Generally, business firms require capital for meeting long term financial needs and for meeting working capital needs. Long Term Financial needs include cost for purchase of building and plant and machinery. Roberto (2007:2). This amount would remain blocked for more than one year. It may even remain blocked for the entire life of the project. Hence, the purchase of plant and machinery, Land and Building that is, Fixed Assets has to be funded through Long Term Sources of Finance. All these capital expenditure decisions involve huge investments, however the benefits of the same can be perceived in the Long Term only. Moreover, these expenses are irreversible in nature; this means that once the expenses are incurred they cannot be altered. Hence, these expenditures need to be planned carefully to avoid liquidity crises. The firm has planned to meet the Long Term Capital needs through Owner's Capital and long term debt from relatives. We conclude that this is a sound decision as it reduces the liquidity risk.
Firms also require capital for meeting short term financial requirements include working capital which means the capital required for meeting the short term cash requirements for purchase of raw materials etc. Robert (2001:3). These are generally held in form of cash, for meeting short term requirements. ...
Moreover, money can be blocked in accounts receivables, customers to whom goods are sold on credit basis. Liabilities are economic obligations of a business towards others to pay money or provide goods or services. Ronald (1986:4). There may be short term liabilities which need to be paid such as accounts payables, bills payable, outstanding expenses etc. The current assets and liabilities have to be managed efficiently. The firm is kept 1000 for meeting working capital needs, in order to fund the purchase of raw material and meeting short term manufacturing expenses.
Cost of Capital
The capital of the firm includes 40,000 loan (debt) and 10,000 as owner's capital (equity). The cost of capital of a business is the minimum rate of return it should earn to satisfy the various categories of investors who have contributed to the capital of the company. We have to determine the Weighted Average Cost of Capital. Roger, Shannon (2008:5). Here, we take debt and equity as weights. The rate of return required by equity investors is higher than the return required by debt holders. This is because there more risk associated with equity capital than debt capital. The debt capital holders will receive a fixed interest income every year and the equity shareholders receive dividends only in case there is profit. Hence, the rate of return required by equity shareholders is assumed to be 20% and the interest cost on debt is @ 8% p a. The interest cost is tax deductible. Hence, it reduces the cost of capital significantly.
The weighted average cost of capital (WACC) is determined by the following formula:
D/(D+E) X Kd (1-T) + E/(D+E) X Ke
D = Debt Capital
E = Equity Capital
Kd= Interest rate on Debt
T = Tax