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Cost of Capital Concept and Measurement

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The concept of cost of capital budgeting is concerned with cost of capital . The concept of cost of capital is significant not only for capital budgeting it is also indispensable in other areas of financial management. In operational terms the cost of capital is the rate of return of a firm must earn on its investments so that market value of the concern remain unchanged.

Cost of capital is the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged It is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard rate of return

Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure. Soloman Ezra

(i) Designing the optimal Capital structure (ii) Assisting in investment decisions (iii) Helpful in evaluation of expansion projects (iv) Rational allocation of national resources

Borrowed Rs 100 cr @ 12 % from IDBI

IVRCL

Air port R = 15 %

National Highway R = 11 %

Toll bridge

R = 13 %

Mr X has taken the following loan from various bank

Particulars Personal loan 2 Wheeler loan

Bank SBI Bajaj Auto Finance

Loan amount Rs 2,00,000 Rs 50,000 Rs 20,00,000 Rs 2,00,000

Rate of interest 15 % 9% 8% 24 %

Housing loan HDFC Credit card Citi bank

What is the total cost of loan ?

Components of capital
   

Debentures Preference Shares Equity shares Retained earnings

Equity shares Rs 25,00,000 Expected return 20 %

15 % Preference shares of Rs 10,00,000

10 % Debentures of Rs 15,00,000

Step 1 (Computation of specific cost)

Find the cost of individual components in the capital,let us say cost of debt, equity and retained earnings

Step 2 (Computation of overall cost of capital or weighted average cost of capital)

CONCEPT AND MEASUREMENT OF COST OF CAPITAL


Importance and Concept

Measurement of Specific Costs Computation of Overall Cost of Capital Cost of Capital Practices in India Solved Problem Mini Case

Conceptually, it is the minimum rate of return that a firm must earn on its investments so as to leave market price of its shares unchanged. It is also referred to as cut-off rate, target rate, hurdle rate, required rate of return and so on. In operational terms, it is defined as the weighted average cost of capital (k0) of all long-term sources of finance. The major long-term sources of funds are 1) Debt, 2) Preference shares, 3) Equity capital, and 4) Retained earnings.
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Assumptions The theory of cost of capital is based on certain assumptions. A basic assumption of traditional cost of capital analysis is that the firms business and financial risks are unaffected by the acceptance and financing of projects Business Risk Business risk is the risk to the firm of being unable to cover fixed operating costs. Business risk measures the variability in operating profits [earnings before interest and taxes (EBIT)] due to change in sales Financial Risk Financial risk is the risk of being unable to cover required financial obligations such as interest and preference dividends. Capital budgeting decision determines the business risk complexion of the firm. The financing decision determines its financial risk.

Explicit Cost The explicit cost of capital is associated with the raising of funds (from debt, preference shares and equity). The explicit cost of any source of capital (C) is the discount rate that equates the present value of the cash inflows (CIo) that are incremental to the taking of financing opportunity with the present value of its incremental cash outflows (COt). Symbolically,

CO t CI 0 ! t t !1  C 1
n

(1)

where CI0 = initial cash inflow, that is, net cash proceeds received by the firm from the capital source at time O, CO1 + CO2 ... + COn = cash outflows at times 1, 2 ... n, that is, cash payment from the firm to the capital source.

If CI0 is received in instalments, then, CI0

CI 1 CI 2 CI 3 CI n    ... CI 0  1 2 3 1  C 1  C 1  C 1  C n CO1 CO 2 CO 3 CO n !    ... 1 2 3 1  C 1  C 1  C 1  C n

( 2)

It is evident from the above mathematical formulation that the explicit cost of capital is the rate of return of the cash flows of the financing opportunity

Implicit Cost
Retained earnings involve no future cash flows to, or from, the firm. Therefore, the retained earnings do not have explicit cost. However, they carry implicit cost in terms of the opportunity cost of the foregone alternative (s) in terms of the rate of return at which the shareholders could have invested these funds had they been distributed to them/or not retained by the firm.

There are four types of specific costs 1) Cost of Debt 2) Cost of Preference Shares 3) Cost of Equity Capital 4) Cost of Retained Earnings

Cost of debt is the after tax cost of long-term funds through borrowing. The debt carries a certain 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 by the amount of tax shield it provides. The debt can be either

1) Perpetual / irredeemable Debt 2) Redeemable Debt

In the case of perpetual debt, it is computed dividing effective interest payment, i.e., I (1 t) by the amount of debt/sale proceeds of debentures or bonds (SV). Symbolically

I SV I  t 1 kd ! SV ki !

(3) ( 4)

ki kd I SV t

= Before-tax cost of debt = Tax-adjusted cost of debt = Annual interest payment = Sale proceeds of the bond/debenture = Tax rate

Example 1

A company has 10 per cent perpetual debt of Rs 1,00,000. The tax rate is 35 per cent. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10 per cent discount, and (iii) 10 per cent premium.

(i)

Debt issued at par Before-tax cost, ki = (Rs 10,000 / Rs 1,00,000) = 10 per cent After-tax cost, kd = ki (1 t) = 10% (1 0.35) = 6.5 per cent Issued at discount Before-tax cost, ki = (Rs 10,000 / Rs 90,000) = 11.11 per cent After-tax cost, kd = 11.11% (1 0.35) = 7.22 per cent

(ii)

(iii) Issued at premium Before-tax cost, ki = (Rs 10,000 / Rs 1,10,000) = 9.09 per cent After-tax cost, kd = 9.09% (1 0.35) = 5.91 per cent

In the case of redeemable debt, the repayment of debt principal (COP) either in installments or in lump sum (besides interest, COI) is also taken into account. kd is computed based on the following equations:

When principal is paid in lump sum, CI0 !

COIt 1 t  COPn n t 1 k d 1 t !1  k d
n

(5)

When principal is paid in instalment s, CI0 !

COIt 1 t  COPt t (6) t 1 k d 1 t !1  k d

where CI0 = Net cash proceeds from issue of debentures or from raising debt COI1 + COI2 + ... + COIn = Cash outflow on interest payments in time period 1,2 and so on up to the year of maturity after adjusting tax savings on interest payment. COPn = Principal repayment in the year of maturity kd = Cost of debt. The cost of debt is generally the lowest among all sources partly because the risk involved is low but mainly because interest paid on debt is tax deductible.

Example 2 A company issues a new 10 per cent debentures of Rs 1,000 face value to be redeemed after 10 years The debenture is expected to be sold at 5 per cent discount. It will also involve floatation costs of 5 per cent of face value. The companys tax rate is 35 per cent. What would the cost of debt be? Illustrate the computations using (1) trial and error approach and (2) shortcut method.
Solution (1) Trial and Error/Long Approach Cash Flow Pattern of the Debentures Years 0 1-10 10 Cashflow + Rs 900 (Rs 1,000 Rs 100, that is, par value less flotation cost less discount) - Rs 100 (interest outgo) - Rs 1,000 (repayment of principal at maturity)

We are to determine the value of k in the following equation : d 10 Rs 65 Rs 900 !  Rs 1,000 t 10 t!1 1 k 1 k d d

The value of kd for this equation would be the cost of debt. The value of kd can be obtained, as in the case of IRR, by trial and error. Determination of PV at 7% and 8% Rate of Interest Year(s) Cash outflows 1 10 10 Rs 65 1,000 PV factor at 7% 7.024 0.508 8% 6.710 (Table A-4) 0.463 (Table A-3) Total PV at 7% 8%

Rs 456.56 Rs 436.15 508.00 ______ 964.56 463.00 ______ 899.15

The value of kd would be 8 per cent.

(2) Shortcut Method The formula for approximating the effective cost of debt can, as a shortcut, be shown in the Equation

I 1  t  f  d  pr  pi /N m k ! d RV  SV /2

(7)

where I = Annual interest payment RV = Redeemable value of debentures/debt SV = Net sales proceeds from the issue of debenture/debt (face value of debt minus issue expenses) Nm = Term of debt f = Flotation cost d = Discount on issue of debentures pi = Premium on issue of debentures pr = Premium on redemption of debentures t = Tax rate

kd !

Rs 100 1  0.35  Rs 50  Rs 50 /10 ! 7.9% Rs 1000  Rs 900 /2

Example 3 A company has issued 10 per cent debentures aggregating Rs 1,00,000. The flotation cost is 4 per cent. The company has agreed to repay the debentures at par in 5 equal annual installments starting at the end of year 1. The companys rate of tax is 35 per cent. Find the cost of debt. Solution Net proceeds from the sale of debenture = Rs 96,000. Since the cash outflows are higher in the initial years than the average (Rs 23,900), let us try to determine PV at 7 per cent and 8 per cent. Cash outflows 26,500 25,200 23,900 22,600 21,300 PV factor at 7% 0.935 0.873 0.816 0.763 0.713 8% 0.926 0.857 0.794 0.735 0.681 Total PV at 7% Rs 24,777 22,000 19,502 17,244 15,187 98,710 @Rs 20,000 principal + Rs 10,000 interest (1 0.35) The value of kd = 8 per cent. 8% Rs 24,539 21,596 18,977 16,611 14,505 96,228

The cost of preference share (kp) is akin to kd. However, unlike interest payment on debt, dividend payable on preference shares is not tax deductible from the point of view assessing tax liability. Irredeemable Preference Shares Redeemable Preference Shares

The cost of preference shares in the case of irredeemable preference shares is based on dividends payable on them and the sale proceeds obtained by issuing such preference shares, P0 (1 f ). In terms of equation:
Kp ! kp ! P0 1  f Dp ( 8) (8  A )

Dp 1  D t P0 1  f

where kp Dp P0 f Dt

= Cost of preference capital = Constant annual dividend payment = Expected sales price of preference shares = Flotation costs as a percentage of sales price = Tax on preference dividend

Example 4 A company issues 11 per cent irredeemable preference shares of the face value of Rs 100 each. Flotation costs are estimated at 5 per cent of the expected sale price. (a) What is the kp, if preference shares are issued at (i) par value, (ii) 10 per cent premium, and (iii) 5 per cent discount? (b) Also, compute kp in these situations assuming 13.125 per cent dividend tax Solution ( a ) ( i ) Issued at par Rs 11 ! 11.6% kp ! Rs 100 1  0.05 ( ii ) Issued at Premium kp ! Rs 11 ! 10.5% Rs 110 1  0.05 ( b ) ( i ) Issued at par Rs 11(1.13125 ) ! Rs 12.44 ! 13.1% kp ! Rs 95 ( ii ) Issued at Premium kp ! Rs 12.44 ! 11.9% Rs 104.5

( iii ) Issued at Discount kp ! Rs 11 ! 12.2% Rs 95 1  0.05

( iii ) Issued at Discount kp ! Rs 12.44 ! 13.8% Rs 90.25

The cost of redeemable preference shares requiring lump sum repayment (P) is determined on the basis of the following equation:
P0  f ! 1

t !1

k 1
t p

Dp  Dt 1

P n n  kp 1

where P0 f Dp Pn

= Expected sale price of preference shares = Floatation cost as percentage of P0 = Dividends paid on preference shares = Repayment of preference capital amount

Example 5 ABC Ltd has issued 11 per cent preference shares of the face value of Rs 100 each to be redeemed after 10 years. Flotation cost is expected to be 5 per cent. Determine the cost of preference shares (kp). Solution
Rs 95 !
10 t !1

1  k p t 1  k p 10

Rs11

Rs 100

The value of k p is likely to be between 11 and 12 per cent as the rate of dividend is 11 per cent.

Determination of PV at 11% and 12% Year 1 10 10 Cash outflows Rs 11 100 PV factor at 11% 5.889 0.352 12% 5.65 0.322 Total PV at 11% Rs 64.78 35.15 99.93 12% Rs 62.15 32.20 94.35

Kp=11.9 per cent

The computation of cost of equity capital (ke) is conceptually more difficult as the return to the equityholders solely depends upon the discretion of the company management. It is defined as the minimum rate of return that a corporate must earn on the equity-financed portion of an investment project in order to leave unchanged the market price of the shares. There are two approaches to measure ke: 1) Dividend Valuation Model Approach 2) Capital Asset Pricing Model (CAPM) Approach.

As per the dividend approach, cost of equity capital is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. The cost of equity capital can be measured with the following equations: (A) When dividends are expected to grow at a uniform rate perpetually:
n D0 1  g D 1  g D 0 1  g D 0 1  g P0 1  f ! ! 1  ...   1  k e 1 1  k e 2 1  k e n t !1 1  k e t 1 2 n t 1

(10)

k e in Eq. 10 is the rate of return (discount rate) which equates the two sides of the equation. Simplifying Eq. 10, we get D1 P0 ! (11) ke  g ke ! D1 g P0

(12)

where

D1 P0 g

= Expected dividend per share = Net proceeds per share/current market price = Growth in expected dividends

The calculation of ke on the basis of Eq. 12 is based on certain assumptions with respect to the behaviour of investors and their ability to forecast future values:  the market value of shares depends upon the expected dividends;  investors can formulate subjective probability distribution of dividends per share expected to be paid in various future periods;  the initial dividend, D0, is greater than zero (D0 > 0);  the dividend pay-out ratio is constant;  investors can accurately measure the riskiness of the firm so as to agree on the rate at which to discount the dividends. Note: Under the provisions of Section 115(O), of the Income Tax Act, 1961, a domestic company is liable to pay tax at a flat rate of 11.5 per cent (plus surcharge) on dividends declared/distributed/paid on/after April 1, 2003. The payment of the dividend tax will reduce the growth (g) in dividends:

g ! b.r, where b ! retention rate, r ! rate of return. 1 1 DPS  Dt EPS  DPS  Dt b ! 1 ! EPS EPS where Dt ! Dividend tax r ! EPS/P0 @ g ! b.r ! EPS EPS  ? DPS  Dt A EPS  DPS 1  D t 1 v ! P0 EPS P0 (12  A)

Obviously, g without Dt would be higher.

(B) Under different growth assumptions of dividends over the years: Equation 12 will have to be modified to take into account two (or more, if necessary) growth rates. The solution in the following Equation 13 for ke would give the cost of equity capital:
g D  gb 1 D  gc 1 P0 ! 0  n t t !1 t ! n 1 1  k e 1  k e t n t 1 t 1

(13)

whereg h ! Rate of growth in earlier years gc ! Constant growth in later years

Example 6 Suppose that dividend per share of a firm is expected to be Re 1 per share next year and is expected to grow at 6 per cent per year perpetually. Determine the cost of equity capital, assuming the market price per share is Rs 25. Solution: This is a case of constant growth of expected dividends. The ke can be calculated by using Equation D k e ! 1  g ! Rs 1  0.06 ! 10% Rs 25 P 0

The dividend approach can be used to determine the expected market value of a share in different years. The expected value of a share of the hypothetical firm in Example 6 at the end of years 1 and 2 would be as follows
2 ! Rs 1.06 ! Rs 26.50 (i) Price at the end of the first year (P ) ! 1 k e  g 0.10  0.06 3 ! Rs 1.124 ! Rs 28 (ii) P ! 2 k e  g 0.10  0.06 D D

Example 7 From the under mentioned facts determine the cost of equity shares of company X: (i) Current market price of a share = Rs 150. (ii) Cost of floatation per share on new shares, Rs 3. (iii) Dividend paid on the outstanding shares over the past five years: Year 1 2 3 4 5 6
Dividend per share Rs 10.50 11.02 11.58 12.16 12.76 13.40

(iv) Assume a fixed dividend pay out ratio. (v) Expected dividend on the new shares at the end of the current year is Rs 14.10 per share.

Solution As a first step, we have to estimate the growth rate in dividends. Using the compound interest table (Table A-1), the annual growth rate of dividends would be approximately 5 per cent. (During the five years the dividends have increased from Rs 10.50 to Rs 13.40, giving a compound factor of 1.276, that is, Rs 13.40/Rs 10.50. The sum of Re 1 would accumulate to Rs 1.276 in five years @ 5 per cent interest).

Rs 14.10 ke !  5% ! 14.6% Rs 147 Rs 150  Rs3

The CAPM describes the relationship between the required rate of return or the cost of equity capital and the non-diversifiable or relevant risk of the firm as reflected in its index of non-diversifiable risk, that is, beta. Symbolically, Ke = Rf + b (Km Rf ) (14) Rf = Required rate of return on risk-free investment b = Beta coefficient**, and Km = Required rate of return on market portfolio, that is, the average rate or return on all assets Beta is degree of responsiveness or co-movement of return on an investment with the market return.

Beta for the market portfolio as measured by the broad based market index equals 1. Beta coefficient of 1 would imply that the risk of the specified security is equal to the market. The interpretation of zero coefficient is that there is no market related risk to the investment. A negative coefficient would indicate a relationship in the opposite direction. The going required rate of return in the market for a given amount of systematic risk is called the Security Market Line.

Example 8 The Hypothetical Ltd wishes to calculate its cost of equity capital using the capital asset pricing model approach. From the information provided to the firm by its investment advisors along with the firms own analysis, it is found that the risk-free rate of return equals 10 per cent; the firms beta equals 1.50 and the return on the market portfolio equals 12.5 per cent. Compute the cost of equity capital. Solution Ke = 10% + [1.5 (12.5% 10%)] = 13.75 per cent

Example 9: As an investment manager you are given the following information Investment in equity shares of A Cement Ltd Steel Ltd Liquor Ltd B Government of India Bonds Risk-free return, 8 per cent You are required to calculate (i) expected rate of returns of market portfolio, and (ii) expected return in each security, using capital asset pricing model
Initial price Rs 25 35 45 1,000 Dividends Year-end market price Rs 50 60 135 1,005 Beta risk factor 0.80 0.70 0.50 0.99

Rs 2 2 2 140

Solution (i) Expected Returns on Market Portfolio Security Dividends A Cement Ltd Steel Ltd Liquor Ltd B Government of India Bonds Rs 2 2 2 140 146 Return Capital Appreciation Rs 25 25 90 5 145 Total Rs 27 27 92 145 291 Rs 25 35 45 1,000 1,105 Investment

Rate of return (expected) on market portfolio = Rs 291/Rs 1,105 = 26.33 per cent (ii) Expected Returns on Individual Security (in percent) ke = Rf + b(km Rf) Cement Ltd = 8% + 0.8 (26.33% 8%) Steel Ltd = 8% + 0.7 (26.33% 8%) Liquor Ltd = 8% + 0.5 (26.33% 8%) Government of India Bonds = 8% + 0.99 (26.33% 8%) 22.66 20.83 17.16 26.15

The capital assets pricing model (CAPM) approach to calculate the cost of equity capital is different from the dividend valuation approach in some respects. In the first place, the CAPM approach directly considers the risk as reflected in beta in order to determine the Ke. The valuation model does not consider the risk; it rather uses the market price as a reflection of the expected risk-return preference of investors in the market. Secondly, the dividend model can be adjusted for flotation cost to estimate the cost of the new equity shares. The CAPM approach is incapable of such adjustment as the model does not include the market price which has to be adjusted. Both the dividend and CAPM approaches are theoretically sound. But major problems are encountered in the practical application of the CAPM approach in collecting datawhich may not be readily available or in a country like India may be altogether absent regarding expected future returns, the most appropriate estimate of the risk-free rate and the best estimates of the securitys beta.

Cost of Retained Earnings The cost of retained earning (kr) is equally difficult to calculate in theoretical terms. Since retained earnings essentially involves use of funds, it is associated with an opportunity/implicit cost. The alternative to retained earnings is the investment of the funds by the firm itself in a homogeneous outside investment. Therefore, kr is equal to ke. However, it might be slightly lower than ke in the case of new equity issue due to flotation costs.

Weighted Average Cost of Capital Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firm;s capital structure. Assignment of Weights The aspects relevant to the selection of appropriate weights are: 1) Historical weights a) Book value weights or b) Market value weights Marginal Weights

2)

Historical Weights Historic weights either book or market value weights are based on actual capital structure proportion to calculate weights. Market Value Weights Market value weights use market values to measure the proportion of each type of capital to calculate weighted average cost of capital. Book Value Weights Book value weights use accounting (book) values to measure the proportion of each type of capital to calculate the weighted average cost of capital Marginal Weights Marginal weights use proportion of each type of capital to the total capital to be raised.

Mechanics of Computation Example 10: Book Value Weights (a) A firms after-tax cost of capital of the specific sources is as follows: Cost of debt Cost of preference shares (including dividend tax) Cost of equity funds (b) The following is the capital structure Source Debt Preference capital Equity capital Amount Rs 3,00,000 2,00,000 5,00,000 10,00,000 8% 14 17

(c) Calculate the weighted average cost of capital, k0 using book value weights.

Table

1: Solution Computation Value Methods) Amount (2)

of

weighted

average

cost

of

capital

(Book

Source of funds (1) Debt Preference capital Equity capital

Proportion (3) 0.3 (30) 0.2 (20) 0.5 (50) 1.00 (100)

Cost (%) (4) 0.08 0.14 0.17

Weighted cost (3 x 4) (5) 0.024 0.028 0.085 0.137

Rs 3,00,000 2,00,000 5,00,000 10,00,000

Weighted average cost of capital 13.7% An alternative method of determining the k0 is to compute, as shown in Table 2, the total cost of capital and then divide this figure by the total capital. This procedure obviously avoids fractional calculations. TABLE 2 Computation of Weighted Average Cost of Capital (Alternative Method) Sources (1) Debt Preference capital Equity capital Total Amount (2) Rs 3,00,000 2,00,000 5,00,000 10,00,000 Cost (%) (3) 8 14 17 Total cost (2 3) (4) Rs 24,000 28,000 85,000 1,37,000

Weighted average cost of capital = [(Rs 1,37,000 / Rs 10,00,000) x 100] = 13.7 per cent

Example 11 (Market Value Weights)

From the information contained in Example 10, calculate the weighted average cost of capital, assuming that the market values of different sources of funds are as follows: Source Debt Preference shares Equity and retained earnings Total
Market value Rs 2,70,000 2,30,000 7,50,000 12,50,000

Assume allocation of 80:20 between equity and retained earnings.

(2) After the determination of market value, k0 is calculated as shown in Table 3.

TABLE 3 Computation of Weighted Average Cost of Capital (Market Value Weights) Sources (1) Debt Preference shares Equity capital Retained earnings Total Market value (2) Rs 2,70,000 2,30,000 6,00,000 1,50,000 12,50,000 Cost (per cent) (3) 8 14 17 17 Total cost (3 2) (4) Rs 21,600 32,200 1,02,000 25,500 1,81,300

k0 = (Rs 1,81,300/Rs 12,50,000) 100 = 14.5 per cent

Example 12 The firm of Example 10 wishes to raise Rs 5,00,000 for expansion of its plant. It estimates that Rs 1,00,000 will be available as retained earnings and the balance of the additional funds will be raised as follows: Long-term debt Preference shares Using marginal weights, compute the weighted average cost of capital. Rs 3,00,000 1,00,000

Solution The computation is illustrated in Table 4. TABLE 4 Weighted Average Cost of Capital (Marginal Weights) Sources of funds (1) Debt Preference shares Retained earnings Amount (2) Rs 3,00,000 1,00,000 1,00,000 5,00,000 0.60 0.20 0.20 1.00 Proportion (3) (60) (20) (20) (100) Cost (%) (2 4) (4) 8 14 17 Total cost (5) Rs 24,000 14,000 17,000 55,000

Weighted average cost of capital = (Rs 55,000/Rs 5,00,000) 100 = 11 per cent

COST OF CAPITAL PRACTICES IN INDIA The main features of the cost of capital practices followed by the corporates in India are as follows:  The most frequently used (67 per cent of cases) discount rate (i.e., minimum acceptable/required rate of return) to evaluate capital budgeting decision is based on the overall cost (WACC) of the corporate.  Depending on the risk characteristics of the project, multiple risk-adjusted discount rates are used by about one-fifth of the corporate enterprises.  The specific cost of capital used to finance the project (i.e. if the discount rate for a project that will be financed entirely with retained earnings is the cost of retained funds) is used by one-fourth of the sample corporates.  The CAPM is the most popular method of estimating the cost of equity capital (54 per cent). The Gordons dividend model is equally popular method to compute the cost of equity capital (52 per cent). The earnings yield approach is used by one-third of the sample corporates to estimate the cost of equity capital. The use of the multi-factor model is used by very few corporates (7 per cent).  A significant feature of the methods used to estimate the cost of equity capital is that while the CAPM is significantly used by the large corporates, the Gordons discount model is more popular with small firms. Moreover, the highly profitable corporate (based on ROCE and EAV) give significantly low importance to dividend yield and earnings yield to compute the cost of equity capital than the less profitable corporates.

CONTD.
 The Government of India (GOI) 10-year bonds are the most widely used risk-free rate to compute the cost of capital using the CAPM approach. The industry average beta is the most popular measure of the systematic risk used by the corporates. Each of the published sources of beta and the self-calculated beta are also used by about one-fifth of the corporates respectively.  The self-calculated beta is more popularly used by the large and/highly profitable corporates. The small and low profitable corporates rely more on the published sources of beta.  The majority of corporates (two-thirds) considers the last 5-year monthly share price data to estimate the equity beta. The highly profitable firms use weekly share price data for the purpose.  The average market risk premium (9-10 per cent) is the most widely used measure by the corporates. The average of historical return and the implied return on the market portfolio are also fairly popular as an input while using the CAPM.  As regards the cost of debt, the most widely used method is the interest tax shield (i.e., tax advantage of interest on debt).  While the majority of the corporates revise their estimates of cost of capital annually, some of the sample corporates continuously revise it with every investment.  Apart from project choice criterion, the cost of capital is also used widely for (a) divisional performance measurement , (b) EVA computation and (c) CVA computations.

CONTD.  Majority of the sample companies adopt theoretically sound and conceptually correct basis of determining the cost of capital, namely, the weighted average cost of long-term sources of finance. However, there is no systematic procedure followed to compute it. It is more likely to be subjective in nature. The Indian corporates use of mix of the WACC, marginal cost of capital of additional funds and management judgment in this regard.  There is wide divergence in the corporate practices as regards the computation of the cost of equity capital. About one-tenth of the corporates do not attach any cost to equity capital. Another one-tenth treat the cost of equity capital as equivalent to primary rate of return available on securities of balanced mutual funds and debentures issued by blue chip companies.  However, the vast majority of companies (two-thirds of the sample) follow the conceptually sound methods (i.e. primary rate of return plus risk premium, dividend valuation model and CAPM) of determining the cost of equity capital.  About one-fifth of the sample corporates consider retained earnings as a cost-free source of finance. However, a sizeable proportion of the sample companies (75 per cent) regard cost of retained earnings either as equivalent to opportunity cost of using these funds by the corporate/equity-holders or equal to the cost of equity capital.

As a financial analyst of a large electronics company, you are required to determine the weighted average cost of capital of the company using (a) book value weights and (b) market value weights. The following information is available for your perusal. The companys present book value capital structure is: Debentures (Rs 100 per debenture) Preference shares (Rs 100 per share) Equity shares (Rs 10 per share) Rs 8,00,000 2,00,000 10,00,000 20,00,000 All these securities are traded in the capital markets. Recent prices are: Debentures, Rs 110 per debenture Preference shares, Rs 120 per share Equity shares, Rs 22 per share

Anticipated external financing opportunities are: (i) Rs 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4 per cent flotation costs, sale price, Rs 100. (ii) Rs 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5 per cent flotation costs, sale price, Rs 100. (iii) Equity shares: Rs 2 per share flotation costs, sale price = Rs 22. In addition , the dividend expected on the equity share at the end of the year is Rs 2 per share; the anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 35 per cent. Solution: Determination of specific costs:
(i)Cost of debt, (k d ) ! 1(1 - t)  f z Nm Rs 11 0.35  Rs 4 z 10 v 100 ! 7.7% ! RV  SV z 2 Rs 100  Rs 96 z 2 D  f z Nm Rs 12  Rs 5 z 10 v 100 ! 12.8% ! RV  SV z 2 Rs 100  Rs 95 z 2

(ii)Cost of preference shares (k p ) ! (iii)Cost of equity shares (k e ) !

D1 Rs2  g!  0.07 ! 17% P0 1  f Rs 20

Using these specific costs we can calculate the book value and market value weights as follows: (a) k0 based on book value weights Source of capital Debentures Preference shares Equity shares Book value (BV) Rs 8,00,000 2,00,000 10,00,000 20,00,000 k0 = Rs 2,57,200/Rs 20,00,000 = 12.86 per cent (b) k0 based on market value weights Source of capital Debentures Preference shares Equity shares Total capital Market (MV) value Specific cost (k) (%) Total costs [MV () k] 7.7 12.8 17.0 Rs 67,760 30,720 3,74,000 4,72,480 Specific cost (k) (%) Total costs [BV () k] 7.7 12.8 17.0 Rs 61,600 25,600 1,70,000 2,57,200

Rs 8,80,000 2,40,000 22,00,000 33,20,000

k0 = Rs 4,72,480/Rs 33,20,000 = 14.23 per cent