You are on page 1of 12

# Name G M Firoz Khan

## Roll No. 520931217

Program MBA
Financial Management
Subject
[Set 2]
Code MB 0029

## Learning Systems Domain –Indira Nagar,

Centre Bangalore [2779]

Set 2 MB0029
1 Is Equity Capital Free of cost? Substantiate your statement.

## Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment.
There is no legal requirement (unlike in the case of loans or debentures
where the rates are governed by the deed) to pay regular dividends to
them. Measuring the rate of return to equity holders is a difficult and
complex exercise. There are many approaches for estimating return – the
dividend forecast approach, capital asset pricing approach, realized yield
approach, etc. According to dividend forecast approach, the intrinsic value of
an equity share is the sum of present values of dividends associated with it.
Ke = (D1/Pe) + g
This equation is modified from the equation Pe={D1/Ke-g}. Dividends
cannot be accurately forecast as they may sometimes be nil or have a
constant growth or sometime supernormal growth periods.
Equity Capital is not free of cost:
Some people are of the opinion that equity capital is free of cost for the
reason that a company is not legally bound to pay dividends and also the
rate of equity dividend is not fixed like preference dividends. This is not a
correct view as equity shareholders buy shares with the expectation of
dividends and capital appreciation. Dividends enhance the market value of
shares and therefore equity capital is not free of cost.
Example:
Suraj Metals are expected to declare a dividend of Rs. 5 per share and the
growth rate in dividends is expected to grow @ 10% p.a. The price of one
share is currently at Rs. 110 in the market. What is the cost of equity capital
to the company?

Solution:
Ke = (D1/Pe) + g
= (5/110) + 0.10
= 0.1454 or 14.54%

## 2 a. What is the rate of return for a company if the β is 1.25, risk

free rate of return is 8% and the market rate of return is 14%.
Use CAPM model.

Set 2 MB0029
β = 1.25
Risk free Rate of Return= 8%
Market Rate of return = 14%
Rate of return for a company is given by,
Ke = Rf + β [Rm-Rf]

Ke = 0.08 + 1.25(0.14-0.08)
Ke = 0.08 + 0.275
= 0.155 or 15.5%
Therefore the rate of return for the company is 15.5%

each

## The market price per equity is Rs 54. The company is expected to

declare a dividend per share of Rs.2 per share and there will be a
growth of 10% in the dividends for the next 5 years. The preference
shares are redeemable at a premium of Rs.5 per share after 8 years.
The current market price of preference share is Rs.92. Debenture
redemption will take place after 7 years at a discount of 2% and the
current market price is Rs.91 per debenture. The corporate tax rate
is 40%. Calculate WACC.

Solution:
Market price per equity = PO = 54
Expected dividend per share = D1 = Rs.2
Rate of growth of dividend = g =0.1

## Step I is to determine the cost of each component.

Set 2 MB0029
Cost of equity capital, Ke =( D1/P0) + g
= (2/54) + 0.1
= 0.137 or 13.7%
Preference dividend payable = D = 12
Present value P =92
Future Value F =105
Period n =8
Cost of preference capital, Kp = [D + {(F—P)/n}] / {F+P)/2}
= [12 + (105—92)/8] / (105+92)/2
=13.625/98.5
= 0.1383 or 13.83%
Cost of retained earnings, Kr = Ke this is 13.7%
Annual interest payable per unit debenture = I = 12%
Corporate tax rate = T = 40%
Redemption price per debenture = F = 105
Net amount realized per debenture = P= 92
Maturity period = n = 7

## Cost of debentures, Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}

= [12(1—0.4) + (105—92)/7] / (105+92)/2
= [7.2 + 1.857] / 98.5
= 0.09195 or 9.2%
Cost of term loans, Kt = I (1–T)
= 0.14(1–0.4)
= 0.084 or 8.4%
Step II is to calculate the weights of each source.
We = 250/1000 = 0.25
Wp = 100/1000 = 0.1
Wr = 150/1000 = 0.15
Wd = 350/1000 = 0.35
Wt = 150/1000 = 0.15
Step III Multiply the costs of various sources of finance with corresponding
weights and WACC calculated by adding all these components.

Set 2 MB0029
WACC = WeKe + WpKp +WrKr + WdKd + WtKt
= (0.25*0.137) + (0.1*0.1383) + (0.15*0.137) + (0.35*0.092) +
(0.15*0.084)
= 0.03425 + 0.01383 + 0.021 + 0.0322 + 0.0126
= 0.1139 or 11.39%

3 The effective cost of debt is less than the actual interest payment
made by the firm. Do you agree with this statement? If yes/no

The effective cost of debt is less than the actual interest payment made by
the firm. Any organization requires funds to run its business. These funds
may be acquired from short-term or long-term sources. Long-term funds are
raised from two important sources – capital (owners’ funds) and debt. Each
of these two has a cost factor, merits and demerits. Having excess debt is
not desirable as debt-holders attach many conditions which may not be
possible for the companies to adhere to. It is therefore desirable to have a
combination of both debt and equity which is called the ‘optimum capital
structure’. Optimum capital structure refers to the mix of different sources of
long term funds in the total capital of the company.
Capital budgeting decisions involve evaluation of specific investment
proposals. Here the word capital refers to the operating assets used in
production of goods or rendering of services. Budgeting involves formulating
a plan of the expected cash flows during the future period. When we
combine Capital with budget we get Capital budget. Capital budget is a blue
print of planned investments in operating assets. Therefore, Capital
budgeting is the process of evaluating the profitability of the projects under
consideration and deciding on the proposal to be included in the Capital
budget for implementation. Capital budgeting decisions involve investment
of current funds in anticipation of cash flows occurring over a series of years
in future. All these decisions are Strategic because they change the profile of
the organizations. Successful organizations have created wealth for their
shareholders through Capital budgeting decisions. Investment of current
funds in long-term assets for generation of cash flows in future over a series
of years characterizes the nature of Capital Budgeting decisions.
Designing of capital structure requires a number of factors to be considered
such as:

Set 2 MB0029
• Return: The capital structure of a company should be most
advantageous. It should generate maximum returns to the shareholders
for a considerable period of time and such returns should keep
increasing.
• Risk: As already discussed in the previous chapter on leverage, use of
excessive debt funds may threaten the company’s survival. Debt does
increase equity holders’ returns and this can be done till such time that
no risk is involved.
• Flexibility: The company should be able to adapt itself to situations
warranting changed circumstances with minimum cost and delay.
• Capacity: The capital structure of the company should be within the debt
capacity. Debt capacity depends on the ability for funds to be generated.
Revenues earned should be sufficient enough to pay creditors’ interests,
principal and also to shareholders to some extent.
• Control: An ideal capital structure should involve minimum risk of loss of
control to the company. Dilution of control by indulging in excessive debt
financing is undesirable.
With the above points on ideal capital structure, raising funds at the
appropriate time to finance firm’s investment activities is an important
activity of the Finance Manager. Golden opportunities may be lost for
delaying decisions to this effect. A combination of debt and equity is used to
fund the activities. What should be the proportion of debt and equity? This
depends on the costs associated with raising various sources of funds. The
cost of capital is the minimum rate of return a company must earn to meet
the expenses of the various categories of investors who have made
investment in the form of loans, debentures, equity and preference shares.
A company not being able to meet these demands may face the risk of
investors taking back their investments thus leading to bankruptcy. Loans
and debentures come with a pre-determined interest rate, preference shares
also have a fixed rate of dividend while equity holders expect a minimum
return of dividend based on their risk perception and the company’s past
performance in terms of pay-out of dividends.
Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds
from issue of debentures to the expected cash outflows – interest and
principal repayments.
The debentures carry a fixed rate of interest. Interest qualifies for tax
deduction in determining tax liability. Therefore the effective cost of debt is
less than the actual interest payment made by the firm.

Set 2 MB0029
1 Why capital budgeting decision very crucial for finance managers?

## Capital structure is the mix of long-term sources of funds like debentures,

loans, preference shares, equity shares and retained earnings in different
ratios. It is always advisable for companies to plan their capital structure.
Decisions taken by not assessing things in a correct manner may jeopardize
the very existence of the company. Firms may prosper in the short-run by
not indulging in proper planning but ultimately may face problems in future.
With unplanned capital structure, they may also fail to economize the use of
their funds and adapt to the changing conditions.
There are many reasons that make the Capital budgeting decisions
the most crucial for finance managers
• These decisions involve large outlay of funds now in anticipation of cash
flows in future. For example, investment in plant and machinery. The
economic life of such assets has long periods. The projections of cash
flows anticipated involve forecasts of many financial variables. The most
crucial variable is the sales forecast.
a. For example, Metal Box spent large sums of money on expansion of
its production facilities based on its own sales forecast. During this
period, huge investments in R & D in packaging industry brought
about new packaging medium totally replacing metal as an
important component of packing boxes. At the end of the expansion
Metal Box Ltd found itself that the market for its metal boxes had
declined drastically. The end result is that metal box became a sick
company from the position it enjoyed earlier prior to the execution
of expansion as a blue chip. Employees lost their jobs. It affected
the standard of living and cash flow position of its employees. This
highlights the element of risk involved in these type of decisions.
b. Equally we have empirical evidence of companies which took
decisions on expansion through the addition of new products and
adoption of the latest technology creating wealth for shareholders.
The best example is the Reliance group.
c. Any serious error in forecasting Sales and hence the amount of
capital expenditure can significantly affect the firm. An upward bias
may lead to a situation of the firm creating idle capacity, laying the
path for the cancer of sickness.
d. Any downward bias in forecasting may lead the firm to a situation
of losing its market to its competitors. Both are risky fraught with
grave consequences.

Set 2 MB0029
• A long term investment of funds sometimes may change the risk profile
of the firm. A FMCG company with its core competencies in the business
decided to enter into a new business of power generation. This decision
will totally alter the risk profile of the business of the company. Investor’s
perception of risk of the new business to be taken up by the company will
change his required rate of return to invest in the company. In this
connection it is to be noted that the power pricing is a politically sensitive
area affecting the profitability of the organization. Therefore, Capital
budgeting decisions change the risk dimensions of the company and
hence the required rate of return that the investors want.
• Most of the Capital budgeting decisions involve huge outlay. The funds
requirements during the phase of execution must be synchronized with
the flow of funds. Failure to achieve the required coordination between
the inflow and outflow may cause time over run and cost overrun. These
two problems of time over run and cost overrun have to be prevented
from occurring in the beginning of execution of the project. Quite a lot
empirical examples are there in public sector in India in support of this
argument that cost overrun and time over run can make a company’s
operations unproductive. But the major challenge that the management
of a firm faces in managing the uncertain future cash inflows and out
flows associated with the plan and execution of Capital budgeting
decisions.
• Capital budgeting decisions involve assessment of market for company’s
products and services, deciding on the scale of operations, selection of
relevant technology and finally procurement of costly equipment. If a firm
were to realize after committing itself considerable sums of money in the
process of implementing the Capital budgeting decisions taken that the
decision to diversify or expand would become a wealth destroyer to the
company, then the firm would have experienced a situation of inability to
sell the equipments bought. Loss incurred by the firm on account of this
would be heavy if the firm were to scrap the equipments bought
specifically for implementing the decision taken. Sometimes these
equipments will be specialized costly equipments. Therefore, Capital
budgeting decisions are irreversible.
• The most difficult aspect of Capital budgeting decisions is the influence of
time. A firm incurs Capital expenditure to build up capacity in anticipation
of the expected boom in the demand for its products. The timing of the
Capital expenditure decision must match with the expected boom in
demand for company’s products. If it plans in advance it may effectively
manage the timing and the quality of asset acquisition. But many firms

Set 2 MB0029
suffer from its inability to forecast the future operations and formulate
strategic decision to acquire the required assets in advance at the
competitive rates.
• All Capital budgeting decisions have three strategic elements. These
three elements are cost, quality and timing. Decisions must be taken at
the right time which would enable the firm to procure the assets at the
least cost for producing the products of required quality for customer.
Any lapse on the part of the firm in understanding the effect of these
elements on implementation of Capital expenditure decision taken, will
strategically affect the firm’s profitability.
• Liberalization and globalization gave birth to economic institutions like
World Trade organization. General Electrical can expand its market into
India snatching the share already enjoyed by firms like Bajaj Electricals
or Kirloskar Electric Company. Ability of G E to sell its products in India at
a rate less than the rate at which Indian Companies sell cannot be
ignored. Therefore, the growth and survival of any firm in today’s
business environment demands a firm to be pro-active. Pro-active firms
cannot avoid the risk of taking challenging Capital budgeting decisions for
growth. Therefore, Capital budgeting decisions for growth have become
essential characteristics of successful firms today.
• The social, political, economic and technological forces generate high
level of uncertainty in future cash flows streams associated with Capital
budgeting decisions. These factors make these decisions highly complex.
• Capital expenditure decisions are very expensive. To implement these
decisions, firm’s will have to tap the Capital market for funds. The
composition of debt and equity must be optimal keeping in view the
expectation of investors and risk profile of the selected project.

## 5. A road project require an initial investment of Rs.10,00,000. It is

expected to generate the following cash flow in the form of toll
tax recovery.
Year Cash Inflows
1 4,50,000
2 4,25,000

Set 2 MB0029
3 3,00,000
4 3,50,000
What is the IRR of the project?

Step I:

## Compute the average of annual cash inflows

Cash
Year inflows
1 450000
2 425000
3 300000
4 350000
Tota
l 1525000

Average = 1525000 /4

= Rs. 381250

Step II:

## Divide the initial investment by the average of annul cash inflows:

= 1000000/381250

= 2.62

Step III:

From PVIFA table for 4 years, the annuty factor very near 2.62 is 19%.
Therefore the first initial rate is 19%

## Cash PVIF factor @ PV of cash

Year
flows 19% flows
1 450000 0.84 378000
2 425000 0.706 300050

Set 2 MB0029
3 300000 0.593 177900
4 350000 0.499 174650
Total 1030600
Since the initial investment of Rs. 10,00,000 is less than computed value at
19% of Rs. 1030600 the next trail rate is 20%

## Cash PVIF factor @ PV of cash

Year flows 20% flows
1 450000 0.833 374850
2 425000 0.694 294950
3 300000 0.579 173700
4 350000 0.482 168700
Total 1012200

## Cash PVIF factor @ PV of cash

Year flows 21% flows
1 450000 0.826 371700
2 425000 0.683 290275
3 300000 0.564 169200
4 350000 0.467 163450
Total 994625
Since the investment of Rs.10,00,000 lies between 21% and 20%, the IRR
by interpolation is,

20+1000000-1012200(1000000-994625) x 1

IRR = 20.7%

## 5. What is sensitivity analysis? Mention the steps involved in it.

Sensitivity Analysis:
There are many variables like sales, cost of sales, investments, tax rates etc
which affect the NPV and IRR of a project. Analysing the change in the
project’s NPV or IRR on account of a given change in one of the variables is
called Sensitivity Analysis. It is a technique that shows the change in NPV
given a change in one of the variables that determine cash flows of a
project. It measures the sensitivity of NPV of a project in respect to a
change in one of the input variables of NPV.

Set 2 MB0029
The reliability of the NPV depends on the reliability of cash flows. If forecasts
go wrong on account of changes in assumed economic environments,
reliability of NPV & IRR is lost. Therefore, forecasts are made under different
economic conditions viz pessimistic, expected and optimistic. NPV is arrived
at for all the three assumptions.
Following steps are involved in Sensitivity analysis:
1. Identification of variables that influence the NPV & IRR of the project.
2. Examining and defining the mathematical relationship between the
variables.
3. Analysis of the effect of the change in each of the variables on the NPV of
the project.

Set 2 MB0029