CHANAKYA NATIONAL LAW UNIVERSITY

Cost of Equity-debt , Preference share capital,

Bond , weighted average capital of 2013-14,
2014-15, 2015-16 and its impact on the
profitability of SAIL
Financial Management

FACULTY- Dr. Kameshwar Pandey

SESSION 2016-2021

NAME C . MONICA

ROLL No. - 1617

SESSION 2016 21

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ACKNOWLEDGMENT

I am feeling highly elated to work on under the guidance of my Financial Management

faculty Dr. Kameshwar Pandey . I am very grateful to him for the exemplary guidance. I
would like to enlighten my readers regarding this topic and I hope I have tried my best to bring
more luminosity to this topic.

I also want to thank all of my friends, without whose cooperation this project was not
possible. Apart from all these, I want to give special thanks to the librarian of my
university who made every relevant materials regarding to my topic available to me at the
time of my busy research work and gave me assistance.

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RESEARCH METHODOLOGY

The method used for research is the doctrinal method and involves research in the library and on
the internet.

AIMS AND OBJECTIVES

The main aim here is to find out the impact of the cost of equity, debt, preference share capital,
bond and weighted average capital on the profitability of a firm.

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Table of Contents
INTRODUCTION ............................................................................................................................................. 5
Defination of Finance ................................................................................................................................ 5
Functions of Finance ................................................................................................................................. 6
Types of Finance ....................................................................................................................................... 7
FINANCIAL MANAGEMENT ........................................................................................................................... 9
Financial Management Decisions ............................................................................................................... 14
OBJECTIVES OF FINANCIAL MANAGEMENT ............................................................................................ 15
IMPORTANCE OF FINANCIAL MANAGEMENT ......................................................................................... 19
COST OF CAPITAL ........................................................................................................................................ 20
Definitions ........................................................................................................................................... 21
WEIGHTED AVERAGE COST OF CAPITAL ..................................................................................................... 28
ANALYSIS OF SAIL ........................................................................................................................................ 33
FINANCIAL STATEMENT .............................................................................................................................. 37
CONCLUSION............................................................................................................................................... 50
BIBLIOGRAPHY ............................................................................................................................................ 51

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 INTRODUCTION

Finance is the life blood of business. Before discussing the nature and scope of financial
management, the meaning of finance has to be explained. In fact, the term, finance has to be
understood clearly as it has different meaning and interpretation in various context. The time and
extent of the availability of finance in any organization indicates the health of a concern. Every
organization, may it be a company, firm, college, school, bank or university requires finance for
running day to day affairs. As every organization previews stiff competition, it requires finance
not only for survival but also for strengthening themselves. Finance is said to be the circulatory
system of the economy body, making possible the required cooperation between the innumerable
units of activity.

Defination of Finance

According to F.W.Paish, Finance may be defined as the position of money at the time it is
wanted.

In the words of John J. Hampton, the term finance can be defined as the management of the
flows of money through an organization, whether it will be a corporation, school, bank or
government agency.

According to Howard and Upton, finance may be defined as that administrative area or set of
administrative functions in an organization which relates with the arrangement of each and credit
so that the organization may have the means to carry out the objectives as satisfactorily as
possible.

In the words of Bonneville and Dewey, Financing consists in the raising, providing, managing of all the
money, capital or funds of any kind to be used in connection with the business.

As put forth by Hurband and Dockery in his book Modern Corporation Finance, finance is defined as
an organism composed of a myriad of separate enterprise, each working for its own ends but
simultaneously making a contribution to the system as a whole, some force is necessary to bring about

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direction and co-ordination. Something must direct the flow of economic activity and facilitate its
smooth operation. Finance is the agent that produces this result.

The Encyclopedia Britannica defines finance as "the act of providing the means of payment." It is thus
the financial aspect of corporate planning which may be described as the management of money.

An analysis of the aforesaid definition, makes it clear that finance directs the flow of economic activity
and facilitates the smooth operation. Finance provides the required stimulus for continued business
operations of all categories. Finance is essential for expansion, diversification, modernization,
establishment, of new projects and so on. The financial policy of any organization to a greater extent,
determines not only its existence, and survival but also the performance and success of that
organization. Finance is required for investment, purposes as well as to meet substantial capital
expenditure projects

Functions of Finance

According to Paul G. Hasings, "finance" is the management of the monetary affairs of a company. It
includes determining what has to be paid for and when, raising the money on the best terms available,
and devoting the available funds to the best uses. Kenneth Midgley and Ronald Burns state: "Financing is
the process of organising the flow of funds so that a business can carry out its objectives in the most
efficient manner and meet its obligations as they fall due."

Finance squeezes the most out of every available rupee. To get the best out of the available funds is the
major task of finance, and the finance manager performs this task most effectively if he is to be
successful. In the words of Mr.A.L.Kingshott, "Finance is the common denominator for a vast range of
corporate objectives, and the major part of any corporate plan must be expressed in financial terms."

The description of finance may be applied to money management provided that the following three
objectives are properly noted :

Many activities associated with finance such as saving, payment of things, giving or getting credit, do not
necessarily require the use of money.

In the first place, the conduct of international trade has been facilitated. The development of the
pecuniary unit in the various commercial nations has given rise to an international denominator of

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values. The pecuniary unit makes possible a fairly accurate directing of capital to those parts of the
world where it will be most productive. Within any given country, the flow of capital from one region to
another is guided in a similar manner.

The term finance refers to the financial system in a rudimentary or traditional economy, that is, an
economy in which the per capita output is low and declining over a period of time. The financial
organisation in rudimentary finance is characterized by the absence of any financial instruments of the
saving deficit units of their own which they can issue and attract savings. There will not be any
inducement for higher savings by offering different kinds of financial assets to suit the varied interests
and preferences of the investing public. The other characteristic of such a financial system is that there
are no markets where firms can compete for private savings.

Types of Finance

Business Finance:

The term business finance is very comprehensive. It implies finances of business activities.
The term, business can be categorized into three groups: commerce, industry and service. It is a
process of raising, providing and managing of all the money to be used in connection with
business activities.

It encompasses finance of sole proprietary organizations, partnership firms and corporate

organizations. No doubt, the aforesaid organizations have different characteristics, features,
distinct regulations and rules. And financial problems faced by them vary depending upon the
nature of business and scale of operations. However, it should be remembered that the same
principles of finance are applicable to large and small organizations, proprietary and
nonproprietary organizations.

According to Guthmann & Dougall, business finance can be broadly defined as the activity
concerned with planning, raising, controlling and administering of funds used in the business.

Business finance deals with a broad spectrum of the financial activities of a business firm. It
refers to the raising and procurement of funds and their appropriate utilisation. It includes within
its scope commercial finance, industrial finance, proprietary finance corporation finance and
even agricultural finance.

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The subject of business finance is much wider than that of corporation finance. However, since
corporation finance forms the lion's share in the business activity, it is considered almost inter-
changeable with business finance.

Business finance, apart from the financial environment and strategies of financial planning,
covers detailed problems of company promotion, growth and pattern. These problems of the
corporate sector go a long way in widening the horizon of business finance.

The finance manager has to assume the new responsibility of managing the total funds
committed to total assets and allocating funds to individual assets in consonance with the overall
objectives of the business enterprise.

Direct Finance

The term 'direct', as applied to the financial organisation, signifies that savings are effected
directly from the saving-surplus units without the intervention of financial institutions such as
investment companies, insurance companies, unit trusts, and so on.

Indirect Finance

The term 'indirect finance' refers to the flow of savings from the savers to the entrepreneurs
through intermediary financial institutions such as investment companies, unit trusts and
insurance companies, and so on. Finance administers economic activities. The scope of finance is
vast and determined by the financial needs of the business enterprise, which have to be identified
before any corporate plan is formulated. This eventually means that financial data must be
obtained and scrutinised. The main purpose behind such scrutiny is to determine how to maintain
financial stability.

Public Finance

It is the study of principles and practices pertaining to acquisition of funds for meeting the
requirements of government bodies and administration of these funds by the government

Private Finance

It is concerned with procuring money for private organization and management of the money by
individuals, voluntary associations and corporations. It seeks to analyse the principles and
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practices of managing ones own daily affairs. The finance of non-profit organization deals with
the practices, procedures and problems involved in the financial management of educational
chartable and religions and the like organizations.

FINANCIAL MANAGEMENT

Financial management has undergone fundamental changes as regards its scope and coverage.
Financial management is the application of planning and control to the finance function. It helps
in profit planning, measuring costs, controlling inventories, accounts receivables. It also helps in
monitoring the effective deployment of funds in fixed assets and in working capital. It aims at
ensuring that adequate cash is on hand to meet the required current and capital expenditure. It
facilitates ensuring that significant capital is procured at the minimum cost to maintain adequate
cash on hand to meet any exigencies that may arise in the course of business. Financial
management helps in ascertaining and managing not only current requirements but also future
needs of an organization.

It ensures that funds are available at the right time and procurement of funds does not
interfere with the right of management / exercising control over the affairs of the company.

It influences the profitability / return on investment of a firm.

It influences cost of capital. Efficient fund managers endeavour to locate less cost source so as
to enhance profitability of organization.

It affects the liquidity position of firms.

It enhances market value of the firm through efficient and effective financial management.

Financial management is very much required for the survival, growth, expansion and
diversification of business.

It is required to ensure purposeful resource allocation.

Financial Management Definition

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According to Weston and Brigham, financial management is an area of financial decision
making, harmonizing individual motives and enterprise goals. In the words of Phillippatus,
financial management is concerned with the managerial decisions that result in the acquisition
and financing of long-term and short-term credits for the firm. As such it deals with the
situations that require selection of specific assets / combination of assets, the selection of specific
liability / combination of liabilities as well as the problem of size and growth of an enterprise.
The analysis of these decisions is based on the expected inflows and outflows of funds and their
effects upon managerial objectives.

Financial Management Key Areas

The key areas of financial management are discussed in the following paragraphs.

(i) Estimating the Capital requirements of the concern. The Financial Manager
should exercise maximum care in estimating the financial requirement of his firm. To
do this most effectively, he will have to use long-range planning techniques. This is
because, every business enterprise requires funds not only for long-term purposes for
investment in fixed assets, but also for short term so as to have sufficient working
capital. He can do his job properly if he can prepare budgets of various activities for
estimating the financial requirements of his enterprise. Carelessness in this regard is
sure to result in either deficiency or surplus of funds. If his concern is suffering
because of insufficient capital, it cannot successfully meet its commitments in time,
whereas if it has acquired excess capital, the task of managing such excess capital
may not only prove very costly but also tempt the management to spend
extravagantly.
(ii) Determining the Capital Structure of the Enterprise. The Capital Structure of an
enterprise refers to the kind and proportion of different securities. The Financial
Manager can decide the kind and proportion of various sources of capital only after
the requirement of Capital Funds has been decided. The decisions regarding an ideal
mix of equity and debt as well as short-term and long-term debt ratio will have to be
taken in the light of the cost of raising finance from various sources, the period for
which the funds are required and so on. Care should be taken to raise sufficient long-
term capital in order to finance the fixed assets as well as the extension programme of

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 the enterprise in such a wise manner as to strike an ideal balance between the own
funds and the loan funds of the enterprise.
(iii) (iii) Finalising the choice as to the sources of finance. The capital structure finalised
by the management decides the final choice between the various sources of finance.
The important sources are share-holders, debenture-holders, banks and other financial
institutions, public deposits and so on. The final choice actually depends upon a
careful evaluation of the costs and other conditions involved in these sources. For
instance, although public deposits carry higher rate of interest than on debentures,
certain enterprises prefer them to debentures as they do not involve the creation of
any charge on any of the company's assets. Likewise, companies that are not willing
to dilute ownership, may prefer other sources instead of investors in its share capital.
(iv) Deciding the pattern of investment of funds. The Financial Manager must
prudently invest the funds procured, in various assets in such a judicious manner as to
optimise the return on investment without jeopardising the long-term survival of the
enterprise. Two important techniques (i) Capital Budgeting; and (ii) Opportunity
Cost Analysiscan guide him in finalising the investment of long-term funds by
helping him in making a careful assessment of various alternatives. A portion of the
long-term funds of the enterprise should be earmarked for investment in the
company's working capital also. He can take proper decisions regarding the
investment of funds only when he succeeds in striking an ideal balance between the
conflicting principles of safety, profitability and liquidity. He should not attach all the
importance only to the canon of profitability. This is particularly because of the fact
that the company's 36 solvency will be in jeopardy, in case major portion of its funds
are locked up in highly profitable but totally unsafe projects. .
(v) Distribution of Surplus judiciously. The Financial Manager should decide the
extent of the surplus that is to be retained for ploughing back and the extent of the
surplus to be distributed as dividend to shareholders. Since decisions pertaining to
disposal of surplus constitute a very important area of Financial Management, he
must carefully evaluate such influencing factors as(a) the trend of earnings of the
company; (A) the trend of the market price of its shares; (c) the extent of funds

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 required for meeting the self-financing needs of the company; (d) the future
prospects; (e) the cash flow position, etc.
(vi) Efficient Management of cash. Cash is absolutely necessary for maintaining enough
liquidity. The Company requires cash to(a) pay off creditors; (b) buy stock of
materials; (c) make payments to labourers; and (d) meet routine expenses. It is the
responsibility of the Financial Manager to make the necessary arrangements to ensure
that all the departments of the Enterprise get the required amount of cash in time for
promoting a smooth flow of all operations. Short-age of cash on any particular
occasion is sure to damage the credit- worthiness of the enterprise. At the same time,
it is not advisable to keep idle cash also. Idle cash should be invested in near-cash
assets that are capable of being converted into cash quickly without any loss during
emergencies. The exact requirements of cash during various periods can be assessed
by the Financial Manager by preparing a cash-flow statement in advance.

Finance Manager Functions

Finance manager is an integral part of corporate management of an organization. With his

profession experience, expertise knowledge and competence, he has to play a key role in optimal
utilization of financial resources of the organization. With the growth in the size of the
organization, degree of specialization of finance function increases. In large undertakings, the
finance manager is a top management executive who participants in various decision making
functions. He has to update his knowledge with regard to Foreign Direct Investment (FDI),
Foreign portfolio investment, mergers, amalgamations acquisitions, and corporate restructuring,
performance management, risk management corporate governance, investor relations, working
capital management, derivative trading practices, investor education and investor protection etc.

1) Forecasting of Cash Flow. This is necessary for the successful day to day operations of the
business so that it can discharge its obligations as and when they rise. In fact, it involves
matching of cash inflows against outflows and the manager must forecast the sources and timing
of inflows from customers and use them to pay the liability.

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2) Raising Funds: the Financial Manager has to plan for mobilising funds from different sources
so that the requisite amount of funds are made available to the business enterprise to meet its
requirements for short term, medium term and long term.

3) Managing the Flow of Internal Funds: Here the Manager has to keep a track of the surplus in
various bank accounts of the organisation and ensure that they are properly utilised to meet the
requirements of the 38 business. This will ensure that liquidity position of the company is
maintained intact with the minimum amount of external borrowings.

4) To Facilitate Cost Control: The Financial Manager is generally the first person to recognise
when the costs for the supplies or production processes are exceeding the standard
costs/budgeted figures. Consequently, he can make recommendations to the top management for
controlling the costs.

5) To Facilitate Pricing of Product, Product Lines and Services: The Financial Manager can
supply important information about cost changes and cost at varying levels of production and the
profit margins needed to carry on the business successfully. In fact, financial manager provides
tools of analysis of information in pricing decisions and contribute to the formulation of pricing
policies jointly with the marketing manager.

6) Forecasting Profits: The Financial manager is usually responsible for collecting the relevant
data to make forecasts of profit levels in future.

7) Measuring Required Return: The acceptance or rejection of an investment proposal depends

on whether the expected return from the proposed investment is equal to or more than the
required return. An investment project is accepted if the expected return is equal or more than the
required return. Determination of required rate of return is the responsibility of the financial
manager and is a part of the financing decision.

8) Managing Assets: The function of asset management focuses on the decision-making role of
the financial manager. Finance personnel meet with other officers of the firm and participate in
making decisions affecting the current and future utilization of the firm's resources. As an
example, managers may discuss the total amount of assets needed by the 39 firm to carry out its
operations. They will determine the composition or a mix of assets that will help the firm best

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achieve its goals. They will identify ways to use existing assets more effectively and reduce
waste and unwarranted expenses. The decision-making role crosses liquidity and profitability
lines. Converting the idle equipment into cash improves liquidity. Reducing costs improves
profitability.

9) Managing Funds: In the management of funds, the financial manager acts as a specialised staff
officer to the Chief Executive of the company. The manager is responsible for having sufficient
funds for the firm to conduct its business and to pay its bills. Money must be located to finance
receivables and inventories, 10 make arrangements for the purchase of assets, and to identify the
sources of long-term financing. Cash must be available to pay dividends declared by the board of
directors. The management of funds has therefore, both liquidity and profitability aspects.

Financial Management Decisions

As our discussion above suggests, the financial manager must be concerned with three basic
types of questions. We consider these in greater detail next.

Capital Budgeting

The first question concerns the firms long-term investments. The process of planning and
managing a firms long-term investments is called capital budgeting. In capital budgeting, the
financial manager tries to identify investment opportunities that are worth more to the firm than
they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an
asset exceeds the cost of that asset. Regardless of the specific investment under consideration,
financial managers must be concerned with how much cash they expect to receive, when they
expect to receive it, and how likely they are to receive it. Evaluating the size, timing, and risk of
future cash flows is the essence of capital budgeting. In fact, whenever we evaluate a business
decision, the size, timing, and risk of the cash flows will be, by far, the most important things we
will consider.

Capital Structure

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The second question for the financial manager concerns how the firm obtains the financing it
needs to support its long-term investments. A firms capital structure (or financial structure)
refers to the specific mixture of long-term debt and equity the firm uses to finance its operations.
The financial manager has two concerns in this area. First: How much should the firm borrow?
Second: What are the least expensive sources of funds for the firm? In addition to deciding on
the financing mix, the financial manager has to decide exactly how and where to raise the
money. The expenses associated with raising longterm financing can be considerable, so
different possibilities must be carefully evaluated. Also, corporations borrow money from a
variety of lenders in a number of different ways. Choosing among lenders and among loan types
is another job handled by the financial manager.

Working Capital Management

The third question concerns working capital management. The term working capital refers to a
firms short-term assets, such as inventory, and its short-term liabilities, such as money owed to
suppliers. Managing the firms working capital is a day-to-day activity that ensures the firm has
sufficient resources to continue its operations and avoid costly interruptions. This involves a
number of activities related to the firms receipt and disbursement of cash. Some questions about
working capital that must be answered are the following: (1) How much cash and inventory
should we keep on hand? (2) Should we sell on credit to our customers? (3) How will we obtain
any needed short-term financing? If we borrow in the short term, how and where should we do
it? This is just a small sample of the issues that arise in managing a firms working capital.

OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management.

Objectives of Financial Management may be broadly divided into two parts such as:

1. Profit maximization

2. Wealth maximization

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Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways
to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern. 4. Profit maximization objectives help to reduce the risk
of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the
business concern:

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.

(iii) Profit reduces risk of the business concern.

(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

(i) Profit maximization leads to exploiting workers and consumers.

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(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.

(iii) Profit maximization objectives leads to inequalities among the sake holders such as
customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization
is also known as value maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business.

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.

(ii) Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business operation. It
provides extract value of the business concern.

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(iii) Wealth maximization considers both time and risk of the business concern.

(iv) Wealth maximization provides efficient allocation of resources.

(v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.

(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.

(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoy certain benefits.

(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.

(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern.

APPROACHES TO FINANCIAL MANAGEMENT

Financial management approach measures the scope of the financial management in various
fields, which include the essential part of the finance. Financial management is not a
revolutionary concept but an evolutionary. The definition and scope of financial management has
been changed from one period to another period and applied various innovations. Theoretical
points of view, financial management approach may be broadly divided into two major parts.

Traditional Approach Traditional approach is the initial stage of financial management, which
was followed, in the early part of during the year 1920 to 1950. This approach is based on the
past experience and the traditionally accepted methods. Main part of the traditional approach is
rising of funds for the business concern. Traditional approach consists of the following important
area.

Arrangement of funds from lending body.

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 Arrangement of funds through various financial instruments.
Finding out the various sources of funds.

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their
smooth running of the business concern and also maintain the business carefully to achieve the
goal of the business concern. The business goal can be achieved only with the help of effective
management of finance. We cant neglect the importance of finance at any time at and at any
situation.

Some of the importance of the financial management is as follows:

Financial Planning
Financial management helps to determine the financial requirement of the business
concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise.
Acquisition of Funds
Financial management involves the acquisition of required finance to the business
concern. Acquiring needed funds play a major part of the financial management, which
involve possible source of finance at minimum cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the
business concern. When the finance manager uses the funds properly, they can reduce the
cost of capital and increase the value of the firm.
Financial Decision
Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there
is a direct relationship with various department functions such as marketing, production
personnel, etc.
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of
funds by the business concern. Financial management helps to improve the profitability
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 position of the concern with the help of strong financial control devices such as budgetary
control, ratio analysis and cost volume profit analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the
investors and the business concern. Ultimate aim of any business concern will achieve the
maximum profit and higher profitability leads to maximize the wealth of the investors as
well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings. Nowadays financial management is also popularly
known as business finance or corporate finances. The business concern or corporate
sectors cannot function without the importance of the financial management.

COST OF CAPITAL

Cost of capital is an integral part of investment decision as it is used to measure the worth of
investment proposal provided by the business concern. It is used as a discount rate in
determining the present value of future cash flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the
firms are using different sources of finance, the finance manager must take careful decision with
regard to the cost of capital; because it is closely associated with the value of the firm and the
earning capacity of the firm.

Meaning of Cost of Capital Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds.

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

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Definitions
The following important definitions are commonly used to understand the meaning and concept
of the cost of capital.

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 market place.

According to the definition of Solomon Ezra, Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure.

According to the definition of James C. Van Horne, Cost of capital is A cut-off rate for the
allocation of capital to investment of projects. It is the rate of return on a project that will leave
unchanged the market price of the stock. According to the definition of William and Donaldson,
Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the
cost elements of the burden at the time they are due.

Assumption of Cost of Capital Cost of capital is based on certain assumptions which are closely
associated while calculating and measuring the cost of capital. It is to be considered that there are
three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.

3. It consis of three important risks such as zero risk level, business risk and financial risk. Cost
of capital can be measured with the help of the following equation.

K=rj + b + f.

Where,

K = Cost of capital.

rj = The riskless cost of the particular type of finance.

b = The business risk premium.

f = The financial risk premium.

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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.

Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the computation of cost of
capital. Explicit cost is the rate that the firm pays to procure financing.

Implicit cost is the rate of return associated with the best investment opportunity for the firm and
its shareholders that will be forgone if the projects presently under consideration by the firm
were accepted.

Average and Marginal Cost Average cost of capital is the weighted average cost of each
component of capital employed by the company. It considers weighted average cost of all kinds
of financing such as equity, debt, retained earnings etc.

Marginal cost is the weighted average cost of new finance raised by the company. It is the
additional cost of capital when the company goes for further raising of finance.

Historical and Future Cost

Historical cost is the cost which as already been incurred for financing a particular project. It is
based on the actual cost incurred in the previous project.

Future cost is the expected cost of financing in the proposed project.

Expected cost is calculated on the basis of previous experience.

Specific and Combine Cost

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The cost of each sources of capital such as equity, debt, retained earnings and loans is called as
specific cost of capital. It is very useful to determine the each and every specific source of
capital. The composite or combined cost of capital is the combination of all sources of capital. It
is also called as overall cost of capital. It is used to understand the total cost associated with the
total finance of the firm.

IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial management to decide
the capital structure of the business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. According to net
present value method, present value of cash inflow must be more than the present value of cash
outflow. Hence, cost of capital is used to capital budgeting decision.

Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long term securities. A firm
uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to
take decision regarding structure.

Importance to Evolution of Financial Performance

Cost of capital is one of the important determine which affects the capital budgeting, capital
structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions Apart from the above points, cost of capital is also used
in some other areas such as, market value of share, earning capacity of securities etc. hence, it
plays a major part in the financial management.

COMPUTATION OF COST OF CAPITAL

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs

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2. Measurement of overall cost of capital

Measurement of Cost of Capital It refers to the cost of each specific sources of finance like:

Cost of equity

Cost of debt

Cost of preference share

Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to
determine its share value. Conceptually the cost of equity capital (Ke) defined as the Minimum
rate of return that a firm must earn on the equity financed portion of an investment project in
order to leave unchanged the market price of the shares.

Cost of equity can be calculated from the following approach:

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 Dividend price (D/P) approach

Dividend price plus growth (D/P + g) approach

Earning price (E/P) approach

Realized yield approach.

Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain the present
market price of equity shares.

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earning
prospects of the equity.

Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this method, cost of equity is
calculated on the basis of return actually realized by the investor in a company on their equity
capital.

Cost of Debt

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.

Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt.

Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

Cost of Preference Share Capital

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Cost of preference share capital is the annual preference share dividend by the net proceeds from
the sale of preference share.

There are two types of preference shares irredeemable and redeemable.

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as the
cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost
of equity capital.

Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted
average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firms capital structure.
The computation of the overall cost of capital (Ko) involves the following steps.

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(a) Assigning weights to specific costs.

(b) Multiplying the cost of each of the sources by the appropriate weights.

(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula;

Ko = Kd Wd + Kp Wp + Ke We + Kr Wr

Where,

Ko = Overall cost of capital

Kd = Cost of debt

Kp = Cost of preference share

Ke = Cost of equity Kr = Cost of retained earnings

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Wd= Percentage of debt of total capital

WEIGHTED AVERAGE COST OF CAPITAL

Weighted average cost of capital is a weighted average of cost of equity, debt and preference
shares and the weights are the percentage of capital sourced from each component respectively in
market value terms. It is better known as Overall WACC i.e. the overall cost of capital for the
company as a whole. The advantages of using such a WACC are its simplicity, easiness, and
enabling prompt decision making. The disadvantages are its limited scope of application and its
rigid assumptions coming in the way of evaluation of new projects.

The importance and usefulness of weighted average cost of capital (WACC) as a financial tool
for both investors and the companies are well accepted among the financial analysts. It is
important for companies to make their investment decisions and evaluate projects with similar
and dissimilar risks. Calculation of important metrics like net present values and economic value
added requires WACC. It is equally important for investors for arriving at valuations of
companies.

WACC analysis can be looked at from two angles the investor and the company. From the
companys angle, it can be defined as the blended cost of capital which the company has to pay
for using the capital of both owners and debt holders. In other words, it is the minimum rate of
return a company should earn to create value for the investors. From investors angle, it is the

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opportunity cost of their capital. If the return offered by the company is less than its WACC, it is
destroying value and hence, the investors may discontinue their investment in the company.

ASSUMPTIONS

The WACC can very well work as a hurdle rate in evaluating the new projects provided the
following two underlying assumptions are true for those new projects.

No Change in Capital Structure: The capital mix or structure of the new project
investment should be same as the companys existing structure. It means that if the
company has 70:30 ratio of debt to equity in their current balance sheet, an inclusion of
the new project will maintain the same.
No change in Risk of New Projects: The risk associated with the new project will be
like the existing projects. For example, a textile manufacturer expands and increases the
no. of looms from 60 to 100. Since the industry and business are same, there will be
almost no change in the risk profile of the current business and the new expansion.

If the assumptions of using plain WACC are not true for a project or a division, it is
advisable to evaluate with Project or Divisional WACC.

ADVANTAGES

Simple and Easy: The biggest advantage of using WACC as a hurdle rate to evaluate
the new projects is its simplicity. The calculation does not involve too much of
complication. The manager just needs to apply weights of each source finances with
its cost and aggregate the result.
Single Hurdle Rate for All Projects: One single hurdle rate for all projects saves a
lot of time of the managers in an evaluation of the new projects. If the projects are of
same risk profile and there is no change in the proposed capital structure, the current
WACC can be applied and effectively used.
Prompt Decisions Making: It is said that the same opportunity never knocks twice.
For taking advantage, the right decisions have to be taken at the right time. Since the

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 single rate is used for all new projects, the decisions can arrive at a faster pace and the
new opportunity can be grabbed and taken benefit of.

DISADVANTAGES

The disadvantages are stemmed mainly from the assumptions of the applicability of WACC. The
practicability and limitations of the assumptions are discussed below. The remedy to overcome
the problem is also specified.

Difficulty in Maintaining the Capital Structure: The impractical assumptions of No

Change in Capital Structure has rare possibilities of prevailing all the time. It suggests
the same capital structure for new projects. There are two possibilities for funding the
project in this way. The remedy to this problem is that the target capital structure should
be taken into consideration and not the existing. and therefore, the calculation of WACC
should be adjusted accordingly.
Accepting Bad Projects and Rejecting Good Projects: The impractical assumptions of
No Change in Risk Profile of New Projects again has its inbuilt drawbacks. The risk is a

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 very wide term and is affected by a big list of factors. Under that situation, assuming no
change in the risk profile of new projects would be very unrealistic.
The remedy to this problem is that the WACC should be adjusted to take effect of the
change in risk.
Difficulty in Acquiring Current Market Cost of Capital: The WACC used for
evaluation of new projects require consideration of present day cost of capital and
knowing such costs is difficult. The WACC considers mainly equity, debt and preferred.
The interest cost of debt keeps changing in the market depending on the economic
changes. The expected dividend of the preferred also keeps changing with the market
sentiments and the most fluctuating is the expected cost of equity.
Important Sources of Capital Avoided: While making WACC calculations, only
equity, debt and preference shares are considered for the sake of simplicity assuming that
they cover a major portion of the capital. In support of absolutely correct approach
towards discounting rate, if we include convertible or callable preference shares, debt, or
stock market-linked bonds, or puttable or extendable bonds, warrants, etc also which are
also a claimant to the profits of the company like equity, debt and preference shares, it
will make the calculations very complex. Too much complexity is a probable reason for
mistakes. On the similar grounds, the short-term borrowings and the cost of trade credit
are also not taken into consideration. Factors like such if introduced, will definitely
change the WACC. We will not go into the magnitude of the difference these things will
have on the calculations of the WACC but the impact is there.

IMPORTANCE AND USE OF WACC Analysis

The following points will explain why WACC is important and how it is used by investors and
the company for their respective purposes:

INVESTMENT DECISIONS BY THE COMPANY

WACC is widely used for making investment decisions in the corporate by evaluating their
projects. Let us categorize the investments in projects in the following 2 ways:

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 Evaluation of Projects with the Same Risk: When the new projects are of similar risk
like existing projects of the company, it is an appropriate benchmark rate to decide the
acceptance or rejection of these projects. For example, a furniture manufacturer wishes to
expand its business in new locations i.e. establishing a new factory for the same kind of
furniture in a different location. To generalize it to some extent, a company entering new
projects in its own industry can reasonably assume the similar risk and use WACC as a
hurdle rate to decide whether it should enter into the project or not.
Evaluation of Projects with Different Risk: WACC is an appropriate measure to be
used to evaluate a project provided two underlying assumptions are true. The
assumptions are same risk and same capital structure. What to do in this situation?
Still, WACC can be used with certain modification with respect to the risk and target
capital structure. Risk-adjusted WACC, adjusted present value etc are the concepts to
circumvent the problems of WACC assumptions.

DISCOUNT RATE IN NET PRESENT CALCULATIONS

Net present value (NPV) is the widely used method of evaluating projects to determine the
profitability of the investment. WACC is used as discount rate or the hurdle rate
for NPV calculations. All the free cash flows and terminal values are discounted using the
WACC.

CALCULATE ECONOMIC VALUE ADDED

EVA is calculated by deducting the cost of capital from the net profits of the company. In
calculating the EVA, WACC serves as the cost of capital of the company. This is how WACC
may also be called a measure of value creation.

VALUATION OF COMPANY

Any rational investor will invest time before investing money in any company. The investor will
try to find out the valuation of the company. Based on the fundamentals, the investor will project
the future cash flows and discount them using the WACC and divide the result by no. of equity
shareholders. He will get the per-share value of the company. He can simply compare this value
and the current market price (CMP) of the company and decide whether it is worth investment or

32
not. If the valuations are more than the CMP, the scrip is under-priced and if it is less than CMP,
it is overpriced.

IMPORTANT INFERENCES FROM WACC

Some important inferences from WACC can be drawn to understand various important issues
that the management of the company should address.

Effect of Leverage: Considering the Net Income Approach (NOI) by Durand, the effect
of leverage is reflected in WACC. So, the WACC can be optimized by adjusting the debt
component of the capital structure. Lower the WACC, higher will be the valuations of the
company. Lower WACC also widens the scope of the company by allowing it to accept
low return projects and still create value.
Effect of Leverage: Considering the Net Income Approach (NOI) by Durand, the effect
of leverage is reflected in WACC. So, the WACC can be optimized by adjusting the debt
component of the capital structure. Lower the WACC, higher will be the valuations of the
company. Lower WACC also widens the scope of the company by allowing it to accept
low return projects and still create value.

The analysis using WACC should also consider the advantage and disadvantages of WACC.

ANALYSIS OF SAIL
Steel Authority of India Limited (SAIL) is the leading steel-making company in India. It is a
fully integrated iron and steel maker, producing both basic and special steels for domestic
construction, engineering, power, railway, automotive and defense industries and for sale in
export markets.

The company is ranked amongst the top ten public sector companies in India in terms of
turnover, SAIL manufactures and sells a broad range of steel products, including hot and cold
rolled sheets and coils, galvanized sheets, electrical sheets, structurals, railway products, plates,
bars and rods, stainless steel and other alloy steels. Bhilai Steel Plant (BSP) is India's sole

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producer of rails and heavy steel plates and major producer of structural has won Prime
Minister's Trophy for best Integrated Steel Plant in the country for Nine times.

The growth of mining / industry significantly contribute towards economic progress of the
country. However, any project progress brings along with it a number of environmental
problems. Many of these problems can be avoided, if adequate environmental control
considerations are thought of during conceptual stage of the project. In accordance with Mission
and Objectives of M/s. Steel Authority of India Limited and National Steel Policy, SAIL
proposes to develop Kalwar and Nagur villages with a rated production capacity of 1.0 Million
Tone per annum. The Mining lease area under is 938.059 Ha.

Location

BSP proposes to develop Kalwar - Nagur Iron Ore Project, at Kalwar and Nagur villages,
Bhanuprathappur taluk, Kanker district, Chhatisgarh state The deposit is located in the Nos. 64
D/15 and 64 H/3 between longitude 80 56' 44M to8100'48" E and between latitude
2025'00"to2027, 31" N.The Kalwar-Nagur lease area is well connected by road lying at a
distance of 111 kms. South-West of Bhilai Steel Plant. The Iron ore produced from this mine is
being transported by road to Dalli-Rajhara Iron ore Complex located at a distance of 23km. The
proposed mining block of Kalwar-Nagur lease can be approached from Mahamaya-Dulki mine
towards south by a Kuccha road for a distance of another 3 kms.

Manpower requirement

The requirement of manpower at the rated capacity of 1.0 Mt of ore has been estimated as 37
numbers.

Socio economic

As per 2001 census, the study area consisted of 17538 persons inhabited in 37 villages. The
configuration of male and females indicates that the males constitute to about 49.37% and
females to about 50.63% of the study area population. The study area at an average has 1025.64
females per 1000 males. Majority of the people in the study area belong to Hindu religion. The
study area also contains Scheduled Castes (SC) and Scheduled Tribes (ST).

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In the study area 2.78% of the population belongs to Scheduled Castes (SC) while 77.55% to
Scheduled Tribes (ST), thus indicating that about 80.33% of the population is formed by SC and
ST population. Scheduled Caste and Scheduled Tribe sections are predominant in this area.The
study area experiences a moderate literacy rate of 61.57%. The male literacy i.e. the percentage
of literate males to the total males of the study area is observed as 70.07% while female literacy
rate, which is an important indicator for social change, is observed as 53.29% in the study area.

Anticipated Environmental Impacts And Mitigation Measures

Impact on Land use

The topography within the mining area will have marked changes in the quarry area, the dump
area and the mining equipment area. No appreciable change in the topography is anticipated out
side mining area. Total scenario of landscape and land use pattern will undergoes a stark change
within the mining area. There will be a stark change in surface drainage and new pattern
drainage will be developed within the mining area.

Impact on Air Quality

The major source of air pollution into the atmospheric environment are:

1. Removal and dumping of over burden

2. Drilling and blasting operations

3. Extraction of ore by machinery.

4. Loading of ore into trucks.

5. Dump yard waste material.

Medical Facilities

The project authorities have adopted following measures to prevent occupational diseases and
health hazards.

Pre-employment, pre-placement and periodic medical examination of employees.

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 Regular monitoring of working environment and implementation of safety and control
measures, to prevent hazards.

Use of protective equipments, clothing, helmets, Gas mask, shoes, etc.

Periodical medical examination-of every worker is done once in five years to detect
preventable and curable diseases at an early stage.

Cases suspected having Pneumoconiosis is examined by a Special Board constituted by the

Chief Medical Officer.

Established cases are suitably compensated and their job is changed if required.

Literacy Drive

An action plan for achieving 100% literacy among workers to be implemented by establishing
Educational Institutions / adoption with modern facilities.

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FINANCIAL STATEMENT

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 ANALYSIS OF 2013 - 14

Cost of Equity
P0 = d/ ke g

g = 991.32 999.60 / 991.32 = - 0.0083

Market price of share = 42.5

d = 8.03

Therefore, 42.5 = 8.03 / ke + 0.0083

42.5 ke + 0.3527 = 8.03

Hence , ke = 0.1806

Cost of reserves and surplus = 0.1806

Cost of debt = d (1 t)

Weighted Average Cost Of Capital

SOURCE AMOUNT(Cr.) WEIGHT COST WEIGHT X COST

Equity 4130.53 0.0716 0.1806 0.0129

Reserves and surplus 38535.82 0.6680 0.1806 0.1206

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Debt 15013.52 0.2602 0.0402 0.0104

Total 57679.87 0.1439

ANALYSIS OF 2014-15

Cost of Equity
P0 = d / Ke g
g = 999.60 722.84 / 999.60 = 0.2768
d = 5.80
Market price of share = 48.8
Therefore, 48.8 = 5.80 / ke 0.2768
48.8 Ke = 19.30
Ke = 0.3956
Cost of Reserves and Surplus = 0.3956
Cost of Debt = d ( 1 t )
= 0.093 ( 1 34.61/100)
= 0.0608
Weighted Average Cost Of Capital

SOURCE AMOUNT WEIGHT COST WEIGHT X

COST
Equity 4130.53 0.0702 0.3956 0.0277

Reserves and surplus 39374.25 0.6699 0.3956 0.2650

Debt 15264.28 0.2597 0.0608 0.0157

Total 58769.06 0.3084

ANALYSIS OF 2015 16

Cost of equity

48
 P0 = d / Ke g
g = 722.84 103.26 / 722.84 = 0.8571
d = 0.82
Market Price of share = 61.2
Therefore, 61.2 Ke = 53.2745
Ke = 0.8704
Cost of Reserves and suplus = 0.8704
Cost of Debt = d ( 1 t )
= 0.1031 ( 1 34.61 / 100)
= 0.0674
Weighted Average Cost Of Capital
SOURCE AMOUNT WEIGHT COST WEIGHT X
COST
Equity 4130.53 0.0730 0.8704 0.0635

Reserves and 35150.73 0.6215 0.8704 0.5409

Surplus
Debt 17270 0.3053 0.0674 0.0205

Total 56551.96 0.6249

INFERENCE DRAWN FROM THE ABOVE DATA

The inference drawn from the above data is that the profits of the company for these three
consecutive years were as follows:
2013 14 2616.48
2014 15 2092.68
2015 16 4137.26

Hence, the profit from the year 2013-14 declined to the year 2014-15 by 20% and from
the year 2014-15 increased to the year 2015-16 by 97.73% .
While the expenditure from 2013-14 increased to the year 2014- 15 by 16.45% and from
the year 2014-15 increased to the year 2015-16 by 31.65 %.

49
 Therefore , from 2013-14 to 2014-15 the profit declined while the expenditure rose and
hence the firms financial condition may not be that strong and they need to keep a
control on their expenses in order to balance profit and risk.
While from 2014-15 to 2015-16 the profit increased by a very high margin and the
expenditure increased by low margin in comparison and therefore the inference can be
drawn that at that point the financial condition of SAIL was good.

CONCLUSION
Broadly speaking, a company's assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its respective use
in the given situation. By taking a weighted average, we can see how muh the company has to
pay for every rupee in finance. A firm's WACC is the overall required return on the firm as a
whole and, as such, it is often used internally by company directors to determine the economic
feasibility of expansionary opportunities and mergers.

The liquidity position and profitability of a company playing a crucial role in the survival of the
company and compete successfully in the market. The liquidity position of SAIL Company was
below the traditional standards and the profitability ratio showing the positive sign but it varying
frequently during the study period. There is a positive correlation between liquidity and
profitability ratios but there is a negative correlation between ROA and liquidity ratio. The
calculated Z score values are too healthy to the company but it is in declining trend. The
company must take proper measures to increase the financial performance using the available
resources.

Disadvantages are associated with everything in this world so does with WACC. This does not
prove the concept futile. It can be used under different circumstance by making some
adjustments to it. There are other theories like Adjusted WACC and Adjusted Present Value
Approach to circumvent the disadvantages of WACC.

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WACC is an important metric used for various purposes but it has to be used very carefully. The
weights of the capital components should be expressed in market value terms (Refer: Market
Value vs. Book Value WACC). The market values should be determined carefully and
accurately. Faulty calculations of WACC will result in faulty investment decisions as well. There
are issues such as no consideration given to the floatation cost which is not worth ignoring. The
complications increase if the capital consists of callable, puttable or convertible instruments,
warrants etc.

BIBLIOGRAPHY
PRIMARY SOURCES

BOOKS
Financial Management, Text , problems and cases, MY Khan & PK Jain, 7th edition,
2014
Essentials of Financial Management , I M Pandey ,3rd edition, 2011
Financial Management, , Paresh Shah, 2nd edition, 2009

SECONDARY SOURCES

WEBSITES
https://www.sail.co.in/
https://www. sailsjs.com/
https://www.annualreports.com/
https://www.bseindia.com/
https://www.mca.gov.in/
https://www.investopedia.com/
https://www.wallstreetoasis.com
https://www.managementstudyguide.com/
https://www.knowhownonprofit.org/
https://www.managementhelp.org/

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