1.

INTRODUCTION

The Cost of Capital is a central concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposals, etc., The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". Cost of Capital is the weighted average of the costs of various sources of funds, weights being the proportion of each source of funds. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. The items on the financing side of the balance sheet are called capital components. The major capital components are equity, preference and debt. Capital, like any other factor of production, has a cost. Any use of capital imposes an opportunity cost on investors as investors have access to a host of financial market alternatives. So, the use of capital by a company must be benchmarked against the alternatives in financial market. The cost of capital provides this benchmark. A companys cost of capital is the average cost of the various capital components employed by it. Financial markets give capital to different borrowers at different prices. This is obviously evident in debt, where a bond issued by firm A may offer a return of 20% while a bond issued by firm B could run at 11%. The cost of equity capital is also sharply different across firms. The simplest way to see this is to compare P/E ratios. A firm with a P/E of 100 is getting capital at a much lower price than a firm with a P/E of 10. Why is the cost of capital different across firms? One key factor, obviously, is risk. A riskier project will require a higher return, i.e. a risk premium. In addition, there is a liquidity premium. A more liquid security requires lower returns, in the eyes of an investor, than a less liquid security. What can a firm do to improve it's own cost of capital? Modern finance has produced important insights into the behaviour of financial markets, which can be usefully applied into improving financial strategy at the level of a firm. This has strong consequences. Suppose firm A and B are competitors. If B faces a lower cost of capital than A, then it enables B to
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compete more effectively, by investing in more long-term and more risky projects. Hence, firms should benchmark themselves against their competitors on the question of cost of capital. The next area where firms can influence their own cost of capital is liquidity. The best measure of liquidity is the bid-offer spread. A security with a tight bid-offer spread is more liquid than a security with a wide bid-offer spread. A firm can compare itself against its competitors by taking readings of the spread from an NSE terminal. Liquidity is affected by two major factors: the number of investors and asymmetries in information amongst speculators. A larger number of owners of a security benefits liquidity of the security. It may seem easy for a company to knock on the doors of a few large investors in placing a primary issue. But this comes at a cost, which the company will suffer for life, in terms of a liquidity premium. It is very difficult to change over to a widely dispersed retail ownership structure after an issue is completed. This suggests that firms should emphasise large-scale retail distribution of bonds or shares, even if it entails somewhat higher issue costs. The Cost of Capital is concerned with what a firm has to pay for the capital- that is, the debt, preferred stock, retained earnings and common stock. It can also be considered as the rate of return required by investors in the firms securities. As such, the firms Cost of Capital is determined in the capital markets and is closely related to the degree of risk associated with new investment, existing assets, and the firms Capital Structure. In general, the greater the risk of a firm as perceived by investors, the greater the return investors will require and the greater will be the Cost of Capital. The Cost of Capital can also be thought of as the minimum rate of return required on new investments undertaken by the firm. If a new investment earns as internal rate of return that is greater than the cost of capital, the value of the firm increases. Correspondingly, if a new investment earns a return less than the firms cost of capital, the firms value decreases. A company's cost of capital is exactly as its name implies. When a company raises capital from its lenders and owners, both types of investors require a return on their investment. Lenders expect to be paid interest on their loans, while owners expect a return, too.
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A stable, predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital. That means, all else equal, that the riskier company's future cash flows are worth less in present value terms, which is why stocks of stable companies often look more expensive on the surface. The cost of capital used in a DCF model can have a significant impact on the fair value, so it's important to pay attention to this estimated figure. The rate you would use to discount cash flows if using the "cash flow to the firm" method is actually a company's weighted average cost of capital, or WACC. A company's WACC accounts for both the firm's cost of equity and its cost of debt, weighted according to the proportions of equity and debt in the company's capital structure. If a firm wants to use its company cost of capital, popularly called the Weighted Average Cost of Capital (WACC), for evaluating a new investment, two conditions should be satisfied: The business risk of the new investment is the same as the average business risk of existing investments. In other words, the new investment will not change the risk complexion of the firm. The Capital Structure of the firm will not be affected by the new investment.

1.1 COST OF CAPITAL IS A FUNCTION OF THE INVESTMENT: The Cost of Capital is the function of the investment, not the investor. The cost of capital comes from the market place, and the market place is the pool of investors pricing the risk of a particular asset. Thus it represents the consensus assessment of the pool of investors that are participants in a particular market. When a business uses a given Cost of Capital to evaluate a commitment of capital to an investment or project, it often refers to that cost of capital as the Hurdle Rate. The Hurdle Rate is the minimum expected rate of return that the business would be willing to accept to justify making the investment. The hurdle rate for any given prospective investment may be at, above or below the businesss overall cost of capital, depending on the degree of risk of the prospective investment compared with the businesss overall risk. The most popular focus of contemporary corporate finance is the companies should be making investments, either capital investments or acquisitions, from the returns will exceed
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the cost of capital for that investment .Doing so creates value and is sometimes referred to as economic value added, economic profit, or shareholder value added. 1.2 IMPORTANCE OF COST OF CAPITAL: The concept of cost of capital is a very important concept in financial management decision making. The concept, is however, a recent development and has relevance in almost every financial decision making but prior to that development, the problem was ignored or by-passed. The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the following managerial decisions.

(1) Capital Budgeting Decision: Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability of all investment opportunities. (2) Designing the Corporate Financial Structure: The cost of capital is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimise the cost of capital so as to increase the market price and the earning per share.

(3) Deciding about the Method of Financing: A capable financial executive must have knowledge of the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from time to time. Whenever company requires additional finance, he may ave a

better choice of the source of finance which bears the minimum cost of capital. Although cost of capital is an important factor in such decisions, but equally important are the considerations of relating control and of avoiding risk. (4) Performance of Top Management: The cost of capital can be used to evaluate the financial performance of the top executives. Evaluation of the financial performance will involve a comparison of actual profitabilities of the projects and taken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. (5) Other Areas: The concept of cost of capital is also important in many others areas of decision making, such as dividend decisions, working capital policy etc. 1.3 CLASSIFICATION OF COST The various concepts of cost of capital are not relevant for all-purpose of decisionmaking. Therefore for a proper understanding of the application of the cost of capital in financial decision-making various concept of cost should be distinguished. These concepts are Future Cost and Historical Cost Future cost of capital refers to the expected cost of funds to be raised to finance a project while historical cost represents cost incurred in the past in acquiring fund. In financial decision future cost of capital is relatively more relevant and significant while evaluating viability of a project historical cost is taken into consideration. Component Cost and Composite Cost Cost of each component of capital such as equity, debenture and preference share etc. is known as component or specific cost of capital. When these component costs are combined to determine the overall cost of capital it is regarded as composite, or combined or weighted cost of capital. For capital budgeting decision composite cost of capital is relatively more relevant even though the firm may finance one proposal with only one source of funds and another proposal with another source.
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Average Cost and Marginal Cost Average cost of capital is the weightage average of the cost of each component of funds employed by the firm, while the marginal cost of capital is the average cost of new or incremental funds raised by the firm. For capital budgeting and most financing decisions marginal cost of capital is more important. Explicit Cost and Implicit Cost Explicit cost of capital of any source is the discount rate that equates the present value of each inflow that is incremental to the taking of the financing opportunity with present value of its incremental cash inflows. It arises when the firm considers alternative uses of the funds raised. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. It may also to be viewed, as opportunity cost 1.4 COMPONENTS OF COST OF CAPITAL: The Cost of Capital is visualized as being composed of several elements. These elements are the cost of each components of capital. The term component means the different sources from which funds are raised by a firm. Each source of funds or each component of capital has its cost. The computation of the cost of capital, involves two steps: The computation of the different elements of the cost in terms of the cost of the different sources of finance, and The calculation of the overall cost by combining the specific costs into a composite cost. Cost of Debt: Cost of debt is the after tax cost of long term funds through borrowings A company may raise debt in various ways. It may borrow funds from financial institutions or public either in the form of public deposits or debentures, bank loans, and debt instruments like commercial papers, credit loans etc., The cost of debt instrument is the yield to maturity of that instrument. This concept is applied to different types of debt instruments.

The cost of debenture is the value of Kd by following equation. Kd = I+ (F P0) / n (0.6 P0 + 0.4 F) Where Kd is the current market price of the debenture I is the annual interest payment F is the maturity value of the debenture and n is the number of years left to maturity Unlike a debenture, a bank loan is not traded in the secondary market. The cost of a bank loan is simply the current interest the bank would charge if the firm were to raise a similar loan now. A Commercial paper is a short term debt instrument which is issued at a discount and redeemed at par. Hence the cost of commercial paper is simply its implicit interest rate. If rate is not given, then you can also calculate cost of debt rate. This rate is called Kd. a. Cost of Debt without Any Adjustment (Kd) = Amount of Interest / Amount of Loan X 100 In case, company issues the bonds or debenture on premium, at that time, we can calculate cost of debt by following formula b. Cost of Debt (Kd) = Interest amount/ (Amount of debenture + Amount of premium) X 100

In case, company issues the bonds or debenture on discount, at that time, we can calculate cost of debt by following formula c. Cost of Debt (Kd) = Interest Amount/ (Amount of Debenture Amount of Discount) X 100

If we have to compare cost of debt with cost of equity then we have to calculate it after adjustment of tax because interest is deducted from profit before tax but dividend is deducted from profit after tax.

d. Cost of Debt = Amount of Interest (1 Tax Rate) / Amount of Loan X 100 For example, interest rate of company is 10% before tax; calculate cost of debt after tax of 30% Cost of Debt = 10 % X (1-30%) = 7% Cost of Preference Capital: Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of the preference share Preference Capital carries a fixed rate of dividend and is redeemable in nature. Even though the obligations of a company towards its preference shareholders are not as firm as those towards its debenture holders, and assumption is that preference dividend will be paid regularly and preference capital will be redeemed as per the original intent. The cost of preference capital is a function of the dividend expected by investors. The preference share may be treated as a perpetual security. Thus, its cost is given by the following equation: Kp = DIV/ P0 Where Kp is the cost of preference share, DIV is the expected preference dividend, and P0 is the issue price of preference share Cost of Equity Capital: Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value Firms may raise equity capital internally by retained earnings and they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. There are two possible approaches that can be employed to calculate the cost of equity capital:

1) Dividend Approach 2) Capital Asset Pricing Model (CAPM) Approach Dividend Approach: This approach is popularly known as Gordon Model. Dividend Valuation model assumes that the value of a share equals to the all future dividends that it is expected to provide over an indefinite period. The 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 of a share. The cost of equity capital can be measured by following equation: Ke = D1 / P0 + g Where Ke is the cost of equity capital, D1 is the expected dividend per share, P0 is the current market price, and g is the growth of expected dividends Capital Asset Pricing Model Approach: Another technique that can be used to estimate the cost of equity is the Capital Asset Pricing Model (CAPM) approach. The CAPM explains the behavior of security prices and provides a mechanism whereby investors could assess the impact of proposed security investment on their overall portfolio risk and return. In other words, it formally describes the risk- return trade-off for securities. It is based on certain assumptions. The basic assumptions of CAPM are related to 1) The efficiency of the security markets and 2) Investors preferences CAPM describes the relationship between the required return or cost of equity capital and the non- diversifiable risk of a firm measured by beta coefficient. Ke = Rf + b (Rm Rf)

Where Ke is the cost of equity, Rf is the rate of return required on a risk- free asset/ security/ investment, b is the beta coefficient, and Rm is the required rate of return on the market portfolio of assests Weighted Average Cost of Capital: The Weighted Cost of Capital is an extremely important input in the Capital Budgeting Decision process. The weighted cost of capital is the discounted rate used when comparing the Net Present Value (NPV) of a project of average risk. Similarly, the weighted cost of capital is the hurdle rate used in conjunction with the Internal Rate of Return (IRR) approach to project evaluation. Thus, the appropriate after tax cost of capital to be used in capital budgeting not only is based on the marginal capital to be raised, but also is weighted by the proportion of the capital components in the firms long range target capital structure. Therefore, the it is called Weighted or Overall Cost of Capital.

WACC = we re + wp rp + wd rd (1 - tc)
Where WACC is the weighted average cost of capital, We is the proportion of equity, Re is the cost of equity, Wp is the proportion of preference, Rp is the cost of preference, Wd is the proportion of debt, Rd is the cost of debt, and Tc is the corporate tax rate.

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2. REVIEW OF LITERATURE

The purpose of this chapter is to present a review of literature relating to the determining cost of capital of companies. Cost of capital is an important ingredient in investment decision making, capital structure of business entities. Whatever studies have conducted, those have exercised profound influence on the understanding cost of capital good number of these studies which pioneered work in this area. Special studies have been undertaken, mostly economists, to study the dynamics of cost of capital which represented largest component of decision making in company. In The Cost of Capital, Corporation Finanace and The Theory of Investment by Franco Modigliani and Merton H. Miller explained What is the Cost of Capital to a firm in a world in which funds are used to acquire assets whose yields are uncertain and in which capital can be obtained by many different media, ranging from pure debt instruments, representing money-fixed claims, to pure equityissues, giving holders only the right to a prorata share in the uncertain venture? This question has vexed at three classes of economists: (1) The corporation finance specialist concerned with the techniques of financing firms so as to ensure their survival and growth, (2) The managerial economist concerned with capital budgeting, and (3) The economic theorist concerned with explaining investment behavior at both the micro and macro levels. In WACC: Definition, Misconceptions and Error by Pablo Fernandez explained the WACC is just the rate at which the free cash flows must be discounted to obtain the same result as in the valuation using Equity Cash Flows discounted at the required return to equity. The WACC is neither a cost nor a required return: it is a weighted average of a cost and a required return. To refer to the WACC as the cost of capital can be misleading because it is not a cost. He explained seven errors caused by not remembering the definition of WACC and shows the relationship between the WACC and the value of the tax shields. In Cost of Capital and Decision Making by Dr. P. K. Srivastava and Dr. (Smt) Sangeeta Srivastava explained Cost of capital represents the rate of return which the company must pay to the suppliers of capital for use of their funds. It is the minimum rate of return that a project must yield to keep the value of the enterprise intact. The significance of the concept
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can be stated in terms of the contribution it makes towards the achievement of the objective of maximization of the wealth of shareholders. The objective is to highlight the different aspect of cost of capital and emphasize the importance of this concept in present business era. Analytical research method is adopted for this purpose where comments views and reviews by noted authorities apart from standard books on this topic have also been consulted and analyzed to arrive at concrete conclusion which envisage that investment decisions which are irreversible and involves huge funds should be taken after considering cost of capital apart from other aspects then only the financial policy will provide healthy platform to the stakeholders of the company. In WACC: Practical Guide for Strategic Decision by Sander M.W explained how risk management can add shareholder value by means of lowering the WACC by breaking down the WACC formula into the different components where the risk-free rate and market premium are taken and to look how the relationship between risk management and the cost of equity, cost of debt, effective tax rate, and optimal leverage. He also explained how risk management is an instrument that can be used to lower the WACC and create shareholder value. In Weighted Average Cost of Capital (WACC) Traditional Vs New Approach for Calculating the Value of Firm by Ramiz ur Rehman gave a critical review on The Weighted Average Cost of Capital (WACC) for Firm Valuation Calculations by Fernando Llano-Ferro was published in International Research Journal of Finance and Economics, Issue 26 (2009). In his study, he explained the important of WACC in the field of finance, and gave an alternative approach to calculate WACC while identifying some errors in traditional approach. His paper presents some backdrops of his study and pinpoints some weak assumptions in his new formula of WACC. His paper also gives an alternative approach to calculate WACC for firm valuation.

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3. RESEARCH METHODOLOGY

Research methodology is a way to systematically solve the research problem. It may be understood as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a researcher in studying his research problem along with the logic behind them. It is necessary for the researcher to know not only the research methods/techniques but also the methodology. Researchers not only need to know how to develop certain indices or tests, how to calculate the mean, the mode, the median or the standard deviation or chi-square, how to apply particular research techniques, but they also need to know which of these methods or techniques, are relevant and which are not, and what would they mean and indicate and why. Researchers also need to understand the assumptions underlying various techniques and they need to know the criteria by which they can decide that certain techniques and procedures will be applicable to certain problems and others will not. All this means that it is necessary for the researcher to design his methodology for his problem as the same may differ from problem to problem. When we talk of research methodology we not only talk of the research methods but also consider the logic behind the methods we use in the context of our research study and explain why we are using a particular method or technique and why we are not using others so that research results are capable of being evaluated either by the researcher himself or by others. 3.1 COLLECTION OF DATA: All the items under consideration in any field of inquiry constitute a universe or population. A complete enumeration of all the items in the population is known as a census inquiry. It can be presumed that in such an inquiry when all the items are covered no element of chance is left and highest accuracy is obtained. But in practice this may not be true. Even the slightest element of bias in such an inquiry will get larger and larger as the number of observations increases. Moreover, there is no way of checking the element of bias or its extent except through a resurvey or use of sample checks. Besides, this type of inquiry involves a great deal of time, money and energy. Not only this, census inquiry is not possible in practice under many circumstances. For instance, blood testing is done only on sample

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basis. Hence, quite often we select only a few items from the universe for our study purposes. The items so selected constitute what is technically called a sample. In this report, data collected is through secondary data sources only. The analysis is done using secondary data. 3.1.a SECONDARY DATA:When an investigator uses the data which has already been collected by others, such data called secondary data. This data is primary for the agency that collects it and becomes secondary data for someone else who uses this data for his own purposes. The secondary data can be obtained from journals, reports, government publications, publication of professional and research organizations and so on. Data collected from: Company Annual Reports Company Website Research Organizations like moneycontrol, moneyrediff etc.,

3.2 SAMPLING: The difference between the population and sample has already been discussed earlier. Sample selection is undertaken for practical impossibility to survey the population. By applying rationality in selection of samples, we generalize the finding of our research. 3.2.a SAMPLING UNIT: The sampling unit is the basic unit containing the elements of the target population. Sample Unit: Different Industries of, IT / ITES Oil and Refineries Electrical Equipment Automobiles Pharmaceuticals

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3.2.b SAMPLING SIZE: The decision about the number of elements to be choosen, i.e.., number of observation in each sample of the target population. Sample Size: 5 Sample Companies are: Tata Consultancy Services Reliance Industries Limited Bharat Heavy Electricals Limited Mahindra & Mahindra Ltd. Dr. Reddy's Laboratories Ltd.

3.3 DEFINITIONS, SCOPE, APPLICABILITY AND PARAMETERS

Definitions For the purpose of this report, the following definitions apply: Discount rate: The discount rate is the interest rate used in discounting future cash flows in a project financing assessment; it is also called capitalization rate or hurdle rate. Credit Rating: A rating assigned by an independent credit rating agency. An opinion of the future ability, legal obligation, and willingness of a bond issuer or other obligor to make full and timely payments on principal and interest due to investors. The opinion is based on a qualitative and quantitative analysis by the rating agency. Equity: Net worth; assets minus liabilities. The stockholders' residual ownership position. The capital invested in a business venture without a contractual obligation from the business venture for repayment or servicing. In project financing, this is the cash or assets contributed by a sponsor.

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Cost of Equity: Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Debt: An amount owed to a person or organization for funds borrowed. Debt can be represented by a loan note, bond, mortgage or other form stating repayment terms and, if applicable, interest requirements. These different forms all imply intent to pay back an amount owed by a specific date, which is set forth in the repayment terms. Cost of Debt: The effective rate that a company pays on its current debt; it can be measured as either before-tax or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity. Preference Shares: Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in

a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. Cost of Preference Shares: Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of the preference share.

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Book Value: A company's common stock equity as it appears on a balance sheet, equal to total assets minus liabilities, preferred stock, and intangible assets such as goodwill. This is how much the company would have left over in assets if it went out of business immediately. Since companies are usually expected to grow and generate more profits in the future, market capitalization is higher than book value for most companies. Since book value is a more accurate measure of valuation for companies which aren't growing quickly, book value is of more interest to value investors than growth investors. The value of an asset as it appears on a balance sheet, equal to cost minus accumulated depreciation. Market Value: Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some circumstances. Scope and Applicability This methodological tool provides procedures to determine the weighted average cost of capital. It can also be used to determine only the cost of equity or the cost of debt. The WACC or its components are required in an investment comparison analysis or a benchmark analysis for the purposes of determining additionality or selecting the baseline scenario. The WACC can be used as financial benchmark and be compared with financial parameters of an investment alternative, such as the internal rate of return (IRR) among others, or it can be used as discount rate in calculating financial parameters of an investment alternative, such as the net present value (NPV) or the levelized costs of production.

Parameters: This report provides procedures to determine the following parameters: Table 1: Parameters and description Parameter WACC Kd Ke Kp Description Weighted Average Cost of Capital Average cost of debt financing Average cost of equity financing Average cost of preference financing

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3.4 METHODOLOGY PROCEDURE The weighted average cost of capital (WACC, ) is calculated as follows: WACC = wd Kd (1-T) + we Ke + wp Kp Where: WACC = Weighted Average Cost of Capital wd = weight of debt financing we = weight of equity financing wp = weight of preference financing kd = Average cost of debt financing ke = Average cost of equity financing kp = Average cost of preference financing T = Applicable corporate tax rate

The parameter WACC calculated as above is to be considered as an after-tax benchmark/discount rate i.e. the economic/financial analysis using this parameter shall include the corporate tax expense. The WACC or its components should be calculated in the same terms (real or nominal) as in the investment comparison analysis or benchmark analysis. Apply the following steps to determine the kd, ke, kp, wd, we, wp and T.

STEP 1: Determine the average cost of debt financing (kd) Use one of the following options to determine kd: Alternative 1: Use the weighted average cost of debt financing of the legal entity. Under this option the project participants should document the following: For bonds: The key parameters of the bond including time to maturity, yield, registration issuance in the financial system and set-up in the market. For loans from a financial institution: the contract of lending between the financial institution and the legal entity owning the assets of the project activity. In absence of the contract, provide a letter from the bank stating its intention to award the loan and the key terms for the loan. If the legal entity uses debt financing from a parent company (corporate treasury or headquarter), the transfer of capital to the legal entity must be documented with:

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Debt with a maturity below one year is typically current debt with different interest rates than the interest rates of long term debt and should not be considered in the analysis. The parameter kd should be calculated as the weighted average cost of debt funding of the legal entity owning the project activity. For bonds, use the weighted average yield of the bonds during the last three months prior to the investment decision. For loans, use the weighted average cost of outstanding long-term debt. Alternative 2: Use the cost of debt of the financial system This option can be used if: The parameter kd should be calculated as the cost of financing in the capital markets (e.g. commercial lending rates and guarantees required for the country and the type of project activity concerned), based on documented evidence from financial institutions with regard to the cost of debt financing of comparable projects. In the case this data is not available, use the commercial lending rate in the host country for the calculation of kd. Alterantive 3: Use the cost of government bond rates as cost of debt This option can be used if: The government of the host country has issued at least one bond. The parameter kd can be assumed as the yield of a 10 years bond issued by the government of the host country or, if this is not available, the bond with the maturity which is closest to 10 years.

In this report the cost of debt financing is computed by taking the average of two years cost of debt which is calculated by following method: Kd = (Interest paid on nth year)*2 / (total debt of nth year + total debt of n-1th year) For Example: The Cost of Debt of Mahindra & Mahindra Ltd is shown as follows Table 2: Calculation of cost of debt of M&M 2011 Interest paid Opening balance of debt Closing balance of debt Kd 974.21 13,485.85 17,068.08 0.063769865 2010 979.83 12190.31 13,485.85 0.076322
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Avg Kd

0.070046

After-Tax Cost-of-Debt: The Cost of Debt is the effective rate of a company's current debt. Taking taxes into consideration the cost of debt could be much less due to interest payments being tax deductible. The cost of debt after factoring in the tax benefits is called the After-Tax Cost-ofDebt. Cost of Debt after tax: Avg Kd * (1-T) Where T is the corporate tax STEP 2: Determine the average cost of equity financing (ke) The cost of equity capital is the most difficult and controversial cost to measure. Equity capital like other sources of funds, does certainly involve a cost to the firm. It may be recalled that the objective of financial management is to maximise shareholders wealth and the maximisation of market price of share is the operational substitute for wealth maximisation. The equity shares, thus, implicitly involve a return in terms of the dividends expected by the investors and therefore carry a cost. The cost of equity capital is relatively the highest among all the sources of funds. The quantum of the rate of return, depends, inter alia, on the business risk and financial risk of a company. Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value Firms may raise equity capital internally by retained earnings and they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. There are two possible approaches that can be employed to calculate the cost of equity capital: 1) Dividend Approach 2) Capital Asset Pricing Model (CAPM) Approach

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In this report cost of equity capital is computed by using both Dividend Approach and Capital Asset Pricing Model (CAPM) Approach. The average of both model is our average cost of equity capital (Ke). Computation of Ke using Dividend Model or Gordon Model: This approach is popularly known as Gordon Model. Dividend Valuation model assumes that the value of a share equals to the all future dividends that it is expected to provide over an indefinite period. The 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 of a share. The cost of equity capital can be measured by following equation: Ke = D1 / P0 + g Where Ke is the cost of equity capital, D1 is the expected dividend per share, P0 is the current market price, and g is the growth of expected dividends Dividend per share is taken from annual reports and company website and compounded dividend growth rate is calculate. Then Ke is calculated by using all the parameters. For example: The Cost of Equity Capital of Reliance Industries Limited (RIL) is shown as follows Table 3: Calculation of cost of equity of RIL Market price Dividend Per Share (Rs) Dividend Growth Rate (g) 1023.35 8 14%

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By using Ke = D1 / P0 + g Ke = 0.1478 Computation of Ke using Capital Asset Pricing Model (CAPM): Another technique that can be used to estimate the cost of equity is the Capital Asset Pricing Model (CAPM) approach. The CAPM explains the behavior of security prices and provides a mechanism whereby investors could assess the impact of proposed security investment on their overall portfolio risk and return. In other words, it formally describes the risk- return trade-off for securities. It is based on certain assumptions. The basic assumptions of CAPM are related to The efficiency of the security markets and Investors preferences CAPM describes the relationship between the required return or cost of equity capital and the non- diversifiable risk of a firm measured by beta coefficient. Ke = Rf + b (Rm Rf) Where Ke is the cost of equity, Rf is the rate of return required on a risk- free asset/ security/ investment, b is the beta coefficient, and Rm is the required rate of return on the market portfolio of assests Computation of Parameters: Risk Free Rate: Risk free rate is the return on a security that is free from default risk and is uncorrelated with returns from anything else in the economy. The rate of return available on assets like T-bills, money market funds or bank deposits is the proxy for risk free rate. It is given on a government bond issued by a national government denominated in the country's own currency. The Risk free rate of India in 2011 and 2010 was 8%

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Risk Premium on market portfolio: Market risk premium or the risk premium on market portfolio is the difference between the expected return on the market portfolio and the risk free rate of return. The expected return is calculated by taking the market returns from NIFTY CNX S&P 50 and is calculated by following method Market Return = (Return of last day Return of first day) / Return of first day The expected return calculated for this report are Table 4: Required rate of return on market Rm 2011 2010 0.1148 0.1304

Beta: In finance, the Beta () of a stock or portfolio is a number describing the correlation of its returns with those of the financial market as a whole. An asset has a Beta of zero if its returns change independently of changes in the market's returns. A positive beta means that the asset's returns generally follow the market's returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset's returns generally move opposite the market's returns: one will tend to be above its average when the other is below its average. In this report Beta () values are downloaded from internet in popular websites like nseindia, moneycontrol etc.,

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BETA VALUES Table 5: Beta values of companies Company TCS RIL BHEL M&M DR REDDY 2011 1.03 0.74 1.05 1.5 0.57 2010 0.76 1.08 0.79 1.22 0.49

Thus Ke through CAPM Approach is calculated by using Ke = Rf + b (Rm Rf) For example: The Cost of Equity Capital of Reliance Industries Limited (RIL) is shown as follows Ke = 0.08 + 0.74*(0.1148 0.08) = 0.1057 The cost of equity is calculated by two approaches and the average of two values is actual Average Cost of Equity. The Average Cost of Equity Ke = (0.1478 + 0.1057) / 2 = 0.1268

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STEP 3: Determine the average cost of preference financing (kp) Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of the preference share Preference Capital carries a fixed rate of dividend and is redeemable in nature. Even though the obligations of a company towards its preference shareholders are not as firm as those towards its debenture holders, and assumption is that preference dividend will be paid regularly and preference capital will be redeemed as per the original intent. The cost of preference capital is a function of the dividend expected by investors. The preference share may be treated as a perpetual security. Thus, its cost is given by the following equation: Kp = DIV/ P0 Where Kp is the cost of preference share, DIV is the expected preference dividend, and P0 is the issue price of preference share In this report Cost of Preference Capital is calculated only to Tata Consultancy Services (TCS). TCS is the company which has preference share in our sample. In this Cost of Preference Capital is calculated as the average of cost of debt and cost of equity of TCS. Cost of Preference Capital (Kp) = (Cost of debt + Cost of equity) / 2 Kp = (0.1953 + 0.1729) / 2 = 0.1841

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STEP 4: Determining weights for each cost: The assignment of weights is relevant to the selection of appropriate weights. This aspect are of: (i) (ii) Historical Weights versus Marginal Weights Historical Weights can be book value weights or market value weights

The first aspect of decision regarding the selection of appropriate weights for computing the overall cost of capital is: which system of weighting marginal or historical is preferable? The critical assumption in any weighting system is that the firm will raise capital in the specified proportions. Marginal Weights: Marginal weights use proportion of each type of capital to the total capital to be raised. The use of marginal weights involve weighting the specific costs by the proportion of each type of fund to the total to be raised. The marginal weights represents the percentage share of different financing sources the firm intends to raise/ employ. In using marginal weights, we concerned with the actual amounts of each type of financing used in raising additional funds to finance new projects by the company. Historical Weights: Historic weights either book or market value weights are based on actual capital structure proportion to calculate weights. The alternative to the use of marginal weights is to use historical weights. The relative proportions of various sources to the existing capital structure are used to assign weights. The use of the historical weights is based on the assumption that the firms existing capital structure is optimal and should be maintained in the future. 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.
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The use of market value weights for calculating the cost of capital is more appealing than the use of book value weights because: (i) Market values of securities closely approximate the actual amount to be received from their sale. (ii) The costs of the specific sources of finance which constitute the capital structure of the firm. Book Value Weights: Book value weights use accounting values to measure the proportion of each type of capital to calculate the weighted average cost of capital. Book values are readily available from the published records of the firms. Also, firms set their capital structure targets in terms of book values rather than market values. The analysis of capital structure in term of debt- equity ratio is based on book value. In this report WACC is calculated by using both Book value weights and Market value weights. For example: The weights for Dr Reddys calculated is shown as follows Table 6: Book value and Market value weights of Dr Reddys Equity Book Value Market Value Weights (BV) Weights (MV) 40318 25419 0.629 0.517 Debt 23705 23705 0.371 0.483 Total 64023 49124 1 1

NOTE: Here the market value of debt is taken same as book value because computation of market value of debt is complicated. So, books value weights are considered as market value weights. Market value is computed by following formula: Market Value of share = Market price Number of outstanding shares
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STEP 5: Determining Weighted Average Cost of Capital (WACC): Once the component costs have been calculated, they are multiplied by the weights of the various sources of capital to obtain a weighted average cost of capital (WACC). The composite, or overall cost of capital is the weighted average of the cost of various sources of funds, weights being the proportion of each source of funds in the capital structure. It should be remembered that it is the weighted average concept, not the simple average, which is relevant in calculating the overall cost of capital. The simple average cost of capital is not appropriate to use because firms use various sources of funds equally in the capital structure. The following steps are used to calculate the weighted average cost of capital: (i) (ii) (iii) Assigning weights to specific costs. Multiplying the cost of each of the sources by the appropriate weights. Add the weighted component costs to get WACC.

The following expression is used to calculate WACC

WACC = we re + wp rp + wd rd (1 - tc)
Where WACC is the weighted average cost of capital, We is the proportion of equity, Re is the cost of equity, Wp is the proportion of preference, Rp is the cost of preference, Wd is the proportion of debt, Rd is the cost of debt, and Tc is the corporate tax rate.

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In this report WACC is calculated using both book value weights and market value weights and component cost of each source of fund. For example: The Weighted Average Cost of Capital (WACC) of Mahindra & Mahindra Ltd is shown as follows Table 7: WACC of M&M Ltd. Equity Costs Book Value weights Market Value weights 0.1798 0.456 0.704 Debt 0.07 0.544 0.296

Corporate Tax = 33% Book Value:

WACC = we re + wd rd (1 - tc)
= ( 0.456 0.1798) + ( 0.544 0.07 ( 1-0.33)) = 0.1074 Market Value:

WACC = we re + wd rd (1 - tc)
= ( 0.704 0.1798) + ( 0.296 0.07 ( 1-0.33)) = 0.1404

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4. ANALYSIS AND INTERPRETATIONS

Analysis: Analysis is a method of studying the nature of something or of determining its essential features and their relations. Analysis - objectives The following are the major objectives of this study Describe the study population and its relationship. Assess potential for bias Estimate measures of strength of association or effect Control and examine effects of other relevant factors Seek further insight into the relationships observed or not observed Evaluate impact or importance

Interpretation: Interpretation refers to the task of drawing inferences from the collected facts after an analytical and/or experimental study. In fact, it is a search for broader meaning of research findings. The task of interpretation has two major aspects The effort to establish continuity in research through linking the results of a given study with those of another, and The establishment of some explanatory concepts.

Why Interpretation? Interpretation is essential for the simple reason that the usefulness and utility of research findings lie in proper interpretation. It is being considered a basic component of research process because of the following: It is through interpretation that the research can well understand the abstract principle that works beneath findings. Interpretation leads to the establishment of explanatory concepts that can serve as a guide for future research studies.

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Cost of Equity (Ke): The average cost of equity of all the five sample companies of two consecutive financial years is shown below:

Average Cost of Equity Capital (Ke) Table 8: Average cost of equity capital 2011 TCS RIL BHEL M&M DRREDDY 0.1953 0.1268 0.177 0.1798 0.1617 2010 0.1724 0.1022 0.151 0.1262 0.1835

Figure 1: Average cost of equity capital

Cost of Equity (Ke)

0.25 0.2 0.15 2011 0.1 0.05 0 TCS RIL BHEL M&M DRREDDY 2010

The cost of equity measure provides investors with a relatively simple way to monitor the status of their investment and helps ensure that investment in those shares continues to be a sound strategy. For individual investors, the COE also reflects the opportunity cost of investment and will differ among companies due to varying levels of risk. A higher cost of equity
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indicates a higher level of risk. Investors should expect a higher rate of return to compensate for an elevated level of risk. There are a number of other ways to estimate the cost of equity, including the Capital Asset Pricing Model (CAPM) and Gordon Model. In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Let's now take a look at what rate of return, in general, an investor should expect from a stock. The return expected of any risky common stock should be composed of at least three different return components: (1) a return commensurate with a risk-free security (Rf); (2) a return that incorporates the market risk associated with common stocks as a whole (Rm); and (3) a return that incorporates the business and financial risks specific to the stock of the company itself, known as the company's beta. In this study the cost of equity of all companies are according to type of business and industry. The companys moderate cost of equity lies between 15% to 20%. The increase/ decrease of cost of equity effects on increase/ decrease of financial leverage of the company. Many factors like dividend policy, investment policies, dividend tax etc., affects the cost of equity.

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Cost of Debt (Kd): The average cost of debt of all the five sample companies of two consecutive financial years is shown below: Average cost of debt (Kd) Table 9: Average cost of debt 2011 TCS RIL BHEL M&M DRREDDY 0.1729 0.0303 0.229 0.07 0.0153 2010 0.0522 0.0289 0.231 0.0721 0.0335

Figure 2: Average cost of debt

Cost of Debt (Kd)

0.25 0.2 0.15 2011 0.1 0.05 0 TCS RIL BHEL M&M DRREDDY 2010

As you know, in recent times debt has almost become taboo, and when mentioned in conversations leads one to think of the current financial crises. The concept of debt really deserves more credit than it has been getting lately. Pun intended. The right amount of debt could have huge beneficial impacts to the WACC, and thus increase value of the firm.
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Nature of debt: The cost debt (up to a point) is usually less expensive than the cost of equity and also has added tax benefits. Interest payments on debt are tax deductible and reduces the firms tax liability acting as a sort of 'tax shield'. The generally lower cost of debt, and tax shield combined together make debt an attractive source of capital. After tax Kd = Pretax Kd * (1-Tax rate) Considering a firm with 0 debt, equity investors would likely be pleased if a reasonable amount of debt were to be added to the firms capital. Debt acts as a type of 'lever' (hence 'leverage') for the firm and magnifies returns to the firm and its shareholders. Because debt obligations represent fixed payments, debt holders do not receive the benefits of increased returns when times are good...the stockholders get that benefit. The returns for stockholders may be disproportionately greater than the increased financial risk of the debt, and thus the leverage effect is realized. Impact on Equity: Increasing proportions of debt increases financial risk for the firm. The cost of equity should increase as debt increases (and not necessarily proportionately). As the firm 'levers up', the leverage effect increases the beta (b) of the firm. As beta increases, perceived risk also increase. If we were to consider CAPM to value the firm's equity. Ke = Rf + b(Rm-Rf) As beta (b) increases, the market risk premium (Rm-Rf) [required return of market minus risk free rate] also increases thus ultimately increasing the cost of equity (Ke). Equity holders expect to be compensated for the additional risk should the firm not meet its legal interest payment obligations. If the firm should be liquidated, stockholders may not see a penny of their principle returned to them as debt holders would be paid off first. Stockholders want to be compensated for the increased risk with a higher rate of return. Optimal Capital Structure: The overall WACC begins to increase as we add more debt. The increased financial risk of additional debt increases the cost of debt and it increases the cost of equity. Thus we begin to reach a point where the increase in debt loses its benefit and the increasing proportion of debt is not enough to offset the additional risk.
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In this study, in 2011 cost of debt is more in TCS and BHEL which increases cost of equity and financial leverage also. The companys moderate cost of debt lies between 6% to 10%. M&M is the company with moderate cost of debt of 7%. RIL as big exporter of oil maintains foreign funds and hedge in global market so it maintains low cost of debt of 3%. Cost of debt of DR REDDY is low of 1.5% because the unsecured loan fund accounts more in total debt funds. Most of borrowings of company from foreign banks with average interest rates of 1.2% - 3% and average interest rates of LIBOR plus 60-100.

Weighted Average Cost of Capital (WACC) using Book Value: The WACC based on book values of all the five sample companies of two consecutive financial years is shown below: WACC (BV) Table 10: WACC based on book value 2011 TCS RIL BHEL M&M DRREDDY 0.195 0.0892 0.1764 0.1074 0.1056 2010 0.1713 0.0762 0.151 0.0818 0.1381

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Figure 3: WACC based on book value

WACC (BV)
0.25 0.2 0.15 2011 0.1 0.05 0 TCS RIL BHEL M&M DRREDDY 2010

As I analyzed book value weights are used to compute WACC because of: Firms in practice set their target capital structure in terms of book values. The book value information can be easily derived from the published sources. The book value debt equity ratios are analyzed by the investors to evaluate the risk of the firms practice. The use of the book value weights can be seriously questioned on theoretical grounds. The component costs are opportunity rates and are determined in the capital markets. The weights should also be market determined. The book value weights are based on arbitrary accounting policies that are used to calculate retained earnings and value of assets. Thus they are not reflecting economic values In this study the WACC based on book values of TCS and BHEL is more compared to other companies, because the percentage weights of cost of equity is 98% of the total weights. The WACC of DR REDDY in 2010 is more than in 2011 because, the cost of debt in 2010 is more than 2011 which increased overall cost of capital of DR REDDY.

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Weighted Average Cost of Capital (WACC) using Market Value: The WACC based on market values of all the five sample companies of two consecutive financial years is shown below: WACC (MV) Table 11: WACC based on market value 2011 TCS RIL BHEL M&M DRREDDY 0.1949 0.1038 0.177 0.1404 0.0886 2010 0.1658 0.0928 0.151 0.1096 0.1048

Figure 4: WACC based on market value

WACC (MV)
0.25 0.2 0.15 2011 0.1 0.05 0 TCS RIL BHEL M&M DRREDDY 2010

Market value weights are theoretically superior to book value weights. They presumably reflect economic values and are not influenced by the accounting policies. They are also consistent with the market determined component costs. Despite their volatility, market value are superior to book value, because in order to justify its valuation the firm must
37

earn competitive returns for shareholder and debtholder on the market value of their investment. In this study a WACC of 14.04% means M&M must earn a return of 14.04% on all its assets and business operations in order to maintain the current stock price at Rs 660 per share. If M&M wants its stock price to go higher, it must achieve a return rate greater than 14.04%. The WACC based on market values of TCS and BHEL is more compared to other companies, because the percentage weights of cost of equity is 90% of the total weights. Book Value VS Market Value The WACC based on book value and market value of all five sample companies of financial year 2011 is shown below

Book Value VS Market Value Table 12: Book Value VS Market Value WACC (BV) TCS RIL BHEL M&M DRREDDY 0.195 0.0892 0.1764 0.1074 0.1056 WACC (MV) 0.1949 0.1038 0.177 0.1404 0.0886

Figure 5: Book Value VS Market Value

Book Value VS Market Value

0.25 0.2 0.15 WACC (BV) 0.1 0.05 0 TCS RIL BHEL M&M DRREDDY WACC (MV)

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The weighted cost of capital can be computed by using both the book value or the market value weights. If there is a difference between book value and market value weights, the WACC would differ according to the weights used. The weighted average cost of capital calculated by using weights will be understated if the market value of the share is higher than the book value and vice-versa. In this study the WACC calculate by using book value and market value are same for TCS and BHEL. Whereas for RIL and M&M the WACC calculated using market value is greater than the WACC calculated using book value. And for DR REDDY book value calculated WACC is more than market value calculated WACC.

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5. FINDINGS
The following are the findings of this study The most frequently used discount rate to evaluate capital budgeting decision is based on the overall cost of capital (WACC) of the corporate. The CAPM is the most popular method of estimating the cost of equity capital. The Gordonss dividend model is equally popular to compute the cost of equity capital. WACC is calculated by using both market value and book value weights. Generally market value weights are superior to book values, because in order to justify its valuation of firm. WACC is used for designing the firms capital structure. WACC is also used for appraising the top managements financial performance. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company.

5.1 Factors affecting WACC:

The Weighted Average Cost of Capital is affected by several factors, some beyond the control of the firm and others dependent on the investment and financing policies of the firm. Factors Outside a firms control: The three most important factors, outside a firms direct control, that have a bearing on the cost of capital are, The level of Interest Rates: If interest rates in the economy rise, the cost of debt to firms increases and vice versa. Interest rates also have a similar bearing on the cost of preference and cost of equity. The risk free rate of interest is an important component of the CAPM. Market Risk Premium:

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The market risk premium reflects the perceived riskiness of equity stocks and investor aversion to risk. A factor beyond the control of individual firms, the market risk premium affects the cost of equity directly and the cost of debt indirectly. Tax Rates: The tax policy of the government has a bearing on coat of capital. The corporate tax rate has a direct impact on the cost of debt as used in the WACC. The capital gains tax rate relative to the rate on ordinary income has an indirect effect on the cost of equity relative to the cost of debt. Factors Within a Firms Control: The factors, within a firms control, that bearing on the cost of capital are, Investment Policy: To estimate the cost of capital, the rate of return required on the outstanding equity and debt of the firm. These rates reflect how risky the firms existing assets are. If a firm plans to invest in assets similar to those currently used, then its cost of capital would be more or less its current cost of capital. On the other hand, if the riskiness of its proposed investments is likely to be very different from the riskiness of its existing investments, its cost of capital should reflect the riskiness of the proposed investments. Capital Structure Policy: To calculate the WACC a given target capital structure is assumed. Of course, a firm can change its capital structure and such a change is likely to affect the cost of capital because the post tax cost of debt is lower than the cost of equity and equity beta, an input for calculating the cost of equity is a function of financial leverage. Dividend Policy: The dividend policy of a firm may affect its cost of equity.

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6. CONCLUSION

Weighted Average Cost of Capital (WACC) is a central concept in financial management. WACC is used as a benchmark hurdle rate that is adjusted for variation in risk and financing patterns. WACC tends to rise as a firm seeks more and more capital. The firms cost of capital is the rate of return expected by capital providers for a new investment. While project cost of capital is the rate of return expected by capital provider for that project. The cost of capital of the firm is the weighted average of the cost of capital of various projects undertaken by the firm. The progressive management always takes notice of the cost of capital while taking a financial decision. The concept is quite relevant in the managerial decisions as (a) It may be used as the measuring road for adopting an investment proposal. The firm, naturally, will choose the project which gives a satisfactory return on investment which would in no case be less than the cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor in deciding the project out of various proposals pending before the management. It measures the financial performance and determines the acceptability all investment opportunities. (b) It is significant in designing the firm's capital structure. The cost of capital is influenced by the chances in capital structure. A capable financial executive always keeps an eye on capital market fluctuations and tries to achieve the sound and economical capital structure for the firm. He may try to substitute the various methods of finance in an attempt to minimize the cost of capital so as to increase the market price and the earning per share.

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7. SUGGESTIONS

The Cost of Capital is a central concept in financial management linking the investment and financing decisions. Hence, it should be calculated correctly and used properly in investment evaluation. Despite this injunction, that several errors characterise the application of this concept. The more common misconceptions, along with suggestions to overcome them are discussed below. The concept of cost of capital is too academic or impractical: Some companies do not calculate the cost of capital because they regard it as academic or impractical or irrelevant. These misgiving about cost of capital appear to be unjustified. The cost of capital is an essential ingredient of discounted cash flow analysis. Since discounted cash flow analysis is now widely used, cost of capital can scarcely be considered academic or impractical. Current Liabilities are considered as capital components: Sometimes it is argued that accounts payable and accruals are sources of funding to be considered in the calculation of the WACC. This is not correct because what is not provided by investors is not capital. Current liabilities arise on account of an operating relationship of the firm with its suppliers and employees. They are deducted when the investment requirement of the project is determined. Hence, they should not be considered in calculating the WACC. The coupon rate on the firms existing debt is used as the pre-tax cost of debt: The coupon rate on the firms existing debt reflects a historical cost. What really matters in investment decision making is the interest rate the firm would pay if it issues debt today. Hence use the current cost of debt, not the historical cost of debt. When estimating the market risk premium in the CAPM method, the historical average rate of return is used along with the current risk free rate: To calculate the market risk premium, one can use historical risk premium or the current risk premium, but not the difference between the historical average return on common stocks and the current return on long term bonds.
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The cost of equity is equal to the dividend rate or return on equity: It should be clearly understood that the cost of equity is the rate of return required by equity investors given the risk they are exposed to. It has nothing to do with the current dividend rate or return on equity, which are mere historical numbers. The project cost of capital is the same as firms WACC: Each project has its own cost of capital which reflects its riskiness and its debt capacity. The WACC is the average of the cost of capital of various projects undertaken by the firm.

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8. BIBLIOGRAPHY

BOOKS: Prasanna Chandra : Financial Management (Theory and Practice), Tata McGraw- Hill Publishing Company Ltd. New Delhi. Khan, M.Y. and P.K Jain : Financial Management, Tata McGraw- Hill Publishing Company Ltd., New Delhi. Maheshwari S. N., Financial Management, Principles & Practice, Sultan Chand & Sons, New Delhi. Pandey, I.M. : Essentials of Financial Management, Vikas Publishing House Pvt. Ltd, New Delhi. Shashi K. Gupta and R. K. Sharma, Financial Management - Theory and Practice, Kalyani Publication, New Delhi. C. R. Kothari : Research Methodology - Methods and Techniques, New Age International Publishers, New Delhi. Simon Benninga and Benjamin Czaczkes : Financial Modelling, Volume R. Charles Moyer, James R McGuigan and William J Kretlow : Contemporary Financial Management. Shannon P Pratt and Roger J Grabowski : Cost of Capital: Applications and Examples. JOURNAL: The Cost of Capital, Corporation Finanace and The Theory of Investment by Franco Modigliani and Merton H. Miller WACC: Definition, Misconceptions and Error by Pablo Fernandez

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Websites: www.tcs.com www.ril.com www.bhel.com www.mahindra.com www.drreddys.com www.moneycontrol.com www.moneyrediff.com www.wikipedia.org www.ehow.com www.google.com

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9. APPENDIX I PROJECT SYNOPSIS

TITLE:

A study on Determining the cost of capital of five companies INTRODUCTION:

Cost of Capital is the weighted average of the costs of various sources of funds, weights being the proportion of each source of funds. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. The items on the financing side of the balance sheet are called capital components. The major capital components are equity, preference and debt. Capital, like any other factor of production, has a cost. Any use of capital imposes an opportunity cost on investors as investors have access to a host of financial market alternatives. So, the use of capital by a company must be benchmarked against the alternatives in financial market. The cost of capital provides this benchmark. A companys cost of capital is the average cost of the various capital components employed by it. The Cost of Capital is a central concept in financial management. It is used for evaluating investment projects, for determining the capital structure, for assessing leasing proposals, etc., The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".

STATEMENT OF THE PROBLEM:

Some companies do not compute cost of capital and plan their capital structure, and develops as a result of the financial decisions taken by the financial manager. These companies may prosper in the short-run, but ultimately they may face considerable difficulties in raising funds to finance their activities. Can the companys cost of capital is used for discounting the cash flows of the investment projects? The cost of capital is one of the most difficult topic in the finance theory.

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OBJECTIVE OF THE STUDY:

To determine the cost of capital of 5 companies of 5 industries. To distinguish between the companys cost of capital and the project cost of capital. To analyze and compare cost of capital and financial leverage of 5 companies.

SIGNIFICANCE OF THE STUDY:

The concept of cost of capital is a very important concept in financial management decision making, the concept is quite relevant in the following managerial decisions Capital Budgeting Decision Valuation of the companies. Designing the Corporate Capital Structure Deciding about the Method of Financing Performance of Top Management Other Areas such as dividend decisions, working capital policy etc.,

RESEARCH METHODOLOGY:
The study on determining cost of capital of five companies in five industries, the required data is collected from different sources. As companies selected are five top companies for determining cost of capital, collecting of primary data is bit difficult. So data is collected from secondary sources. Data Collection: Secondary data

Sample Size: Five

CONCLUSION:
A company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital.

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10. APPENDIX II
WACC OF TCS YEAR 2011 2010 Ke 0.1953 0.1724 Kp 0.1841 0.1123 Kd 0.1729 0.0522 WACC (BV) 0.195 0.1713 WACC(MV) 0.1949 0.1658

WACC OF RIL YEAR 2011 2010 Ke 0.1268 0.1022 Kd 0.0303 0.0289 WACC (BV) 0.0892 0.0762 WACC (MV) 0.1038 0.0928

WACC OF BHEL YEAR 2011 2010 Ke 0.177 0.151 Kd 0.229 0.231 WACC (BV) 0.1764 0.151 WACC (MV) 0.177 0.151

WACC OF M&M YEAR 2011 2010 Ke 0.1798 0.1262 Kd 0.07 0.0721 WACC (BV) 0.1074 0.0818 WACC (MV) 0.1404 0.1096

WACC OF DR REDDYS Ke 2011 2010 0.1617 0.1835 Kd 0.0153 0.0335 WACC (BV) 0.1056 0.1381 WACC (MV) 0.0886 0.1048

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Equity Par Value (Rs) Market price Book Value (Rs crore) No.of Shares Market Value (Rs crore) Dividend Dividend Growth Rate Cost Weights (book value) WACC (book value) Weights (market value) WACC (market Value)

31st March 2011 Preference share 1 1 950.88 59.7501358 24404.81 100 1,95,72,20,996 1,00,00,00,000 186108.23 5975 14 11 26% 19.53% 0.992888414 0.195012632 0.968516538 0.194920815 18.41% 0.004068413

Debt

74.8 74.8

24579.61 192158.03

0.1729 0.003043173

0.031094199

0.000389263

Dividend growth rate

0.259936377 31st March 2010 Equity Preference share 1 1 632.55 151.3802315 18366.72 100 1,95,72,20,996 1,00,00,00,000 123804.01 15138.02 20 17 0.195 0.1724 0.98905491 0.171312263 0.890386283 0.165754796 0.1123 0.005385038

Debt

Par Value (Rs) Market price Book Value (Rs crore) No.of Shares Market Value (Rs crore) Dividend Dividend Growth Rate Cost Weights (book value) WACC (book value) Weights (market value) WACC (market Value)

103.25 103.25

18569.97 139045.28

0.0522 0.005560052

0.108871153

0.000742564

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Interest Paid Opening balance of debt 103.25 563.88 Closing balance of debt 74.8 103.25 Kd 0.297445 0.048266 Avg Kd 0.172855 Tax Rate 33% Rf Rm beta Ke Ke (Gordon) Ke (CAPM) Avg Ke 8% 11.48% 1.03 0.115844 27.47% 11.58% 19.53%

2011 26.48

2010 16.1

2010 2009 Interest Paid 16.1 28.66 Opening balance of debt 563.88 455.02 Closing balance of debt 103.25 563.88 Kd 0.048266 0.056257 Avg Kd 0.052262 Tax Rate 33%

Rf Rm Beta Ke

8% 0.1304 0.76 0.118304

Ke (Gordon) Ke (CAPM) Avg Ke

0.226618 0.118304 0.172461

NOTE: The above calculation is of WACC of TCS. All the calculation of other companies also done in same manner.

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