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Cost of Capital
Cost of Capital
INTRODUCTION
In Accounting, the cost of capital is the cost of a company's funds (both debt and equity), or,
from an investor's point of view "the required rate of return on a portfolio company's existing
securities". It is used to evaluate new projects of a company. It is the minimum return that
investors expect for providing capital to the company, thus setting a benchmark that a new
project has to meet.
For an investment to be worthwhile, the expected return on capital has to be higher than the cost
of capital. Given a number of competing investment opportunities, investors are expected to put
their capital to work in order to maximize the return. In other words, the cost of capital is the rate
of return that capital could be expected to earn in the best alternative investment of equivalent
risk. If a project is of similar risk to a company's average business activities it is reasonable to
use the company's average cost of capital as a basis for the evaluation. However, for projects
outside the core business of the company, the current cost of capital may not be the appropriate
yardstick to use, as the risks of the businesses are not the same.
A company's securities typically include both debt and equity, one must therefore calculate both
the cost of debt and the cost of equity to determine a company's cost of capital. Importantly, both
cost of debt and equity must be forward looking, and reflect the expectations of risk and return in
the future. This means, for instance, that the past cost of debt is not a good indicator of the actual
forward looking cost of debt.
Once cost of debt and cost of equity have been determined, their blend, the weighted average
cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a
project's projected cash flows.
No Change in Capital Structure:
The capital mix or structure of the new project investment should be same as the companys
existing structure. It means that if the company has 70:30 ratio of debt to equity in their current
balance sheet, inclusion of the new project will maintain the same.
No change in Risk of New Projects: The risk associated with the new project will be like the
existing projects. For example, a textile manufacturer expands and increases the no. of looms
from 60 to 100. Since the industry and business is same, there will be almost no change in the
risk profile of current business and the new expansion.
Advantages of Weighted Average Cost of Capital (WACC)
Simple and Easy: The biggest advantage of using WACC as a hurdle rate to evaluate the new
projects is its simplicity. The calculation does not involve too much of complication. The
manager just needs to apply weights of each source finances with its cost and aggregate the
result.
Single Hurdle Rate for All Projects: One single hurdle rate for all projects saves a lot of time of
the managers in evaluation of the new projects. If the projects are of same risk profile and there
is no change in the proposed capital structure, the current WACC can be applied and effectively
used.
Prompt Decisions Making: It is said that the same opportunity never knocks twice. For taking
advantage, the right decisions have to be taken at the right time. Since, single rate is used for all
new projects, the decisions can be arrived at a faster pace and the new opportunity can be
grabbed and taken benefit of.
Disadvantages of Weighted Average Cost of Capital (WACC)
The disadvantages are stemmed mainly from the assumptions of the applicability of WACC. The
practicability and limitations of the assumptions are discussed below. The remedy to overcome
the problem is also specified.
Difficulty in Maintaining the Capital Structure:
The impractical assumptions of No Change in Capital Structure has rare possibilities of
prevailing all the time. It suggests same capital structure for new projects. There are two
possibilities for funding the project in this way.
First is to fund it with the retained earnings. In this case, it would be reasonably correct to
assume that the new project is funded with same capital structure. The limitation here is of
availability of free cash with the company. Even if the free cash is available, it will put a cap on
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the size of the investment. Suppose, the new project requires, $100 million, the company has
only $70 million. What to do for the remaining $30 million?
Second possibility is raising fund in the same capital mix. It is not impossible to do that but at the
same time getting funds at our own terms is not easily possible in the market. On the top of
everything, the primary focus of management of a company would not be to maintain capital
structure ratio but to reduce the cost of capital as low as possible to achieve the shareholders
profit and wealth maximization.
Remedy to this problem is that the target capital structure should be taken into consideration and
not the existing. and therefore the calculation of WACC should be adjusted accordingly.
Accepting Bad Projects and Rejecting Good Projects:
The impractical assumptions of No Change in Risk Profile of New Projects again has its inbuilt
drawbacks. Risk is a very wide term and is affected by a big list of factors. Under that situation,
assuming no change in risk profile of new projects would be very unrealistic. Let us assume two
situations:
Company Expanding in its Own Industry:
The assumption can be reasonably true if the company is expanding in its very own industry and
the same business like the textile example given above. Still it is not completely true because the
risk associated with installing looms in past and today may be different. The technology may be
different and complicated. The quality and cost aspects may be dissimilar.
Company Expanding in Different Industry:
The assumption in this case would surely prove malicious. It is because FMCG and Heavy
Machineries cannot have same risk profile. Having different risk profile, the cost of equity would
also be different and therefore applying the same WACC pose a very high risk of rejecting good
projects that will create value and accepting projects that will diminish the value of the
shareholders wealth.
Remedy to this problem is that the WACC should be adjusted to take effect of the change in risk.
CHAPTER 2
PROFILE OF COMPANY
The Indian Cement industry dates back to 1914, with first unit was set-up at Porbandar with a
capacity of 1000 tones. Currently The Indian cement industry with a total capacity of about 170
m tones (excluding mini plants) in FY07-08, has surpassed developed nations like USA and
Japan and has emerged as the second largest market after China. Although consolidation has
taken place in the Indian cement industry with the top five players controlling almost 50% of the
capacity, the remaining 50% of the capacity remains pretty fragmented. Per capita consumption
has increased from 28 kg in 1980-81 to 115 kg in 2005. In relative terms, Indias average
consumption is still low and the process of catching up with international averages will drive
future growth. Infrastructure spending (particularly on roads, ports and airports), a spurt in
housing construction and expansion in corporate production facilities is likely to spur growth in
this area. South-East Asia and the Middle East are potential export markets. Low cost technology
and extensive restructuring have made some of the Indian cement companies the most efficient
across global majors. Despite some consolidation, the industry remains somewhat fragmented
and merger and acquisition possibilities are strong. Investment norms including guidelines for
foreign direct investment (FDI) are investor-friendly. All these factors present a strong case for
investing in the Indian market.
Now, the Indian cement industry is on a roll. Riding on increased activity in real estate, cement
production has registered a growth of 9.28 per cent in April, 2008, at 14 million tones as against
11.41 million tones in the corresponding period a year ago.
The growth trend has been on for some time now. If these trends are anything to go by, it will not
be long before the sector will match the demand supply gap.
During the Tenth Plan, the industry, which is ranked second in the world in terms of production,
is expected to grow at 10 per cent per annum adding a capacity of 40-52 million tones, according
to the annual report of the Department of Industrial Policy and Promotion (DIPP). The report
reveals that this growth trend is being driven mainly by the expansion of existing plants and
using more fly ash in the production of cement.
Shree Cement Limited is a Beawar based company, located in Rajasthan. The Company is a part
of the Bangur Group and was incorporated on 25th October1979, at Jaipur with a Vision: To
register strong consumer surplus through a superior cement quality at affordable price.
Commercial production commenced from 1st May1985 with a installed capacity of 6 lacs tones
per annum in Beawar dist. Ajmer, the capacity of this plant was upgraded to 7.6 lacs tones per
annum during 1994-95 by a modernization and up gradation programme.
In 1995 - The
Company undertook the implementation of new unit of 1.24 MT capacity per annum named "Raj
Cement. In 1997 The Company commissioned its second cement plant - Raj Cement with a
capacity of 12.4 lacs tones per annum adjacent to its existing plant in order to take full advantage
of its existing infrastructure and already developed captive mining lease enough to sustain a new
cement plan. The cumulative capacity was enhanced by de-bottlenecking and balancing
equipment in December 2001 to 2.6 MTPA. A product called Tuff Cemento has also launched
by the company in April 2007. At present company is producing over 100% capacity utilization,
it is the largest single location cement producer in north India (sixth in country).
COMPANY
PROFILE
COMPANY
INCORPORATION YEAR
1979
REGISTERED OFFICE
BANGUR
NAGAR,
BEAWAR,
AJMER
(RAJASTHAN)
CORPORATE OFFICE
INDUSTRY
CEMENT MANUFACTURING
CHAIRMAN
B.G. BANGUR
MANAGING DIRECTOR
H.M. BANGUR
EXECUTIVE DIRECTOR
M.K. SINGHI
EQUITY CAPITAL
34.84 CRORES
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EQUITY CAPITAL
34.84 CRORES
10
Cement Limited is one of the fastest growing Cement Companies in India. Presently
Shree Cement has 9.1 MTPA capacity in three plants (Shree in Beawar 2.6 MTPA, Ras in Pali
District 3 MT and Khushkhera capacity is 3.5 MTPA) The organization has performed
exceptionally well in the year 2007-08 increasing the PBT by 95% the reasons for this
remarkable achievement and key strengths of the company are discussed in the report. For
the last 18 years, it has been consistently producing many notches above the nameplate capacity.
The company retains its position as north Indias largest single-location manufacturer. Shrees
principal cement consuming markets comprise Rajasthan, Delhi, Haryana, Punjab, Uttar Pradesh
and Uttranchal. Shree manufactures Ordinary Portland Cement (OPC) and Portland Pozzolana
Cement (PPC). It has three brands under its portfolio viz., Shree Ultra Jung Rodhak Cement,
Bangur Cement and Tuff Cemento.
The Shree Vision
To be one of the Indias most respected enterprise through best-in-class performance and
leading by low carbon philosophy making it a progressive organization that all stakeholders
proud to deal with.
The Shree Mission
The company continues to be one of the most operationally efficient and energy conserving
cements producers in the world. Its mission statement is
To continually add value to its products and operation meeting expectations of all its
stakeholders.
To continually build and upgrade skills and competencies of its human resource for
growth
Shree Cement Ltd (SCL) is located at Beawer, Rajasthan, Indias largest cement producing state.
It was incorporated in 1979. Commercial production at its 0.6 million tones per annum (mtpa)
cement plant in Rajasthan commenced in May 1985. Three companies of the Bangur group
promoted SCL. These companies are Shree Digvijay Company Ltd, Graphite India Ltd and Fort
Gloster Industries Ltd. Over the years, SCL's capacity rose and touched 2 mtpa by 1997-98. Its
current cumulative installed capacity stands at 2.6 mtpa& in 2003-04 the company produced 2.84
million tones of
cement making it the largest single location cement producer in north India. It is operating at
over 100% capacity utilization.
Shree caters to cement demand arising in Rajasthan, Delhi, Haryana, UP and Punjab. What is
strategic for SCL is that it is located in central Rajasthan so it can cater to the entire Rajasthan
market with the most economic logistics cost. Also, Shree Cement is the closest plant to Delhi
and Haryana among all cement manufacturers in its state and proximity to these profitable
cement markets renders the company an edge over other cement companies of the company in
terms of lower freight costs. Shrees total captive power plant capacity today stands at 101.5
MW. In 2000-01, the company has succeeded in substituting conventional coke with 100 per cent
pet coke, a waste from refineries, as primary fuel resulting in lower inventory and input costs. In
the past two years the price of coal has gone up. Earlier dependent on good quality imported
coal, the company's switch to pet coke could not have come at a better time. The company also
replaced indigenous refractory bricks with imported substitutes, reducing its consumption per
tonne of clinker. The company has one of the most energy efficient plants in the world. The
captive plant generates power at a cost of Rs 4.5 per unit (excluding interest and depreciation) as
compared to over Rs 5 per unit from the grid. In appreciation of its achievements in Energy
sector, the Company has been awarded the prestigious 'National Energy Conservation Award" for
the year 1997. Shree is rated best by Whitehopleman, an international agency specializing in the
rating of cement plants.
SHREE ULTRA
Launched in 2002, Shree Ultra was the companys first brand, the first manifestation of Shrees
strategic move from commodity to brand marketing.
Its generic OPC version has been joined by a variant, Shree Ultra Jung Rodhak, on the functional
differentiator of rust prevention. Together the two variance have made Shree Ultra the flagship
brand of the company, contributing half of the Shrees total sales.
The brand was launched with powerful media and promotional support, the imaginative
advertising and the momentum has clearly sustained its growth over time.
Today it is present all of Shree Cements market territories. In 07-08 it chalked up its highest
volumes in the home market of Rajasthan, and in the NCR, the main focus of the construction
boom in north India.
Overall, Shree Ultra volumes reflects its acceptance by professional influencers. Which in turn
facilities acceptance by domestic consumers. Their support, as well as sustained local
promotions, has helped to improve brand recall, and prepared the ground for fresh initiatives in
the market place.
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BANGUR CEMENT
Bangur Cement was launched in 2006 as a premium brand, competitive with best in the market
designed to full fill user aspiration for high quality construction, the brand tagline reflects its
promise of top-of-market value: Sasta Nahi, Sabse Achcha.
Given the premium profile design for it the brand is supported by a matching network of
business partners and business associates carefully selected for the track record in selling to high
end market segment.
Its early successes are founded on a two tier marketing and distribution programme. At one level
Shrees field forts takes the trades in to the confident with transparent terms and tested and
proven promotional offrings.
On a more exclusive level, it deploys special teams of highly professional technical sales experts
t conduct direct, one on one interaction with opinion builders and influencers if high standing
among the fraternity of respected construction space list.
Bangur Cement has achieved 95% of its total sales in the trade segment. It has made selective
penetration in both urban and rural markets. Bangur cement maintained its zero outstandings
status in this year as well.
TUFF CEMENTO
This is the latest brand offering from Shree Cement, directed at a highly competitive niche
market, with aggressive and establish competitors.
It has been position as rock strong- on the promise of high performance, able to withstand
exceptionally harsh environmental conditions.
Launched in the first month of the year under review, Tuff Cemento was able to secure a network
of the 1000 dynamic and resourceful dealers in a record time of about four months.
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The brand is consolidated its position in the market, and the making further headway in
Rajasthan, Delhi, Haryana, parts of south Punjab and Western U.P.
While its current status would otherwise be regarded as reasonable. Tuff Cemento has an
altogether more ambitious agenda: to be aggressively competitive and become a leading brand in
the coming months, and to enable Shree Cement to achieve the maximum possible combined
market share in its market.
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North (Punjab, Delhi, Haryana, Himachal Pradesh, Rajasthan, Chandigarh, J&K and
Uttranchal);
West (Maharashtra and Gujarat);
South (Tamil Nadu, Andhra Pradesh, Karnataka, Kerala, Pondicherry, Andaman & Nicobar and
Goa);
East (Bihar, Orissa, West Bengal, Assam, Meghalaya, Jharkhand and Chhattisgarh); and
Central (Uttar Pradesh and Madhya Pradesh).
POLICIES
Quality Policy:
To provide products conforming to national standards and meeting customers requirements to
their total satisfaction.
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Energy Policy:
To reduce to the maximum extent possible the consumption of energy without imparting
productivity which should help in:
Increase in the profitability of the company
Conservation of Energy
Reduction in Environmental pollution at energy producing areas Since Energy is Blood of
Industry, It is the responsibility of all of us to utilize energy effectively and efficiently
Environment Policy:
To ensure :
Clean, green and healthy environment
Efficient use of natural resources, energy, plant and equipment
Reduction in emissions, noise, waste and greenhouse gases
Continual improvement in environment management
Compliance of relevant environmental legislation
Water Policy:
To provide sufficient and safe water to people & plant as well as to conserve water, we are
committed to efficient water management practices viz,
Develop means & methods for water harvesting
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15
Statute enacted shall be honoured in letter & spirit & standard Labour Practices shall be
followed. Every employee shall be accountable to the law of the land & is expected to follow the
same without any deviation
Management will appreciate observance of Business ethics & professional code of conduct
To follow safety & Health. Quality, Environment, Energy Policy
IT Policy:
To provide a robust IT platform suitable to the business processes and integrated management
practices of the company, resulting into better speed, efficiency, transparency, internal controls
and profitability of business
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CHAPTER 3
COST OF CAPITAL OF SHREE CEMENT COMPANY
COST OF CAPITAL
The main objective of a business firm is to maximize the wealth of its shareholders in the longrun, the Management Should only invest in those projects which give a return in excess of cost of
fund invested in the project of the business. The difficulty will arise in determination of cost of
funds, if is raised from different sources and different quantum. The various sources of funds to
the company are in the form of equity and debt. The cost of capital is the rate of return the
company has to pay to various suppliers of fund in the company. There are main two sources of
capital for a company shareholder and lender. The cost of equity and cost of debt are the rate of
return that need to be offered to those two groups of suppliers of the of capital in order to attract
funds from them.
The primary function of every financial manager is to arrange adequate capital for the firm. A
business firm can raise capital from various sources such as equity and or preference shares,
debentures, retain earning etc. This capital is invested in different projects of the firm for
generating revenue. On the other hand, it is necessary for the firm to pay a minimum return to
each source of capital. Therefore, each project must earn so much of the income that a minimum
return can be paid to these sources or supplier of capital. What should be this minimum return?
The concept used to determine this minimum return is called Cost of Capital. On the basis of it
the management evaluates alternative sources of finance and select the optimal one. In this
chapter, concepts and implications of firms cast of capital, determination of cast of difference
sources of capital and overall cost of capital are being discussed.
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Technically and Operationally, the cost of capital define as the minimum rate of return a firm
must earn on its investment in order to satisfy investors and to maintain its market value. I.e. it is
the investors required rate of return. Cost of capital also refers to the discount rate which is used
while determining the present value of estimated future cash flows. In the other word of John J.
Hampton, The cost of capital is the rate of return in the firm requires from investment in
order to increase the value of firm in the market place. For example if a firm borrows Rs. 5
crore at an interest of 11% P.A., then the cost of capital is 11%. Hear its the essential for the firm
to invest these Rs. 5 Crore in such a way that it earn at least Rs. 55 lacks i.e. rate of return at
11%. If the return less then this, then the rate of dividend which the share holder are receiving till
now will go down resulting in a decline in its market value thus the cost of capital is the reward
for the use capital. Solomon Ezra, has called It the minimum required rate of return or the cut
of rate for capital expenditure.
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The cost of capital is very important concept in the financial decision making. The progressive
management always likes to consider the cost of capital while taking financial decisions as its
very relevant in the following spheres...
1.Designing the capital structure: the cost of capital is the significant factor in designing a
balanced an optimal capital structure of a firm. While designing it, the management has to
consider the objective of maximizing the value of the firm and minimising cost of capita. I
comparing the various specific costs of different sources of capital, the financial manager can
select the best and the most economical source of finance and can designed a sound and balanced
capital structure.
2.Capital budgeting decisions: the cost of capital sources as a very useful tool in the process of
making capital budgeting decisions. Acceptance or rejection of any investment proposal depends
upon the cost of capital. A proposal shall not be accepted till its rate of return is greater then the
cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital
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measured the financial performance and determines acceptability of all investment proposals by
discounting the cash flows.
3.Comparative study of sources of financing: there are various sources of financing a project.
Out of these, which source should be used at a particular point of time is to be decided by
comparing cost of different sources of financing. The source which bears the minimum cost of
capital would be selected. Although cost of capital is an important factor in such decisions, but
equally important are the considerations of retaining control and of avoiding risks.
5.Knowledge of firms expected income and inherent risks: investors can know the firms
expected income and risks inherent there in by cost of capital. If a firms cost of capital is high, it
means the firms present rate of earnings is less, risk is more and capital structure is imbalanced,
in such situations, investors expect higher rate of return.
6.Financing and Dividend Decisions: the concept of capital can be conveniently employed as a
tool in making other important financial decisions. On the basis, decisions can be taken regarding
dividend policy, capitalization of profits and selections of sources of working capital.
evaluation of the past performance when compared with standard costs. In financial decisions
future costs are more relevant than historical costs.
were accepted. Thus implicit cost arises only when funds are invested somewhere, otherwise
not. For example, the implicit cost of retained earnings is the rate of return which the shareholder
could have earn by investing these funds, if the company would have distributed these earning to
them as dividends. Therefore, explicit cost will arise only when funds are raised whereas implicit
cost arises when they are used.
The financial and business risks are not affected by investing in new
investment proposals.
Costs of previously obtained capital are not relevant for computing the
cost of capital to be raised from specific source.
tax cost is seen most often. This is one part of the company's capital structure, which also
includes the cost of equity.
Much theoretical work characterizes the choice between debt and equity, in a trade-off context:
Firms choose their optimal debt ratio by balancing the benefits and costs. Traditionally, tax
savings that occur because interest is deductible while equity payout is not have been modeled as
a primary benefit of debt. Large firms with tangible assets and few growth options tend to use a
relatively large amount of debt. Firms with high corporate tax rates also tend to have higher debt
ratios and use more debt incrementally. A company will use various bonds, loans and other forms
of debt, so this measure is useful for giving an idea as to the overall rate being paid by the
company to use debt financing. The measure can also give investors an idea as to the riskiness of
the company compared to others, because riskier companies generally have a higher cost of debt.
Example-: If a company issues 12% debentures worth Rs. 5 lacs of Rs. 100 each at par, then it
must be earn at least Rs.60000(12% of Rs. 5 lacs) per year on this investment to maintain the
income available to the shareholders unchanged. If the company earnws less than this interest
rate (12%) than the income available to the shareholders will be redused and the market value of
the share will go down. Therefore, the cost of debt capital is the contractual interest rate adjusted
further for the tax liability of the firm. But, to know the real cost of debt, the relation of the
interest rate is to be established with the actual amount realised or net proceeds from the issue of
debentures.
To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal
tax rate.
Cost of Debt = (before-tax rate x (1-marginal tax))
The before tax rate of interest can be calculated as below:
100
----------------------------------------
Total Debt
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Net Proceeds:
1. At par
2. At premium
3. At Discount
Shree Cement has not paid any dividend to the Preference Shareholders. Thus the Cost of Preference
Capital is 0 (Zero).
The computation of cost of euity share capital is relatively diffiult because nether the rate of
dividend is predetermind nor the payment of dividend is legally binding, therefore, some
financial experts hold the opinion the p.s capital does not carry any cost but this is not true.
When additional equity shares are issued, the new equity share holders get propranate share in
future dividend and undistributed profits of the company. If reduces the earning per shares of
excistingshare holders resulting in a fall in marker price of shares. Therefore, at the time of issue
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of new equity shares, it is the duty of the management to see that the company must earn atleast
so much income that the market price of its ecisting share remains unchanged. This expected
minimum rate of return is the cast o equity share capital. Thus, cost of equity sahre capital may
be define as the minimum rate of return that a firm must earn on the equity financed portion of a
investment- project in order to leave unchanged the market price of its shares. The cost of equity
can be computed by any of the following method:
would show an increase at the rate of 10%. Therefore, under this method, cost of equity capital is
computed by adjusting the present rate of dividend on the basis of expected future increase in
companys earning.
Ke= DPS\MP*100+G
G= Growth rate in dividend.
4. Realised yield methd:
In case where future dividend and market price are uncertain, it is very difficult to estimate the
rate of return on investment. In order to overcome this difficulty, the average rate of return
actually relise in the past few year by the investors is used to determine the cost of capital. Unddr
this method, the realised yield is discounted at the present value factor, and then compare with
value of investment this method is based on these assumptions. The companys risk doe not
change i.e. dividend and growth rate are stable.
The alternative investment opportuinities, elsewhere for the investor, yield the return wshich is
equal to realisedyiels in the company, and
The market of equity share of the company does not fluctuate widly.
when new equityshare are issued by a company, it is not possible to realise the marlet price per
share, because the company has to incur some expenses on new issue, including underwriting
commission, brokerage etc. so, the amount of net proceeds is calculated by deducting the issue
expenses form the expected marlet value or issue price. To acertain the cost of capital, dividend
per share or EPS is divided by the amount of net proceeds. Any of the following formulae may
be used for this purpose:
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Ke= DPS\NP*100
Or
Ke= EPS\NP*100
Or
Ke=DPS\NP*100+G
Generally, compnays do not distribute the entire profits by way of dividend among their share
holders. A part of such profit is reatianed for future expantion and development. Thus year by
year, companies create sufficiat fund fior the fianancingthrugh internal sources. But , nether the
company pays any cost nor incur any expenditure for such funds. Therefore, it is assumed to cost
free capital that is not true. Though ratain earnings like retained earnings like equity funds have
no explicit cost but do have opportunity cost. The opportunity cost iof retained earnings is the
income forgone by the share holders. It is equal to the income what a share holdersculd have earn
otherwise by investing the same in an alternative investment, If the company would have
distributed the earnings by way of dividend instead of retaining in the busieness. Therefore ,
every share holders expects from the company that much of income on ratined earnings for
which he is deprived of the income arising o its alternative investment. Thus, income forgone or
sacrifised is the cost of retain earnings which the share holders expects from the company.
Once the specific cost of capital of the long-term sources i.e. the debt, the preference share
capital, the equity share capital and the retained earnings have been ascertained, the next step is
27
to calculate the overall cost of capital of the firm. The capital raised from various sources is
invested in different projects. The profitability of these projets is evaluated by comparing the
exprcted rate of return with overall cost of apital of the firm. The overall cost of capital is the
weighted average of the costs of the various sources of the funds, weights being the proportion of
each sources of funds in the total capital structure. Thus, weighted average as the name
implies, is an average of the cost of specific sources of capital employed in the business
properly weighted by the proportion they held in firms capital structure. It is also termed as
Composite Cost of Capital or Overall Cost of Capital or Average Cost of Capital.
1.Assignment of Weights : First of all, weights have to be assigned to each source of capital for
calculating the weighted average cost of capital. Weight can be either book value weight or
market value weight. Book value weights are the relative proportion of various sources of
capital to the total capital structure of a firm. The book value weight can be easily calculated by
taking the relevant information from the capital structure as given in the balance sheet of the
firm. Market value weights may be calculated on the basic on the market value of different
sources of capital i.e. the proportion of each source at its market value. In order to calculate the
market value weights, the firm has to find out the current market price of each security in each
category. Theoretically, the use of market value weights for calculating the weighted average cost
of capital is more appealing due to the following reasons:
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But, the assignment of the weight on the basic of market value is operationally inconvenient as
the market value of securities may frequently fluctuate. Moreover, sometimes, no market value is
available for the particular type of security, especially in case of retained earnings can indirectly
be estimated by Gitmansmethod. According to him, retained earnings are treated as equity
capital for calculating cost of specific sources of funds. The market value of equity share may be
considered as the combined market value of both equity shares and retained earnings or
individual market value (equity shares and retained earnings) may also be determined by
allocating each of percentage share of the total market value to their respective percentage share
of the total values.
For example:- the capital structure of a company consists of 40,000 equity shares of Rs. 10 each
ad retained earning of Rs. 1,00,000. if the market price of companys equity share is Rs. 18, than
total market value of equity shares and retained earnings would be Rs. 7,20,000 (40,000* 18)
which can be allocated between equity capital and retained earnings as follows-
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After ascertaining the weights and cost of each source of capital, the weighted average cost is
calculated by multiplying the cost of each source by its appropriate weights and weighted cost of
all the sources is added. This total of weighted costs is the weighted average cost of capital. The
following formula may be used for this purpose :
Kw = XW/W
Here; Kw = Weighted average cost of capital
X = After tax cost of different sources of capital
W = Weights assigned to a particular source of capital
Example: Following information is available with regard to the capital structure of ABC Limited
:
Sources of Funds
E.S. Capital
3,50,000
.12
Retained Earning
2,00,000
.10
P.S. Capital
1,50,000
.13
Debentures
3,00,000
.09
Source
Amount
Weights
Rs.
(1)
E.S. Capital
(2)
3,50,000
(3)
.35
30
After
tax Weighted
Cost
Cost
(4)
.12
.0420
Retained Earning
2,00,000
.20
.10
.0200
P.S. Capital
1,50,000
.10
.13
.0195
Debentures
3,00,000
.09
.09
.0270
Total
10,00,000
1.00
.1085
.10850 or 10.85%
--------------------------------------------
100
Total Debt
9636.72
Kd (before tax)
---------------------113373.18
31
100
8.50%
Kd (after tax)
Kd (after tax)
8.50% - 30%
= 5.95%
= 30%
6573.02
Kd (before tax)
----------------------
100
= 7.75%
84827.02
Kd (after tax)
7.75% - 30%
= 5.42%
= 30%
32
2143.21
Kd (before tax)
----------------------
100
7%
30617.33
Kd (after tax)
7% - 30%
= 4.90%
Particular
2008-09
2007-08
2006-07
83427.02+1
28617.33+
Bank+Debts)
800
400
2000
=113373.18
=84824.02
=30617.33
9636.72
6573.86
2143.21
8.50%
7.75%
7%
5.42%
4.90%
33
2008-09
2007-08
2006-07
348.37
348.73
348.73
DPS Given
921.85
893.50
50.81
NA
Not given
NA
321146.96
311270.61
Ke = DPS\mP*100 + G
= 1079.40 Rs.
= 10%
= Growth rate
8
Ke
-------------------1079.40
100 + 10%
= 10.74%
= 1079.40 Rs.
74.74
Ke
--------------------
100
6.92%
1079.40
3. Dividend per share method:-
-------------------348.37
2008-09
8
6.92
10.74
35
We = Weight of equity
Wd = Weight of Debt.
Ke = Cost of Equity Share capital
Kd = Cost of Debt. capital
36
Source
Amount
Weight
Afte
Weighte
Rs.
r tax
d Cost
Cost
(2)
(1)
(3)
E.S.
376033.0
Capital
Debenture
113373.1
Total
489406.1
.768
(5)= (3) *
(4)
(4)
10.7
8.248
4
.232
5.9
1.379
5
1.00
9.628
9
Weighted Average Cost of Capital (WACC)
9.628%
Recommendations The study in foregoing chapters and conclusions in this chapter point out the
need of better working capital management in the cement industry for which following
recommendations are made. In our country, cement industry adequate concern is not shown for
proper management of working capital. In order to make industry conscious about the need of
better management. Cement Manufacturers Association should create awareness by arranging
seminars and workshops in which top management and senior officers from the finance and
marketing departments of the industry should be invited. 265 The Cement Manufacturers
Association should also publish literature about working capital management practices in other
countries and invite foreign experts for talk on specific subjects of working capital management.
If Association introduces awards for best working capital managed company, it may encourage
companies to be more concerned to manage their working capital better. Cash ratio to total
37
current assets should be brought down to 2-4 per cent. If some companies can manage within this
range there is no reason why others cannot do so. It is largely due to lack of awareness and
planning, unreliability of forecast for cash flow specially from sundry debtors. There is also lack
of planning with regard to sundry payments. There is an urgent need of cash budgeting by all
cement companies. This requires proper estimation of cash and credit sales, production planning,
purchase planning for inputs, financing plan and capital budget. This also requires estimation of
profits and cost of production properly, which is rarely done at present and if done it is far off
from the mark. Therefore, there is need of accurate forecasting by using modern statistical
techniques which need not be described in this study. The most important fact however is
awareness and monitoring. When there are deviations from the forecast the reasons must be
analysed for it and those responsible should be taken to task and for future better assessment be
made specially of sales and realisation from sundry debtors. Since there are a number of
uncertainties in the business forecast it 266 should not be based on single set of assumptions but
cash budgeting should be done on different assumptions. It is also desirable to estimate from the
estimates that one may remain prepared to meet the eventualities if they arise. The modern
models on computers should be worked out. There are various models available for the purpose
like Baunal Model, General Model, Millen and ORR Model.
The companies with past experience should draw the best model suited to them. The one of the
important factor in cash management is policy variable, which can be aggressive, moderate or
passive. This should not be dependent merely on whims of the top management or on the
recommendations and suggestions of sales department but cost benefit analysis should be done
taking into consideration the risk factor of credit sales and its cost versus the benefit of larger
sales on profitability.
The following variables should be estimated before the policy is decided:
1. Increase in sales by providing credit to buyers.
2. Cost of credit in terms of bad debts to receivables and interest cost.
3. Impact of larger sales on profits. It is regrettable that such calculations are not made and
policy is decided without detailed calculations.
38
BIBLIOGRAPHY
BOOKS:
Accounting World
Chartered Accountant
News Papers
WEBSITES:39
www.shreecementltd.com
www.google.com
40