Document Sample
B.F Powered By Docstoc
					                   Swami Sahajanand College


                    Commerce management

Name : Hariom k. Trivedi

Roll no : 155

Class           : T.Y. B.B.A (B)

Subject : Business Finance

Topic name : Average Cost and Marginal Cost

Submission date :

Faculty sign:                          Student sign:
                Average cost and Marginal cost
      Average cost is the weighted average of all specific costs of various
components of capital used. The weights assigned to different components
of capital are according to their proportion in capital structure. The marginal
cost is the average cost of additional funds raised for a new investment
scheme. For most of the financial decisions and for capital budgeting
purposes, it is the concept of marginal cost which is more important.

      Here too, a distinction can be made between the specific average
cost of additional capital and total marginal cost for the company as a
whole. If additional funds are to be raised through debentures, the cost of
debenture is called marginal cost, while the average capital cost incurred
when these additional funds are raised through difference sources is known
as total marginal cost. In capital budgeting decisions, the concept of total
marginal cost is more useful.

Average cost:-

       So far we dealt with the specific cost for each separate source of
capital, that is, we calculated the specific cost of the source of the capital
which is used to obtain funds for investment project and applied it to
evaluate the profitability of this project. e.g. if funds are to be raised through
the issue of equity shares to finance a new investment project, the cost of
equity capital is calculated and applied to evaluate this project. However
experience has shown that this method does not give satisfactory results.
Hence a combined or composite cost of capital is derived from the various
cost of capital and used to make choice of investment project. The
combined or composite cost means the weighted average of the specific
cost of different sources of capital where each source of capital is assigned
of weightage according to its relative share in capital structure of the
company. Following three stages are involved in the calculation of the
weighted average cost of capital.

          1. The specific cost of each source of capital is calculated
             separately i.e. the cost of equity capital, the cost of debenture
          2. The specific cost of each source of capital is multiplied by its
             relative share in capital structure.
          3. The weighted cost of all sources thus obtain are then added
             together and weighted average is ascertained.

Marginal cost:-

      The second important question is whether the weightage which we
assign to find out the weighted average cost of capital is to be assigned on
the basis of the relative share if different sources of capital in total existing
capital of the company or in the additional capital of the company.e.g.
Suppose total existing capital of the company amounts to Rs. 50lacs in
which equity shares are worth Rs. 20lacs, debentures are worth Rs.15lacs
and retained earnings are of the order of Rs.15lacs. Thus, relative shares
of different sources in existing capital are 20:15:15. This is known as
historical proportion. Suppose the weighted average of the additional
capital is calculated on the basis of historical proportion. Then it is called
weightage according to historical proportion. But suppose the company
wants to raise additional capital of Rs.20lacs which consists of equity
shares worth Rs. 12lacs, debentures of Rs.5lacs in retained earnings is
Rs.3lacs. Here the additional capital of the order of Rs.20lacs is called
marginal capital and the proportion different sources in it 12:5:3.is called
marginal proportion. If the weighted average of additional capital is
calculated on the basis of marginal proportion, it is known as marginal cost
of capital.

Shared By: