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Cost of Capital - R.P.rustagi

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537 views21 pages

Cost of Capital - R.P.rustagi

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Disha Lade
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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  • Cost of Redeemable Debt
  • Cost of Preference Share Capital
  • Cost of Equity Share Capital
  • Cost of Retained Earnings
  • Calculations: Market and Book Values
  • Illustrations
  • Assignments and Problems
rr 137 sr 0F CAPITAL 7 y be . e debt may 5 cost of Capital of Redeemable Debt: The cost of capital of redeemable de © ‘aained with the help of Equation 5.3. i By > G-t) COP, COP, (5.3) 4+ ka* (ekg * Oka? where, 1 = Annual Interest Payment By = Net Proceeds COP; Cash Outflow on account of Amortisation COP, = Cash Outflow on account of Repayment at maturity baie After tax cost of capital of debt. In case, the debt is repayable only at the time of maturity and there is no annual | amortization then the Equation 5.3 will not contain the second element i.e., COP) / (1+kq)'. Equation 5.3 is to he solved for the value of. ka, which will be after tax cost of capital for debt. This equation is to be solved by trial and error procedure (as the IRR equation was solved in Chapter 4). [Example 5.1 ABC Lid. issues 12.5% debentures of face value of Rs. 100 each, redeemable at the end of Tyears. The debentures are issued at a discount of 5% and the flotation cost is estimated to be 1%. Find out the cost of capital of debentures given that the firm has 40% tax rate. Solution: ‘ (Ayton d-© For the given situation, s LV Bo = Rs. 100—Rs.5—Rs. 1=Rs. 94 \2 T= Rs 1250~4)=7.50. iS . Putting these values in Equation 5.3, taQa-* ory 94 = 7.5 (PVAF,,) + 100 (PVF,,,.) ; The value of right hand side of the equation is to be made equal to the amount of Rs. 94 and can be derived by trial and error procedure as follows : at ky = 9%, 17.5 (6.033) + 100 (.547) = 87.75 + 54.70 = 92.45 Be Since the amount is less than Rs. 94, the rate of discount may be reduced to 8% and therefore, at kg = 8%, 7.5 (5.206) + 100 (.583) wr = 39.05 + 58.30 = 97.35 By interpolating between 8% and 9%, the value of ky comes to 8.68%. So, the cost of ‘apital (after tax) of debenture is 8.68%. " alue of k, In order to avoid the cumbersome procedure of trial and error to find out the vi ‘d m Equation 5.3, Equation 5.4 may be used to give an approximation to after-tax cost of Capital of debt. L-t) + (RV-By)/N (5.4) ha = (RV+By)/2 ey fe debenture = Redemption Jue of RV wheres ae 51 Example 5.1, Now, applying Equation 5:4 for a oe oy ha = (100 + 94)/2 861 or 8.61% i imation py Equation 5.4 provides an approximat reult Balt with the help of Equation 5.3. Mot be redeemed at maturity. Tax rate Life of debenture So, the value of ky as giv value of kg can however, be calculated on! 4 can be used only when the debenture is to [Example 5.2 ABC Ltd. issues 15% debenture: per debenture. Find out the cost of ¢ installments of Rs. 200 each starting 30%. Solution: In the given situation, the net i ; proceeds i.e., By is Rs. 1000 — 50 debenture is to be amortized in 5 insté 2 allments of Rs. 200 inter payable only on the reduced balances as follows : aie of face value of Rs. 1000 each at a flotati apital if the debenture is to be redeem from the end of year 1. The tax rate n a 30 These after-tax cash fk lows ; ij jabs made equal a, S507 °° Ciscounted at an appropri aan mh rate 200 Rs.950 = 305 28. Tet et + 268 ap at hy accrues to them proportiona’ Prinei therefore, itely ey , the i » the after-tax cost of d year, The rare e it e 10, Rs. 950 only, the cost of lebt should of - debt (after tax) 10.5% 0, comes to 12.7157 71%, @ cosT OF PREFERENCE SHARE CAPITAL es can raise funds by the issue of prefe tiated fr gonpsal f s rence share capital also. The preference ve capital is differential ‘rom equity share capital on account of two basic features cinta ithe preference shares are entitled to receive dividends at fixed rate in priority over , and (ii) in case of | liquidation of the company , the preference Rn enaiee | get the capital repayment in priority over the equity shareholders. It may be noted that {here is no obligation on the firm to compulsorily pay the _ ‘ference dividend is payable only when the: sufficient profit he equit company has no legal obligation to pa , Tie haven way the funds in preference share, have tat ti cL preference shareholders and thus, there is fixed rate of dividend. The understanding of of capital of preference share capital is conceptually difficult (as there is no legal binding preference dividend) but the calculation does not pose much problem. The fixed rate of dividend on preference shares is the starting point for calculation of cost of capital of reference share capital. As the preference shares may either be redeemable or irredeemable, f capital may also be ascertained accordingly. COST OF CAPITAL OF REDEEMABLE PREFERENCE SHARE : If the preference are redeemable at the end of a specific period, then the cost of capital of preference res can be calculated by Equation 5.5 (which is very similar to Equation 5.3). $ _PD; Pa (5.5) Po = 2, +k, * Gah? where, P) = Net Proceeds on issue of Preference Shares PD = Annual preference dividend at fixed rate of dividend ‘Amount payable at the time of redemption P, = k, = Cost of Preference Share Capital, and 1 = Redemption period of preference shares By \ find out the value of In p,, 0.5.5 is also to be solved by the trial and error ese t as the preference adtion 5.5, neither the kp nor PD require any tly there is no tax shield to the ny, Pavable out of profit after tax and consequent NCE SHARES: In case of OST oF «a1 OF CAPITAL OF IRREDEEMABLE Ee O'all be payable to the “inal preference shares, the dividend at the Ge | Tattsomable preference share "be cae tareholder perpetually. The cost of capital of the “lated with the help of Equation 5.6- is ‘ie ve ate tia . PD = Annual preference sie shares P, = Net Proceeds on ee eaohares k Cost of capital of preft a i issue i any in India can It may be noted that no comp: yee ater 1988 (Section 80 of the Companies Act, [Example 5 ABC Ltd, issues 15% Preference shares of the face value of a cost of 4%. Find out the cost of capital of Preference share it p irredeemable, and (i) ifthe preference shares are redeemable after 10 years 10%, Solution: Pe Ifthe preference shares are irredeemable then the cost of. capital is : 15 hy = 9g 15.63% If the preference shares solving the following equatio are redeemable then the cost of capital mn me no i + hy* Ts ky 16%, the right hand IBCPVAR 65, 10) + 1 15(4. 9 side of the equation may b 10 (PVF 166, 10)) 7) the e quation may be [AR 7g, 10)) + LOVE are, 10)) 7 = 15(4.659) + 110.208) a Rane, = Rs.92.76, *polating between 16% and 17%, » the value of g comes to 16.314 By = 16% 4 (97.46 — 96) ; 4 (87.46 Go75 = 16.31 it ig mat Pe noted thatthe est of nn, 2279) : itis redeemed after 10 Years at 10% reelite of redemption. In thaee emption and the preforenc: capital will be as follows, At hy = the right 3 15@PVaR, de = 1814.98 San = Rs, 94.97 te Of digg, 15%, the ri ount oe rehthand side opine oem /'5%.10) + 96(py_ "© Cduation 247) = 156.019) + 94 ‘a68, 10) = Rs.98.99, F CAPITAL ag 141 ~ orpolating between 15% and 16%, the value off f capital is same at 15.68% p comes to 15.63%, .e cost of capi 5.68 ae it so, ' mredeemable, However, if the preference shares nig the preference shares were treat’yen k, comes to 15.83%, This inerease in cost of eapital te aie paisa? ie luc of premium of Rs. 4 payable at the time of redemption, Thie progian en ae rebolders but reflect a cost to the company as indicated by the ae » approximation to kp: An approximation to k, can be quickly obtained relenae formulation: », - DAG oan (P, + Po)/2 In case the preference share is issued at a net of Rs. 96 and is Pe. atthe end of year 10, then Proceed roieeranl following 15 + (100-96) /10 (100 + 96) /2 © cost OF EQUITY SHARE CAPITAL The measurement. of cost of capital of equity share capital is by far the most typical and conceptually a difficult exercise. The reason being that there is no coupon rate in case of equity shares. In case of cost of capital of debt and preference share capital, the rate of interest and the rate of dividend were the starting point respectively. However, no such strting point is available for cost of equity shares capital. Further, there is no commitment topay equity dividend and it is the sole discretion of the Board of Directors to pay or not to bay dividend or to decide at what rate the dividend be paid to the equity shareholders. Moreover, the equity shareholders are the last claimant on the profits of the company. Therefore, it is often said that the equity shares have no cost of capital as such. But ike Preference share capital, it is also not true for equity share capital. a Equity share capital, like other sources, has a cost. Just as in yu kp = 15.71% case of equity shares is available basically, in tl herefore, the potential investors of equity share c Stream of dividend from the firm. This stream Present value of such stream. “Sunted to deter thy, s° Present ; ‘cal ho}, market value of a share oat po"S and the risk associated with the share: of share ig equal to the present value 0 © sale proceeds realised when the ey haat Dricg by" Pus th BASIC FINANCIAL Current Market Price of Equity Share Share market price after year n Dividends receivable over different years, Required rate of return of the shareholder or Equity Share Capital In Equation 5.7 and the subsequent discussion, it has been ass dividends are payable only annually. Equation 5.7 does not seem to be pr; requires to ascertain the market price at the end of year n, when the sh sold, However, the share price at year n is itself the present value of all the dividends plus the subsequent sal i eee ent sale proceeds. Thus, Equation 5.7 may be modifi where, eee “Dy (sk * Cekget > treated asa with the help of F F CAPITAL 008 ee he-8 » = Dod+e) D an = B, te" pte (6.11) Example 5.4 { i ABC Lid. has just declared and paid a dividend at the rate 15% on the equity share of js 100 each. The expected future growth rate in di ividends is 12%. Find out the cost of capital of equity shares given that the present market value of the shave is Rs 168, Soluti The cost of equity capital in the case may be ascertained by using the Equation 5.11. i, = Peto, 0 = Sat 12 = 22 or 22% The formulations given in Equations 5.10 and 5.11 are subject to the following assumptions 1 2, 3, That the current market price of the share is a function of future expected dividends. Dois > 0, ie., the present dividend is positive. The dividend pay out ratio is constant. Varying Growth Rates in Dividends. Dividends may also be assumed to grow at erent rates for different years. For example, for first 5 years, the growth rate may be 10% ‘annum, then for the next 5 years the growth rate may be 15% per annum and thereafter dividends may grow at 20% per annum infinitely. This means that the dividend will grow 10% per annum for years 1 to 5, and at 15% for years 6 to 10 and at 20% for the year 11 4 thereafter. Equation 5,10 can be modified to take care of such situations of dividend “m and the cost of capital may therefore be calculated with the help of Equation 5.12. 6 } Dw +g Po =a) Do +8 > Gshy (5.12) Gk * iS, Current market price of the equity share Do = Dividend just paid by the company Ds = Dividend payable at the end of year 5 Dio = Dividend payable at the end of year 10 Send gy = Different growth rates, and k. = Cost of Equity Share Capital. Fuation 5.12 can be oper by trial and error procedure to find out the value of ky if : co Of Capital of Newly Issued Capital or External Equity : A firm may fc & tion Where it needs to raise funds by issue of fresh equity “iects, If so, then what return must be earned on these ie es N° project worthwhile. The existing equity share capital + Where, Py = &, BASIC FINANCIAL 144 ’ earned from the existing Some quantum of returns. C ng shares, the new return high eno ends sedividends and this street eee wil alan same wtream ax tnt 92 exist to obtain the $80 ne ‘ aust be utilised to Pro ee st eis just equal to the net proceeds of fresh is present Wy which the new shares expect 2m order to ng shares, isthe cost of fresh equity should therefore, However, in practice, .d to bear additional expenses: of flo oe eccting expenses, brokerage, issue expenses, advertisement and above all T javestor to induce them to subscribe alll the the current price to the potential The cost of new equity shares can be estimated on the basis of Eq determining the net proceeds after flotation cost, eéc., and taking the assum growth rate as follows ream of divid equity capit new shi pect to inthe Theoretically speaking, the firm market price of existing equity share be reduced as the firm will be require D, NP Te co NP = Net Proceeds from fresh issue, and stmay bene van te teotnew ea seplitagb noted that this equation i almost the same as Equation 6 selaced by NP and NPs n, Cost of capital is the os eat the e3 . sals is me than. c reholderg. pam the Pi oncePt of cost of al 4 cay ial structure for the mel Premium 2 ost 06 CAROA ee o 151 ee of capital on existing capital gst of Debt (after tax) ‘compute the after-tax eo ¢ kg =10(1-.3)=7% Pre eae Assuming that the fir following eases pays tax at 40% @), A 14-5% Preference share sold st par. spon rate being 11/25%. ji) A Perpetual bond sold at par, cou! ‘sold at Rs. 950 less 5% under (iit)_A ten year 8% Rs. 1,000 per bond io) An Equity share selling at « market price of Rs, 120 and Paying Re Oper share which is expected to grow at arate of OF, Solution: (i) The Gost of Preference Shares (afer tax) is 145% . Source Gi) The Cost of debt is Eaity Share Capital y= 11 25% (1-4) =675% 106 Pref, Share Capital i) Approximate huis 1 Debentures f= Tax rate RV = Redemption Value of the bond [Mee WACC is 1.8764 By =Net Iarue price ofthe bond =_— IN =Life of the bond ‘iustration 5.3 " 80(1~. 4) + (1000 ~950) +10 Tar ona ta =~ (1000 — 950) +2 gor geent Share is quoted : share and the i 48+ 5 _ 0548 or 543% ae ited to compute "915 bag ) The cor fi 0 sont Eat Cost of Capital ; cut company’s cost of, L. hott calelate market pce eg ante tion 4 dividend at aed Growth rate is 5 per Vis to be paid at the So, D, =9(1+08)=972 Bh aD ig 272 hy Big =S72 09-161 or 181% On, he Bau “WHY cost of capital, & ig + 150 intustration 5.4 “ ol iJable from the Balance Sheet of a oe The following information is 8¥a aquity Share Capital (00 shares of Rs, 100 each) 19% Debentures 18% Termoan kj (Seeured loan) kj(Unecured loan) ‘ot of capital of the company. It np), Income tax rate is 40 peroen caiculation of Weighted Average Cost of Cay Source ital (Before tax): ouity Capital 1e weighted average © Determine the FR, 20 per share dividends ata rate of Solution: kg= 120 -4)= 072 he= 20 Calculation of WACC : Source Amount Weight Equity Shares Rs, 8,00,000 20 12% Debentures 8,00,000 20 So, WACC ( ) 18% Term-Loan 24,00,000 60 u pre tan) eae 40,00,000 1.00 Pn = 2 The following in er nam, owing information Equity share capital ‘Tlustration 5.5 12% Preference Shares 10% Debentures From the following information, calculate the Weighted Average 7 before tax for ABC Ltd. > Determine weightey Btarate of Rs, BW share Re ag share isReqeor 1. Shareholders’ Funds: ‘Share Capital: Equity ‘Total funds Additional Information: (i) Normal yield on Equity Shareholders Funds is 15%, (ii) Dividend rate on Preference Shares 12%. (iii) Interest on Secured Loans is 16.25%. (iv) Interest on Unsecured Loans is 20%. a cost oF Aa, 155 solution sheot of Delew rahe given case, the cost of debt i 12% Debentures 18% Term Loan y © shar Premium 20,000 Reserves 6,00,000, nae Shareholders funds 16,00,000, a 4,00,000, woe uty Share Catal ost ‘eaten bal 12% Perpetual debentures ‘An annual ordinary dividend of Rs. 2 por share BS just been paid, vient have grown ata rate of 1 por cent DOr SS) this rate dividends baie] inerest has recently Boon pad @X ‘the debentures. TE tn continns, abd at Ha 21-50 and the debenture 8t SP Pes cent. Tg Saray ceived to etimate the Weighted Average Cost of GRIGG) values) ‘Solution: Teonder tg ealcuate the WACC, the specific cost of equity capital be calculated as follows ‘The cost of capital (as per premise—) inthis cas, the cost of debt is as above, and the cost of equity i is Equity Share Capital 12% Debentures 18% Term loan Ba.2x110 Rs, 2750 the market value of equity is 80,000 x Rs, 27-50 = Rs, 22,00,000 1 Bel = BST Re. 80 ‘The market value of debt is 400,000 x 80 = Rs, 3 20,000 Now, the WACCis (ionotarsanns (8.20,00025 20,000) x-15 = 176=17 a tia enue, the dividend of Rs, 2 has just been paid Denis Share 6 ble from the Balance jie, Uidend exported after one year from now will ke Dp (L +) = re Captl—20,000shar@sofRe 1Oeagh =D J he = phte= +10= 18% 189% = etd Surplus S% Debentures % Thera a te of tax for the com, Ile the Wer emai 80% Current level of : a ; i Sion Average Cost of Capital usin ee ends at a consistent rate of 20% rate is 40%. ee ‘will it make if the current price of the Rs 157 — jortion After-tax ut of different debt proportions, the firm ‘Amount — PFoP Cost 40%. So, the O} has the minim, Capital etal s 40%. So, ptimal Capital um WACC when the debt Bs. ent) prop vo structure is conan n the = ae oa pope and the WACC would be 13:4%, consisting of 40% Debt and 60% 2,0, = “i z 2% Equity jus 1,80,000 26% 4 jilustration 5.11 — = ‘Reserves and Surplus 170,000 34%. 56%, the foll Debentures 10,00 2h & Co. has the following capital structure as on De oo - 500,000 100% Equity Share Capital 6000 shares af 100 each aes jae ee prive of equity isnot given, the cost of caplealiag 9%) Preference Share Capital a Rs. 5,00,000 AAs the eurrent market pricy * jividend and the face value of i ee sect nec aerece tothe rte 0 10% Debentures Rs. 2,00,000 ae equity shares of the com Rs. 3,00,000 ccarnings is the dividends forege a pany are quoted at 00 st of retained eT ee .cste a dividend of Rs, 9 per shave for the next ges A he OMDany is expected to x) be opportunity ace, ee rant erm he came rate Of Fhare Capital, Thus, the cost of retained earnings oh is equal to the cost of ming the tax rate applicable svorage Cost of Capital, and.) tn® COMPAL ab 30%, caleulato the Weighted ae | Assuming that the company can raise additions Tea ance ifs expansion, calewlate the revised WACO Tia ng the pot capital (after tax) have been made ab from Rs. 102 to Rs, 96 financing may bring down tho market price estimates of the a = Pao Solution: The present Mee may be calculated as follows : Cost of Equity capital = k= (DP) =O) +8 ae = 0/102) +05 =-198 o 138% ‘You are required to find the weighted average cost of capital mt “euides to raise Rs. 5,00,000 by the issue of 12% Loan and the market sae regi ‘pected to go down to Rs, 96, then the WACC may be calculated as Cost of Equity Capi (9796) apital i‘ ‘The WACC of the firm may be ascertained as follows : ai = (06) +05 dtr as oan yp gPT A A 159 Statement Showing Weighted Stat : aio of Capital 40,00,000 wing capital “A Limited bas the follos : AU pauity ehare capital 2.00 ‘000 shares) es aa ‘4g Debentures co cae xx rate is 30 per cent. You ‘The to ost of capit weighted average & weighted average by issuing Rs, 8 and leave the tal based on existing capital structires cost of if the company So per cent debentures. This would 1c growth rate unch @ (@) the new Rs, 20,00,000 debt the expected dividend to Share will fll to Rs. 15 per share. (p) above, er sity share capital wth rate increases to 10 Per Pl (o) The cost of eapital ifin 10% Debentures Solution: (q) The cost of Equity capital is: Dy Bs2 eoBite =o" 14-07 = IT or 17%. ‘The cost of 8% Debentures, after tax, ‘Statement Showing Weighted is8- 9)=56% al fac ll structure of XYZ & Len from fin sone nancial institutions. As a result of this the res would go Pies mee + celaetun angen “ts Sr un eee btepona find out the impact on the WAC ofthe firm given that ele aan ge ae = in Sxpected in dividends, growth rate, market price of 10,00,000 20,00,000, ‘So, Weighted Average Cost of Capital, ky is 11-35% D ® be aBieg Bron 2204-01 = 2108 2%. ‘The cost capital of new Debentures (after tax) is 10% (1— cost OF CAPITAL Jnange from 10-60% (present Source aity funds 3 Preference shares ‘s: Debentures rent sources ave been calculated a5 {Olam fustration 5.15 — \g compat The latest Balance Pr raagstng projects, You Balance Sheet of D 148 Iino esas 1 equipment manufacturin <¢ Capital for evaluating capital Eauity Shares (60,000 shares) Retained Profits ‘Preference Shares 0% Perpetual Debt (Face value Rs, 100 each) Additional Informatio (i) 20 years 14% Debentures of Rs, 2,500 face value, sold at par, 2% flotation costs. (i) 15% Preference shares (iii) Equity shares : Sale price Rs. 115 per ‘The corporate tax rate is 35%. The exp Sale price Rs. 100 per 1 share, flotation costs Coat ected dividend Cont ote eames ‘ost of Preference ‘growth rate in equity dividends is 8% pa. Specific Cost of Perpetua “ta debt 1. +(RV=BYN ha= pve Age" Bs, 50 065) + (2695 -2450)20 Ra. BRS + 245002 Rs. 227-50 + 8°75 931% = Rs. 2537-50 Rs. 15 beau *!* 162 ) Retained em arnings have no market valu, 0 thee reno ineluded in WACC (based on market | mlustration 5-16 © he f ovided sn respect of the specie Sad a cc Anawers 1.) i een an Write short (ai) F, eid) 7, (iid) ted Average Cost of Capital, WACC, using ah ee Calculate the Weigh" on specific east of eapital weights may be caleulated 98 Solution: ‘The WACC on the basis of BV and MV w eights source BY cic auity share cial a. Prnerence saree De ong-term debt —- 5 im, as a The WACC based on BV weights 14a, and. ine ie cia Tae WACC based on MV weights * 14-74%. {B.om, D.v, 201m aula the ae at ‘capital in each of rears Rs, 100 bond of the following cases fm cn be li br pe cara dinner curren sent atk prise of share is Ra ncaa The: nia 450 tha oth aes nn chi = 10, ae ‘oye te ane paid a dividend of ae = sige ete te =a — (iii) Cost of capital does not com ti). Cont of capita sas data for NPY (o) Risk-free interest ate scot of cpital ar same HINER The cutrent CB Dierect are ve same conto EAA, ‘vite wv den ee a wit titra ln be tr b sag suena ce 00 fr expansion (oii) Cast of Debt and Cost of ret hare capital, both, require Os Neel squeak ee ae a the end of (Gx). Bvery souree of fund has a” ox st eost of capital: 4 roan about to paya dividend ogi 1950. The expecta ate rovth in diene i vera cost of capital of tbe BF. UAnewer 774 govthiedvikatetesiataei@e ri same as heat one ‘oan ad fen sarc oan) ovina pone termined by the rts Ke sik ach Fada ot pee igs ere f, (ex sinha 106% discosnt tinued a)

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