Cost of Capital Part I

You may have heard a lot of people talking about the cost of capital of running a business. With consideration of the number of people who use the term on an off-hand basis every day, one would think that they understand the meaning of the term very clearly. But the the truth is quite contrary. Which is why this post will clear all your doubts and misconceptions about cost of capital.

Now before we dive into the main concept, first let’s clear the basics up. A business which is run by a company usually gets the money to run the business from other people. In other words, the company borrows the money from ordinary people like you and me and uses it pay for its expenses of running and buying stuff it needs for the business.

But why would we give the company our money? Why, in return for a guarantee of either a share in the profits of the company, or a share in the management and ownership of the company or for the guarantee of getting more money back than originally lent. The company issues securities or declarations in proof of these promises. These securities are almost as valid as money and can be used by you to take loans for yourself or to pay off some of your own debts.

The money that the company takes from us is its capital and the guarantee is gives us (whether of greater return, or share of profits or ownership) is the cost of that capital to the company. Now, if you have been paying attention this far, then you would have noticed that we have talked about three different types of capital and the three different costs associated with them. Now it’s time to delve deeper.

Firstly, the three types of capital have names by which they are known universally. These are:

          Preference Share Capital: Obtained in exchange of Share of Profit

          Equity Share Capital: Obtained in exchange of Share in Ownership and/or Management

          Debentures and Loans: Obtained in exchange of Greater Returns, usually in the form of Interest compounded at a determined rate for a determined term.

It’s also important to know that the first two types are considered to be owned capital of the company while the last represents borrowed capital. But wait! I just told you that all capital is borrowed! So what’s all this? Watch out for my next post! In the meantime, any comments and questions will be appreciated and answered.

Time to Return

It has been more than three years since I last wrote here. Believe me, I was astonished beyond comprehension to realise that it has been that long. But time and tide wait for no man and I believe it is time again that I should take to this blog and contribute what little knowledge I possess to it. From time to time I have checked the traffic statistics on this blog and I have been overwhelmed each time at the huge volume of traffic that has been directed to this blog inspite of it having such few articles and its author's prolonged absence. It is in response to that overwhelming support on your part that I have chosen to return and write more enriching and fulfilling articles. Thank You.

CONCEPT OF PRIMARY BOOKS AND SUBSIDIARY BOOKS

           Any student of accountancy is familiar with two things of the subject,namely "Journal" and "Ledger". the student is also familiar with the format of the two and the manner in which accounting entries are passed in them. However, very few students are aware of the concepts underlying them. they are equally unaware of the accounting procedure. This post is aimed at clearing that very concept.

           First we must understand the role of journal and ledger in the accounting cycle. Accounting for any transaction begins with passing an entry in the journal. There are separate journals for recording different types of entries. these journals are collectively known as "Books of prime entry","Books of original entry" and "Subsidiary books". These are called by the first two names because all transactions are first recorded in these books. The third name indicates that these are subsidiaries of the Journal. There are eight types of Subsidiary books.

         

           Next comes Ledger. Ledger is the prepared with the total amounts of the different subsidiary books. for example, the total of purchase journal is posted to the debit side of purchase account. In other words, the totals of the different ledgers will be tansferred to ledger accounts of the same name. Ledger too is known by three names: "Primary books" and "Books of secondary entry" and "Principal books". Ledger is known as a primary book and principal book because it is from ledger balances that trial balance and final accounts are prepared. It is called a secondary book because it is prepared after the journal and on the former's basis. Hence it is subsidiary to the journal. The balances of  the ledger accounts are used in preparation of the final accounts of the organisation.

DIFFERENT TYPES OF SUBSIDIARY BOOKS(JOURNALS)

There are eight different types of subsidiary books:

1. Purchase Day Book-  For recording credit purchases
2. Sales Day Book- For recording credit sales
3. Purchase Return Book- For recording purchase returns
4. Sales Return Book- For recording sales returns
5. Bills Receivable Book- For recording all Bills of exchange receivable
6. Bills Payable Book- For recording all Bills of exchange payable
7. Cash Book-For recording all transactions made in cash
8. Journal Proper- For recording all those entries which do not come in the above seven types of journals.

              Cash Book is both a book of prime entry and a book of secondary entry. This is because all cash transactions are first recorded in the Cash Book and it is from the Cash Book only that the balnce of cash is recorded in the final accounts. Cash book is thus both a jounal and a ledger. Hence Cash Book is a JOURNALISED LEDGER.

               

MEANING OF NON-TRADING ORGANISATIONS(NTO)

Contrary to the popular view of a layman, an NTO is not an organisation which does not make profits. It is a well established fact that no organisation can survive without profit and that one of the prime motives of any organisation is to earn and maximise profits. Profit in commercial parlance is defined as the excess of income or revenue over expenditure during a specific period, by whatever name called. In the case of an NTO the profit earned by it is called "surplus". Hence' an NTO earns profit and calls it surplus. Then what is the difference between an NTO an a profit-making organisation is lies in the fact the NTO does not  distribute its surplus among its members(as is the case with other organisations). The surplus earned is transferred to a Capital Fund and is used for the benefit and development of the organisation. This is the prime point of difference between an NTO and a profit-making organisation and the most effective rule of identifying an NTO. It is not enough for a charitable organisation to be called an NTO if it does not pass this test.

ABOUT THIS BLOG

This blog is not a teacher. It is a friend and professional colleague. No matter if you are a student of  CA,CMA,CS,ICFAI,BCOM,MCOM, or even if you are related to commerce in any way, you are most welcome to exchange your views with the author.