FinancialManagement

Unit5

Unit5
Structure

CostofCapital

5.1 Introduction 5.2 DesignofanIdealCapitalStructure 5.3 CostofDifferentSourcesofFinance 5.3.1 CostofDebentures 5.3.2 CostofTermLoans 5.3.3 CostofPreferenceCapital 5.3.4 CostofEquitycapital 5.3.5 CostofRetainedEarnings 5.3.5.1 CapitalAssetPricingModelApproach 5.3.5.2 EarningsPriceRatioApproach 5.4 WeightedAverageCostofCapital 5.5 Summary SolvedProblems TerminalQuestions AnswerstoSAQsandTQs 5.1 Introduction Capitalstructureisthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares, equitysharesandretainedearningsindifferentratios.Itisalwaysadvisableforcompaniestoplan theircapitalstructure.Decisionstakenbynotassessingthingsinacorrectmannermayjeopardize the very existence of the company. Firms may prosper in the shortrun by not indulging in proper planningbutultimatelymayfaceproblemsinfuture.Withunplannedcapitalstructure,theymayalso failtoeconomizetheuseoftheirfundsandadapttothechangingconditions.

SikkimManipalUniversity

72

FinancialManagement

Unit5

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Definecostofcapital. 2. Bringouttheimportanceofcostofcapital. 3. Explainhowtodesignanidealcapitalstructure. 4. ComputeWeightedAverageCostofCapital.

5.2 DesigninganIdealCapitalStructure Itrequiresanumberoffactorstobeconsideredsuchas: Return: The capital structure of a company should be most advantageous. It should generate maximumreturnstotheshareholdersforaconsiderableperiodoftimeandsuchreturnsshould keepincreasing. Risk:Asalreadydiscussedinthepreviouschapteronleverage,useofexcessivedebtfundsmay threatenthecompanyssurvival.Debtdoesincreaseequityholdersreturnsandthiscanbedone tillsuchtimethatnoriskisinvolved. Flexibility: The company should be able to adapt itself to situations warranting changed circumstanceswithminimumcostanddelay. Capacity:Thecapitalstructureofthecompanyshouldbewithinthedebtcapacity.Debtcapacity dependsontheabilityforfundstobegenerated.Revenuesearnedshouldbesufficientenough topaycreditorsinterests,principalandalsotoshareholderstosomeextent. Control:Anidealcapitalstructureshouldinvolveminimumriskoflossofcontroltothecompany. Dilutionofcontrolbyindulginginexcessivedebtfinancingisundesirable. Withtheabovepointsonidealcapitalstructure,raisingfundsattheappropriatetimetofinancefirms investmentactivities is an important activityof the Finance Manager. Goldenopportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities.Whatshouldbetheproportionofdebtandequity?Thisdependsonthecostsassociated with raising various sources offunds. The costof capital is the minimum rate of returna company mustearntomeettheexpensesofthevariouscategoriesofinvestorswhohavemadeinvestmentin theformofloans,debentures,equityandpreferenceshares.Acompanynobeingabletomeetthese demands may face the risk of investors taking back their investments thus leading to bankruptcy.

SikkimManipalUniversity

73

FinancialManagement

Unit5

Loansanddebenturescomewithapredeterminedinterestrate,preferencesharesalsohaveafixed rate of dividend while equity holders expect a minimum return of dividend based on their risk perceptionandthecompanyspastperformanceintermsofpayoutofdividends. The following graph on riskreturn relationship of various securities summarizes the above discussion.

Error!

Requiredrateofreturn

Equity share Preference share Debt Govtbonds Riskfree security

RiskReturnrelationshipofvarioussecurities

5.3 CostofDifferentSourcesofFinance Thevarioussourcesoffinanceandtheircostsareexplainedbelow: 5.3.1 Costofdebentures Thecostofdebentureisthediscountratewhichequatesthenetproceedsfromissueofdebentures totheexpectedcashoutflowsinterestandprincipalrepayments. Kd=I(1T)+{(FP)/n} (F+P)/2 WhereKd isposttaxcostofdebenturecapital, Iistheannualinterestpaymentperunitofdebenture, Tisthecorporatetaxrate, Fistheredemptionpriceperdebenture, Pisthenetamountrealizedperdebenture,

SikkimManipalUniversity

74

FinancialManagement

Unit5

nismaturityperiod. Example: Lakshmi Enterprise wants to have an issue of nonconvertible debentures for Rs. 10 Cr. Each debentureisofaparvalueofRs.100havinganinterestrateof15%.Interestispayableannually andtheyareredeemableafter8yearsatapremiumof5%.Thecompanyisplanningtoissuethe NCDatadiscountof3%tohelpinquicksubscription.Ifthecorporatetaxrateis50%,whatisthe costofdebenturetothecompany? Solution: Kd= I(1T)+{(FP)/n} (F+P)/2 15(10.5)+(10597)/8 (105+97)/2 =7.5+1 101 =0.084or8.4%

5.3.2 CostofTermLoans Termloansareloanstakenfrombanksorfinancialinstitutionsforaspecifiednumberofyearsata predeterminedinterestrate.Thecostoftermloansisequaltotheinterestratemultipliedby1tax rate.Theinterestismultipliedby1taxrateasinterestontermloansisalsotaxed. Kt=I(1T) WhereIisinterest, Tistaxrate. Example: YesLtd.hastakenaloanofRs.5000000fromCanaraBankat9%interest.Whatisthecostofterm loan? Solution Kt=I(1T)=9(10.4)=5.4%

SikkimManipalUniversity

75

FinancialManagement

Unit5

5.3.2 CostofPreferenceCapital The cost of preference share Kp is the discountrate which equates the proceedsfrom preference capitalissuetothedividendandprincipalrepaymentswhichisexpressedas: Kp= D+{(FP)/n} (F+P)/2 WhereKpisthecostofpreferencecapital, Disthepreferencedividendpersharepayable, Fistheredemptionprice, Pisthenetproceedspershare, nisthematurityperiod. Example: C2C Ltd. has recently come out witha preference share issue to the tune of Rs. 100 lakhs. Each preference share has a face value of 100 and a dividend of 12% payable. The shares are redeemableafter10yearsatapremiumofRs.4pershare.ThecompanyhopestorealizeRs.98 persharenow.Calculatethecostofpreferencecapital. Solution Kp= D+{(FP)/n} (F+P)/2 =12+(10498)/10 (104+98)/2 = 12.6 101 Kp=0.1247or12.47% 5.3.4 CostofEquityCapital Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement(unlikeinthecaseofloansordebentureswheretheratesaregovernedbythedeed)to pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and complex exercise. There are many approaches for estimating return the dividend forecast approach,capitalassetpricingapproach,realizedyieldapproach,etc.Accordingtodividendforecast

SikkimManipalUniversity

76

FinancialManagement

Unit5

approach,theintrinsicvalueofanequityshareisthesumofpresentvaluesofdividendsassociated withit. Ke=(D1/Pe)+g ThisequationismodifiedfromtheequationPe={D1/Keg}.Dividendscannotbeaccuratelyforecast astheymaysometimesbenilorhaveaconstantgrowthorsometimesupernormalgrowthperiods. IsEquityCapitalfreeofcost? Somepeopleareoftheopinionthatequitycapitalisfreeofcostforthereasonthatacompanyisnot legally bound to pay dividends and also the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equitycapitalisnotfreeofcost. Example: SurajMetalsareexpectedtodeclareadividendofRs.5pershareandthegrowthrateindividends isexpectedtogrow@10%p.a.ThepriceofoneshareiscurrentlyatRs.110inthemarket.Whatis thecostofequitycapitaltothecompany? Solution Ke=(D1/Pe)+g =(5/110)+010 =0.1454or14.54% 5.3.5 CostofRetainedEarnings Acompanysearningscanbereinvestedinfulltofueltheeverincreasingdemandofcompanysfund requirements or they maybepaid off to equity holders infull or they may be partly heldback and invested and partly paid off. These decisions are taken keeping in mind the companys growth stages.Highgrowthcompaniesmayreinvesttheentireearningstogrowmore,companieswithno growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilizing fundsfor reinvestmentactivities havetobe compensatedforparting with their earnings. Therefore thecostofretainedearningsisthesameasthecostofshareholdersexpectedreturnfromthefirms ordinaryshares.Thatis,Kr=Ke

SikkimManipalUniversity

77

FinancialManagement

Unit5

5.3.5.1CapitalAssetPricingModelApproach This model establishes a relationship between the required rate of return of a security and its systematicrisksexpressedas.Accordingtothismodel, Ke=Rf+(RmRf) WhereKeistherateofreturnonshare, Rfistheriskfreerateofreturn, isthebetaofsecurity, Rmisreturnonmarketportfolio. TheCAPMmodelisbasedonsomeassumptions,someofwhichare: Investorsareriskaverse. Investorsmaketheirinvestmentdecisionsonasingleperiodhorizon. Transactioncostsarelowandthereforecanbeignored.Thistranslatestoassetsbeingbought andsoldinanyquantitydesired.Theonlyconsiderationsmatteringarethepriceandamountof moneyattheinvestorsdisposal. Allinvestorsagreeonthenatureofreturnandriskassociatedwitheachinvestment.

Example: Whatistherateofreturnforacompanyifitsis1.5,riskfreerateofreturnis8%andthemarket rateorreturnis20% Solution Ke=Rf+(RmRf) =0.08+1.5(0.20.08) =0.08+0.18 =0.26or26% 5.3.5.2 EarningsPriceRatioApproach Accordingtothisapproach,thecostofequitycanbecalculatedas: Ke=E1/PwhereE1isexpectedEPSoneyearhenceandPisthecurrentmarketpricepershare. E1iscalculatedbymultiplyingthepresentEPSwith(1+Growthrate). CostofRetainedEarningsandCostofExternalEquity

SikkimManipalUniversity

78

FinancialManagement

Unit5

As we have just learntthat if retainedearningsare reinvested in businessforgrowthactivities the shareholdersexpectthesameamountofreturnsandthereforeKe=Kr.Butitshouldbeborneinmind bythepolicymakersthatfloatinganewissueandpeoplesubscribingtoitwillinvolvehugeamounts of money towards floatation costs which need not be incurred if retained earnings are utilized towardsfundingactivities.Usingthedividendcapitalizationmodel,thefollowingmodelcanbeused forcalculatingcostofexternalequity. Ke={D1/P0(1f)}+g WhereKeisthecostofexternalequity, D1isthedividendexpectedattheendofyear1, P0isthecurrentmarketpricepershare, gistheconstantgrowthrateofdividends, fisthefloatationcostsasa%ofcurrentmarketprice. Thefollowingformulacanbeusedasanapproximation: Ke=ke/(1f) WhereKeisthecostofexternalequity, keistherateofreturnrequiredbyequityholders, fisthefloatationcost. Example: AlphaLtd.requiresRs.400CrtoexpanditsactivitiesinthesouthernzoneofIndia.Thecompanys CFOisplanningtogetRs.250Crthroughafreshissueofequitysharestothegeneralpublicandfor thebalanceamountheproposestouseofthereserveswhicharecurrentlytothetuneofRs.300 Cr. The equity investors expectations of returnsare 16%. The cost of procuring external equity is 4%.Whatisthecostofexternalequity? Solution WeknowthatKe=Kr,thatisKris16% CostofexternalequityisKe=ke/(1f) 0.16/(10.04)=0.1667or16.67%

SikkimManipalUniversity

79

FinancialManagement

Unit5

5.4 WeightedAverageCostofCapital Intheprevioussectionwehavecalculatedthecostofeachcomponentintheoverallcapitalofthe company. The term cost of capital refers to the overall composite cost of cap or the weighted average cost of each specific type of fund. The purpose of using weighted average is to consider each component in proportion of their contribution to the total fund available. Use of weighted average is preferable to simple average method for the reason that firms do not procure funds equallyfromvarioussourcesandthereforesimpleaveragemethodisnotused.Thefollowingsteps areinvolvedtocalculatetheWACC. StepI:Calculatethecostofeachspecificsourceoffund,thatofdebt,equity,preferencecapitaland termloans. StepII:Determinetheweightsassociatedwitheachsource. StepIIIMultiplythecostofeachsourcebytheappropriateweights. StepIV:WACC=WeKe+WrKr+WpKp+WdKd+WtKt Assignmentofweights Weightscanbeassignedbasedonanyofthebelowmentionedmethods: (1) Thebookvaluesofthesourcesoffundsinthecapitalstructure,(2)Presentmarket value of thefunds in the capital structure and (3) in the proportion offinancingplannedfor the capitalbudgettobeadoptedforthenextperiod. Asperthebookvalueapproach,weightsassignedwouldbeequaltoeachsourcesproportioninthe overall funds. The book value method is preferable. The market value approach uses the market values of each source and the disadvantage in this method is that these values change very frequently. Example: PrakashPackersLtd.hasthefollowingcapitalstructure: Rs.inlakhs Equitycapital(Rs.10parvalue) 14% Preference share capital Rs. 100 each Retainedearnings 12%debentures(Rs.100each) 11%TermloanfromICICIbank Total
SikkimManipalUniversity

200 100 100 300 50 750

80

FinancialManagement

Unit5

The market price per equity share is Rs. 32. The company is expected to declare a dividend per shareofRs.2pershareandtherewillbeagrowthof10%inthedividendsforthenext5years.The preferencesharesareredeemableatapremiumofRs.5pershareafter8yearsandarecurrently tradedatRs.84inthemarket.Debentureredemptionwilltakeplaceafter7yearsatapremiumof Rs.5perdebentureandtheircurrentmarketpriceisRs.90perunit.Thecorporatetaxrateis40%. CalculatetheWACC. Solution StepIistodeterminethecostofeachcomponent. Ke=(D1/P0)+g =(2/32)+0.1 =0.1625or16.25% Kp=[D+{(FP)/n}]/{F+P)/2} =[14+(10584)/8]/(105+84)/2 =16.625/94.5 =0.1759or17.59% Kr=Kewhichis16.25% Kd=[I(1T)+{(FP)/n}]/{F+P)/2} =[12(10.4)+(10590)/7]/(105+97)/2 =[7.2+2.14]/101 =0.092or9.2% Kt=I(1T) =0.11(10.4) =0.066or6.6% StepIIistocalculatetheweightsofeachsource. We=200/750=0.267 Wp=100/750=0.133 Wr=100/750=0.133 Wd=300/750=0.4 Wt=50/750=0.06

SikkimManipalUniversity

81

FinancialManagement

Unit5

Step III Multiply the costs of various sources of finance with corresponding weights and WACC calculatedbyaddingallthesecomponents. WACC=WeKe+WpKp+WrKr+WdKd+WtKt =(0.267*0.1625)+(0.133*0.1759)+(0.133*0.1625)+(0.4*0.092)+(0.06*0.066) =0.043+0.023+0.022+0.034+0.004 =0.1256or12.56% Example: JohnsonCoolAirLtdwouldliketoknowtheWACC.Thefollowinginformationismadeavailableto youinthisregard. Theaftertaxcostofcapitalare: Costofdebt9% Costofpreferenceshares15% Costofequityfunds18%

Thecapitalstructureisasfollows: DebtRs.600000 PreferencecapitalRs.400000 EquitycapitalRs.1000000

Solution Fundsource Debt Preference capital Equitycapital Total WACCis14.7% Amount Rs.600000 Rs.400000 Rs. 1000000 Rs. 2000000 Ratio 0.3 0.2 0.5 1.0 Cost 0.09 0.15 0.18 Weighted cost 0.027 0.03 0.09 0.147

SikkimManipalUniversity

82

FinancialManagement

Unit5

Example: ManikyamPlasticsLtd.wantstoenterintothearenaofplasticmouldsnextyearforwhichitrequires Rs.20Cr.topurchasenewequipment.TheCFOhasmadeavailablethefollowingdetailsbasedon whichyouarerequiredtocomputetheweightedmarginalcostofcapital. Theamountrequiredwillberaisedinequalproportionsbywayofdebtandequity(newissueand retainedearningsputtogetheraccountfor50%). ThecompanyexpectstoearnRs.4Crasprofitsbytheendofyearofwhichitwillretain50%and payofftheresttotheshareholders. ThedebtwillberaisedequallyfromtwosourcesloansfromIOBcosting14%andfromtheIDBI costing15%. ThecurrentmarketpriceperequityshareisRs.24anddividendpayoutoneyearhencewillbe Rs.2.40. Solution Sourceoffunds Equitycapital Retainedearnings 14%loanfromIOB 15%IDBIloan Total Ke=(D1/P0)+g =(2.40/24)=0.1or10% Kt=I(1T) =0.14(10.5)=0.07or7% Kt=I(1T) =0.15(10.5)=0.075or7.5% Example: CanaraPaintshaspaidadividendof40%onitsshareofRs.10inthecurrentyear.Thedividends aregrowing@6%p.a.Thecostofequitycapitalis16%.TheCompanystopFinanceManagersof variouszonesrecentlymettotakestockofthecompetitorsgrowthanddividendpoliciesandcame out with the following suggestions to maximize the wealth of the shareholders. As the CFO of the
SikkimManipalUniversity

Weights 0.4 0.1 0.25 0.25

Aftertax cost 0.1 0.1 0.07 0.075

Weightedcost 0.04 0.01 0.0175 0.01875 0.0863or8.63%

83

FinancialManagement

Unit5

company you are required to analyze each suggestion and take a suitable course keeping the shareholdersinterestsinmind. Alternative1:Increasethedividendgrowthrateto7%andlowerKeto15% Alternative2:Increasethedividendgrowthrateto7%andincreaseKeto17% Alternative3:Lowerthedividendgrowthrateto4%andlowerKeto15% Alternative4:Lowerthedividendgrowthrateto4%andincreaseKeto17% Alternative5:increasethedividendgrowthrateto7%andlowerKeto14% Solution WeallknowthatP0=D1/(Keg) Presentcase=4/(0.160.06)=Rs40 Alternative1=4.28/(0.150.07)=Rs.53.5 Alternative2=4.28/(0.170.07)=Rs.42.8 Alternative3=4.16/(0.150.04)=Rs.37.8 Alternative4=4.16/(0.170.04)=Rs.32 Alternative5=4.28/(0.140.07)=Rs.61.14 Recommendation:Thelastalternativeislikelytofetchthemaximumpriceperequitysharethereby increasingtheirwealth. SelfAssessmentQuestions1 1. _________isthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares, equitysharesandretainedearningsindifferentratios. 2. Thecapitalstructureofacompanyshouldgenerate__________totheshareholders. 3. Thecapitalstructureofthecompanyshouldbewithinthe__________. 4. Anidealcapitalstructureshouldinvolve___________tothecompany. 5. ________________donothaveafixedrateofreturnontheirinvestment. 6. AccordingtoDividendForecastApproach,theintrinsicvalueofanequityshareisthesumof ______________associatedwithit.

SikkimManipalUniversity

84

FinancialManagement

Unit5

5.5 Summary Anyorganizationrequiresfundstorunitsbusiness.Thesefundsmaybeacquiredfromshorttermor longtermsources.Longtermfundsareraisedfromtwoimportantsourcescapital(ownersfunds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable asdebtholders attach many conditions which may not be possiblefor the companies to adhereto.Itisthereforedesirabletohaveacombinationofbothdebtandequitywhichiscalledthe optimum capital structure. Optimum capital structure refers to the mix of different sourcesof long termfundsinthetotalcapitalofthecompany. Costofcapitalistheminimumrequiredrateofreturnneededtojustifytheuseofcapital.Acompany obtainsresourcesfromvarioussourcesissueofdebentures,availingtermloansfrombanksand financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilized for further activities. Retained earnings are the only internal sourcetofundthecompanysfutureplans. WeightedAverageCostofCapitalistheoverallcostofallsourcesoffinance. Thedebentures carry afixed rateof interest. Interestqualifiesfor tax deduction in determining tax liability.Thereforetheeffectivecostofdebtislessthantheactualinterestpaymentmadebythefirm. Thecostoftermloaniscomputedkeepinginmindthetaxliability. Thecostofpreferenceshareissimilartodebentureinterest.Unlikedebentureinterest,dividendsdo notqualifyfortaxdeductions. Thecalculationofcostofequityisslightlydifferentasthereturnstoequityarenotconstant. Thecostofretainedearningsisthesameasthecostofequityfunds. SolvedProblems 1. DeepaksteelhasissuednonconvertibledebenturesforRs.5Cr.Eachdebentureisofapar value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are redeemableafter7yearsatapremiumof5%.ThecompanyissuedtheNCDatadiscountof 3%.Whatisthecostofdebenturetothecompany?Taxrateis40%.

SikkimManipalUniversity

85

FinancialManagement

Unit5

Solution Kd=I(1T)+{(FP)/n} (F+P)/2 14(10.4)+(10597)/7 (105+97)/2 =8.4+1.14 101 =0.094or9.4%

2. SupersonicindustriesLtd.hasenteredintoanagreementwithIndianOverseasBankforaloan ofRs.10Crwithaninterestrateof10%.Whatisthecostoftheloanifthetaxrateis45%? Solution Kt=I(1T)=10(10.45)=5.5% 3. Primegroupissuedpreferenceshareswithamaturitypremiumof10%andacouponrateof9%. TheshareshaveafaceavalueofRs.100.andareredeemableafter8years.Thecompanyis planningtoissuethesesharesatadiscountof3%now.Calculatethecostofpreferencecapital. Solution Kp=D+{(FP)/n} (F+P)/2 =9+(11097)/8=9+1.625=10.27% (110+97)/2 TerminalQuestions 1. Thefollowingdataisavailableinrespectofacompany: EquityRs.10lakhs,costofcapital18% DebtRs.5lakhs,costofdebt13% Calculatetheweightedaveragecostoffundstakingmarketvaluesasweightsassumingtaxrate is40%. 2. BharatChemicalshasthefollowingcapitalstructure: Rs.10facevalueequityshares Termloan@13% Rs.400000 Rs.150000 103.5

9%PreferencesharesofRs.100,currentlytraded Rs.100000 atRs.95with6yearsmaturityperiod Total Rs.650000

SikkimManipalUniversity

86

FinancialManagement

Unit5

The company is expected to declare a dividend of Rs. 5 next year and the growth rate of dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market. Assumetaxrateof50%.WhatisWACC? 3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs.60lakhs.Thecostofequityanddebtare15%and12%.WhatistheWACC? 4. A company has 3 divisions X, Y and Z. Each division has a capital structure with debt, preferencesharesandequitysharesintheratio3:4:3respectively.Thecompanyisplanningto raisedebt,preferencesharesandequityforallthe3divisionstogether.Further,itisplanningto takeabankloan@12%interest.ThepreferenceshareshaveafacevalueofRs.100,dividend @12%,6yearsmaturityandcurrentlypricedatRs.88.Calculatethecostofpreferenceshares anddebtiftaxesapplicableare45% 5. Tanishk Industries issues partially convertibledebentures offace valueof is Rs.100 eachand realizes Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxesapplicableare40%.Whatisthecostofdebt? 5.8 AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Capitalstructure 2. Maximumreturns 3. Debtcapacity 4. Minimumriskoflossofcontrol 5. Equityshareholders 6. Presentvaluesofdividends AnswerstoTerminalQuestions: 1,2,3:WACC=WeKe+WpKp+WrKr+WdKd+WtKt 4.Hint:ApplytheformulaKp= D+{(FP)/n} (F+P)/2 5.Hint:ApplytheformulaKd=I(1T)+{(FP)/n} (F+P)/2

SikkimManipalUniversity

87