Financial Management

Unit 5

Unit 5
Structure: 5.1 Introduction Learning objectives 5.2 Design of an Ideal Capital Structure 5.3 Cost of Different Sources of Finance Cost of debentures Cost of term loans Cost of preference capital Cost of equity capital Cost of retained earnings Capital asset pricing model approach Earnings price ratio approach 5.4 Weighted Average Cost of Capital Assignment of weights 5.5 Summary 5.6 Solved Problems 5.7 Terminal Questions 5.8 Answers to SAQs and TQs

Cost of Capital

5.1 Introduction
Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardise the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economise the use of their funds and adapt to the changing conditions.

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5.1.1 Learning objectives

After studying this unit, you should be able to,

Define cost of capital. Bring out the importance of cost of capital. Explain how to design an ideal capital structure. Compute Weighted Average Cost of Capital.

5.2 Design of an Ideal Capital Structure

The design of an ideal capital structure requires five factors to be considered (see in figure 5.1)

Figure 5.1: Design of an ideal capital structure

Return The capital structure of a company should be most advantageous. It should generate maximum returns to the shareholders for a considerable period of time and such returns should keep increasing. Risk Debt does increase equity holders returns and this can be done till such time that no risk is involved. Use of excessive debt funds may threaten the companys survival. Flexibility The company should be able to adapt itself to situations warranting changed circumstances with minimum cost and delay. Capacity The capital structure of the company should be within the debt capacity. Debt capacity depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay creditors interests, principal and also to shareholders to some extent.

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Control An ideal capital structure should involve minimum risk of loss of control to the company. Dilution of control by indulging in excessive debt financing is undesirable.

With the above points on ideal capital structure, raising funds at the appropriate time to finance firms investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds. The cost of capital is the minimum rate of return of a company, which must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures and equity and preference shares. A company now being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy. Loans and debentures come with a pre-determined interest rate. Preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend, based on their risk perception and the companys past performance in terms of pay-out dividends. The following graph on risk-return relationship of various securities summarises the above discussion.

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Required rate of return

Equity share Preference share Debt Govt bonds Risk free security

Risk-Return relationship of various securities

Figure 5.2: Risk return relationship

5.3 Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section. 5.3.1 Cost of debentures The cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows.
The expected cash outflows relate to the interest and principal repayments. Kd =

I (1 T ) F P / n (F P ) / 2

Where Kd is post tax cost of debenture capital, I is the annual interest payment per unit of debenture, T is the corporate tax rate, F is the redemption price per debenture, P is the net amount realised per debenture, n is maturity period.

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Solved Problem - 1 Lakshmi Enterprise wants to have an issue of non-convertible debentures for Rs. 10 Cr. Each debenture is of a par value of Rs. 100 having an interest rate of 15%. Interest is payable annually and they are redeemable after 8 years at a premium of 5%. The company is planning to issue the NCD at a discount of 3% to help in quick subscription. If the corporate tax rate is 50%, what is the cost of debenture to the company? Solution
Kd I(1 T ) ( F P ) / n (F P ) / 2

15 (1 0.5 ) (105 97 ) / 8 (105 97 ) / 2

7 .5 1 101 0.084 0r 8.4%

5.3.2 Cost of Term Loans Term loans are loans taken from banks or financial institutions for a specified number of years at a pre-determined interest rate. The cost of term loans is equal to the interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on term loans is also taxed. Kt = I (1T) Where I is interest, T is tax rate
Solved Problem - 2

Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is the cost of term loan if the tax rate is 40%?
Solution:

Kt = I (1T) = 9(10.4) = 5.4% The cost of term loan is 5.4%

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5.3.3 Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments. It is expressed as: Kp = (D + {(F P) / n} / ((F + P) / 2)

Where Kp is the cost of preference capital, D is the preference dividend per share payable, F is the redemption price, P is the net proceeds per share, n is the maturity period.
Solved Problem - 3

C2C Ltd. has recently come out with a 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 redeemable after 10 years at a premium of Rs. 4 per share. The company hopes to realise Rs. 98 per share now. Calculate the cost of preference capital.
Solution:

Kp

D ( F P ) / n (F P ) / 2

12 (104 98 ) / 10 (104 98 ) / 2

12.6 101

Kp = 0.1247 or 12.47% The cost of preference capital now will be 12.47%

5.3.4 Cost of Equity Capital Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular dividends to them.

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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, capital asset pricing approach, realised yield approach etc. According to dividend forecast approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it. Ke = (D1/Pe) + g This equation is modified from the equation, Pe= {D1/Ke-g}. Dividends cannot be accurately forecasted as they may sometimes be nil or have a constant growth or sometime have supernormal growth periods.
Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is not legally bound to pay dividends and also as 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 equity capital is not free of cost.
Solved Problem - 4

Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10% p.a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company? Solution Ke = (D1/Pe) + g = (5/110) + 0.10 = 0.1454 or 14.54% Cost of equity capital is 14,54% 5.3.5 Cost of Retained Earnings A companys earnings can be reinvested in full to fuel the ever-increasing demand of companys fund requirements or they may be paid off to equity holders in full or they may be partly held back and invested and partly paid
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off. These decisions are taken keeping in mind the companys growth stages. High growth companies may reinvest the entire earnings to grow more, companies with no 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 utilising funds for reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of retained earnings is the same as the cost of shareholders expected return from the firms ordinary shares. So, Kr = Ke 5.3.6 Capital Asset Pricing Model Approach This model establishes a relationship between the required rate of return of a security and its systematic risks expressed as . According to this model, Ke = Rf + (Rm Rf) Where Ke is the rate of return on share, Rf is the risk free rate of return, is the beta of security, Rm is return on market portfolio
The CAPM model is based on some assumptions, some of which are:

Investors are risk-averse. Investors make their investment decisions on a single-period horizon. Transaction costs are low and therefore can be ignored. This translates to assets being bought and sold in any quantity desired. The only considerations that matter are the price and amount of money at the investors disposal. All investors agree on the nature of return and risk associated with each investment.

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Solved Problem - 5

What is the rate of return for a company if its is 1.5, risk free rate of return is 8% and the market rate or return is 20%
Solution:

Ke = Rf + (Rm Rf) = 0.08 + 1.5(0.2-0.08) = 0.08 + 0.18 = 0.26 or 26% The rate of return is 26% 5.3.7 Earnings Price Ratio Approach Under the case of earnings price ratio approach, the cost of equity can be calculated as: Ke = E1/P Where E1 = expected EPS per one year P = current market price per share E1 is calculated by multiplying the present EPS with (1 + Growth rate). Cost of Retained Earnings and Cost of External Equity
As we have just learnt that if retained earnings are reinvested in business for growth activities, the shareholders expect the same amount of returns and therefore Ke=Kr However, it should be borne in mind by the policy makers that floating of a new issue and people subscribing to the new issue will involve huge amounts of money towards floating costs which need not be incurred if retained earnings are utilised towards funding activities. From the dividend capitalisation model, the following model can be used for calculating cost of external equity.

Ke = {D1/P0(1f)} + g Where, Ke is the cost of external equity, D1 is the dividend expected at the end of year 1, P0 is the current market price per share, g is the constant growth rate of dividends, f is the floatation costs as a % of current market price
The following formula can be used as an approximation:

Ke = Ke/(1f)
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Where Ke is the cost of external equity, Ke is the rate of return required by equity holders, f is the floatation cost. Solved Problem - 6 Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern zone of India. The companys CFO is planning to get Rs. 250 Cr through a fresh issue of equity shares to the general public and for the balance amount he proposes to use of the reserves which are currently to the tune of Rs. 300 Cr. The equity investors expectations of returns are 16%. The cost of procuring external equity is 4%. What is the cost of external equity?
Solution

We know that Ke=Kr, that is Kr is 16% Cost of external equity is Ke = Ke/(1f) 0.16/(1 0.04) = 0.1667 or 16.67% Hence, cost of external equity is 16.67%

Key Point Dividends cannot be accurately forecasted as they might sometimes become nil or have a constant growth or sometimes have supernormal growth periods.

5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the overall capital of the company. The term cost of capital refers to the overall composite cost of capital 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 equally from various sources and
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therefore simple average method is not used. The following steps are involved to calculate the WACC Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference capital and term loans. Step II: Determine the weights associated with each source. Step III: Multiply the cost of each source by the appropriate weights. Step IV: WACC = W e Ke + W r Kr + W p Kp + W d Kd + W t Kt
Assignment of weights

Weights can be assigned based on any of the following methods The book value of the sources of the funds in capital structure Present market value of funds in the capital structure and Adoption of finance planned for capital budget for the next period
As per the book value approach, weights assigned would be equal to each sources proportion in the 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.

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Solved Problem -7 The capital structure of Prakash Packers ltd. is as shown in table 5.1
Table 5.1 : Capital structure in lakhs Equity capital (Rs. 10 par value) 14% Preference share capital Rs. 100 each Retained earnings 12% debentures (Rs. 100 each) 11% Term loan from ICICI bank Total 200 100 100 300 50 750

The market price per equity share is Rs. 32. The company is expected to declare a dividend per share of Rs. 2 per share and there will be a growth of 10% in the dividends for the next 5 years. The preference shares are redeemable at a premium of Rs. 5 per share after 8 years and are currently traded at Rs. 84 in the market. Debenture redemption will take place after 7 years at a premium of Rs.5 per debenture and their current market price Rs.90 per unit. The corporate tax rate is 40%. Calculate the WACC. Solution

Step I is to determine the cost of each component. Ke = ( D1/P0) + g = (2/32) + 0.1 = 0.1625 or 16.25%
Kp = [D + {(FP)/n}] / {F+P)/2}

= [14 + (10584)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or 17.59% Kr = Ke which is 16.25% Kd = [I(1T) + {(FP)/n}] / {F+P)/2} = [12(10.4) + (10590)/7] / (105+90)/2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6%
Kt = I(1T)

= 0.11(10.4) = 0.066 or 6.6%

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Step II is to calculate the weights of each source. 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 Step III Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
= (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 + 0.0384 + 0.004 = 0.1304 or 13.04% The value of WACC is 13.04%

Solved Problem - 8 Johnson Cool Air Ltd would like to know the WACC. The following information is made available to you in this regard. The after tax cost of capital are Cost of debt 9% Cost of preference shares 15% Cost of equity funds 18% The capital structure is as follows Debt Rs.6,00,000 Preference capital Rs. 4,00,000 Equity capital Rs. 10,00,000

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Solution WACC is calculated from the table 5.2

Table 5.2: WACC Fund source Debt Preference capital Equity capital Total 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 0.030 0.090 0.147

WACC is 14.7%.

Solved Problem - 9

Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds next year for which it requires Rs. 20 Cr. to purchase new equipment. The CFO has made available the following details based on which you are required to compute the weighted marginal cost of capital The amount required will be raised in equal proportions by way of debt and equity (new issue and retained earnings put together account for 50%) The company expects to earn Rs.4Cr. as profits by the end of the year after which it will retain 50% and pay-off rest to the shareholders. The debt will be raised equally from two sources- loans from IOB costing 14% and from the IDBI costing 15%. The current market price per equity share is Rs.24 and the dividend pay-out one year hence will be Rs.2.40. Tax rate is 50% Solution
Ke =( D1/P0)

= (2.40 / 24) = 0.1 or 10% Cost of equity Ke = cost of retained earnings Kt = I(1 T) [14% loan from IOB] = 0.14(1 0.5) = 0.07 or 7% Kt = I(1 T) [15% IDBI loan] = 0.15(1 0.5) = 0.075 or 7.5%

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Computation of weighted marginal cost of capital is as shown in table 5.3

Table 5.3 Weighted cost of capital Weights After tax cost 0.4 0.1 0.1 0.1 0.25 0.07 0.25 0.075 Total Weighted average cost of capital 8.63% Solved Problem - 10 Source of funds Equity capital Retained earnings 14% loan from IOB 15% IDBI loan Weighted cost 0.040 0.010 0.0175 0.0188 0.0863

Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the current year. The dividends are growing @ 6% p.a. The cost of equity capital is 16%. The companys top Finance Managers of various zones recently met to take stock of the competitors growth and dividend policies 8.63% WACC = and came out with the following suggestions to maximise the wealth of the shareholders. As the CFO of the company, you are required to analyse each suggestion and take a suitable course keeping the shareholders interests in mind.
Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15% Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17% Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15% Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17% Alternative 5: increase the dividend growth rate to 7% and lower Ke to 14% Solution

We all know that P0 = D1/(Ke g) Present case = 4/(0.16-0.06) = Rs 40 Alternative 1 = 4.28/(0.15 0.07) = Rs. 53.5 Alternative 2 = 4.28/(0.17 0.07) = Rs. 42.8 Alternative 3 = 4.16/(0.15 0.04) = Rs. 37.8 Alternative 4 = 4.16/(0.17 0.04) = Rs. 32 Alternative 5 = 4.28/(0.14 0.07) = Rs. 61.14 Recommendation The last alternative is likely to fetch the maximum price per equity share thereby increasing the wealth.
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Self Assessment Question Fill in the blanks: 1. ________ is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. 2. The capital structure of the company should generate _______ to the shareholders. 3. The capital structure of the company should be within the _____. 4. An ideal capital structure should involve _____ to the company. 5. _______ do not have a fixed rate of return on their investment. 6. According to dividend forecast approach, the intrinsic value of an equity share is the sum of ______ associated with it.

5.5 Summary
Any organisation requires funds to run its business. These funds may be acquired from short-term or long-term sources. Long-term funds are raised from two important sources capital (owners funds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable as debt-holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the optimum capital structure. Optimum capital structure refers to the mix of different sources of long term funds in the total capital of the company.
Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilised for further activities. Retained earnings are the only internal source to fund the companys future plans. Weighted Average Cost of Capital is the overall cost of all sources of finance. The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm.

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The cost of term loan is computed keeping in mind the tax liability. The cost of preference share is similar to debenture interest. Unlike debenture interest, dividends do not qualify for tax deductions. The calculation of cost of equity is slightly different as the returns to equity are not constant. The cost of retained earnings is the same as the cost of equity funds.

5.6 Solved Problems

11. Deepak Steel has issued non-convertible debentures for Rs. 5 Cr. Each debenture is of a par value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are redeemable after 7 years at a premium of 5%. The company issued the NCD at a discount of 3%. What is the cost of debenture to the company? Tax rate is 40%. Solution:
Kd I(1 T ) ( F P ) / n (F P ) / 2

14 (1 0.4 ) (105 97 ) / 7 8.4 1.14 = 0.094 or 9.4% (105 97 ) / 2 101

12. Supersonic industries Ltd. has entered into an agreement with Indian Overseas Bank for a loan of Rs. 10 Cr with an interest rate of 10%. What is the cost of the loan if the tax rate is 45%?

Solution: Kt=I(1 T) = 10(1 0.45) = 5.5% 13. Prime group issued preference shares with a maturity premium of 10% and a coupon rate of 9%. The shares have a face a value of Rs. 100. and are redeemable after 8 years. The company is planning to issue these shares at a discount of 3% now. Calculate the cost of preference capital. Solution :
Kp D ( F P ) / n (F P ) / 2

(110 97 ) / 8 9 .1.625 10.27% (110 97 ) / 2 103.5

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5.7 Terminal Questions

1. The following data is available in respect of a XYZ company. The market value of Equity is Rs.10 lakhs and the cost of equity is 18%. The market value of debt is Rs.5 lakhs, cost of debt 13%. Calculate the weighted average cost of funds as weights assuming tax rate as 40% 2. Bharat chemicals has the following capital structure as shown in table 5.4
Table 5.4: Capital structure Rs. 10 face value equity shares Term loan @ 13% 9% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period Total Rs. 400000 Rs.150000 Rs. 100000 Rs. 650000

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. Assume tax rate of 50%. What is WACC? 3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The cost of equity and debt are 15% and 12%. What is the WACC if the tax rate is 50%? 4. A company has 3 divisions X, Y and Z. Each division has a capital structure with debt, preference shares and equity shares in the ratio 3:4:3 respectively. The company is planning to raise debt, preference shares and equity for all the 3 divisions together. Further, it is planning to take a bank loan at the rate of 12% interest. The preference shares have a face value of Rs. 100, dividend at the rate of 12%, 6 years maturity and currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes applicable are 45% 5. Tanishk Industries issues partially convertible debentures of face value of Rs. 100 each and retains Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%, taxes applicable are 40%. What is the cost of debt if the coupon interest is 12%

5.8 Answers to SAQs and TQs

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Answers to Self-Assessment Questions

1. 2. 3. 4. 5. 6.

Capital structure Maximum returns Debt capacity Minimum risk of loss of control Equity shareholders Present values of dividends

Answers to Terminal Questions

1. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt Ans = 14.57% 2. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt 3. Hint: Use the equation WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt Ans = 8.97% 4. Hint: Apply the formula Kp D 5. Hint: Apply the formula Kd

(F P ) / n
F P ) / 2

I (1 T ) ( F P) / n ( F P) / 2

Ans 8.09%

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