Competition and Policies towards

Chapter
Monopolies and Oligopolies, Privatization
7 and Regulation

COMPETITION

The study of markets in which firms operate enhances our knowledge of competition as a dynamic process.
Understanding how the competitive process works when firms are price takers, will also contribute to our understanding
of the process as it applies to many price searchers.

Competition as a dynamic process means, rivalry or competitiveness between or among parties (for example, producers
or input suppliers) to deliver a better deal to buyers in terms of equality, price and product information.

PRICE TAKERS

In price-takers market, the firms all produce identical products (e.g., eggs, rice or regular unleaded gasoline) and each
seller is small relative to the total market. Price takers can sell all their output at the market price, but cannot sell any of
their output at a higher price. When a firm is a price taker, there is no pricing decision to be made.

Price takers try to choose the output level that will maximize profit, given their costs and the price determined by the
market. They cannot thrive or even survive in a competitive environment unless they are sensitive to cost. To compete,
each firm has to provide a high level of delivered benefits per peso, compared with what consumers can find elsewhere.

In the real world, most firms are not price takers. In most cases firms that lower their prices are able to attract additional
customers. Correspondingly, firms are usually able to increase their prices, at least a little, without losing all their
customers.

PRICE SEARCHERS

These are firms that face a downward-sloping demand for their product. This means that, the amount the firms are able
to sell is inversely related to the price they charge. To maximize their profits, price searchers must not only decide how
much to produce, but also what price to charge.

Historically, the term pure competition refers to a market structure characterized by a large number of small firms
producing an identical product in an industry (market area) that permits complete freedom of entry and exit. These
markets are increasingly referred to as “price-takers market.”

SIGNIFICANCE OF COMPETITION

Competition motivates business to produce efficiently, cater to the views of consumers and search for innovative
improvements.

The price-taker model highlights the importance of the competitive process. Competition puts pressure on producers to
operate efficiently and use resources wisely. Each competing firm will have a strong incentive to produce its products as
economically as possible. holding quality constant, lower costs will mean more profit. Therefore, pursuit of profit will
encourage each firm to maximize its cost of production – to use the set of resources least valued in other uses to
produce the desired output. Firms that fail to keep costs low will be driven from the market.

Similarly, a firm in competitive markets has a strong incentive to discover and produce goods and services that
consumer’s value highly relative cost. Thus, resources will be drawn to those uses where they are most productive, as
judged by the consumers’ willingness to pay. The ability of firms freely to expand or contract their business and enter or
exit markets means that, resources will not be trapped unproductively in a particular industry when they are valued
more highly elsewhere.

If firms are going to be successful in competitive markets, they must also be innovative and forward looking. The
production techniques and product offerings that lead to success today will not necessarily pass the competitive market
test tomorrow. Producers who survive in a competitive environment cannot become complacent. One on the contrary,
they must be willing to experiment and quick to adopt improved methods.

In competitive markets, business firms must serve the interests of consumers. As Adam Smith noted more than 200
years ago, competition harnesses personal self-interest and channels it into activities that enhance our living standards.
Smith stated:

“It is not from the benevolence of the butcher, the brewer, or the baker,
that we expect our dinner, but from their regard to their own self-interest.
We address ourselves, not to their humanity but to their self-love,
and never talk to them of our own necessities, but of their advantages.”

Sellers, of course, profit when they supply products valued more highly than the resources needed to make them. But
their actions also help the rest of us get more value from those resources than we would otherwise. Paradoxical as it
may seem, personal self-interest (a characteristic many view as less than admirable) is a powerful source of economic
progress of economic progress when it is directed by the competitive market process.

INCOME INEQUALITY AND POVERTY

Computation of cost of capital is very important part of the financial management to decide the capital structure of the
business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. according to net present value method,
present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to
capital budgeting decision.

Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long terms securities. A firm uses particular type of
sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.

Importance to Evolution to Financial Performance

Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the
firm. Hence, it helps to evaluate the financial performance of the firm.

Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning
capacity of securities etc. hence, it plays a major part in the financial management.

COMPUTATION OF COST CAPITAL

It refers to the cost of each specific sources of finance like:

 Cost of equity
  Cost of debt
 Cost of preference share
 Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share
value.

Conceptually, the cost of equity capital (K e ) defined as the “Minimum rate of return that a firm must earn on
the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:

 Dividend price (D/P) approach

 Dividend price plus growth (D/P + g) approach
 Earning price (E/P) approach
 Realized yield approach.

Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain the present market price of
equity shares.

Dividend price approach can be measured with the help of the following formula:

D
Ke = +g
Np

Where,

K e = Cost of equity capital

D = Dividend per equity share

𝑁𝑝 = Net proceeds of an equity share

Example

A company issues 10,000 equity shares of 100 pesos each at a premium of 10%. The company has been paying
25% dividend to equity shareholders for the past five years and expects to maintain the same in the future also.
Compute the cost of equity capital. Will it make any difference if the market price of equity share is 175 pesos?

Solution
D
Ke = N
p

25
= 100 x 100

=22.72%

If the market price of an equity share is 175 pesos.

 D
Ke =
Np

25
= 175 x 100

= 14.28%

Dividend Price Plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be
measured with the help of the following formula:

D
Ke = N + g
p

Where,

K e = Cost of equity shares

D = Dividend per equity shares

g = Growth in expected dividend

Np = Net proceeds of an equity share

Example
(a) A company plans to issue 10000 new shares of 100 pesos each at a par. The floatation costs are expected to be 4% of
the share price. The company pays a dividend of 12 pesos per share initially and growth in dividends is expected to be
5%. Compute the cost of new issue of equity shares.

(b) If the current market price of an equity share is 120 pesos. Calculate the cost of existing equity share capital.

Solution

(a)
D
Ke = N + g
p

12
K e = 100−4 + 5 = 17.5 %

(b)
D
Ke = N + g
p
 12
K e = 120 + 5 = 5%

Example

The current market price of the shares of ABC company is 95 pesos. The floatation costs are 5 pesos per share amounts
to 4.50 pesos and is expected to grow at a rate of 7%. You are required to calculate the cost of equity share capital.

Solution

Market price = 95 pesos

Dividend = 4.50 pesos

Growth = 7%
D
Ke = N + g
p

4.50
Ke = x 100 + 7%
95

= 4.73 % + 7% = 11.73%

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earning prospects of the
equity. The formula for calculating the cost of equity according to this approach is as follows.
E
Ke =
Np

Where,

K e = Cost of equity capital

E = Earning per Share

Np = Net proceeds of an equity share

Example

A firm is considering an expenditure of 750,000 pesos for expanding its operations. The relevant information is
as follows:

Number of existing equity shares = 1,000,000 pesos

Market value of existing share = 100 pesos

Net earnings = 10,000,000 pesos

Compute the cost of existing equity share capital and of new equity capital assuming the new shares will be
issued at a price of 92 pesos per share and the costs of new issue will be 2 pesos per share.

Solution:
Cost of existing equity share capital:
E
Ke = N
p

10,000,000
Earnings Per Share (EPS) Ke = 1,000,000
= 10 pesos

10
K e = 100 x 10

= 10%

Cost of Equity Capital

E
Ke = N
p

10
K e = 92−2 x 100

= 11.11%

Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this method, cost of equity is calculated
on the basis of return actually realized by the investor in a company on their equity capital.

𝐾𝑒 =PVf x D

Where,

𝐾𝑒 = cost of equity capital

PV f= present value of discount factor.

D= Dividend per share

Cost of Debt

Cost of debt is the after tax cost of long term funds through borrowing. Debt may be issued at par, at premium or at a
discount and also it may be perpetual or redeemable.

Debt Issued at Par

Debt issued at par means, Debt is issued at the face value of the debt. It may be calculated with the help of the following
formula.

𝐾𝑑 = ( 1 – t) R

Where,

𝐾𝑑 = cost of debt capital

t =Tax rate

R= Debenture interest rate

Debt Issued at Premium or Discount

If the debt is issued at premium or discount , the cost of debt is calculated with the help of the following formula.
𝐼
𝐾𝑑 = 𝑁𝑝 ( 1 – t)

Where,

𝐾𝑑 = cost of debt capital

I = Annual interest payable

Np = Net proceeds of debenture

t = tax rate

Example

An ABC Issues Php 100,000, 8% debentures at par. The tax rate applicable to the company is 50% . Compute the cost of
debt capital.

Solution
𝐼
𝐾𝑑𝑎 = 𝑁 ( 1 -t )
𝑝

8,000
= x (1 – 0.5)
100,000

8,000
= x 0.5
100,000

= 4%

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different form other sources like debt,
equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscribed issue of
additional shares, which is measured by the cost of equity capital. Cost of retained earnings can be calculated with the
help of the following formula:

𝐾𝑟 = 𝐾𝑒 (1 – t) (1 – b)

Where,
𝐾𝑟 = Cost of retained earnings

𝐾𝑒 = Cost of Equity

t = Tax rate

b = Brokerage cost
Example

A firms 𝐾𝑒 (return available to shareholders) is 10%, the average tax rate of shareholders is 30% and it is expected that
2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is
the cost of retained earnings?

Solution:

Cost of Retained Earnings, 𝐾𝑟 = 𝐾𝑒 (1 – t) (1 – b)

Where,

𝐾𝑒 = rate of return available to shareholders

t= tax rate

b= brokerage cost

So, 𝐾𝑟 = 10% (1 – 0.5) (1 – 0.02)

=10% x 0.5 x 0.98

= 4.9%

Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted average cost of capital is the
expected average future cost of funds over the long run found by weighting the cost each specific type of capital by its
proportion in the firm’s capital structure.

The composition of the overall cost of capital (𝐾𝑜 ) involves the following steps.

(a) Assigning weights to specific cost.

(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula;
𝐾𝑜 = 𝐾𝑑 𝑊𝑒 + 𝐾𝑝 𝑊𝑝 + 𝐾𝑒 𝑊𝑒 +𝐾𝑟 𝑊𝑟

Where,