Swami Sahajanand College Of 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 etc. 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.
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