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Computing the Cost of Capital for the company A case study by S.A. Murali Prasad

The basic tool for determination of the Cost of financing is the Cost of Capital. The Cost of capital is determined as a mix of Cost of Equity and Cost of Debt, which is the Weighted Average Cost of Capital. This study on WACC was conducted for Auto Anc.Ltd. by a consulting firm. Auto Anc Limited is a family owned professionally managed company whose shares are quoted in the Mumbai Stock Exchange. Cost of Debt: Interest rate of Borrowing 9.5% Tax Shield 33.7% Cost of debt (Post tax) 6.3% Formulae: Interest rate of borrowing * (1-t)

Cost of Equity: The factors involved in computation of Cost of Equity are Risk free rate of return, the relative risk of the undertaking (beta) and the risk premium. There are two well-known methods to determine the relative risk of the undertaking. First, measuring the price movement of the share in question vis--vis the movement of the stock market index, known as beta. Secondly, Using parameters such as operating leverage, financial leverage, contribution volatility etc, known as fundamental beta. Cost of Equity Risk free rate of return + Beta * Risk Premium The Risk free rate of return was taken as the Yield on a 10-year maturity GOI Bonds viz 7.40% The Risk Premium data was collected from a secondary source, a study for the period 19912004 which gives the following figures. Risk Premium BSE Sensex 9.70% BSE 100 11.30%

Beta is calculated in a different way for listed companies and unlisted companies. For listed companies beta is computed based on the share price and market index movement over the period and for unlisted companies, the surrogate measure that is other parameters have been used. If the volatility of any company is more relative to index, then it indicates higher risk and therefore higher beta. If the company is almost as volatile as the index then it indicates that risk is in line with the index and the beta would be closer to 1. Cost of Equity of Auto anc. Ltd Risk free rate + Beta * Risk Premium 7.4% + 1.044*11.3% = 19.20% Fundamental beta for computing cost of capital is preferred for the following reasons y It is a more Conservative Measure y Volumes traded are thin and hence market based data are not totally reliable. Weighted Average Cost of Capital (WACC): Cost of Equity * Proportion of Equity in Capital Employed + Cost of debt * Proportion of Debt in Capital Employed

Auto Anc. Ltds WACC: (19.2%*94%) + (6.3%*6%) = 18.42% The WACC tends to be higher for companies whose debt factor is very low. This can also be stated as loss of Tax shield. As per Auto Ancs Finance policy, a debt up to 30% must be used. Therefore, when 30% debt is factored, WACC Changes. WACC Auto Anc @ 30% Leverage : (19.2% x 0.70) + (6.3% X 0.30) = 15.33% Comparing Cost of equity using Fundamental Beta: Drivers: The following drivers were identified. y y y Financial Leverage (FL) Operating Leverage (OL) Contribution Volatility (CV) 1. Dividend Pay out Ratio 2. Earnings Variability 3. Size 4. Earnings Growth 5. Current Asset / Current Liability

Only FL, OL and CV were found to have statistical significance and hence used to determine Fundamental Beta Based on a cross section of 110 listed companies, using a regression tool, a relationship was established between Beta, Financial Leverage (FL), Contribution% Volatility (CV) and Operating Leverage (OL)

E 0.7048


F1 F2 0.3479 3.773 Parameters FL CV 22% 2.0%

F3 0.617 OL 35%

Beta = E + F1 X FL + F2 X CV + F3 X OL Beta= 0.705 + 0.348 X FL + 3.77 X CV +0.617 X OL

Definitions: Equity

Share Capital, Reserves & Deferred Tax Liability Short & Long term borrowing Equity + Debt Debt / Capital Employed Fixed Cost* / Total Cost Contribution % Variation over the last five years.

Debt Capital Employed Financial Leverage (FL) Operating Leverage (OL) Contribution Volatility (CV)

WACC Beta (F)

Weighted average Cost of Capital Measure of Risk