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Hurdle Rate: An Empirical Analysis

OBJECTIVE: To analyze the financing decision through the capital structure (debt equity distribution) and
estimate the Weighted Average Cost of Capital.
RESEARCH METHODOLOGY:

[( ) + ( (1 ))]
=
+
Equity Capital = Market Price per Share * Number of Outstanding Shares
Cost of Equity (Using CAPM ) = Rf + (levered * IERP)
levered and IERP used are same as those obtained in the previous parts of the assignment.
Cost of Debt:
Our companies have used short term and long term loans as their sources of debt capital, so no outstanding
company debt instruments were available for cost of debt calculation.
Therefore, we have used the sum of risk free rate of the country and Default Spread of the company, wherein
the default spread is calculated using the Interest Coverage Ratio (ICR)
ICR = (EBIT / Interest Expense)
Since debt capital is tax deductible, we have multiplied the cost of debt obtained above with (1 marginal tax
rate) to remove the tax benefit on interest paid on debt.
We have taken the value of Marginal Tax Rate as equal to 34.61%.
Debt Capital: Market Value of Debt is calculated using the formula:

() =
Where,
E = Annual Interest Expense
R = Cost of Debt
T = Total Book Value of Debt
Y = Average Maturity of Debt (in years)

1
(1 (
))
(1 + )

(1 + )

For the calculation of T, we have taken the short term borrowings, long term borrowings, Notes Payable,
Current maturities of Long term loans.
For the calculation of Y, we have taken the weighted average of the maturities of each loan with its respective
fraction of debt as the weight.
This data was not provided for Bajaj Auto Ltd., hence we have assumed this value to be equal to 6% due to long
term borrowing forming the majority of its debt capital.
DATA COLLECTED:
Data has been collected from the 2014 15 annual reports of the companies. The historical stock prices and
returns have been collected from the NSE and BSE websites.
The marginal tax rate source:
http://www.tradingeconomics.com/india/corporate-tax-rate
The default spread was obtained using the synthetic ratings from this source, based on interest coverage ratio:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/syntrating.htm
LIMITATIONS:
1. Companies usually do not have actively traded debt securities, hence calculation of cost of debt is
difficult.
2. Companies may not disclose their debt obligations in its entirety, hence calculation of market value of
debt is difficult.
FINDINGS:
In India, the debt security market is not highly developed. So, most companies raise majority of their capital by
raising equity capital as can be seen by the We Wd values.
As we saw earlier in our assignment, the beta values with respect to the BSE (Sensex) and NSE (Nifty) indices
were slightly different, yet we arrive at slightly different values for the cost of capital.
The cost of capital values for TVS Motors Ltd. and Bajaj Auto Ltd are close (12.03% and 10.48% respectively)
whereas that for Ashok Leyland is much higher (19.98%).
This can be seen as both TVS Motors and Bajaj Auto deal in 2, 3, 4- wheelers, whereas Ashok Leyland is in the
Heavy-weight Vehicle business, hence riskier.

COMPANY

NIFTY
We

COE

TVS MOTORS

0.999999997

ASHOK
LEYLAND
BAJAJ AUTO

Wd

COD

COD*(1-t)

WACC

0.120288433 3.41E-09

0.18466

0.120749174

0.120288433

0.999998576

0.199776157 1.42E-06

0.18466

0.120749174

0.199776146

0.1047789

0.17166

0.112248474

0.1047789

1.35E-10

CONCLUSION:

1. The proportion of equity capital is more than that of debt capital in the capital structure for all three
companies.
2. Our results show that cost of debt is more than cost of equity. These companies have taken significant
proportion of short-term loans which have higher interest rates, hence tend to be costly, thus increasing
the cost of debt.

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