410 Financial Management Unit - IV Long Term Capital Managemen, — Cost of Capital — Basic concepts — Rational and assumptions ~ Cost of equity capital — Cost of debt — Cost of preference — Cost of retained earnings Cost of | Capital 1 u ut ate “Cost of Capital’. Explain its signifi financial decision making, f ™ ty stnengs S.C, Kuchhal points o1 concept in formulating a fi cornerstones of the theory of has received considerable titioners. Two major sch basic difference on the r optimal policy is taken a company,Long Term Capital Management 411 isk is involved, the minimum rate of return is higher. The cost of js clearly related to the break-even point, which relates to operat- wi capital ; ses ts, while the optimum cost of capital is the financial break-even ing cos! point. According to some authors, the cost of capital is a concept which should be expressed in quantitative terms, if it is to be useful. It is a technical term which can be defined in one of the following several ways: (a) The minimum required ROI for proposals for using capital funds; (b) The cuts-off rate for capital expenses; (co) The target ROI which must be serviced if the capital used is to be justified; (d)_ The financial standard. ‘The firm has many investment projects undertaken by it. There- fore, the firm’s cost of capital will be overall, or average, required rate of return on the aggregate of the investment projects. ‘Thus the firm’s cost of capital is not the same thing as the project’s cost of capital. The firm’s cost of capital can be used for discounting the cash flows of those investment projects which have risk equivalent to the average risk of the firm. As a first step, however, the firm's cost of capital can be used as a standard for { required rates of return of the individual inys firm’s cost of capital can be used as a standare required rates of return of the individual i firm’s cost of capital can be adjusted up account for differential riskness of inves! There are different opinions as to the ¥ capital can be measured. Irrespective of the mel is computed, it should be noted that it is a. con the financial decision-making. G investment decisions, designing th financial performance of top The object of measuring the standard for evaluating the invest412 Financial Management is accepted if it has an internal rate of return greater than the, of capital Thus, the cost of capitalisthe minimum required rater on the investment project. It is also known as the cutoff, or the Large, op the hurdle, rate. In case a project provides a positive NPV when its cash flows i discounted by the cost of capital makes a net contribution to the weak, of shareholders. In case the project has zero NPV, it means that its flows have yielded a return just equal to the cost of capital and the acceptance or rejection of the project will not affect the wealth of shareholders. The cost of capital is the minimum required rate of retury on the investment project that kceps the present wealth of shareholders unchanged. It may be thus noted that the cost of capital represents 4 financial standard for allocating the firm’s funds, supplied by: owners and creditors, to the various investment projects in the most efficient manner, Among other things, the cost of capital significantly influence and determine the debt policy of a company. While preparing the financing policy, that is, the proportion of debt and equity in the capital structure, the firm aims at minimising the overall cost of capital. The cost of capital helps to decide point of time. For example, costs may be leasing and borrowing. Of course, control and risk. It also helps to evaluate ment. Such an evaluation profitabilities of the investment incurred by management in It facilitates the manag in current assets. Examine the different Cost of equity. Cost of equity share capital The cost of equity capi e firm’s equityLong Term Capital Management 413 1 of equity ranging from simple to complex ones, In computing than ‘one method may be used to provide a reasonable practice he firm's cost of capital. ; esti ile computing the cost of equity, no adjustment for taxes is ae dividends are paid out of profits after taxes. requ 28. si act are () Historical Rate of Return The cost of equity capital is known as historical rate of ret is applied by calculating the rate of return earned by a sharehol isassymed to have purchased the share some time in the past, the present, and sold it at current market prices. In this, method the cost of capital is not relevant for future dec when situations may change. This method can be used for future cost of capital with the following assumptions: (2) No significant change in the firm’s future performani (>) There will not be changes in the level of interest rates (©) The investors attitude towards risk does not change. However, these conditions are superfluous,414 Financial Management (ii) Earnings/Price Ratio This ratio is calculated by dividing earnings per share by the Average price per share, Thus, the cost of eq JMity (Ke) is measured by: Ke = E/P where, P = Current Illustration E = Earnings Per share market price per share. The share capital of a company is represented by 20,000 shares of Rs. 10 each, fully paid. The current market Drice of the share is Rs. 29, Earnings available to the Shareholders amount to Rs, 60,000 at the eng of a period, Calculate the cost of equity share capital using earn. ings/price Tatio. Earnings per share (EPs) = oe = Rs.3 Current market Price of share = Rs. 20 E ity capital = Earnings per share Aghos Cost of equity capital = ent market price rem j Rs.3 § ~ Rs.29 * 100 = 15%, The carnin, assumes that: gS/price ratio of measurement of Ost Of equity capital F ae ws Sara (1) market Price of shares is influence. carnings of the firm; (2) future e: ata constant rate. The E/P ratio matches two Unrelated factor, historical Xperience (EPS) with a Price (P) that jg investors? Perception of the Prese; ‘nt value of the fy (iii) Dividend Growth Model ___ Inthis Model, cost of equity is ¢ dividend 8rowth rate, Symbolically, Ke= Dp + g arnings which can be expressed he divident y,Long Term Capital Management 415 = dividend per share at the end of a period; where at market price, and P= ffowthratein dividend. a the dividend: growth model reflects a market val ) ing the cost of equity capital. The basic logic of this method is that the market price of a share equals the cash flow of expected future incomes, both dividends and market price dtotheir present value. A simplifying, assumption appreciation, discounted js made that incomes will grow at a constant compound rate. ording to Banerjee, Acc! 1S ue approach to determini Illustration If the rate growthrate in dividend are given 20% given in the previous illustration, the cost of equity puted as follows: Dividend per share: 20% of Rs. 10 = Rs.2 of current dividend to equity shareholders and the and 5% respectively, using the data capital can be com- Market price of share: Rs. 20 Growth rate in dividend: 5% p.a. Ke = De-+ g= 45 + 05 = 150715% For entities in which dividend flow is relat may be used reliably. In many enterprises the gro not remain constant over time for obvious reason. of ‘g’ becomes difficult in such cases. However, il the past trend in earnings per share will contint aper cent may be used as the dividend growth ra this alternative approach to determination of val rate in earnings and that in dividends may not Dt (iv) Earnings Growth Model This model replaces dividend by ca by the equation: Ke=EP +g where, E = earnings per share P = current market price of shares, and & = growth rate in earnings.416 Financial Management Ifthe growth rate in carningsis given to be 10%, p.a. and the. as used in method two are taken into account, the cost equity wood pe a, Ke = 3/20 + 1 = 25 or 25% Walker feels that this earnings model is preferable to the diy, model because the “growth of dividends would be extremely dite not impossible - to calculate” because of many variables, such as tax; gencral economic conditions, earnings, share-holders Teaction ete, The Principal reason for recommending the earnings model is “4 o capital’s primary Purpose is to serve as a minimum criterion for invest, ment decisions; and since carnings is the goal, we should approach the. Problem directly; that is, use the earnings model, Cost of Preferred Capital How is the cost of Preferred Capital and Debt Capital computea? The cost per share of preferred stock may divided ided into Proceeds received from its sale and the dividends paid to its 0 The cost of preferred stock is given with the help of formula: a 43, vd D :. Ke =e i where, Kp is the cost Per share of preferred stock Dis the beginning dividend P, is the net proceeds from the sale of preferred A company issues without a maturity date, 6.5 per cent preference a Cost of preference capital = 6.5/139 = 005 When there preferred stock i are different types of pl is derived with the help of the Di 2 Diicaae FoF an tae + ; ° +k) (1+ ky? (+k? where Po is the net amount of funds received in the peri Dt is the dividend paid in Period t2 Long Term Capital Management 417 jg the market discount factor appropriate for the risk associated with x particular company involved. Cost of Debt Capital The cost of debt capital may be derived by using a formula that equates the present value of the expected future receipts with the cost of the project. It is the interest rate which equates the present value of the ro} , ° expected future receipts with the cost of the project. The present value oftax-adjusted interest costs plus repayments of the principal is equated with the amount received at the time the loan is consummated. ACOs Ce = any A+ W' where Clo is the net amount received from the lender COr is the tax-adjusted sum of interest costs plus the repayment of the rincipal kis the market discount factor, Exhibit A firm negotiates a term debt unt (1) Interest rate is 10 per cents (2) The principal of Rs. 5,000% from 1975 onwards. ‘ (3) The tax rate is 65%. Year Repayment Tax-Adjusted Total Principal Interest Cash Flows ea ee es418. Financial Management - is between 2 per cent ci it the rate of interest is be 2p a t Mra ea secericed by interpolation. This is 3.5 pe, oat cent, The cost of debt, therefore, is 3.5 per cent. : charge (Nate: To eX O-TR) X Interest rate = 5,000 X (1-0.65) x 10 = 175 (for 1975) 4,000 X (1-65) x.10 = 140 (for 1976) 3,000 X (1-65) X.10 = 105 (for 197) 2,000 X (1-.65) x.10 = 70 (for 1978) 1,000 x (1-.65) x.10 = 35 (for 1979) In most cases, the cost of debt can be calculated in a simp! The cost is simply the interest rate adjusted by the tax rate and with the help of the following formula: [c+ | (1=TR) ier nares i where 2 Kt is the cost of debt capital Cis the annual interest Pis the par value Mis the price of debentures Nis the number of Years to maturity TR is the amount of the shareholders’ tax rate.Long Term Capital Management 419 Before accepting or rejecting a capital ¢: i ject, i eS : xpenditure project, its ‘oftability should be compared with the specific source lit ibtds used fo finance the project. ‘The main purposes of computing overall cost of capital is to use shi rate as the decision criterion in capital budgeting or investment decisions. In general, it may be stated that this cost of capital is usually taken to be the cut-off rate for determining the profitability of proposed -ojects- There are a number of justifications for using overall or weighted average cost in investment decisions. First, by accepting projects yielding more than the weighted average cost, the firm is able to increase the market price of its shares. Secondly, it recognises the fact that most investment proposals are not financed solely from one source put from some combination of various sources. ‘Thirdly, as a standard or cut-off rate, the overall cost of capital rate in such a case provides abasis for comparison among projects. But if specific costs are taken for dif- ferent projects as the costs of financing, true comparison is not possible and also decision cannot be taken on a consistent basis. Selection of specific costs for the purpose will mean use of shifting standards from time to time. This point will be clear from the graph that shows the relationship between specific costs and average cost of capital of a firm. Fourthly, use of weighted average cost of capital resultsin \dget- ing or investment decisions that tend to be opti 3 COST OF CAPITALIx420 Financial Management The following steps are used to calculate the weighted erage of capital: ific sources of funds (; . To calculate the cost of the speci : Ge, k eat cost of equity, cost of preference capital etc,), ” C08 og 2. To multiply the cost of each sources by its Proportion in the structure. abit Toadd the weighted costs of all sources of funds to get the weiohyay cost of capital. 4 the cost of capital should be cal, | , the component costs to be used ty should be the after-tax costs, t of capital is shown below:) Tn financial decision-making, lated on an after-tax basis. Therefore, measure the weighted cost of capital computation of weighted average cos! YY " Mlustration WY The following is the capital structure of a firm: Source of finance al Equity share capital Retained €arnings (Reserves) Preference share capital Debt The firm’s after- finance are as follows: Source Cost Equity Capital “14%, Retained earnings B Preference capital 10 Debt : 45 The weigh: follows:Long Term Capital Management 421 Computation of Weighted Average Cost of Capital Source Amt. Proportion After-tax Weighted cost cost @ Q) (3) (4) (5) = @)x(4) i it 30% ity capital Rs.900,000 45% 14% 6.30% PEE carnings 300,000 15% B% 1.95% Pre. capital 200,000 10% 10% - 1.00% Debt 600,000. 30% 4.5% 1.35% Weighted Average Cost of Capital 10.60% The weighted average cost of capital of the firm can also be calculated as follows: Computation of Weighted Average Cost of Capital (alternative method) sn dancentame sera puis Source Amount After-tax _After-tax cost (Rate) cost (Amount) ) Q @ = @x8) EEE Equity capital 900,000 14% Retained earnings 300,000. 13% Pre, capital 200,000 10% Debt 4.5% Rationale for after-tax weighted average Cost of The weighted average cost of capital can] or after-tax. However, the measurement of ‘after-tax’ basis is more appropriate because of | @ Generally, the average cost of capital is the specific costs of capital. Cost of eq are generally computed after-tax where be computed before or after-tax, The: these specific sources into an overall ©422 Financial Management fter-tax basis is adopted in order to bring in uniformity a after- sis ti various components of cost of capital. Hf ose of measuring the cost of capital ig its (2) ee eee or in investment decisions where Cost of capita taken as the cut-off rate or the discounting rate, in the former the yield to shareholders is the relevant figure. It is needless oll mention that dividend is paid only out of after-tax profits, fore, it is better that the cost of capital is computed On after, basis. Further, for discounting cash flows cost of capitalis Benerally used. Since net cash flows are ascertained after deducting tay liability, it is suggested to compute the overall cost of capital onl after-tax basis, Importance of Cost of Capital in Decision Making The cost of capital is a very important concept in fin (management) decision making, Though, it is a recent d has relevance in almost every financial decision making but p1 development, the problem was ignored or by-passed. A ment always takes notice of the cost of capital while tz decision. The concept is quite relevant in the follo decisions:. 1. Capital Budgeting Decision Cost of capital to disi of Return method, I) budgeting, the Cost the proposals. count the future cash inflows, Uj RR is compared with the Cost of e of capital Provides the criterion of 2. It helps to design the Corporate Financia} Struc The cost of cap} 1 ital plays an j capital structure. The cost, a aeLong Term Capital Management 423 capital structure. A financial manager examines the capital market fluc- tuations and tries to achieve the sound and economical capital structure for the firm. Generally, the objective of financial management is to maximise the shareholders’ wealth, the financial excentive logically fol- Jows that he should try to substitude 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. It helps to decide the method of Financing A financial manager must the fluctuations in the capital market and should analyse the rate of interest on loans and normal dividend rates in the market from timé to time. As and when a firm wants toraise additional finance, he may have a better choice of the source of finance which bears the minimum cost of capital. Thus, cost of capital is examines akcy factor in making decisions, and cqually important are the considerations of retaining control and of avoiding risk. 4. The results of the Top Management Generally, the cost of capital examines the financial of the top executives. Evaluation of the financial performance’ acomparison of actual profitabilities of the projects undertaken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the required funds. f SEALS eh: BU 5. Other Areas The cost of capital is also used making, such as dividend decisions, wor) Various Relevant Costs The following costs are consid associated with the problem of cost of c (1) Marginal cost of Capital The existing rate of interest on lon} return is treated as the marginal cost o! new or incremental funds raised by th as more important in capital budge! increase proportionately as the amour a:424 Financial Management nd Implicit Cost (2) Explicit Costa iledual tc hat counee eam “The explicit co Fare incremental to the taking of the Fev of the cash inflows ee atl incremental cash outfloyy, ¢S opportunity with the Ei om a particular source, there is a serieg Whey a company raises fun e inflow to the extent of amount raiseq , % foe etarting WA of outflows equal (0 the aniCoaehel interea followed by 2 serics ai ‘payment of principal. Suppose, a coms.” eigen pe ia 0% rawentaes for Rs.5,00,000, the cash j ba ope finds by, ee f issue followed by an annual cash willbe Rs. 5,00,000 in the year o hel Outfoy | of Rs. 5,00,000 cach year and Rs. 5,00,000 ee ast Year When the principal amount of debt is due for a ¢ rate to return ¢ equates the present value of cash inflows wit! he present value of, outflows is the explicit cost, Therefore, the explicit cost of a debt be zero, if it is free of interest. The explicit cost of gift or windfall y minus 100 per cent as no cash outflow would take place. This meth 0 beextended to retained earning and to explicit cost maybe taken 100 per cent as nothing is to be paid by way of dividend or carnings. The implicit cost refers to the opportunity cost, of return’ associated with the best investment opportunity and its sharcholders that will be foregone if the Project consideration by the firm were accepted. It is not Particular source of finance. The explicit cost considers only the cost of capita ignores the other factors such as risks involved, fl characteristics Which are adversely affected with 3. Future Cost and Historical Cost The future costs ar i isi i and the financial deciie Ee ‘i ae sider the Projects, expecter the expected (future) cost decision, Similarly, time of designing aLong Term Capital Management 425 cost) cannot be minimised. Historical costs are used to forecast the future costs and provide an cvaluation of the past performance when compared with standard costs. (4) Specific Cost and Inclusive or Combined or Composite Cost of Capital Specific cost of capital is generally concerned with a specific component of capital structure (c.g. debentures, perference shares etc). In decision making exercise the management takes a decision weighing the profitability rate of each project on the basis of cost of capital of the specific source of funds used in financing the particular projects. When rofitability rate is higher than the cost of capital, the project may be accepted. The higher the profitability rate, the greater is the chance for its approval. Inclusive cost or combined or composite cost of capital is an egate of the cost or capital from all sources i.c., Debt, equity and preference capital. In other words, it is weighted cost of capital. This is relevant in capital expenditure decisions as an acceptance criterion. It is the overall mix of financing over time which is important in valuing firm Ese as an ongoing overall entity. @10B = (5) Spot Costs and Normalised ~ Costs a Spot costs refers to such cost, prevailing in the market at a certain time. This cost is considered in financing decisions involving altcrnative appraisal. Normalised costs indicate an estimate of cost by some ing process from which cyclical element is removed. Th used in taking investment decisions. sates Retained Earnings diyidend on retained earnings. Therefort cost free source of finance but it is no opportunity cost which can be computet retained earnings in a company is the forgoes by not putting his funds elsewhi opportunity cost figure to determine the of retained earnings to the shareholder can get by investing the after tax divi Opportunities. 7426 Financial Management fe! fits that are not disty; rnings refer to pro! istri Re Sharcholders s dividend and have been Tetaj company to d for future expansion. They are re to be use Presenteal aauited or frec reserves and surplus. The company jg sipidends on retained earnings. It is, therefore, observed th, Sas is cost free. But this view 1s not oe Retaj is rtunity cost, The opportunity cost o retained lin ea eiee Totegead by the shareholders by not Putting fin where. ; From sharcholder’s point of view, the Opportunity cost ofr earnings is the rate of return that they can obtain by pi dividend in the other securities of equal qualities, if earnings ar, them as dividend in cash, An individual pays income tax on gi hence he would only be able invest the amount remained after individual income tax on such earnings. This can be expressed following equation:- i AS Ke = Ke (1- tp) (1-B) Here K- = Cost of retained earnings Ke = Required rate of return to shareholders tp = Personal tax rate B = Brokerage on purchase of securities Suppose, a firm keeps Rs. 50,000 out of its c1 rer excepted rate of return to the shareholders, if they hadi elsewhere, is 10%. The brokerage is 2% and the 30% tax bracket. The cost or retained earnings may K; = Ke (1- tp) (1-B) = .10 (1 - 30) (1-.02) = .10 (,70) (,98) = .0686 or 6.85% Tt will be less than the shareholders reaniced I a : Generally, the cost of retained i capital on equity shares (i.e K, = Ke) if the shareho ancome tax on dividends, and inc} dividend received. ieLong Term Capital Management 427 The problem in estimating the cost of retained earnings is that the ersonal rates of taxation cannot be determined with certainty as they are in different tax brackets. To overcome this difficulty a weighted average tax rate is suggested, but it is also not an casy task. According to Mr. Solomon, there is yet another approach for valuing the cost of retained earnings known as ‘external yield criterion’. Itis based on the notion that the firm should evaluate external investment opportunities as a possible use of retained earnings. The yield presented py the best external opportunity would be used as the opportunity cost of the retained earnings. According to some financial experts, that there is no need for adjusting the market capitalisation rate for shareholder's tax liability and thereby suggest that the cost of retained earnings in the same a8 the market rate of capitalisation for the equity share. According to them, the cost of retained earnings is the opportunity cost to the company and not to the shareholders. However, in reality, when the overall rate of return is determined by using the market value of equity shares, there is no need for calculating separate cost of retained earnings because both the weighing factors and the rate of return are embodied in market value. | Capital Assets Pricing Model (CAPM) |438 Financial Management cl f 10% per annum, It j, in si es of similar type carrying return o! 5 Be eae that the shareholders will have to incur 2% of the net hem as brokerage cost for making new inyest. ds received by tl aT shareholders of the company are in 30% tax bracket, Calculate the cost of the retained earnings of the company, Solution: Inorder to calculate the cost of retained carnings to the company, it is necessary to calculate the nct amount available to the shareholders for investment and the likely return earned by them. Rs. Dividends payable to the shareholders 50,000 (-) Income tax at 30% 15,000 After tax dividends 35,000 (-) Brokerage cost at 2% 700 Net amount available for investments 34300 Since the shareholders have the investment opportunity of earning 10%, the amount of earning received by them on their investment will amount to Rs. 3,430 i.e., 10% of Rs. 34,300 - Rs. 3,430. -_ 3430. ed The return expected is 50,000 x 100 = 6.86% ’ The Cost of retained earnings after making adjustment for income tax and brokerage cost payable by the shareholders can be determined according to the following formula. Kr = Ke(1-T)(1-B) Kr —__= Cost of retained earnings, T = Tax rate, B = Brokerage cost Kr = 10% (1-3) (1-.2) = 10% x.7x.98 = 6.86%Long Term Capital Management 439 ; Weighted Average Cost of Capital he details regarding the Capital structure of a com- re of capital value Market value Specific cost y Rs. Rs. % Pebentures 40,000 38,000 5% preference capital 10,000 11,000 8% Equity Capital 60,000 12,000 13% Retained earnings 20,000 . — a 1,30,000, 1,69,000 You are Fed! required to determine the weighted coverage cost of capital ysing (@) Book value as weights (b) Market value as weights. (M.BA.- = Nov. 1996) Solution: WW i 1 = Book Value Weights We Type of Book Value Weights Cost Weighted Cost Capital Rs. % % Debentures 40,000 31 5% 1.557% Preference capital 10,000 08 8% 0.64% Equity capital 60,000 46 13% 5.98% Retained earnings 20,000 15 9% 135% ——— ae 130,000 wacc 9.52% Market Value Weights : a een NE i ctype of Capital Market Weights Cost Weighted cost Value440 Financial Management Debentures 38 000 2 BH 1g Preference Capital 11,000 a re 056 Equity Capital 1,20,000 7 13% 923 ae —_ 1,69,000 WACC 10.29% é the following capital structure of a company, calculate the cost of capital using (a) book value weights and (b) market value ts. The after-tax cost of different sources of finance is as follows; Equity share capital 14%, Retained earnings 13%, Preference share capital 10%, Debentures 5% Book Value Weights Source Amount Weight Cost Weighted Rs. Cost he i Pa Equity share capital 45,000 45 14% 6.3% Retainedearnings 15,000 ab) B% 195% Preference share capital 10,000 10 10% 1.00% debentures 30,000 30 5% 150% WACC. 10.75% Market value weights Source. Amount Weight Cost Weight Rs. Cost Equity Share capital 90,000 692 14% 9.688% Preference Share capital 10,000 .077 10% .TI0% Debentures 30,000 .231 5% 1.155% ‘WACC 11.613% —————————Long Term Capital Management 441 industries Ltd has assets of Rs. 1,60,000 which has been ja, ABC. tod 57,000 of debt sind Rs. 90,000 of equity ands of Rs. 1 |. The firm’s total profits after interest and taxes for ee ged 31st March 1998 were Rs. 13,500. It pays 8% interest an spe sear emdeigs and is im the 50% tax bracket. It has 900 equity shares porre 100 each selling at a market price of Rs. 120 per share. Calculate S Re gnted average cost of capital. tion: —— Balance = Liabilities Assets Equity shares of Total Assets 1,60,000 ai each 90,000 Reserves 18,000 Me borrowed funds 52,000 io 160,000 Calculation of earning per share ings aftcr interest and tax available for equity sharcholders No. of equity. shares outstanding, _ Rs. 13500 _ in Soigharceamas Cost of debt = Kd = 8% (IT) = 4% f 15 Cost of equity = Ke = 179 100. = 12.5% Market Value Weights Source Amount Weight Cost Debt 52,000 33 4% Equity 1,08,000 67 12.5% WACC442 Financial Management My din the market at Rs. 20. The com, 14, The Sonpany ss iyi sie and the inyestor expects a oon pays as dividen ar, Calculate (a) The cost of equity capital; (b) Suppose na op PaaS growth rate is 6% p.a., calculate the indicated oan ae (c) if the company’s cost of capital is 3% and the bi wal re rate is 5%; Calculate the indicated market Price op aie of Rs. 1 per share is to be maintained, Solution: “4 The relationship among cost of capital, pected growth rate is given by the following for: Dividend (a) Cost of equity capital = Price + Growth dividend, price and cy. mula. Ke = x100 + 5% = 10% Dividend Meain 7 Coat tena expects Re. LPs OME OI gi Rs. 25 fl . Rel aig (©) Market Price = 8% 5% = 3 = Rs. 3333 a 15. XY Ltd. intends to issue new equity shares. It’s Present shares are being sold in the market at Rs, 125 a share. The company’s past record regarding payment of dividends is as follows: 1994 ~ 10.7%; 1995 . 11.45%; 1996 - 12.25%; 1997 . 13.11%; 1998 . 14.03%, The floatation costs ae (@) Growth rate in dividends; _ The dividends have grown from 10.7% to 14.03%, Compound factor434 Financial Management (a) Issued at par 10,000 Pee Kd before Tax 1,00,000 10,000 = After tax = 10,000 1-55) = 45% (b) Issued at discount 10,000 oe Kd before tax 90,000 11% 10,000 After tax = 90,0004 55) = 5% (©) Issued at 10% premium _ 10,000, _ Le ere en ond Zao, Ahertae 2 Tipp 55) = 45% 3 = DP_10, = ~Tiooogt!0 = 9.09% (Gi) When Preference Shares are issued at 10 ; = DP_ 10,000 ; Kp NP ~ 90,009 * 100 = 11.11%,Long Term Capital Management 437 14.10 5 60% = 9.6% + 6% = 156 puys the s res of ¥ Co. Ltd. for Rs. 10. He expects the company to S dividends of Rs. 10.5, Rs. 11.025 and Rs. 11.575 in three years Bay ctvelY> He futher expects the market price be Rs. 243.10 at the en! respectively He ime (a) growth rate of dividend (b) current dividend 3 ye veld © compute the cost of equity. 5 : Solution: oe Compound factor = use = 1.102 Growth rate of dividend = 4% Current dividend yield = 12 ee Ke = 703.10" 4 Ke = 0.04 + 0.04 = 8% (iii) Earning price approach (Cost of equity) (E/P) 9. Thecompany’s share capital consist of 1,00,000 shares of Rs. 100 each. ‘The current earnings are Rs. 10 Jakhs per annum. ‘The company wants to raise additional funds of Rs. 25 lakhs by issuing new shares. You are required to calculate the cost of equity capital where in the flotation cost is 10% 2 Solution: * a Ke = 5p *100 = 11% Cost of Retained Earnings 10. XYZ Ltd is earning a net profit of Rs. §,000 . §,000 per annum. 1 shareholders’ required rate of return is 10%. It is expected that earnings, if distributed among the shareholders, can be invested by436 Financial Management (il) Dividend price plus growth (D/P + G) approach Ree eek Rare eee ee ee fa company ig Rg. ‘ket price of an equity share o| 99, mee Ser dieiaatd ee share is Rs, 4.50, In case, the dividends are The Sad ta ero at the rate of 7%, calculate the cost of equity capital, expec Solution ee MP = 0.5 + 07 = 120r 12% 7, From the following details of Vijay Ltd., calculate the cost of equity — capital, (i) Each share is of Rs. 150 each. (ii) The underwriting cost per share amount to 2%, (iii) The following are the dividends paid by thecompany for the last years. 4.50 Ke = Ft g = 2407 Year Dividend per share Year 1991 10.50 1994 1992 11.00 1995 1993 12.50 (iy) The company has a fixed dividend Payout ratio, (v) The expected dividen share. d on the new shares amounts to Rs, 4 Solution; Sees The dividends are 8rown from Rs. 10.50 to 2B i . a = 1.276 compound factor by looking to the “ the rupee tables” in the line of 4 years accumulate to 1.276 in 4 years at6% of dividends is 6%, ‘compound s} 7Long Term Capital Management 435 ompany, has 10% redeemable preference shares redeemable at the 4. ncn oth year from the oftheir issue. The underwriting costs 4 io 2% Catcuiate the effective cost of preference shure capital. cal solution p+(P—NP)/n _ 10,0004(,00 000—98,000)/10, PaNPy/2 EP (1,00,000+98,000)/2 ce 10,200 , 499 = 10.30 99,000 * i Cost of Equity Capital (i) Dividend price (D/P) approach 5, Xcompany Ltd. offers for public subscription of: equity shares of Rs. 10 each at a premium of 10%. "The company payS 5% of the issue price as unl ting commission. The rate ofdividend by the equity shareholders is 20%. You are required to calculate the cost of equity capital. , Willyour cost of capital be differentif itis to be calculated on the present f the equity shares issued for Rs. 15,- market value 0 Solution: pal ei wy Ae Ke = Dy Keim Gpag OU OEE wee (Rs. 11- Re 0.55 = Rs. 10.45) ed ee) Dee venti Kem ee Ct ae vanes %Long Term Capital Management 443 B Joking, to the compound sum of one rupee table is in the line y necan find that the compound rate js 15%. Hence, the growth Ke : = 1201 + 1% = 19.01% «me cost of new equity shares Ket = +8 15.01 = 75-3.15 x100 + 7% 15.01 = 7125 x100 + 7% = 12.38% + 1% = 19.38% 16, Alpha Ltd. has the following capital structure: x Equity Share capital(2,00,000 shares) 40,00,000 6% Preference shares 40,00,000 $% debentures 30,00,000 The market price of the company's equity share is Rs. 20. t ed that the company will pay acurrent dividend of Rs.2 pers which will grow at 1% forever. The tax rate may be presumed at Compute the following: < (a) Weighted ‘Average Cost of Capital based on existing capit structure. . . (b) The new weighted average cost of capital if the company F an additional Rs. 20,00,000 debt by issuing 10% debentures. This wou!Long Term Capital Management 431 Long Term Capital Management - Cost of Capital Formats / Formulaes Cost of Debt (Irredeemable) and Bonds ae I Kd = ned“) where Kd = Cost of debt after tax 1 = Annual Interest payment NP = Net Proceeds of loans or debentures: T = Taxrate Cost of Redeemable debt . 4 Seah (4 _ 1L+(P=NP)/n Kd (before tax) = Sa one where I = Annual interest payment P = Par value of debentures NP = Net proceeds of deben n = Number of years $6 maturity Cost of Preference Capitgl (Irre pea a SDE, NP Where KP = Cost of preferenc DP = Fixed preference d NP =Net Proceeds of p Cost of redeemable Preference Capit xp = DP+(P=NP)/n P+NP)/2432. Financial Management where KP = Cost of Redeemable Preference Share capital P. = par value of preference share capital NP = Net proceeds of preference share capital n = Noofyears t maturity Cost of Equity capi (a) Dividend Price appraoch (D/P) Ke = Son where Ke = Cost of equity D = Equity dividend NP = Net proceeds MP = Market price (b) Dividend price plus growth P+} Ki SDK Ke = og + 8 (c) Earning Price (E/P) approach EPS NPP # \ Weighted Average Cost of Capital (WACC) WACC = KeW1 + Kdw2 + KPW3 Cost of Retained earnings (KR) : “ad (@® Rights offer Approach : _ADG-T) me © IPU=Te Ke = AD = Change in dividend Per share AP = Change in Market Price of share = Marginal rate Of tax on income Te = Capital gains taxLong Term Capital Management 433 qhe revised formula for cost of retained earnings under rights er 0pprouch ‘will be as follows: fe! ‘ pd=T) KR =p (1-Te) _p = Dividend per share were = Market Price per share the shareholders have no tax liablity, then the following Where S d for calculation of KR formula is use KR => x100 (cara) Cee fs A firm issues debentures of Rs, 1,00,900 and realises Rs. 98,000 after allowing 2% commission to brokers. Debentures carry interest rate of 10%. The debentures and due for maturity at the end of 10th year at par. Calculate cost of debt. + Solution: ee Kd _I+(P=NP)/n nee Pt NE Z = 10,000+G, Kd = = 1,00,000+98,000)/2 = roost = 10.30% before tax i 2. A company issues 10% irredeemable debentures of Rs. 1,00,000. The company is in $5% tax bracket. Calculate the cost ‘of debt (before as well as after tax) ifthe debentures are issued at (a) par (b) 10% discount and (©) 10% premium. Calculate cost of debt. Solution444 Financial Management Wah eeandl, > expected dividend to Rs. 3 and leave the gr eu sakangdd but 7] ies of share will fall to Rs. 15 per share, ‘Owth chal rate un Solution: D R82 Ke= is +8 = peop + 0.07 = 10 + 07 = 17% (a) WACC (Book Value) Source Amount Weight Cost Equityshare —_40,00,000 -50 17% capital Preference share 10,00,000 135 6% capital Debentures 3,00,000 375 4% WACC (b) D Rs.3 eee Mela S eqs 07 = .20 + 07 = 27% WACC (Book Value) Source Amount Weight Cost Equity share Capital 40,00,000 40 27% 6% Preference Share capital _10,00,000 10 6% 8% debentures 30,00,000 30 4% 10% debentures 20,00,000 20 5% WACC (c) The cost of capital ifin (b) above, growth rate increases to 10%, Weighted Cost 85% 0.15% 150% 10.75% Weighted Cost 10.8% 0.6% 1.20 1.00 13.6% attiLong Ter™ Capital Management 445 WACC (Book Value) gourc® Amount Weight Cost Weighted Cost Faw share ; cai frente 40,00,000 40 30% 42.0% ec Sago es ‘a 2% 16 epentures 20,00,000 -20 5% fe — wACcc 148%