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Financial Management - Capital Budgeting – A Conceptual Framework

Determination of Cost of Capital – Problems Involved

   Posted On :  20.06.2018 01:03 am

It is not an early task to determine the cost of capital of a firm. While determining the cost of capital of a firm, the funds manager is confronted with a large number of problems both conceptual and practical.

Determination of Cost of Capital – Problems Involved
 
It is not an early task to determine the cost of capital of a firm. While determining the cost of capital of a firm, the funds manager is confronted with a large number of problems both conceptual and practical.
 
Computation of cost of equity: The cost of equity capital is the minimum rate of return that a company must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. This implies that to find out the cost of equity capital one has to quantity the expectations of the shareholders from the particular equity shares. As it is a difficult task, a precise measure of cost of equity capital is also an arduous task.

Computation of cost of retained earnings and depreciation funds: The cost of capital raised through these sources will depend on the approach adopted for computing the cost of capital. As there are different views, the funds manager has to face a difficult task in subscribing and selecting an appropriate approach.

Marginal Vs average cost of capital: For decision – making purposes, it is the future cost of capital and not historical cost of capital which is relevant. If therefore creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital.

Problem of weights: The assignment of weights of each type of funds is a complex issue. If a financial executive wants to ascertain the average cost of capital than the problem of weights also arises. The finance manger has to make a choice between the book value of each source of funds and the market value of each source of funds. Both have their any merits as well as weaknesses.

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