# Slm Unit 05 Mbf201

Oct 24, 2014

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Financial Management

Unit 5

Unit 5Structure: 5.1 Introduction Learning objectives 5.2 Design of an Ideal Capital Structure 5.3 Cost of Different Sources of Finance Cost of debentures Cost of term loans Cost of preference capital Cost of equity capital Cost of retained earnings Capital asset pricing model approach Earnings price ratio approach 5.4 Weighted Average Cost of Capital Assignment of weights 5.5 Summary 5.6 Solved Problems 5.7 Terminal Questions 5.8 Answers to SAQs and TQs

Cost of Capital

5.1 IntroductionCapital 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 jeopardise 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 economise the use of their funds and adapt to the changing conditions.

Sikkim Manipal University

Page No. 87

Financial Management

Unit 5

5.1.1 Learning objectivesAfter studying this unit, you should be able to,

Define cost of capital. Bring out the importance of cost of capital. Explain how to design an ideal capital structure. Compute Weighted Average Cost of Capital.

5.2 Design of an Ideal Capital StructureThe design of an ideal capital structure requires five factors to be considered (see in figure 5.1)

Figure 5.1: Design of an ideal capital structure

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 Debt does increase equity holders returns and this can be done till such time that no risk is involved. Use of excessive debt funds may threaten the companys survival. 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.

Sikkim Manipal University

Page No. 88

Financial Management

Unit 5

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 firms 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 of a company, which must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures and equity and preference shares. A company now 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 companys past performance in terms of pay-out dividends. The following graph on risk-return relationship of various securities summarises the above discussion.

Sikkim Manipal University

Page No. 89

Financial Management

Unit 5

Required rate of return

Equity share Preference share Debt Govt bonds Risk free security

Risk-Return relationship of various securities

Figure 5.2: Risk return relationship

5.3 Cost of Different Sources of FinanceThe various sources of finance and their costs are explained in this section. 5.3.1 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.The expected cash outflows relate to the interest and principal repayments. Kd =

I (1 T ) F P / n (F P ) / 2

Where Kd is post tax cost of debenture capital, I is the annual interest payment per unit of debenture, T is the corporate tax rate, F is the redemption price per debenture, P is the net amount realised per debenture, n is maturity period.

Sikkim Manipal University

Page No. 90

Financial Management

Unit 5

Solved Problem - 1 Lakshmi Enterprise wants to have an issue of non-convertible debentures for Rs. 10 Cr. Each debenture is of a par value of Rs. 100 having an interest rate of 15%. Interest is payable annually and they are redeemable after 8 years at a premium of 5%. The company is planning to issue the NCD at a discount of 3% to help in quick subscription. If the corporate tax rate is 50%, what is the cost of debenture to the company? SolutionKd I(1 T ) ( F P ) / n (F P ) / 2

15 (1 0.5 ) (105 97 ) / 8 (105 97 ) / 2

7 .5 1 101 0.084 0r 8.4%

5.3.2 Cost of Term Loans Term loans are loans taken from banks or financial institutions for a specified number of years at a pre-determined interest rate. The cost of term loans is equal to the interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on term loans is also taxed. Kt = I (1T) Where I is interest, T is tax rateSolved Problem - 2

Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is the cost of term loan if the tax rate is 40%?Solution:

Kt = I (1T) = 9(10.4) = 5.4% The cost of term loan is 5.4%

Sikkim Manipal University

Page No. 91

Financial Management

Unit 5

5.3.3 Cost of Preference CapitalThe cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments. It is expressed as: Kp = (D + {(F P) / n} / ((F + P) / 2)

Where Kp is the cost of preference capital, D is the preference dividend per share payable, F is the redemption price, P is the net proceeds per share, n is the maturity period.Solved Problem - 3

C2C Ltd. has recently come out with a preference share issue to the tune of Rs. 100 lakhs. Each preference share has a face value of 100 and a dividend of 12% payable. The shares are redeemable after 10 years at a premium of Rs. 4 per share. The company hopes to realise Rs. 98 per share now. Calculate the cost of preference capital.Solution:

Kp

D ( F P ) / n (F P ) / 2

12 (104 98 ) / 10 (104 98 ) / 2

12.6 101

Kp = 0.1247 or 12.47% The cost of preference capital now will be 12.47%

5.3.4 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.

Sikkim Manipal University

Page No. 92

Financial Management

Unit 5

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, realised 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 forecasted as they may sometimes be nil or have a constant growth or sometime have supernormal growth periods.Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is not legally bound to pay dividends and also as 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.Solved Problem - 4

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% Cost of equity capital is 14,54% 5.3.5 Cost of Retained Earnings A companys earnings can be reinvested in full to fuel the ever-increasing demand of companys fund requirements or they may be paid off to equity holders in full or they may be partly held back and invested and partly paidSikkim Manipal University Page No. 93

Financial Management

Unit 5

off. These decisions are taken keeping in mind the companys growth stages. High growth companies may reinvest the entire earnings to grow more, companies with no growth opportunities return the funds earned to their owners and companies with constant growth invest a little and return the rest. Shareholders of companies with high growth prospects utilising funds for reinvestment activities have to be compensated for parting with their earnings. Therefore the cost of retained earnings is the same as the cost of shareholders expected return from the firms ordinary shares. So, Kr = Ke 5.3.6 Capital Asset Pricing

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