Untitled-29

(^26) Financial Management
Average Cost and Marginal Cost
Average cast represents the weighted average of the costs of each source of funds
employed by the enterprise, the weights being the relative share of each source of
funds in the capita! structure. Marginal cost of capital, by contrast refers to incremental
cost associated with new funds raised by the firm. Average cost is the average of the
component marginal costs, while the marginal cost is the specific concept used to
comprise additional cost of raising new funds. In financial decisions the marginal cost
concept is most significant.
Explicit Cost and Implicit Cost
Cost of capital can be either explicit cost or implicit. The explicit cost of any source
of capital is the discount rate that equates the present value of the cash inflows that
are incremental to the taking of the financing opportunity with the present value of its
incremental cash outlay. Thus, the explicit cost of capital is the internal rate of return
of the cash flows of financing opportunity.
A series of each flows are associated with a method of financing. At the time of
acquisition of capital, cash inflow occurs followed by the subsequent cash outflows in
the form, of interest payment, repayment of principal money or payment of dividends.
Thus, if a company issues 10 per cent perpetual debentures worth Rs. 10,00,000, there
will be cash inflow to the firm of the order of 10,00,00. This will be followed by the
annual cash outflow of Rs. 1,00,000. The rate of discount, that equates the present
value of cash inflows with the present value of cash outflows, would be the explicit
cost of capital.
The technique of determination of the explicit cost of capital is similar to the one used
to ascertain IRR, with one difference, in the case of computation of the IRR, the cash
outflows occur at the beginning followed by subsequent cash inflows while in the
computation of the IRR, the cash outflows occur at the beginning followed by subsequent
cash inflows, while in the computation of explicit cost of capital, cash inflow takes
place at the beginning followed by a series of cash inflow subsequently.
The formula used to compute the explicit cost of capital (C) is:

CI 0 =

CO

C

t

t

t

n


= 1 ( 1 + ) ...(1)

Where,

CI 0 = net cash inflow in period O.

COt = cash outflow in period under reference

C = Explicit cost of capital

The explicit cost of an interest bearing debt will be the discount rate that equates the

present value of the contractual future payments of interest and principal with the net

amount of cash received today. The explicit cost of capital of a gift is minus 100 per

cent, since no cash outflow will occur in future.