Object of financial management
Objective of financial management is to maximise shareholder wealth, it
is measure by market capital of the company. Market capital is represented by
number of share multiplied with share price.
Market
capital = Number of share x Market share price
Shareholder is the owner of the company they
appoint management the company, manager should manages the company in the best
interest of shareholder. Management acquire fund at optimum cost and utilise it
with the minimum risk to earn maximum return and distribute dividend to
shareholder or retained earnings for further investment to generate maximum
possible return.
THE cost of capital of a firm is the minimum
rate of return which the firm must earn on its investments in order to satisfy
the expectations of investors who provide funds to the firm.
It is the weighted
average of the cost of various sources of finance used by it. The method of
computing the cost of capital is to compute the cost of each type of capital
and then find the weighted average of all types of costs of capital.
In other
words, two steps are involved in determination of cost of capital of a firm:
(i) computation of cost of different sources of capital, and
(ii) determining
overall cost of capital of the firm by weighted average or total cost divided by
total fund.
Kc- kc
would be weighted average of effective cost of debt and equity
Kc = weight of debt x
post-tax cost of debt + weight of equity x cost of equity.
Kc= wd x post-tax kd + we x
ke
Cost of debt is to be
calculated as follows.
Irredeemable debt:
Annual
interest (1 - Tax rate)
Cost of debt =————————————------×
100
Net
proceeds of debt
For debt redeemable after
certain period
(iii)
Earning price ratio.
Price is how many times of Earning Per Share.
Price= Earning Per Share X P/E ratio
Price is how many times of Earning Per Share.
Price= Earning Per Share X P/E ratio
P/E
ratio = 1/ke, Ke = 1/PE ratio.
Component of interest (Required rate of return)
Rf ( Risk free real rate )= it is compensation for sacrifice of current
consumption
Inflation premium = it is compensation for loss of Purchasing Power
Risk Premium = it is
compensation for bearing risk.
All rate should be taken in
to factor while calculation in below.
Risk free nominal rate = Rf
( Risk free real rate ) x Inflation Premium
Risk adjusted rate = Rf (
Risk free real rate ) x Risk Premium
Risk adjusted nominal rate
= Rf ( Risk free real rate ) x Inflation Premium x Risk Premium
When we invest in a inflation protected security
we donot demand inflation premium i.e, rate would be Rf real. When we invest in
a corporate security, there is default risk involved therefor we demand risk
premium.
All interest rate are
combine in multiplication fashion except CAPM, RADR & Spread.
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