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SCMS Journal of Indian Management, July - September, 2008.

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Journal of Indian Management, July - September, 2008. 18 Concept and Measurement: Cost of Capital Hitesh

Concept and Measurement:

Cost of Capital

Hitesh J.Shukla

The cost of capital is an integral part of investment and financing decision as it
The cost of capital is an integral part of investment and financing decision as it is used to measure
the worth of investment proposal. It has received considerable attention from both theorists and
practitioners. The concept of cost of capital is
investment evaluation, and financial performance
useful in determining optimal capital structure,
appraisal. It is a difficult decision that involves a
complex trade off among several considerations like income, risks, flexibility, control, timing and so
on. The rationale of this study is to understand the concept of cost of capital and measuring cost
of each component as well overall cost of capital
the concept better, researcher uses the example
of a business firm. To help one, in understanding
of ACC Limited, and analyse cost of capital for
a period of six years i.e. 2000-01 to 2005-06. With the help of necessary secondary data, drawn
from the annual reports of the firm. The CAPM based cost of equity for ACC was much lower than
the estimates according to the dividend growth
model. CAPM was theoretically superior to the
dividend-growth model. ACC’s market value weighted average cost of capital was found higher
than the book value weighted average cost of capital.

C ost of capital is a central concept in financial management, viewed as one of the corner stones in the theory of financial

management. It has received considerable attention from both theorists and practitioners. Cost of capital from the firm’s point of view, is the minimum required rate of return needed to justify the use of capital. It is the rate of return that a firm must pay to the fund suppliers, who have provided the capital. In other word, cost of capital is the weighted average cost of various sources of finance used by the firm. These sources are equity, preference, long-term debts and short-term permanent debt. The

concept of cost of capital is useful in determining optimal capital structure, investment evaluation, and financial performance appraisal. (Sudhindra Bhat, 2008) It is an important concept in formulating a firm’s capital structure. Capital structure, the part of financial structure that represents long-term sources, is generally defined to include only long term debt and total stockholder investment (Solomon, Ezra, 1963). To quote Bogen (1957) it may consist of single class of stock or several

issues may complicate it. The inherent financial stability of an enterprise and risk of insolvency to which it is exposed, primarily depends on the source of its funds as well as the type

Dr.Hitesh J.Shukla, Associate Professor, Department of Business Management, Saurashtra University, Rajkot-360 005,
Dr.Hitesh J.Shukla, Associate Professor,
Department
of
Business
Management,
Saurashtra
University,
Rajkot-360
005,
Email: hjshkula@rediffmail.com

SCMS Journal of Indian Management, July - September, 2008.

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of assets it holds and relative magnitude of such assets categories (Leopold 1974). To quote Ezra optimum leverage is the mix of debt and equity that maximizes market value of the firm and minimises the firm’s overall cost of capital. As observed by Van Horn (1996), in the optimum capital structure, the marginal real cost of each available financing is the same. To Guthmann and Dougall (1962), the capital structure balances the financing, so as to achieve the lowest average cost of long-term funds. A study of capital structure involves a study of the debt-equity mix with the object of lowering the overall cost of capital and with a view to maximizing the market value of the firm’s securities (Weston 1972). The theory of cost of capital is based on certain assumption. A basic assumption of traditional cost of capital analysis is that the firm’s business and financial risk are unaffected by the acceptance and financing of projects (Gitam 1997).

The rationale of this study is to understand the concept of cost of capital and measuring cost of each component as well overall cost of capital of a business firm. Understanding and measuring cost of different sources of fund can be studied from different perspectives but to remain focused, the study limits its scope to levered firm through ACC Ltd. for a period of six years starting from 2000-01 to 2005-06, with the help of necessary secondary data, drawn from the annual reports of the entity. Since the research is mostly based on the information collected from the annual reports of the sample unit, the limitations of the data are apprehended to be the limitations of the study. In unison it is believed that such type of limitations, if any, will not affect the validity and reliability of the study to a great extent.

The Sample

 

ACC is India’s foremost manufacturer of cement and concrete. It was incorporated in the year 1936. It came into existence consequent to ten existing cement companies belonging to four prominent business groups - Tatas, Khataus, Killick Nixon and F.E.Dinshaw groups joined under one umbrella in a historic merger. The company has been a trendsetter and important benchmark for the cement industry in respect of its production, marketing and personal management process. The company has 14 cement plants all over India, three refractory plants and 6 Ready Mix Concrete plants near to four metro cities of India. It has also extended its services overseas to the Middle East, Africa and South America, where it has provided technical and managerial consultancy to a variety of consumers, and also helps in the operation and maintenance of cement plants abroad. In September 2006, the company has changed its name from Associated Cement Companies Limited to ACC Limited.

Analysis

A

firm may obtain its capital through equity capital in two

ways, retention of earnings and issue of additional shares

to

the public. Cost of equity or the required returns by the

shareholders is the same in both the cases, since in both cases; the shareholders are providing funds to the firm to finance their investment proposals. The cost of retained earning involves opportunity cost (Khan and Jain 2007). A firm can raise capital even through debt to get benefits of leverage. Sample firm has raised its capital through equity as

 

Table 1: Capital

Structure – 2006

 
 

(mn Rs.)

 

Source of Capital

BV

 

BV Weights

MV

MV Weights

 

Share Capital

187.48

 

0.0462

16,754.85

0.8123

Reserves

2,955.16

 

0.7281

2,955.16

0.1433

Total Debt

915.98

 

0.2257

915.98

0.0444

Total Capital

4,058.62

 

1.0000

20,625.99

1.0000

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Table 2: Financial Indicators

 
 

ACC

EPS

DPS

Dividend

Pay-

 

Book

Market

ROCE

RONW

Div

 

Ltd

(Rs.)

(Rs.)

(%)

out

Value

Value

(%)

(%)

Yield

(%)

(Rs.)

(Rs.)

(%)

Dec-06

63.60

15.07

150.00

23.70

 

167.63

1,085.55

41.28

41.56

1.38

Dec-05

37.79

10.68

106.67

28.26

 

115.63

534.20

19.08

22.08

1.50

Mar-05

20.19

7.02

70.00

34.76

 

89.36

360.45

18.46

25.65

1.94

Mar-04

10.78

4.00

40.00

37.08

 

76.28

254.55

13.86

16.48

1.57

Mar-03

5.75

2.50

25.00

43.42

 

62.92

138.50

8.46

6.67

1.81

Mar-02

7.63

3.00

30.00

39.29

 

59.64

153.95

12.56

13.77

1.95

Mar-01

2.57

1.99

20.00

77.59

 

67.40

129.80

9.73

7.26

1.54

well debt. Table - 1 provides the details of capital structure of ACC during 2006. It leads to the conclusion that the unit has huge reserves and surplus in compare to its paid up capital that shows the internal financial strength of the unit. While looking to the market capitalization, paid up capital has the highest weight due to high market price.

 

yield of the sample has varied from 1.38 to 1.95 percent with an average yield of 1.67 percent. The researcher assumed that the current dividend yield of 1.38 percent was a fair approximation of ACC’s expected yield. To understand the estimation of growth rate, two methods can be used, one, internal growth: Where internal growth is the product of retention ratio and return on equity. It can be calculated as (Panda I M 2005);

g = Retention ratio x ROE

Table 2 provides data on ACC’s EPS, DPS, Payout Ratio, Market Value, Book Value, Dividend Yield, ROCE (percent), and RONW (percent) for the years March 2001 to December 2006. All the above variables move in upward direction during the period of the study. Since 2003 all the variables were doubling-up year-to-year it was a positive indication for the investors. The market capitalization (the market value of equity) of ACC in December 2006 was Rs.20,625.99 million. The market value of debt was assumed to be the book value.

Cost of equity can be calculated through dividend growth model (Panda I M 2005). The basic formula for calculation of equity is as;

This approach may be used when the firm has a stable dividend policy. ACC’s pay out ratio has fluctuated over years. However, on an average, it has distributed about 40.58 percent of its net profit and retained 59.42 percent in the past few years. In 2006, it retained about 76.30 percent of its profit. The company’s RONW in 2006 is 41.56 percent. Assuming that the current retention ratio of 76.30 percent and RONW will continue in future, then ACC’s dividend was expected to grow at 31.71 percent per year.

   

= 76.30 percent x 41.56 percent

 
 

Ke = (DIV 1 / Po) + g

 

= 31.71 percent = g

 

Here, term, DIV 1 / Po represents expected dividend yield and g represents expected (constant) growth in dividends. ACC’s dividend yield in 2006 was 1.38 percent. The dividend

 

The constant growth model has its limitations. It cannot be applicable to those companies that have highly unstable dividend policy (or retention ratio) and fluctuating ROE. In

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practice, to estimate ACC’s cost of equity may be relatively more reliable based exclusively on its own data.

 

calculation of the arithmetic average and the geometric average. The EPS growth in 2001 was calculated as; g 1 = (EPS00-EPS01) / EPS00. Growth for other years was calculated similarly. The arithmetic average growth for the period from (2001-06) was founded as follows (Panda I M 2005):

Past Average Growth

In practice, growth may be based on past EPS rather than DPS since companies do not change their DPS frequently with changes in EPS. Thus, DPS grows at a slower rate. The average of EPS past growth rates may be used as a proxy, for the future growth. There are two alternatives available for calculating the average (1) the Arithmetic Average and (2) Geometric Average would give a compounded average and is preferable when there is much variability in EPS data. Table 3 provides

Arithmetic average = g 1 + g 2 + …

+ g n

 

N

 

The geometric mean is calculated as follows:

 

Geometric mean = (1 + g 1 ) x (1 + g 2 ) x …… x (1 + g n ) 1/n – 1

Table 3: EPS Growth of ACC

 
   

ACC Ltd

EPS (Rs.)

 

gEPS

1+gEPS

 
 

06-Dec

63.60

 

0.6800

1.68

 

05-Dec

37.79

 

0.8717

1.87

 

05-Mar

20.19

 

0.8729

1.87

 

04-Mar

10.78

 

0.8747

1.87

 

03-Mar

05.75

 

-0.2464

0.75

 

02-Mar

07.63

 

1.9689

2.97

 

01-Mar

02.57

 

1.5700

2.57

 

AM

   

1.6880

 
 

Avg. Geometric Mean

     

1.98

 

Table 4: Estimate of Growth Rates and Cost of Equity

 
 

Method

 

Growth Rate

Cost of Equity

 

(%)

 

(%)

Arithmetic Avg.

168.80%

   

170.19%

Geometric Avg.

198.00%

   

199.39%

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Above data makes us clear that EPS of the sample w a s d o u b l i n g - u p y e a r -t o -y e a r. A r i t h m e t i c a v e r a g e of growth of EPS for the period was found 1.69 while average geometric mean of the same was found 1.98 for the unit for the period.

For different growth rates of ACC’s cost of equity was calculated in Table 4. It varies from 170.19 percent to 199.39 percent for the study period.

 

Cost of Equity through Capital Asset Pricing Model

CAPM model was developed by William F. Sharpe (1964). It explains the relationship between the required rate of return / the cost of equity capital and the non-diversifiable or relevant risk, of the firm as reflected in its index of non- diversifiable risk that is beta. A more objective alternative model for calculating cost of equity is the CAPM. The use of CAPM requires information like expected risk-free rate of return, expected risk premium and Beta of returns.

 

Table 5: Return Annually

 
 

Year

 

Return

December 2006

 

103.21%

December 2005

 

57.72%

December 2004

 

27.33%

December 2003

 

49.50%

December 2002

 

12.01%

December 2001

 

-5.48%

Above table provides annual returns of the sample unit for the study period. It varies from –5.48 percent to 103.21 percent. The risk free rate is generally approximated by the highly liquid government security. The yield on 91-day T- bills in India in December 2006 was about six percent. This rate could be used as a proxy of the risk-free rate. The market premium was excess of the expected market return over the expected risk-free rate of return. One could use the historical average over a very long period as a proxy for the market premium. There were no estimates of the market premium available in India. Researcher has used nine percent as the market premium for the calculations. Beta was 1.0353 for the sample unit. Table 5 shows ACC’s yearly return on market (Sensex) and ACC’s share prices.

ACC’s cost of equity = Risk free rate + (Market rate – Risk free rate)

 

The CAPM based cost of equity for ACC (15.3 percent) was much lower than the estimates according to the dividend growth model. CAPM is theoretically superior to the dividend-growth model. One could use 15.3 percent as ACC’s cost of equity.

ACC has both short-term and long-term debt in its capital structure. It has also short-term current liabilities that might be carrying some cost. As there was no bifurcation of the interest paid to whom and nothing was specification about the interest to be paid on each debt. So researcher has considered total debt and total interest for the calculation. Thus, researcher has assumed that the interest was paid to all type of debt of the company and the corporate tax was to be assumed at 35 percent. The after-tax weighted cost of ACC’s debt would be:

ACC’s Beta

= 0.0821 (1 – 0.35)

= 0.06 + (0.09 x 1.0353)

= 0.0534

= 0.1532 # 0.153 or 15.3 percent

= 5.34 percent approx.

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Researcher has estimated ACC’s cost of equity and cost of total debt. The cost of equity also includes the reserves and surplus. The composite cost of capital implies an average of the cost of each of the source of funds employed by the firm property, weighted by the proportion they hold in the firm’s

capital structure. As the weights are being assigned in two different forms i.e. book value of the company and the market value of the company, the weighted average cost of capital will be also calculated on two different weights – book value weights and market value weights, which could be calculated as under:

 

Table No. 6: Weighted Average Cost of Capital (Book Value and Market Value)

   
   

Source of

Cost of

 

BV W

 

MV W

WACC BV

WACC

 

Capital

Capital

 

MV

 

Equity

0.1532

 

0.7743

 

0.9556

 

0.1186

0.1464

 

Debt

0.0534

 

0.2257

 

0.0444

 

0.0121

0.0024

 

Total

   

1.0000

 

1.0000

 

0.1307

0.1488

           

13.07%

14.88%

Above table makes clear that the weighted average cost of capital was approximately 13.07 percent at the book value weight and 14.88 percent at the market

value weights. Its market value weighted average cost of capital was higher than the book value weighted average cost of capital.

Table No.7: Interest Coverage Ratio and Interest to Sales Ratio

 
 

Year

Net Sales

Interest

 

Interest to

Interest

 

Sales Ratio

Cover Ratio

200612

5660.34

75.19

 

1.33

20.21

200512

3160.18

66.19

 

2.09

6.92

200503

3887.40

96.32

 

2.48

5.61

200403

3274.61

112.17

 

3.43

3.26

200303

2853.56

 

134.29

4.71

1.59

200203

2827.91

146.71

 

5.19

2.28

200103

2576.37

170.18

 

6.61

1.52

Above table shows the two different financial aspects interest to sales ratio and interest coverage ratio. The interest to sales ratio was highest in the year 2001 at 6.61 whereas it was declining year after year to 1.33 for the year 2006 that

show the decrease in interest paid by the company or in other words increases in sales of the company. On the other side, the interest coverage ratio of the company was showing volatile trend over the years but it has shown much

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higher growth in last year to 20.21 highest of all in comparison to 1.52 in the year 2001.

Conclusion

Financing decision is a difficult decision that involves a complex trade off among several considerations like income, risk, flexibility, control, timing and so on. Considering the objective of maximising market value, the empirical evidence from the above study suggests that debt financing enhance value. One should remember that the cost of equity is also impacted by the debt equity ratio. Typically equity investors demand a significantly higher return where leverage is higher. Hence the impact of using a higher leverage in the WACC many not be as pronounced as what the relative difference in cost of debt and cost of equity may imply. While examine risk for Investor, a distinction is made between systemic risk and unsystematic risk. The CAPM based cost of equity for ACC was much lower than the estimates according to the dividend growth model. CAPM is theoretically superior to the dividend-growth model. ACC’s market value weighted average cost of capital was found higher than the book value weighted average cost of capital.

Keywords

Non-Diversified risk, Risk-free return, Market premium, Interest coverage.

References

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Gitman, L.J. “Principles of Managerial Finance.” Harper and Row, New York (1997): 33.

Guthmann and Dougall. “Corporate Financial Policy.” New Jersey: Prentic Hall, (1962): 234.

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2007.

Leopold, A.B. “Financial Statement Analysis.” Home Wood, Illinois, (1974): 428.

Panda, I.M. “Financial Management.” 9 th Edition, Vikas Publishing House Pvt. Ltd. 2005.

Solomon, Egra. “The Theory of Financial Management.” University Press, (1963):42.

Sudhindra Bhat. “Financial Management.” Excel Book, 2008.

Van Horn, J.C. and Wachowicz, J.M. “Fundamentals of Financial Management.” New Delhi: PHI (1996): 434.

Weston and Brigham. “Managerial Finance.” New York:

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