut-off rate for evaluating the capital budgeting proposals.

    The Classification of Cost of Capital:

    The cost of capital defines as the minimum rate of return a firm must earn on its investment in order to satisfy investors and to maintain its market value. It is the investors required the rate of return. Cost of capital also refers to the discount rate which is used while determining the present value of estimated future cash flows. The major classification of the cost of capital is:

    Historical Cost and future Cost:

    Historical Cost represents the cost which has already been incurred in financing a project. It is calculated on the basis of the past data. Future cost refers to the expected cost of funds to be raised for financing a project. Historical costs help in predicting future costs and provide an evaluation of the past performance when compared with standard costs. In financial decisions, future costs are more relevant than historical costs.

    Specific Costs and Composite Cost:

    Specific costs refer to the cost of a specific source of capital such as equity shares, Preference shares, debentures, retained earnings etc. Composite cost of capital refers to the combined cost of various sources of finance. In other words, it is a weighted average cost of capital. It is also termed as ‘overall costs of capital’. While evaluating a capital expenditure proposal, the composite cost of capital should be as an acceptance/ rejection criterion. When capital from more than one source is employed in the business, it is the composite cost which should be considered for decision-making and not the specific cost. But where capital from only one source is employed in the business, the specific cost of those sources of capital alone must be considered.

    Average Cost and Marginal Cost:

    The average cost of capital refers to the weighted average cost of capital calculated on the basis of the cost of each source of capital and weights are assigned to the ratio of their share to total capital funds. The marginal cost of capital may be defined as the ‘Cost of obtaining another dollar of new capital.’ When a firm raises additional capital from only one source (not different sources) than marginal cost is the specific or explicit cost. Marginal cost is considered more important in capital budgeting and financing decisions. Marginal cost tends to increase proportionately as the amount of debt increase.

    Explicit Cost and Implicit Cost:

    Explicit cost refers to the discount rate which equates the present value of cash outflows or value of the investment. Thus, the explicit cost of capital is the internal rate of return which a firm pays for procuring the finances. If a firm takes the interest-free loan, its explicit cost will be zero percent as no cash outflow in the form of interest is involved. On the other hand, the implicit cost represents the rate of return which can be earned by investing the funds in the alternative investments. In other words, the opportunity cost of the funds is the implicit cost.

    Implicit cost is the rate of return with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. Thus implicit cost arises only when funds are invested somewhere, otherwise not. For example, the implicit cost of retained earnings is the rate of return which the shareholder could have earn by investing these funds if the company would have distributed these earning to them as dividends. Therefore, the explicit cost will arise only when funds are raised whereas implicit cost arises when they are used.

    The Importance of Cost of Capital:

    The cost of capital is a very important concept in financial decision making. Cost of capital is the measurement of the sacrifice made by investors in order to invest with a view to getting a fair return in future on his investments as a reward for the postponement of his present needs. On the other hand from the point of view of the firm using the capital, cost of capital is the price paid to the investor for the use of capital provided by him. Thus, the cost of capital is the reward for the use of capital. The progressive management always likes to consider the importance cost of capital while taking financial decisions as it’s very relevant in the following spheres:

    Designing the capital structure: 

    The cost of capital is the significant factor in designing a balanced and optimal capital structure of a firm. While designing it, the management has to consider the objective of maximizing the value of the firm and minimizing the cost of capital. Comparing the various specific costs of different sources of capital, the financial manager can select the best and the most economical source of finance and can design a sound and balanced capital structure.

    Capital budgeting decisions: 

    The cost of capital sources as a very useful tool in the process of making capital budgeting decisions. Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines the acceptability of all investment proposals by discounting the cash flows.

    Comparative study of sources of financing: 

    There are various sources of financing a project. Out of these, which source should be used at a particular point in time is to be decided by comparing the costs of different sources of financing. The source which bears the minimum cost of capital would be selected. Although the cost of capital is an important factor in such decisions, equally important are the considerations of retaining control and of avoiding risks.

    Evaluations of financial performance: 

    Cost of capital can be used to evaluate the financial performance of the capital projects. Such as evaluations can be done by comparing the actual profitability of the project undertaken with the actual cost of capital of funds raised to finance the project. If the actual profitability of the project is more than the actual cost of capital, the performance can be evaluated as satisfactory.

    Knowledge of firms expected income and inherent risks: 

    Investors can know the firms expected income and risk inherent therein by the cost of capital. If a firms cost of capital is high, it means the firms present rate of earnings is less, the risk is more and capital structure is imbalanced, in such situations, investors expect the higher rate of return.

    Financing and Dividend Decisions: 

    The concept of capital can be conveniently employed as a tool for making other important financial decisions. On the basis, decisions can be taken regarding dividend policy, capitalization of profits and selections of sources of working capital.

    In sum, the importance of cost of capital is that it is used to evaluate the new project of the company and allows the calculations to be easy so that it has a minimum return that investor expectations for providing investment to the company.

    Cost of Capital Meaning Classification and Importance - ilearnlot

  • Capital Budgeting: Nature, Importance, and Limitations

    Capital Budgeting: Nature, Importance, and Limitations

    Definition and Meaning of Capital Budgeting: Economics is concerned with the allocation of scarce resources between alternative or choice uses to obtain the best purpose. The Concept of Capital Budgeting: Nature of Capital Budgeting, Importance of Capital Budgeting, and Limitations of Capital Budgeting. Capital expenditure/budgeting, on the other hand, concentrates on these allocations over time; on decisions that involve current outlays in return for expectations of future benefits, i.e., a return for an anticipated flow of future benefits. Also learned, Capital Budgeting: Nature, Importance, and Limitations!

    Learn, Explain Capital Budgeting and its Nature, Importance, and Limitations. 

    In other words, it is applied to evaluate expenditure decisions that involve current outlays but the benefits are likely to be produced in the future, i.e., over a longer period. The said benefits may be earned either in the form of the reduction in cost or the form of increased revenues. And that is why it includes addition, alteration, modification, disposition, and replacement of fixed assets.

    Nature of Capital Budgeting:

    It is the way toward settling on speculation choices in capital expenditures. Capital Expenditure may define as an expenditure for the benefits of which are expected to be received over a period exceeding one year.

    The main characteristic of capital expenditure is that the expenditure incurs or endure at one spot in time whereas the benefits of the expenditure are collected with realized at different spots in time in the future. In simple language, we may say that capital expenditure incurs or endure for acquiring or improving the fixed assets, the benefits of which expect to receive over several years in the future.

    The following are some of the examples of capital expenditure:

    • Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc.
    • Cost of addition, expansion, improvement, or alteration in the fixed assets.
    • Research and development project cost, etc.
    • Cost of replacement of permanent assets.

    Capital expenditure:

    Capital expenditure involves the non-flexible long-term commitment of funds. Thus, capital expenditure decisions are also called long-term investment decisions. Capital budgeting involves the planning and control of capital expenditure. It is the process of deciding whether or not to commit resources to a particular long-term project whose benefits are to realize over some time, longer than one year. Capital budgeting also knows as Investment Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure, and Analysis of Capital Expenditure.

    • Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long-term planning for making and financing proposed capital outlays.”
    • According to G.C. Philippatos, “Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earnings from a project, with the immediate and subsequent streams of expenditures for it”.
    • Richard and Greenlaw have referred to capital budgeting as acquiring inputs with the long-run return.
    • In the words of Lynch, “Capital budgeting consists of planning development of available capital to maximize the long-term profitability of the concern.”

    Features, characteristics, symptoms, or highlights of Capital Budgeting:

    From the above description, it’s going to conclude that the important features which distinguish capital budgeting decision from the standard day to day business decisions are:

    • Capital budgeting decisions involve the exchange of current funds for the advantages to realize within the future.
    • The money or funds are invested in non-flexible and long-term activities, any funds can be investing for the long-term to get more profitable or return.
    • They have a long-term and significant effect on the profitability of the priority.
    • They involve, generally, huge funds.
    • The future benefits are expected to be realized over a series of years, and.
    • They are irreversible decisions.

    They are “strategic” investment decisions, involving large sums of cash, a serious departure from the past practices of the firm, a significant change of the firm’s expected earnings related to a high degree of risk, as compared to “tactical” investment decisions which involve a comparatively bit of funds that don’t end in a serious departure from the past practices of the firm.

    Need and Importance of Capital Budgeting:

    Capital budgeting means planning for capital assets.

    Capital budgeting decisions are vital to any organization as they include the choices as to:

    • Whether or not funds should invest in long-term projects such as setting an industry, purchase of plant and machinery, etc.
    • Analyze the offer with a proposal for expansion or creating additional efficiency.
    • To decide the replacement of permanent assets such as building and types of equipment.
    • To make the financial analysis of various proposals regarding capital investments to choose the best out of many alternative proposals.

    The importance of capital budgeting can well understand from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern.

    The following the need, significance, or importance of capital budgeting arises mainly thanks to the follows below are:

    1] Large Investments:

    Capital budgeting decisions, generally, involve the large investment of funds. But the funds available with the firm always limit and the demand for funds far exceeds the resources. Hence, a firm needs to plan and control its capital expenditure.

    2] Long-term Commitment of Funds:

    Capital expenditure involves not only a large number of funds but also funds for long-term or more or less permanently. The long-term commitment of funds increase and grow the financial risk involved in the investment decision. The greater the risk involved, the greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.

    3] Irreversible Nature:

    The capital expenditure decisions are irreversible. Once the decision for realization or acquiring a permanent asset takes; it becomes very difficult to dispose or determine of these assets without enduring and incurring heavy losses.

    4] Long-Term Effect on Profitability:

    Capital budgeting decisions have a long-term and significant effect on the profitability of a priority. Not only these earnings of the firm affect by the investments in capital assets but also the longer-term growth and profitability of the firm depend on the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the priority. Capital budgeting is of utmost importance or significance to avoid over-investment or under-investment in fixed assets.

    Difficulties of Investment Decisions:

    The long-term investment decisions are difficult to take because:

    • The decision extends to a series of years beyond the current accounting period,
    • Uncertainties of future and
    • The higher the degree of risk.
    1] National Importance:

    Investment decision though taken by individual concern is of national importance because it determines employment, economic activities, and economic process. Thus, we may say that without using capital budgeting techniques a firm may involve itself during a losing project. Proper timing of purchase, replacement, expansion, and alternation of assets is important.

    2] Importance of Capital Budgeting:

    Capital Budgeting decisions have given the first importance to financial decision-making since they’re the foremost crucial and important business decisions as they need a big impact on the profitability aspect of the firm. As the capital budgeting/expenditure decision affects the fixed assets only which are the sources of earning revenue, i.e., the profitability of the firm, special attention must give to their treatment.

    Capital budgeting decisions have established greater accentuation or emphasis due to:

    3] Capital budgeting has long-term implications:

    The most significant reason that capital budgeting decisions take is that its long-term implications, i.e. its effects will extend into the longer term, and can need to be endured for an extended period than the results of current operating expenditure. Because, a correct investment decision can yield spectacular returns, whereas a wrong investment decision can endanger the very survival of the firm.

    That is why it’s going to state that the capital budgeting decisions determine the longer-term destiny of the firm. Moreover, it also changes the danger of the complexion of the enterprise. When the typical benefits of the firm increase as a result of an investment proposal which can cause frequent fluctuations in its earnings which will become a risky situation.

    4] Capital budgeting requires a large number of funds:

    Capital investment decisions require a large number of funds which the majority of the firms cannot provide since they have scarce capital resources. As a result, investment decisions must be thoughtful, wise, and correct. Because a wrong/incorrect decision would result in losses and the same prevents the firm from earning profits from other investments as well due to the scarcity of resources.

    5] Capital budgeting is not reversible:

    Once the capital budgeting decisions take, they are not easily reversible. The rationale is that there may neither be any marketplace for such second-hand capital goods nor there’s any possibility of conversion of such capital assets into other usable assets, i.e., the sole remedy is to dispose-off an equivalent sustaining an important loss to the firm.

    They are the most difficult decisions:

    Capital investment decisions are, no doubt, the foremost significant since they’re very difficult to form. It is because their assessment depends on the future uncertain events and activities of the firm. Similarly, it is practically a difficult task to estimate the accurate future benefits and costs in terms of money as there are economic, political, and technological forces that affect the said benefits and costs.

    Capital Budgeting Nature Importance and Limitations Image
    Capital Budgeting: Nature, Importance, and Limitations, Image from Pixabay.

    Limitations of Capital Budgeting:

    Capital budgeting techniques suffer from the following limitations:

    • All the technology of capital budgeting presumes that various investment offers with proposals under opinion are mutually exclusive; which may not practically be true in some exceptional circumstances.
    • The techniques of capital budgeting require the estimation of future cash inflows and outflows. The future is always uncertain and the data collected for the future may not be exact. Obliviously the results based on wrong data may not be good.
    • There are certain factors like the morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.
    • Urgency is another limitation in the assessment of capital investment decisions.
    • Uncertainty and risk pose the biggest limitation to the technology of capital budgeting.
  • Capital Budgeting: Meaning, Definition, Nature, and Procedure

    Capital Budgeting: Meaning, Definition, Nature, and Procedure

    Capital expenditure budget or Capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sales such as land, building, machinery, or furniture. Meaning of Capital Budgeting: Capital Budgeting is the process of making the investment decision in fixed assets or capital expenditure. Capital Budgeting also knows as an investment, decision making, planning of capital acquisition, planning and analysis of capital expenditure, etc. Also, learn about EVA and MVA.

    Learn, Explain Capital Budgeting and its Meaning, Definition, Concept, Nature, and Procedure. 

    The word investment refers to the expenditure which requires making in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to the process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of the overall objectives of the firm.

    What is a capital expenditure? It is a very difficult question to answer. The terms capital expenditure associate with accounting. Normally capital expenditure is one which intends to benefit future periods i.e., in more than one year as opposed to revenue expenditure, the benefit of which suppose to exhaust within the year concern.

    Definition of Capital Budgeting:

    It is the process by which a company determines whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth pursuing. A scheme or plan or project is worth pursuing if it increases the value of the company.

    A project and scheme typically add value to the company if it earns a rate of return that exceeds the cost of capital. The opportunity cost of capital expects to return that is foregone by investing in the scheme rather than in comparable financial securities, such as shares, with the same risk as to the project under consideration.

    While capital budgeting is a fairly straightforward or easy process from a conceptual viewpoint, it can be very challenging in practice or training. Not only is it difficult to determine the group’s appropriate cost of capital, but it is also often even trickier to accurately forecast the incremental cash flows that result from taking on the project.

    Concept of Capital Budgeting:

    Capital budgeting may define as the decision-making process by which, firms evaluate the purchase of major fixed assets, including buildings, machinery, and equipment; It also covers decisions to acquire other firms, either through the purchase of their common stock; or, groups of assets that can use to conduct ongoing business.

    They scribes the firm’s formal planning process for the acquisition and investment of capital; and, results in capital budgets that is the firm’s formal plan for the expenditure of money to purchasing assets. A capital-budgeting decision is a two-sided process. First, the analyst must evaluate a proposed project to calculate the likely or expected return from the project.

    This calculation generally begins with the expenditure of the project’s service life; and, a stream of cash flowing into the firm over the life of the project. The calculation of expected, the turn may be done by two methods: 1) internal rate of return or 2) net present value, These two methods discuss later in this.

    Explanation;

    The second side of a capital-budgeting decision is to determine the required return from a project. We may calculate the likely return to being 12 percent but the question is whether this is good enough for the proposal to accept. To determine whether the return is adequate; the analysts must evaluate the degree of risk in the project and then must calculate the required return for the given risk level. Two techniques may use to perform this analysis.

    The weighted-average cost of capital uses when the new proposal assumes to have the same degree of risk as the firm’s existing activities. The capital asset pricing model uses if the risk in the project views as different from the firm’s current risk level. It is important for the future well-being of the firm; it is also a complex, conceptually difficult topic.

    A, we shall see later in this article, the optimum capital budget-the the level of investment that maximizes the present value of the firm simultaneously determined by the interaction of supply and demand forces under conditions of uncertainty. Supply forces refer to the supply of capital, the firm, or its cost of capital schedule or panel.

    Demand forces related to the investment opportunities or chance open to the firm; as measured by the stream of revenues that will result from an investment decision Uncertainty or non-calculability enters the decision; because, it is impossible to know exactly either the cost of capital; or, the stream of revenues that will derive from a project.

    Nature of Capital Budgeting:

    Nature of capital budgeting can explain in brief as under:

    • Capital expenditure plans involve a huge investment in fixed assets.
    • Capital expenditure once approved represents the long-term investment that cannot reserve or withdrawn without sustaining a loss.
    • Preparation of coital budget plans involves forecasting of several years profits in advance to judge the profitability of projects.

    It may assert here that the decision regarding capital investment should take very carefully; so that the plans of the company do not affect adversely.

    Capital Budgeting Meaning Definition Concept Nature and Procedure Image
    Capital Budgeting: Meaning, Definition, Concept, Nature, and Procedure, Image from Pixabay.

    The procedure of Capital Budgeting:

    Capital investment decisions of the firm have a pervasive influence on the entire spectrum of entrepreneurial activities; so careful consideration should regard in all aspects of financial management.

    In the capital budgeting process, the main points to be borne in mind how much money will need of implementing immediate plans; how much money is available for its completion, and how are the available funds going to assign tote various capital schemes or projects under consideration. The financial and risk policy of the management should be clear in mind before proceeding with their process.

    The following procedure may adopt in preparing capital budgeting:

    1] The organization of Investment Proposal.

    The first step in the capital budgeting process is the conception of a profit-making idea. The proposals may come from rank and file worker of any department or any line officer. The department head collects all the investment proposals and reviews them in light of the financial; and, risk policies of the organization to send them to the capital expenditure planning committee for consideration.

    2] Screening the Proposals.

    In large organizations, a capital expenditure planning board or committee establishes and sets up for the screening of various offers with the best proposals received by it from the heads of various departments and the line officers of the company. The committee screens the various proposals within the long-range policy-framework of the organization. It is to ascertain by the committee whether the proposals are within the selection criterion of the firm; or, they do no lead to department imbalances or they are profitable.

    3] Evaluation of Projects. 

    The next step in the capital budgeting process is to evaluate the different proposals in term of the cost of capital; the expected returns from alternative investment opportunities and the life of the assets with any of the following evaluation technology;

    • The degree of Urgency Method (Accounting Rate of return Method).
    • Pay-back Method.
    • Return on Investment Method, and.
    • Discounted Cash Flow Method.
    4] Establishing Priorities.

    After the proper screening of the proposals, uneconomic or unprofitable proposals drop. The profitable projects or in other words accepted projects than put in priority. It facilitates their acquisition or production according to the sources available and avoids Immaterial or unnecessary and costly delays and serious cot-overruns. Generally, priority is fixed in the following order.

    • Current and incomplete projects give priority.
    • Plans and schemes for maintaining the present efficiency of the firm.
    • Projects for supplementing income.
    • Safety projects and projects are necessary to carry on the legislative requirements.
    • Projects for the expansion of a new product.
    5] Final Approval.

    Proposals finally recommended by the committee are sent to the top management along with the detailed report; both of the capital expenditures and sources of funds to meet them. The management affirms its final seal to proposals with offers taking in view the urgency, beneficial or profitability of the projects, schemes, and the available financial resources. Projects are then sent to the budget committee for incorporating them into the capital budget.

    6] Evaluation. 

    Last but not the least important step in the capital budgeting process is an evaluation of the program after it has been fully implemented. Budget proposals and the net investment in the projects compare periodically and based on such evaluation; the budget figures may review and present more realistically.

  • What is the Difference Between Money and Capital Market?

    What is the Difference Between Money and Capital Market?

    Money and Capital Market Difference; What the differences between things are you first need to understand what each of the items is. In this case, before you can understand the difference between the money market and the capital market, you are going to need to understand. What money market is and what capital markets are. Once you understand the two items are it will be easier to see what the difference or differences are between the two markets. Also learn, What is the Difference Between an Intrapreneur and Entrepreneur? the Difference Between Money and Capital Market!

    Learn and Understand, the Difference Between Money and Capital Market!

    The following Difference below is:

    What is the Money Market?

    The money market is the global financial market for short-term borrowing and lending and provides short-term liquid funding for the global financial system. The average amount of time that companies borrow money in a money market is about thirteen months or lower. Some of the more common types of things used in the money market are certificates of deposits, bankers’ acceptances, repurchase agreements, and commercial paper to name a few.

    What the money market consists of are banks. That borrow and lend to each other, but other types of finance companies are involving in the money market. What usually happens is the finance companies fund themselves by issuing large amounts of asset-backed commercial paper. That is securing by the promise of eligible assets into an asset-backed commercial paper conduit. Your most common examples of these are auto loans, mortgage loans, and credit card receivables.

    What is Capital Market?

    The capital market is a type of financial market. It includes the stocks and bonds market as well. But in general, the capital market is the market for securities. Where either companies or the government can raise long-term funds. One way that the companies or the government raise these long-term funds is through issuing bonds.

    Which is where a person buys the bond for a set price and allows the government or company to borrow. Their money for a certain time but they are promising a higher return for allowing them to borrow the money. The higher return is paying through the interest that accrues on the money that the government or company borrows. The Difference between Revaluation and Realization Account!

    Another way that the companies or government can raise money in the capital market is through the stock market. Most of the time you don’t see the government as a part of the stock market. But it can happen so we need to include them. But how the stock market works is that the companies decide to sell shares of their stock. Which is ownership in the company, to ordinary people and other companies, as a way to raise money. The people who buy the stock are usually given dividends each year if the company agrees to pay out dividends. So, that is another possible return on their investment.

    The capital market consists of two markets. The first market is the primary market and it is where new issues are distributing to investors and the secondary market where existing securities are trading. Both of these markets are regulating so that fraud does not occur and in India, the Securities and Exchange Board of India (SEBI) is in charge of regulating the capital market.

    The Difference Between Money and Capital Market!

    The difference between the money market and capital market is that money markets are more of a short-term borrowing or lending market. Where banks borrow and lend between each other. As well as, finance companies and everything that is borrowing, is usually paying back within thirteen months. Whereas capital markets are for long-term investments, companies are selling stocks and bonds to borrow money from.

    Their investors to improve their company or to purchase assets. Another difference between the two markets is what is being used to do the borrowing or lending. In the money markets, the most common things used are commercial paper and certificates of deposits. Whereas with the capital markets the most common thing used is stocks and bonds.

    The money market is distinguishing from the capital market based on the maturity period, credit instruments, and the institutions, the Difference Between Money and Capital Market:

    Basic Role:

    The basic role of the money market is that of liquidity adjustment. The basic role of the capital market is that of putting capital to work, preferably to long-term, secure, and productive employment. Learn about the Difference Between Management and Leadership!

    Maturity Period:

    The money market deals with the lending and borrowing of short-term finance. While the capital market deals in the lending and borrowing of long-term finance.

    Credit Instruments:

    The main credit instruments of the money market are called money, collateral loans, acceptances, bills of exchange. On the other hand, the main instruments used in the capital market are stocks, shares, debentures, bonds, securities of the government.

    Nature of Credit Instruments:

    The credit instruments dealt with in the capital market are more heterogeneous than those in the money market. Some homogeneity of credit instruments is needed for the operation of financial markets. Too much diversity creates problems for investors.

    Institutions:

    Important institutions operating in the money market are central banks, commercial banks, acceptance houses, non-bank financial institutions, bill brokers, etc. Important institutions of the capital market are stock exchanges, commercial banks, and non-bank institutions. Such as insurance companies, mortgage banks, building societies, etc.

    Purpose of Loan:

    The money market meets the short-term credit needs of the business; it provides working capital to the industrialists. The capital market, on the other hand, caters to the long-term credit needs of the industrialists and provides fixed capital to buy land, machinery, etc.

    Risk:

    The degree of risk is small in the money market. The risk is much greater in the capital market. The maturity of one year or less gives little time for a default to occur, so the risk is minimizing. Risk varies both in degree and nature throughout the capital market.

    Relation with Central Bank:

    The money market is closely and directly linked with the central bank of the country. The capital market feels the central bank’s influence, but mainly indirectly and through the money market.

    Market Regulation:

    In the money market, commercial banks are closely regulating. In the capital market, the institutions are not much regulated.

    What is the Difference Between Money and Capital Market - ilearnlot
    What is the Difference Between Money and Capital Market?