This is for MBA

1. Gino G. Lacandula
Discussant

2. What is Cost of Capital?
• Cost of capital refers to the return a company expects on a specific
investment to make it worth the expenditure of resources. In other
words, the cost of capital determines the rate of return required to
persuade investors to finance a capital budgeting project.
• The cost of capital is heavily dependent on the type of financing used
in the business. A business can be financed through debt or equity.
However, most companies employ a mixture of equity and debt
financing. Therefore, the cost of capital comes from the weighted
average cost of all capital sources.

3. Classification of Cost of Capital:
Cost of capital may be classified into the following types on the
basis of nature and usage:
• Explicit and Implicit Cost.
• Average and Marginal Cost.
• Historical and Future Cost.
• Specific and Combined Cost.

4. How to calculate cost of capital:
To calculate the weighted average cost of capital (WACC), you
must first calculate the cost of debt and the cost of equity, which
are represented by these formulas:
1. Cost of debt
The cost of debt refers to interest rates paid on any debt,
such as mortgages and bonds. Interest expense is the interest
paid on current debt.

5. How to calculate cost of capital:
2. Cost of equity
Cost of equity refers to the return a company requires to determine
capital requirements are met in an investment. Cost of equity also
the amount the market demands in exchange for owning the asset and
therefore holding the risk of ownership.
The cost of equity is approximated by the capital asset pricing
(CAPM):
In this formula:
•Rf= risk-free rate of return
•Rm= market rate of return
•Beta = risk estimate

6. How to calculate cost of capital:
3. Weighted average cost of capital
The cost of capital is based on the weighted average of the cost of
debt and the cost of equity.
• In this formula:
• E = the market value of the firm's equity
• D = the market value of the firm's debt
• V = the sum of E and D
• Re = the cost of equity
• Rd = the cost of debt
• Tc = the income tax rate

7. How to calculate cost of capital:
3. Weighted average cost of capital
The cost of capital is based on the weighted average of the cost of
debt and the cost of equity.
• In this formula:
• E = the market value of the firm's equity
• D = the market value of the firm's debt
• V = the sum of E and D
• Re = the cost of equity
• Rd = the cost of debt
• Tc = the income tax rate

9. Working capital management (WCM)
• is also known as short term financial management and is mainly
concerned with the decisions relating to current assets and current
liabilities.
• It is concerned with the problems that arise in attempting to manage
the current assets, the current liabilities and the interrelationship that
exist between them.
• “Working Capital is the excess of C.A. over current liabilities.”

10. There are two concepts of working capital:
• Gross working capital
refers to the firm’s investments in all the current assets taken together. Thus it
total of investments in all the current assets. Also called as total working
capital.
• Net working capital
It refers to the excess of total current assets over current liabilities.

11. Current assets and current liabilities are –
Current Assets - Anything owned by
your business that can be converted into
cash within 12 months is a current asset.
• Cash-at-bank
• Cash equivalents (investments that can
be quickly converted into cash, like
government bonds)
• Accounts receivable (e.g. outstanding
invoices)
• Stock (including raw materials, work-in-
process, finished goods and packaging)
• Short-term investments
• Prepaid expenses
Current Liabilities - include any bills or
debt that you haven’t paid yet, including:
• Accounts payable (e.g. supplier
payments)
• Bank overdrafts
• Sales, payroll, and income taxes
• Wages
• Rent
• Short-term loans
• Outstanding expenses

12. Working Capital Formula and Ratio Formula:
Working Capital Formula
• The working capital calculation
is Working Capital = Current Assets -
Current Liabilities.
• For example, if a company’s balance
sheet has 300,000 total current assets
and 200,000 total current liabilities, the
company’s working capital is 100,000
(assets - liabilities).
Working Capital Ratio
Formula
• The working capital ratio formula shows the
ratio of assets to liabilities, i.e. how many
times a company can pay off its current
liabilities with its current assets. The working
capital ratio is Working Capital Ratio =
Current Assets / Current Liabilities.
• Using figures from the balance sheet above
for example, the working capital ratio would
be 300,000 / 200,000 = a working capital
ratio of 1.5.

13. Below is an example balance sheet used to calculate working capital:

14. Characteristics of Current Assets:
• In management of working capital, two characteristics of current
assets must be considered –
Short life span – normally it is less than one year.
Swift transformation into other asset forms – each current asset is
swiftly transformed into other assets, like – cash is used for acquiring
raw materials, r/m is transformed into finished goods, finished goods
generally sold on credit thus converted into a/r, and finally a/r, on
realisation, generates cash.

15. Thus current asset cycle may be shown as -

16. Factors Influencing Working Capital
Requirement:
• Nature of Business
• for service / trading firm, lower to modest working capital is required; while
for manufacturing concern, substantial WC is required.
• Seasonality of operations
• firms which have marked seasonality in their operations usually have high
fluctuations in working capital requirement.
• Production Cycle
• The time taken to convert raw materials into finished products is referred to
as the production cycle or operating cycle. The longer the production cycle,
the greater is the requirements of the working capital.

17. Factors Influencing Working Capital
Requirement:
• Market Conditions
• degree of competition in marketplace has a strong influence on WC
requirement. If competition is strong, higher amount of WC required,
otherwise if competition is weak low level of WC will suffice
• Supply Conditions
• if supply of raw materials, spares, other goods, is prompt, adequate and
predictable, the firm can manage with small inventory (or working capital).

18. Working Capital Policy:
The working capital management need not necessarily have a
target of increasing the wealth of the shareholders, but it helps in
attaining the objective by providing sufficient liquidity to the firm.
Thus, efficient WCM is important from the point of view of both
the liquidity and profitability. Poor and inefficient WCM means that
funds are unnecessarily tied up in idle assets.

19. Types of Working Capital Needs:
For any business, two kinds of working capital may be required. It is –
Permanent WC – this refers to minimum amount of investment in
current assets which is required at all times to carry out minimum level
of business operations.
Temporary WC – apart from PWC, the firm may also require additional
working capital in order to meet the requirement arising out of
fluctuations in sales volume. This extra working capital needed to
support the increased volume of sales is called as TWC.

20. The difference between permanent and
temporary working capital can be shown as -
Normally the permanent working capital is increasing with time in of
growing concern. Thus PWC line I not horizontal with base line. This is
shown in second graph.