Cost of PREFERENCE and share

Presented by- 306,319,323,330,337

Content :1)Meaning of share and share capital 2)Types of shares

i) Types of equity shares, Advantages, II) Types of preference shares, Advantages

3)Cost of preference share

i) Cost of redeemable and irredeemable preference share i) Cost of internal equity, when there is normal and supernormal growth respectively. II) CAPM

4)Cost of equity

Meaning of share and share capital

A share is one unit to which the total share capital is divided. Share capital of the company is explained as a fund or sum with which a company is formed to carry on the business and which is raised by the issue of the shares. Shares are the marketable instruments issued by the companies in order to raise the required capital. These are very popular investments which are traded everyday in the stock market and the value of the share at the end of the day decides the value of the firm.

Types of shares
The shares that are issued by the companies are of two types Equity shares Preference shares

Types of equity share

Blue chip equity shares Income equity shares Growth equity shares Cyclical equity share Defensive equity share Speculative equity share Authorized share capital

Issued share capital

Subscribed share capital

Paid up share capital

Advantages and Disadvantages of equity shares

Easily transferable High return Easy liquidation Right to vote Right to choose the board of directors Equity share holders have the right to oppose any of the decisions taken by the board of the directors Ex This is what happened , when mr. ramalinga raju tried to buy maytas company

Disadvantages
High risk In worst case less privileges is given to equity share holders

Types of preference share

Cumulative & Non cumulative Redeemable & Non-redeemable Convertible & Non-convertible Participating & Non-participating

Advantages and Disadvantages of preference shares

Yield fixed rate of return Its a hybrid instrument having some of the characteristics of the debentures and equity shares Apart from this preference shareholders are entitled to vote if dividend has remain unpaid in case of cumulative as well as non cumulative for two years.

Disadvantages
No voting rights If the company earns a huge profit even though they dont get any extra bonus

Cost of preference share

Cost of preference share = Kp= amount of preference dividend/ preference share capital Kp = D/P

Let us calculate the cost of 10% preference capital of 10,000 preference shares whose face value is $100. The market price of the share is currently $115. Annual dividend = 10% of $100 = $10 per share Kp = $10/$115 = 8.7% =.087

Cost of redeemable share

Kp= PD+(RV-NP)/N

RV+NP 2 PD= Annual preference dividend RV- Redemption value of preference shares NP= Net proceeds on issue of reference shares N= Life of preference shares Illustration- Let us calculate the cost of 10% preference capital of 10,000 preference shares whose face value is Rs.100. The market price of the share is currently Rs.95. If the company proposes to redeem to prefrence shares at the end of 10th year from the date of issue. Calculate the cost of preference share

Cont
Solution- Kp= PD+(RV-NP)/N RV+NP 2 Kp= 10+(100-95)
10 (100+95) 2 = .107(approx)

Cost of irredeemable share

Cost of irredeemable share= PD/PO Where PD= Annual preference dividend PO= Net proceeds in issue of preference shares Cost of irredeemable preference shares where dividend tax is paid over the actual dividend payment=PD(1+Dt)/PO PD= Annual preference dividend PO= Net proceeds in issue of preference shares Dt= Tax on preference dividend

Illustration-Let us calculate the cost of 10% preference capital of 10,000 preference shares whose face value is Rs.100. The market price of the share is currently Rs.95. Annual dividend = 10% of Rs.100 = Rs.10 per share Kp = Rs.10*10000/Rs.95*10000= 10/95= .1053(approx)

Cost of equity
Cost of equity is the return that equity investors require to be repaid. Cost of equity share capital is that part of cost of capital which is payable to equity shareholder. Every shareholder gets shares for getting return on it. So, for company point of view, it will be cost and company must earn more than cost of equity capital in order to leave unaffected the market value of its shares.

Cost of internal equity

The dividend-growth model A firms internal equity consists of its retained earnings .Here they expect dividend and capital gain from their investment. The required rate of return of shareholders can be determined from the dividend valuation model. Cost of equity , when there is normal growth If dividends are expected to grow at a constant rate of g then

Po

= DIV1
----------------------,

Ke-g

Where DIV1= DIV0(1+g) =) Ke= DIV1

------------------------------------

+g

Illustration
Illustration- Suppose that the current market price of a companys share is rs 90 and the expected dividend per share next year is rs 4.50. if the dividends are expected to grow at a constant rate of 8 percent , the shareholders required rate of return is
Ke= DIV1
--------------------

+g

=) Ke= rs.4.50
--------------------------

Po

+ 0.08 =) .05+.08= .13 or 13%

Rs. 90

Supernormal growth
The supernormal growth rate can vary. Dividend valuation model is used to calculate the cost of equity. Po=DIVo(1+gs)t)/(1+ke)t)+pn/(1+ke)n
Pn=DIVn+1/ ke-gn Ke--cost of equity PN--DISCOUNTED VALUE
GN----PERPETUAL GROWTH

ILLUSTRATION
ASSUME THAT A COMPANYS SHARE IS CURRENTLY SELLING FOR RS 134.CURRENT DIVIDENDS=RS 3.50/ SHARE & ARE EXPECTED TO GROW AT 15% FOR NEXT 6YRS AND THEN AT 8% FOREVER.

SOLUTION
134=3.50(1.15)^t/(1+ke)^t +DIV7/(ke0.08) *1/(2+ke)^6

4.03(PV A1,ko) + 4.63(PV A2,KE)+ 5.33(PV A3,KE) +6.13(PV A4,KE)+ 7.05(PV A5,KE)
+8.11(A6,KE) + (8.76/KE-0.08) *PV A6,KE)

BY TRAIL AND ERROR METHOD KE=.12

ZERO GROWTH
IT IS THE NO GROWTH SITUATION OF A COMPANY DIVIDEND VALUATION MODEL IS USED TO ESTIMATE THE ZERO GROWTH KE=DIV1/P0
ZERO GROWTH MEANS NO EARNINGS FOR THE COMPANY KE=DIV1/P0 =EPS1/P0

Cost of External equity

Definition
The minimum rate of return, which the equity shareholders require on funds supplied by them by purchasing new shares to prevent a decline in existing market price of the equity share is cost of external equity.

Types
The dividend growth model ke = DIV1 + g
P1

Price ratio and the cost of equity

ke = EPS1 P0

Example of the dividend growth model

The share of a company is currently selling for Rs 100. it wants to finance its capital expenditures for Rs 100 million either by retaining earnings or selling new shares. If the company sells new shares, the issue price will be Rs 95. The dividend per share next year, DIV1 is 4.75 and it is expected to grow at 6 percent. Calculate the cost of external equity.

Soln.The cost of external equity Ke=0.06+ 4.75/95= 0.06+0.05= 0.11=11%

Illustration
A firm is currently earning Rs 100000 and its share is selling at a market price of Rs 80. the firm has 10000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has payout ratio of 100 percent. What is the cost of equity? If the firms payout ratio is assumed to be 60 per cent and that it earns 15 per cent rate of return on its investment opportunities, then, what would be the firms cost of equity?

CAPM approach
As per the CAPM , the required rate of return on equity is given by the following relationship

Ke= Rf+ (Rm- Rf) *beta Ke= Cost of equity Rf= Risk free rate Rm= Market rate Beta= Systematic risk of an ordinary share in relation to the market

Illustration
If in year 2002 the risk free rate is 6% , the market risk premium is 9% and beta of L&Ts share is 1.54 . The cost of equity for L&T isKl&t = 0.06+0.09*1.54= .1986= 20% approx

UERY