Cost of Capital : Cost of Capital Presented by: CA Tarun Mahajan
What is Cost of Capital ? : What is Cost of Capital ? Fund needed to finance a project by a company is raised from various sources, e.g., common equity, preferred shares & debt
Providers of these funds expect some return from the company
Hence cost of capital is nothing but expectation investors.
Why do we need to calculate cost of capital? : Why do we need to calculate cost of capital? In capital budgeting (Investment) decisions future cash flows are discounted to arrive at some decision.
The discounting rate used above should be the cost of capital
How to calculate cost of capital? : How to calculate cost of capital? To calculate overall cost of capital first one should calculate cost of components of capital, i.e.,
Cost of debt
Cost of preferred stock
Cost of retained earnings
Cost of common equity
After this weighted average of component cost is calculated which is termed as WACC.
Calculation of after tax cost of debt : Calculation of after tax cost of debt After tax cost of debt = Kd (1-t)
Here t = tax rate
Kd = Current Interest rate or current yield
For Redeemable Debt For Irredeemable Debt
Example (Cost of Debt) : Example (Cost of Debt) Current Market Price = Rs.90 Redemption Price = Rs.100, Coupon=Rs.10, N=5, t= 0.35 Calculate after tax Cost of Debt.
Kd = 10+2 / 95 = 12.63%
Kd(1-t) = 12.63 (1-0.35) = 8.21%
Current Market Price = Rs.95, Coupon Rs.10 t = 0.35. Calculate after tax cost of debt.
Kd = 10/95 = 10.53%
Kd(1-t) = 8.21 (1-0.35) = 5.34%
Cost of Preference Shares : Cost of Preference Shares Dps = Dividend on preferred stock
Pnet = net issue price after deduction of floatation cost
Current Market Price=Rs.110, Issue exp.= 2% on issue price, Dividend=Rs.10, Calculate cost.
10/107.8 = 9.28%
Cost of Retained Earnings : Cost of Retained Earnings Though the company is not required to pay any return on retained earning but it has also certain cost
Cost of retained earnings is nothing but expectations of the common equity holders.
Following are the various methods for calculation of cost of retained earnings:
Cost of Retained Earnings : Cost of Retained Earnings Dividend Capitalization Approach
Earning Capitalization Approach
Growth Approach (Gordon’s Model)
CAPM
Bond Yield Plus risk premium Kr = Bond Risk + Risk Premium
Dividend Capitalization Approach : Dividend Capitalization Approach A company has been constantly paying dividend per share of Rs.5 its current market price is Rs.62.5 Calculate its cost of retained earnings
Kr = 5/62.5 = 8%
Earning Capitalization Approach : Earning Capitalization Approach A company with unstable dividend policy is having current market price of Rs.1800 and EPS of Rs.210. Calculate its cost of retained earnings.
Kr = 210/1800 = 11.67%
Dividend Yield plus growth rate approach : Dividend Yield plus growth rate approach Last year’s dividend = Rs.5, Return on equity 18%, Retention Rate = 50%, Current Market Price = Rs.50, Calculate Kr
g = 18 x 50% = 9%
D1 = 5 x 1.09 = 5.45
Kr= 5.45/50 + 9% = 19.9% D1 = Next Year’s dividend = D0 (1+g)
P0= Current Market Price
g = Growth rate = ROE x RR
Capital Asset Pricing Model : Capital Asset Pricing Model Kr = RFR + [E(Rmkt.) –RFR] ß
RFR =Risk free rate of return, Short term t-bill rate (some analyst feel long term t-bill rate should be used)
Rmkt. = Return on market portfolio
ß = Risk Index
Example: RFR = 8%, Rmkt. = 15%, ß = 2, Kr = ?
Kr = 8 +(15-8)2 = 8+14 = 22%
Bond Yield plus risk premium : Bond Yield plus risk premium Kr =Bond yield of the company +Risk Premium
Example: Bond yield for ABC company is 10% if the equity risk premium is 7% calculate Kr.
Kr = 10 +7 = 17%
Cost of newly issued equity : Cost of newly issued equity Cost of newly issued equity (Ke) is same as Kr, i.e., expectation of investors.
Ke is slightly higher than Kr because issue of new equity involves floatation cost.
In the formulas use P (1-F) instead of P. Here F is the percentage public issue expenses.
Next years’ expected dividend is Re.1. Current market price Rs.10. issue expenses 5%. Growth rate 5% calculate Ke
Ke = 1/9.5 + 5% = 15.53%
Weighted Average Cost of Capial : Weighted Average Cost of Capial WACC = Kd(1-t)xWd + KpsxWps + KexWe
Here Wd+Wps+We = 1
Types of Weights:
Market Value Weights
Target Capital Structure Weights
Example: Kd=10%, Ke=15% t = 0.40, Wd= 0.6 We=0.4. Calculate WACC
WACC = 10x0.6x0.6 + 15x0.4 = 9.6
Marginal Cost of Capital : Marginal Cost of Capital While WACC represents average cost of total funds, marginal cost represents cost of one more dollar of capital.
Normally as the company raises more fund marginal cost hence WACC increases (But at a slower rate).
WACC=9.6% Total Fund Rs.100
Marginal cost 11% Marginal fund Rs.10,
New WACC= ?
New WACC = (9.6%x100+11%x10)/110=9.72%
Marginal Cost of Capital Schedule : Marginal Cost of Capital Schedule Kd(1-t) = 6 Kr=15 Ke=17 D/E=1:1 make a marginal cost of capital schedule if next years retained earnings are expected to be Rs.60
Solution:
Calculate Break Point = retained earnings/We
60/0.5 = 120
Calculate Marginal cost upto & above break point as follows:
Marginal Cost of Capital Schedule : Marginal Cost of Capital Schedule
Factors affecting cost of capital : Factors affecting cost of capital Factors not under the control of the firm
Level of interest rates in the economy
Tax Rates
Factors under the control of the firm
Capital structure policy: moving towards the optimum capital structure
Dividend policy: Distributing appropriate dividend
Investment Policy: accepting less risky projects
Basics of Capital Budgeting : Basics of Capital Budgeting Presented by: CA Tarun Mahajan
What is Capital Budgeting? : What is Capital Budgeting? Budgeting for Long term Assets
Capital Budgeting decision is an investment decision, i.e., whether to invest money in long term project or not.
These are important decisions due to the following interrelated reasons:
Huge money is invested
Long term consequences
Irreversibility of the decision
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Methods of Evaluation : Methods of Evaluation Pay back Period
Discounted Pay back Period
Net Present Value Method (NPV)
Internal rate of Return (IRR)
Profitability index (PI)
Pay Back Period Method : Pay Back Period Method Pay back period is the time required to recover the initial investment in the project
Pay back period =
Initial Investment/Annual Cash inflows
Example: Initial Investment= Rs.100000, Annual CF= Rs.20000
Payback period = 100000/20000 = 5 years
Pay Back PeriodUneven cash flows : Pay Back PeriodUneven cash flows Pay Back Period = = 2 + 30000 /50000 = 2.6 Years
Pay Back Period : Pay Back Period Decision:
In case of two mutually exclusive proposals, one should accept the proposal with shorter maturity period
In case of independent proposals if the payback period is less than the benchmark pay back period, accept the proposal, else reject it.
Pay Back Period : Pay Back Period Advantages:
It considers risk & liquidity of the project. Lower the payback period lower the risk
It is easy to understand & simple to calculate
Disadvantages:
It ignores time value of money
It does not consider cash flows after the payback period
Pay Back: Ignore Time Value of Money : Pay Back: Ignore Time Value of Money According to pay back Project A is good. But Considering time value of money B is Better.
Payback: Ignores post pay back cash flows : Payback: Ignores post pay back cash flows According to pay back Project A is good. But Considering post pay back cash flows B is Better.
Discounted Pay back period : Discounted Pay back period It considers time value of money
First, Cash flows are discounted and then cumulative total is made to arrive at discounted pay back period
Disadvantage:
It does not consider post payback cash flows
Discounted Pay Back Period : Discounted Pay Back Period
Net Present Value Method : Net Present Value Method NPV = PV of inflows – PV of outflows
If Inflows are more than outflows, i.e., NPV is positive then accept the proposal
In case of mutually exclusive proposals accept the one which has higher NPV
The suitable discounted rate is the WACC, which reflects risk of the project.
Calculate NPV : Calculate NPV Calculate NPV for the following Projects @10%
Internal Rate of Return (IRR) : Internal Rate of Return (IRR) IRR is the discounting rate at which NPV is zero.
If IRR is 15%, it means that on the outstanding investment in the project we are able to earn a rate of return of 15%
IRR is calculated using trial & error method & interpolation or using a financial calculator.
Calculate IRR : Calculate IRR Also Calculate Break Even Discounting Rate (crossover Rate), i.e., the rate at which NPV of both the proposals is same Break Even Discounting Rate = 12.48%, above this Rate B is better than A
NPV vs. IRR : NPV vs. IRR Here We can observe that as per NPV method A is Better and as per IRR method B is better.
This conflict in decision is due to time disparity.
Project A has higher total cash inflows hence it has higher NPV if the discounting rate is 0.
But It has higher cash flows in later years. Hence with increase in discounting rate its NPV reduces at a faster pace.
At 12.48% NPV of both the projects are same and beyond that B has higher NPV.
NPV vs. IRR (Size Disparity) : NPV vs. IRR (Size Disparity) Another reason for conflict between NPV & IRR is difference in the size of the projects. A Big project may have higher NPV even if it has lower IRR. Example:
NPV: Pro & cons : NPV: Pro & cons Advantage: It measures the benefits in absolute (dollar) terms hence supports the basic objective of Financial Management
Disadvantage: It ignores size of the project, e.g., project of Rs.1000 having NPV of Rs.100 will be accepted against Project of Rs.100 having NPV of Rs.90.
IRR: Pros & Cons : IRR: Pros & Cons Advantage: it provides safety margin information to the management, e.g., if IRR is 15% & WACC is 12%, more than 3% reduction in return will result in capital loss to the company
Disadvantage:
Multiple IRR (-160, 1000, -1000)
No IRR (+15, -45, +37.4)
Post audit in Capital Budgeting : Post audit in Capital Budgeting It Means comparison of Estimated and actual return & risk of the project
It is useful to improve forecasting methods.
Cash flows estimation in Capital Budgeting : Cash flows estimation in Capital Budgeting Presented by: Tarun Mahajan
Why Cash Flows ? : Why Cash Flows ? Different firms follow different accounting policies that leads to different net income hence different decisions
Cash flows are unaffected by the choice of accounting policy hence cash flows are used for capital budgeting decision
Net Cash flows includes return on capital as well as return of capital. It means it not only includes revenue but also capital cash flows.
How to Calculate Net Cash Flows? : How to Calculate Net Cash Flows? Net Cash Flow =
Net income + Depreciation (Non cash Charges) or
[(Revenue - Cost- Dep.)(1-t)] + Dep.
(Revenue – Cost) (1-t) + Dep. x t
Revenue 100, Cost 60, Dep. 10, t = 0.40
NCF = (100-60-10)x 0.6 + 10 = 18+10 =28
or (100-60)x0.6 + 10x0.4= 24+4 =28
Incremental Cash Flows? : Incremental Cash Flows? Means the cash flows which are relevant for decision making. In other words cash flows which will arise only due to acceptance of the project. Consider following points:
Sunk Cost: means the cost which has already been incurred. Should be excluded for analysis.
Opportunity Cost: means the loss of opportunity due to acceptance of this project. It should be treated as an outflow of cash
Idle Resources: means the resources which are a waste if these project is not accepted. Cost of Idle resources should be ignored.
Incremental Cash Flows? : Incremental Cash Flows? Externalities: means loss or gain in other projects due to acceptance of this project. Loss should be treated as an outflow while gain should be treated as an inflow for analysis of this project.
Apportioned Cost: Means an apportionment of general overheads to the project under consideration. It should be ignored. Because even if we does not accept this project, these cash flows will occur.
Net Working Capital : Net Working Capital Working capital is an asset not an expenditure.
Amount of working capital required to run a project should be treated as an outflow of cash at year zero and the same amount should be treated as inflow of cash at the end of useful life of the project
Example: WC = Rs.5000, Life 5 years
Rs.5000 should be treated as an outflow at year 0 and Rs.5000 should be treated as an inflow at the end of 5th Year.
Change in WC : Change in WC Increase in WC in any year should be treated as an outflow in that year
Decrease in WC should be treated as an inflow in that year.
Steps for Calculation : Steps for Calculation All the Cash flows during the life of the project may be classified as follows:
Initial Cash Flows:
Cost of Fixed Assets
Shipping & Installation Cost
Change in Working Capital
Tax on Gain/Loss on sale of old assets
Annual Cash flows
Revenue Cash Flows
Additional Investment
Change in Working Capital
Steps for Calculation : Steps for Calculation Contd….
Terminal Cash Flows:
Salvage Value of Assets
Working Capital Realized
Tax on Capital Gain/loss of sale of Assets
Other Cash Flowss
Example : Example Building Cost = $24000 Plant Cost = $16000
Ending WDV = $21816 Ending WDV = $2720
Ending Market Value=$15000 Market Value = $4000
Working Capital = $12000 Life = 4 years
Annual Sales= $80000. Variable Cost = 60%
Cash Fixed Cost = $10000
Dep. = $3512, $5744 $3664 $2544
Tax Rate = 40% Discounting Rate = 12%
Maximum Acceptable Pay back period = 5 years
Calculate NPV, IRR & Pay Back.
Replacement Decision : Replacement Decision Replacement decision means a decision that whether the existing asset should be continued or replaced.
There are two ways to arrive at a replacement decision:
Evaluation of two Mutually exclusive proposals, i.e., Old vs. New
Evaluation of one incremental proposal (new-old) if the NPV is positive accept new but if it is negative continue old
Example : Example Existing Asset:
Original Cost $15000, Original Life 15 year, Dep. SLM, Remaining life 5 year, Current book value $5000, current Market value $2000
New Asset:
Cost $24000, Life 5 years, Salvage Value $4000, Dep. $7920, 10800, 3600, 1680, 0.
Cash Profit will increase by $6000p.a. Tax rate 40% and discounting rate is 11.5%.
Projects with unequal Lives : Projects with unequal Lives If two mutually exclusive projects have unequal lives than we can not arrive at a decision simply by comparing their NPVs
There are two methods to handle this situation:
Replacement Chain (Common Life) Method
Equivalent Annual Annuity Method
Example : Example
Effect of inflation : Effect of inflation Expectation of an investor =
(compensation for deferment of consumption + Inflation + Risk Premium )
Hence discounting Rate (WACC) already includes the effect of inflation
Hence estimated future cash flows should also be adjusted upward to include the effect of inflation.
Corporate Governance : Corporate Governance Prepared by: CA Tarun Mahajan
What is corporate Governance? : What is corporate Governance? There is a divorce of management & ownership in the company form of business organization.
Shareholders are owners of the company but they are scattered hence management of the company remains in the hands of promoters.
Therefore the company need to have a rules to protect shareholders.
Corporate governance is the set of internal controls, processes, and procedures by which firms are managed.
It defines the appropriate rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. It is the firm’s series of checks and balances
Objectives of Corporate Governance : Objectives of Corporate Governance The board of directors protects shareholder interests.
The board acts independently from management.
The firm acts lawfully and ethically in dealings with shareholders.
The rights of shareholders are protected and shareholders have a voice in governance.
The firm’s financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner.
There are proper procedures and controls covering management’s day-to-day operations.
Independence of Board : Independence of Board To be independent, a board member must not have any material relationship with:
The firm and its subsidiaries, including former employees, executives, and their families.
Individuals or groups, such as a shareholder(s) with a controlling interest, which can influence the firm’s management.
Executive management and their families.
The firm’s advisers, auditors, and their families.
Any entity which has a cross-directorship with the firm.
Qualification of board members : Qualification of board members Can make informed decisions about the firm’s future.
Can act with care and competence as a result of their knowledge and experience.
Have other board experience.
Regularly attend meetings.
Are committed to shareholders. Do they have significant stock positions? Have they eliminated any conflicts of interest?
Have necessary experience and qualifications?
Have served on board for more than 10 years. While this adds experience, these board members may be too closely allied with management.
Committees of Board of Directors : Committees of Board of Directors A committee of board consist some of the directors. It is formed for a specific purpose. Following are some important committees:
Audit committee: for appointment of internal & external auditors & fixation of their remuneration. It will also review the performance of auditor
Compensation committee: to decide managerial remuneration. It should link compensation to the long term performance of the company (not the short term)
Nomination committee: propose candidates for election of board of directors.
Normally all the above committees consist of at least 3 independent directors.