# 4 Financing Decisions

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1 4 Financing Decisions BASIC CONCEPTS AND FORMULAE 1. Cost of Capital Cost of capital refers to the discount rate that is used in determining the present value of the estimated future cash proceeds of the business/new project and eventually deciding whether the business/new project is worth undertaking or now. It is also the minimum rate of return that a firm must earn on its investment which will maintain the market value of share at its current level. It can also be stated as the opportunity cost of an investment, i.e. the rate of return that a company would otherwise be able to earn at the same risk level as the investment that has been selected 2. Components of Cost of Capital The cost of capital can be either explicit or implicit. Explicit Cost: The discount rate that equals that present value of the cash inflows that are incremental to the taking of financing opportunity with the present value of its incremental cash outflows. Implicit Cost: It is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm was accepted. 3. Measurement of Specific Cost of Capital The first step in the measurement of the cost of the capital of the firm is the calculation of the cost of individual sources of raising funds. (a) Cost of Debt A debt may be in the form of Bond or Debenture. (i) Cost of Debentures: The cost of debentures and long term loans is the contractual interest rate adjusted further for the tax liability of the company. Cost of Irredeemable Debentures: Cost of debentures not redeemable during the life time of the company.

2 4.2 Financial Management (ii) (b) (c) K d I 1 NP ( t) Cost of Redeemable Debentures: If the debentures are redeemable after the expiry of a fixed period, the cost of debentures would be: K d I(I t) + (RV NP) / N RV + NP 2 Amortisation of Bond: A bond may be amortised every year i.e. principal is repaid every year rather than at maturity. In such a situation, the principal will go down with annual payments and interest will be computed on the outstanding amount. Cost of Preference Share n C t V B t 1 + t (1 k ) The cost of preference share capital is the dividend expected by its holders. Cost of Irredeemable Preference Shares PD Cost of irredeemable preference shares PO d Cost of Redeemable Preference Shares: If the preference shares are redeemable after the expiry of a fixed period the cost of preference shares would be: Cost of Equity K p PD + (RV NP) / N RV + NP 2 Cost of equity capital is the rate of return which equates the present value of expected dividends with the market share price. Methods for Computation of Cost of Equity Capital Dividend Price Approach: Here, cost of equity capital is computed by dividing the current dividend by average market price per share. D K e P 1 o

3 Financing Decisions 4.3 Earning/ Price Approach: The advocates of this approach co-relate the earnings of the company with the market price of its share. K e (E/P) Realized Yield Approach: According to this approach, the average rate of return realized in the past few years is historically regarded as expected return in the future. The yield of equity for the year is: Y t D t + P P t 1 t 1 Capital Asset Pricing Model Approach (CAPM): CAPM model describes the risk-return trade-off for securities. It describes the linear relationship between risk and return for securities. K e R f + b (R m R f ) (d) Cost of Retained Earnings It is the opportunity cost of dividends foregone by shareholders. DCF K s D P G CAPM (e) Cost of Depreciation K s R f + b (R m R f ) Depreciation provisions may be considered in a similar manner to retained earnings - they have an opportunity cost and represent an increased stake in the firm by its shareholders. 4. Weighted Average Cost of Capital (WACC) It represents the investors' opportunity cost of taking on the risk of putting money into a company. Since every company has a capital structure i.e. what percentage of funds comes from retained earnings, equity shares, preference shares, debt and bonds, so by taking a weighted average, it can be seen how much cost/interest the company has to pay for every rupee it borrows/invest. 5. Marginal Cost of Capital K 0 % D(mkt) (K i ) (1 t) + (% Psmkt) K p + (C s mkt) Ke It may be defined as the cost of raising an additional rupee of capital. To calculate the marginal cost of capital, the intended financing proportion should be applied as

4 4.4 Financial Management weights to marginal component costs. The marginal cost of capital should, therefore, be calculated in the composite sense. The marginal weights represent the proportion of funds the firm intends to employ. 6. Capital Structure Capital structure refers to the mix of a firm s capitalisation (i.e. mix of long term sources of funds such as debentures, preference share capital, equity share capital and retained earnings for meeting total capital requirement). While choosing a suitable financing pattern, certain factors like cost, risk, control, flexibility and other considerations like nature of industry, competition in the industry etc. should be considered. 7. Optimal Capital Structure (EBIT-EPS Analysis) The basic objective of financial management is to design an appropriate capital structure which can provide the highest earnings per share (EPS) over the firm s expected range of earnings before interest and taxes (EBIT). EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen. 8. Capital Structure Theories ( EBIT I1)(1 T) (EBIT I2 )(1 T ) E E 1 Net Income Approach: According to this approach, capital structure decision is relevant to the value of the firm. Net Operating Income Approach: NOI means earnings before interest and tax. According to this approach, capital structure decisions of the firm are irrelevant. Modigliani-Miller Approach: Modigliani-Miller derived the following three propositions: (i) (ii) Total market value of a firm is equal to its expected net operating income dividend by the discount rate appropriate to its risk class decided by the market. The expected yield on equity is equal to the risk free rate plus a premium determined as per the following equation: K c K o + (K o K d ) B/S (iii) Average cost of capital is not affected by financial decision. Traditional Approach: The principle implication of this approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimises cost of capital. 2

5 Financing Decisions Over Capitalisation It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest. 10. Under Capitalisation It is just reverse of over-capitalisation. It is a state, when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity. 11. Leverages In financial analysis, leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc. 12. Types of Leverages Operating Leverage: It exists when a firm has a fixed cost that must be defrayed regardless of volume of business. It can be defined as the firm s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Degree of operating leverage (DOL) is equal to the percentage increase in the net operating income to the percentage increase in the output. Degree of Operating Leverage Contribution EBIT Financial Leverage: It involves the use fixed cost of financing and refers to mix of debt and equity in the capitalisation of a firm. Degree of financial leverage (DFL) is the ratio of the percentage increase in earnings per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT). Degree of Financial Leverage EBIT EBT Combined Leverage: It maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm. Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect the sales changes will have on EPS. Degree of CombinedLeverage DOL DFL

6 4.6 Financial Management UNIT I : COST OF CAPITAL Question 1 What is Optimum Capital Structure? Optimum Capital Structure: The capital structure is said to be optimum when the firm has selected such a combination of equity and debt so that the wealth of firm is maximum. At this capital structure, the cost of capital is minimum and the market price per share is maximum. Question 2 What is meant by weighted average cost of capital? Illustrate with an example. Meaning of Weighted Average Cost of Capital (WACC) and an Example: The composite or overall cost of capital of a firm is the weighted average of the costs of the various sources of funds. Weights are taken to be in the proportion of each source of fund in the capital structure. While making financial decisions this overall or weighted cost is used. Each investment is financed from a pool of funds which represents the various sources from which funds have been raised. Any decision of investment, therefore, has to be made with reference to the overall cost of capital and not with reference to the cost of a specific source of fund used in the investment decision. The weighted average cost of capital is calculated by: (i) Calculating the cost of specific source of fund e.g. cost of debt, equity etc; (ii) Multiplying the cost of each source by its proportion in capital structure; and (iii) Adding the weighted component cost to get the firm s WACC represented by k 0. k 0 k 1 w 1 + k 2 w Where, k 1, k 2 are component costs and w 1, w 2 are weights. Example of WACC Capital structure of a firm is given as under: Equity Capital 5,00,000 Reserves 2,00,000 Debt 3,00,000 10,00,000 The component costs (before tax) are: Equity Capital 18% and Debt 10%.

7 Financing Decisions 4.7 Tax Rate is 35%. WACC is required to be computed. Cost of Debt 10% (1 0.35) 6.5% Cost of Retained Earnings is taken to be same as cost of equity. Computation of WACC Source Proportion After- tax Cost Weighted Cost of Capital Equity Capital Retained Earnings Debt Weighted Average Cost of Capital 14.55%. (Note: The above example is just illustrative in nature.) Question 3 Discuss the dividend-price approach, and earnings price approach to estimate cost of equity capital. In dividend price approach, cost of equity capital is computed by dividing the current dividend by average market price per share. This ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors. It is computed as: Where, D K e P 1 o D 1 Dividend per share in period 1 P 0 Market price per share today Whereas, on the other hand, the advocates of earnings price approach co-relate the earnings of the company with the market price of its share. Accordingly, the cost of ordinary share capital would be based upon the expected rate of earnings of a company. This approach is similar to dividend price approach, only it seeks to nullify the effect of changes in dividend policy. Question 4 The following is the capital structure of Simons Company Ltd. as on :

8 4.8 Financial Management Equity shares : 10,000 shares (of ` 100 each) 10,00,000 10% Preference Shares (of ` 100 each) 4,00,000 12% Debentures 6,00,000 ` 20,00,000 The market price of the company s share is ` 110 and it is expected that a dividend of ` 10 per share would be declared for the year The dividend growth rate is 6%: (i) If the company is in the 50% tax bracket, compute the weighted average cost of capital. (ii) (i) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of ` 10 lakhs bearing 14% rate of interest, what will be the company s received weighted average cost of capital? This financing decision is expected to increase dividend from ` 10 to ` 12 per share. However, the market price of equity share is expected to decline from ` 110 to ` 105 per share. Computation of the weighted average cost of capital Source of finance Proportion After tax cost (%) (1-tax rate i.e. 50%) Weighted average cost of capital (%) (a) (b) (c) (d)(b)x(c) Equity share (Refer to working note 1) 10% Preference share % Debentures Weighted average cost of capital (ii) Computation of Revised Weighted Average Cost of Capital Source of finance Proportion After tax cost (%) (1-tax rate i.e. 50%) Weighted average cost of capital (%) (a) (b) (c) (d) (b) (c) Equity shares (Refer to working note 2) 10% Preference shares % Debentures % Loan Revised weighted average cost of capital 10.66

9 Financing Decisions 4.9 Working Notes: (1) Cost of equity shares (k e ) Dividend per share k e + Growth rate Market price per share or 15.09% (2) Revised cost of equity shares (k e ) 12 Revised k e Question or 17.42% XYZ Ltd. has the following book value capital structure: Equity Capital (in shares of ` 10 each, fully paid up- at par) ` 15 crores 11% Preference Capital (in shares of ` 100 each, fully paid up- at par) ` 1 crore Retained Earnings ` 20 crores 13.5% Debentures (of ` 100 each) ` 10 crores 15% Term Loans ` 12.5 crores The next expected dividend on equity shares per share is ` 3.60; the dividend per share is expected to grow at the rate of 7%. The market price per share is ` 40. Preference stock, redeemable after ten years, is currently selling at ` 75 per share. Debentures, redeemable after six years, are selling at ` 80 per debenture. The Income tax rate for the company is 40%. (i) (ii) Required Calculate the weighted average cost of capital using: (a) (b) book value proportions; and market value proportions. Define the weighted marginal cost of capital schedule for the company, if it raises ` 10 crores next year, given the following information:

10 4.10 Financial Management (a) (b) (c) (d) (i) the amount will be raised by equity and debt in equal proportions; the company expects to retain ` 1.5 crores earnings next year; the additional issue of equity shares will result in the net price per share being fixed at ` 32; the debt capital raised by way of term loans will cost 15% for the first ` 2.5 crores and 16% for the next ` 2.5 crores. (a) Statement showing computation of weighted average cost of capital by using Bookvalue proportions Source of finance Amount (Book value) (` in crores) Weight (Book value proportion) Cost of capital Weighted cost of capital (a) (b) (c) (a)x(b) Equity capital (W.N.1) 11% Preference capital (W.N.2) Retained earnings (W.N.1) 13.5% Debentures (W.N.3) 15% term loans (W.N.4) Weighted average cost of capital or 13.93% (b) Statement showing computation of weighted average cost of capital by using market value proportions Source of finance Amount (` in crores) Weight (Market value proportions) Cost of capital Weighted cost of capital (a) (b) (c)(a)x(b) Equity capital (` 1.5 crores x ` 40) (Refer to working note 1)

11 Financing Decisions % Preference capital (` 1 lakh x ` 75) (Refer to working note 2) 13.5% Debentures (` 10 lakhs x ` 80) (Refer to working note 3) 15% Term loans (Refer to working note 4) Weighted average cost of capital or 14.59% Note: Since retained earnings are treated as equity capital for purposes of calculation of cost of specific source of finance, the market value of the ordinary shares may be taken to represent the combined market value of equity shares and retained earnings. The separate market values of retained earnings and ordinary shares may also be worked out by allocating to each of these a percentage of total market value equal to their percentage share of the total based on book value. (ii) Statement showing weighted marginal cost of capital schedule for the company, if it raises ` 10 crores next year, given the following information: Chunk Source of finance Amount (` in crores) Weight Cost of capital Weighted cost of capital (a) (b) (c)(a)x(b) 1. Retained earnings (Refer to working note 1) Debt (Refer to working note 6) Weighted average cost of capital or 12.5% 2. Equity shares (Refer to working note 5) Debt (Refer to working note 6) Weighted average cost of capital or % 3. Equity shares (Refer to working note 5)

12 4.12 Financial Management Debt (Refer to working note 6) Weighted average cost of capital or % Working Notes (W.N.): 1. Cost of equity capital and retained earnings (K e ) D 1 K e + g P 0 Where, K e Cost of equity capital D 1 Expected dividend at the end of year 1 P 0 Current market price of equity share g Growth rate of dividend Now, it is given that D 1 ` 3.60, P 0 ` 40 and g 7% Therefore, K e ` ` 40 + or K e 16% 2. Cost of preference capital (K p ) K p D F + F + n P n P Where, D Preference dividend F Face value of preference shares P Current market price of preference shares N Redemption period of preference shares Now, it is given that D 11%, F` 100, P ` 75 and n 10 years ` 100 ` Therefore K p % ` ` 75 n2

13 Financing Decisions Cost of debentures (K d ) F P r (1 t) K d n F + P n Where, r Rate of interest t Tax rate applicable to the company F Face value of debentures P Current market price of debentures n Redemption period of debentures Now it is given that r 13.5%, t40%, F` 100, P` 80 and n6 years Therefore, K d ` 100 ` (1 0.40) ` ` % 4. Cost of term loans (K t ) K t r(1-t) Where, r Rate of interest on term loans t Tax rate applicable to the company Now, r 15% and t 40% Therefore, K t 15% (1-0.40) 9% 5. Cost of fresh equity share (K e ) K e D 1 g P + Now, D 1 ` 3.60, P ` 32 and g0.07 Therefore, K e ` ` %

14 4.14 Financial Management 6. Cost of debt (K d ) K d r (1-t) Question 6 (For first ` 2.5 crores) r 15% and t 40% Therefore, K d 15% (1-40%) 9% (For the next 2.5 crores ) r 16% and t 40% Therefore, K d 16% (1-40%) 9.6% JKL Ltd. has the following book-value capital structure as on March 31, Equity share capital (2,00,000 shares) 40,00, % preference shares 10,00,000 10% debentures 30,00,000 ` 80,00,000 The equity share of the company sells for ` 20. It is expected that the company will pay next year a dividend of ` 2 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate. Required: (i) Compute weighted average cost of capital (WACC) of the company based on the existing capital structure. (ii) Compute the new WACC, if the company raises an additional ` 20 lakhs debt by issuing 12% debentures. This would result in increasing the expected equity dividend to ` 2.40 and leave the growth rate unchanged, but the price of equity share will fall to ` 16 per share. (iii) Comment on the use of weights in the computation of weighted average cost of capital.

15 Financing Decisions 4.15 (i) Weighted Average Cost of Capital of the Company (Based on Existing Capital Structure) After tax cost Weights Weighted cost (Refer to working note 4) (a) (b) (a) (b) Equity share capital cost (Refer to working note 1) Cost of preference share capital (Refer to working note 2) Cost of debentures (Refer to working note 3) Weighted average cost of capital % Working Notes: 1. Cost of equity capital: Dividend K e + g Current market price of share ` 2 5% 15% or 0.15 ` Cost of preference share capital: Annual preference share dividend Net proceeds in the issue of preference share ` 1,15,000 ` 10,00, Cost of Debentures: 1 Net proceeds ( Interest Tax)

16 4.16 Financial Management 1 ` 30,00,000 ( ` 3,00,000 - ` 1,05,000) Weights of equity share capital, preference share capital and debentures in total investment of `80,00,000: Weight of equity share capital Total equity share capital Total investments Weight of preference share capital Weight of debentures ` 40,00,000 ` 80,00, Total preference share amount Total investments ` 10,00,000 ` 80,00,000 Total debentures Total investments ` 30,00,000 ` 80,00, (ii) New Weighted Average Cost of Capital of the Company (Based on new capital structure) After tax cost Weights Weighted cost (Refer to working note 4) (a) (b) (a) (b) Cost of equity share capital (Refer to working note 2) Cost of preference share Cost of 10% Cost of Weighted average cost of capital 12.66%

17 Financing Decisions 4.17 Working Notes: 1. Weights of equity share capital, preference share and debentures in total investment of `100,00,000 Weight of equity share capital ` 40,00, ` 1,00,00,000 Weight of preference share capital Weight of Weight of ` 10,00, ` 1,00,00,000 ` 30,00, ` 1,00,00,000 ` 20,00, `1,00,00, Cost of equity capital: Dividend K e + g ` % 20% Current market price of share ` 16 + (iii) Comment: In the computation of weighted average cost of capital weights are preferred to book value. For example, weights representing the capital structure under a corporate financing situation, its cash flows are preferred to earnings and market. Balance sheet is preferred to book value balance sheet. Question 7 ABC Limited has the following book value capital structure: Equity Share Capital (150 million shares, `10 par) ` 1,500 million Reserves and Surplus ` 2,250 million 10.5% Preference Share Capital (1 million shares, `100 par) ` 100 million 9.5% Debentures (1.5 million debentures, `1000 par) ` 1,500 million 8.5% Term Loans from Financial Institutions ` 500 million The debentures of ABC Limited are redeemable after three years and are quoting at ` per debenture. The applicable income tax rate for the company is 35%. The current market price per equity share is ` 60. The prevailing default-risk free interest rate on 10-year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The beta of the company is

18 4.18 Financial Management The preferred stock of the company is redeemable after 5 years is currently selling at ` per preference share. Required: (i) (ii) Calculate weighted average cost of capital of the company using market value weights. Define the marginal cost of capital schedule for the firm if it raises ` 750 million for a new project. The firm plans to have a target debt to value ratio of 20%. The beta of new project is The debt capital will be raised through term loans. It will carry interest rate of 9.5% for the first 100 million and 10% for the next ` 50 million. Working Notes: 1) Computation of cost of debentures (K d ) : (1+ ytm) (1+ ytm) (1+ ytm) 3 Yield to maturity (ytm) 10% (approximately) K d ytm (1 Tc) 10% (1 0.35) 6.5% 2) Computation of cost of term loans (K T ) : i ( 1 T c ) 8.5% ( ) 5.525% 3) Computation of cost of preference capital (K P ) : (1+ YTM) (1+ YTM) (1+ YTM) (1+ YTM) (1+ YTM) 5 YTM K p 11% 11% (approximately) 4) Computation of cost of equity (K E ) : r f + Average market risk premium Beta 5.5%+ 8% % 5) Computation of proportion of equity capital, preference share, debentures and term loans in the market value of capital structure:

19 Financing Decisions 4.19 (` in million) Market value of capital structure ` Proportion Equity share capital (150 million share `60) 10.5% Preferential share capital (1 million shares 98.15) 9.5 % Debentures (1.5 million debentures `981.05) 9, , % Term loans , (i) Weighted Average cost of capital (WACC) : (Using market value weights) WACC K d D V T P + KT + KP + KE V V 6.5% % % % % * For the values of K d, K T, K P and K E and weights refer to working notes 1 to 5 respectively. (ii) Marginal cost of capital (MCC) schedule : Question 8 K E (New Project) 5.5% + 8% % K d 9.5% ( ) 6.175% 10% (1 0.35) 6.5% MCC 17% x % + 6.5% 14.86% (Approximately) The R&G Company has following capital structure at 31 st March 2004, which is considered to be optimum: ` 13% debenture 3,60,000 E V

20 4.20 Financial Management 11% preference share capital 1,20,000 Equity share capital (2,00,000 shares) 19,20,000 The company s share has a current market price of ` per share. The expected dividend per share in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue: Year EPS (`) The company can issue 14 percent new debenture. The company s debenture is currently selling at ` 98. The new preference issue can be sold at a net price of ` 9.80, paying a dividend of ` 1.20 per share. The company s marginal tax rate is 50%. (i) (ii) Calculate the after tax cost (a) of new debts and new preference share capital, (b) of ordinary equity, assuming new equity comes from retained earnings. Calculate the marginal cost of capital. (iii) How much can be spent for capital investment before new ordinary share must be sold? (Assuming that retained earnings available for next year s investment are 50% of 2004 earnings.) (iv) What will be marginal cost of capital (cost of fund raised in excess of the amount calculated in part (iii))if the company can sell new ordinary shares to net ` 20 per share? The cost of debt and of preference capital is constant. The existing capital structure is assumed to be optimum. Existing Capital Structure Analysis Type of capital Amount (`) Proportions 13% debentures 3,60, % Preference 1,20, Equity 19,20, ,00, (i) (a) After tax cost of debt K d 14 (1 0.5)

21 Financing Decisions 4.21 (ii) (b) After tax cost of preference capital (new) Kp After tax cost of retained earnings K e g (Here g is the growth rate) Types of capital Proportion Specific cost Product (1) (2) (3) (2) (3) Debt Preference Equity Marginal cost of capital at existing capital structure.1528 or 15.28% (iii) The company can spend the following amount without increasing its MCC and without selling the new shares. Retained earnings ,00,000 2,77,300 The ordinary equity (retained earnings in this case) is 80% of the total capital. Thus 2,77,300 investment before issuing equity ` 3,46,625 (iv) If the company spends more than ` 3, 46,625, it will have to issue new shares. The cost of new issue of ordinary share is : K e The marginal cost of capital of ` 3,46,625 Types of capital (1) Proportion (2) Specific cost (3) Product (2) (3) Debt

22 4.22 Financial Management Preference Equity(new) Marginal cost of capital at existing or % capital structure Question 9 A Company issues ` 10,00,000 12% debentures of ` 100 each. The debentures are redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax bracket. Required: (i) (ii) Calculate the cost of debt after tax, if debentures are issued at (a) (b) (c) K d Par 10% Discount 10% Premium. If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par? (RV I (1 Tc ) + NP Where, RV + 2 N NP) I Annual Interest Payment NP Net proceeds of debentures RV Redemption value of debentures T c Income tax rate N Life of debentures (i) (a) Cost of debentures issued at par. (10,00,000 10,00,000) 1,20,000 (1 0.35) , % 10,00, ,00,000 10,00,000 2

23 Financing Decisions 4.23 (ii) (b) Cost of debentures issued at 10% discount (c) (10,00,000 9,00,000) 1,20,000 (1 0.35) , , % 10,00, ,00,000 9,50,000 2 Cost of debentures issued at 10% Premium (10,00,000 11,00,000) 1,20,000 (1 0.35) ,000 14,286 K d 6.07% 10,00, ,00,000 10,50,000 2 Cost of debentures, if brokerage is paid at 2% and debentures are issued at par Question 10 (10,00,000 9,80,000) 1,20,000 (1 0.35) ,857 K d 8.17% (10,00,000 20,000) + 10,00,000 9,90,000 2 You are required to determine the weighted average cost of capital of a firm using (i) book-value weights and (ii) market value weights. The following information is available for your perusal: Present book value of the firm s capital structure is: Debentures of ` 100 each 8,00,000 Preference shares of ` 100 each 2,00,000 Equity shares of ` 10 each 10,00,000 All these securities are traded in the capital markets. Recent prices are: ` 20,00,000 ` 110, Preference ` 120 and Equity ` 22. Anticipated external financing opportunities are as follows: (i) ` 100 per debenture redeemable at par : 20 years maturity 8% coupon rate, 4% floatation costs, sale price ` 100. (ii) ` 100 preference share redeemable at par : 15 years maturity, 10% dividend rate, 5% floatation costs, sale price ` 100. (iii) Equity shares : ` 2 per share floatation costs, sale price ` 22.

24 4.24 Financial Management In addition, the dividend expected on the equity share at the end of the year is ` 2 per share; the anticipated growth rate in dividends is 5% and the firm has the practice of paying all its earnings in the form of dividend. The corporate tax rate is 50%. (a) Working Notes: Determination of Specific Costs: (i) Cost of Debentures before tax (k d ) (P NP) I + k d n (P + NP) 2 Where, I Annual interest payment P Redeemable/payable value of debenture at maturity NP Net sale value from issue of debenture/face value expenses (100 96) 8 + k d or 8.36% ( ) 98 2 Cost of debenture after tax K d (1 t) 8.36 (1.50) 4.18%. (ii) Cost of Preference Shares (k p ) (P NP) D + k p n (P + NP) 2 Where, D Fixed annual dividend P Redeemable value of preference shares n Number of years to maturity.

25 Financing Decisions 4.25 (100 95) 10 + K p or 10.59% ( ) (iii) Cost of Equity (k e ) (i) D k e + g NP Where, D Expected dividend per share NP Net proceeds per share g Growth expected in dividend 2 2 k e or 15% Computation of Weighted Average Cost of Capital based on Book Value Weights Source of Capital Book Value ` Weights to Total Capital Specific Cost Total Cost Debentures (` 100 per debenture) 8,00, Preference Shares (` 100 per share) 2,00, Equity Shares (` 10 per share) 10,00, ,00, Cost of Capital 10.23% (ii) Computation of Weighted Average Cost of Capital based on Market Value Weights Source of Capital Market Value ` Weights to Total Capital Specific Cost Total Cost Debentures (` 110 per debenture) 8,80, Preference Shares (` 120 per share) 2,40, Equity Shares (` 22 per share) 22,00, ,20, Cost of Capital 11.81%

26 4.26 Financial Management Question 11 The following is the capital structure of a Company: Source of capital Book value Market value Equity ` 100 each 80,00,000 1,60,00,000 9 per cent cumulative preference ` 100 each 20,00,000 24,00, per cent debentures 60,00,000 66,00,000 Retained earnings 40,00,000 2,00,00,000 2,50,00,000 The current market price of the company s equity share is ` 200. For the last year the company had paid equity dividend at 25 per cent and its dividend is likely to grow 5 per cent every year. The corporate tax rate is 30 per cent and shareholders personal income tax rate is 20 per cent. You are required to calculate: (i) (ii) (iii) (i) Cost of capital for each source of capital. Weighted average cost of capital on the basis of book value weights. Weighted average cost of capital on the basis of market value weights. Calculation of Cost of Capital for each source of capital: 1. Cost of Equity Capital: DPS (1+ g) K e g MP 25 ( ) %. 2. Cost of preference capital or K p 9%. 3. Cost of Debentures: K d (after tax) r (1 T) 11 (1 0.3) 7.7%. ` `

27 Financing Decisions Cost of Retained Earnings: K r K e (1 T p ) (1 0.2) 14.5%. (ii) Weighted Average Cost of Capital Source (On the basis of Book Value Weights) Amount (Book Value) (`) Weights Cost of Capital (after tax) (%) WACC (%) (1) (2) (3) (4) (5) (3) (4) Equity Capital 80,00, Preference Capital 20,00, Debentures 60,00, Retained earnings 40,00, ,00,00, Hence, WACC on the basis of Book Value Weights 13.36%. (iii) Weighted Average Cost of Capital (On the basis of Market value weights) Source Amount (Market Value) (`) Weights Cost of Capital (after tax) (%) WACC (%) (1) (2) (3) (4) (5) (3) (4) Equity Capital 1,60,00, Preference Capital 24,00, Debentures 66,00, Retained earnings 2,50,00, Hence, WACC on the basis of Market Value Weights %

28 4.28 Financial Management Question 12 The capital structure of a company as on 31 st March, 2009 is as follows: Equity capital : 6,00,000 equity shares of ` 100 each Reserve and surplus ` 6 crore 1.20 crore 12% debenture of ` 100 each 1.80 crore For the year ended 31 st March, 2009 the company has paid equity Dividend is likely to grow by 5% every year. The market price of equity share is ` 600 per share. Income-tax rate applicable to the company is 30%. Required: (i) Compute the current weighted average cost of capital. (ii) The company has plan to raise a further ` 3 crore by way of long-term loan at 18% interest. If loan is raised, the market price of equity share is expected to fall to ` 500 per share. What will be the new weighted average cost of capital of the company? (i) Computation of Current Weighted Average Cost of Capital Cost of Debentures (k d ) I 12 k d (1 t) (1-0.30) 8.4% NP 100 Cost of Equity Share Capital (k e ) D 1 k e + g P 0 24 ( ) % % Source Amount (` in crores) Weight Cost of Capital Weighted Cost of Capital Equity % 7.36 Debentures % 1.68 Weighted Average Cost of Capital 9.04 Current Weighted Average Cost of Capital 9.04 %

29 Financing Decisions 4.29 (ii) Computation of New Weighted Average Cost of Capital Cost of Existing Debentures (k d ) Cost of existing debentures 8.4% Cost of Loan 18 Cost of Loan (1-0.30) % 100 Cost of Equity Share Capital (k e ) 24 (1.05) 25.2 k e + 5% % Source Amount (` in crores) Weight Cost of Capital Weighted Cost of Capital Equity % Debt (Loan) % 3.15 Debentures % % New Weighted Average Cost of Capital % Question 13 The capital structure of a company consists of equity shares of ` 50 lakhs; 10 percent preference shares of ` 10 lakhs and 12 percent debentures of ` 30 lakhs. The cost of equity capital for the company is 14.7 percent and income-tax rate for this company is 30 percent. You are required to calculate the Weighted Average Cost of Capital (WACC). Calculation of Weighted Average Cost of Capital (WACC) Source Amount Weight Cost of Capital after tax WACC ` Equity Capital 50,00, % Preference Capital 10,00, % Debentures 30,00, * Total 90,00, * Cost of Debentures (after tax) 12 (1 0.30) 8.4% Weighted Average Cost of Capital %

30 4.30 Financial Management Question 14 Z Ltd. s operating income (before interest and tax) is ` 9,00,000. The firm s cost of debt is 10 per cent and currently firm employs ` 30,00,000 of debt. The overall cost of capital of firm is 12 per cent. Required: Calculate cost of equity. Calculation of Cost of Equity Calculation of value of firm (v) Market value of equity (S) EBIT Overall cost of capital ( K o ) 9,00,000 R` 75,00, V Debts Market value of debts (D) 30,00,000 K e Question 15 (Cost of equity) K o V K S d D S 75,00,000 30,00,000 ` 45,00,000 75,00,000 30,00, ,00,000 45,00, K e 13.3%. ABC Ltd. wishes to raise additional finance of ` 20 lakhs for meeting its investment plans. The company has ` 4,00,000 in the form of retained earnings available for investment purposes. The following are the further details: Debt equity ratio 25 : 75. Cost of debt at the rate of 10 percent (before tax) upto ` 2,00,000 and 13% (before tax) beyond that. Earnings per share, ` 12. Dividend payout 50% of earnings.

31 Financing Decisions 4.31 Expected growth rate in dividend 10%. Current market price per share, `60. Company s tax rate is 30% and shareholder s personal tax rate is 20%. Required: (i) (ii) (iii) Calculate the post tax average cost of additional debt. Calculate the cost of retained earnings and cost of equity. Calculate the overall weighted average (after tax) cost of additional finance. Pattern of raising capital ,00,000 Debt 5,00,000 Equity 15,00,000 Equity fund (` 15,00,000) Retained earnings ` 4,00,000 Equity (additional) ` 11,00,000 Total ` 15,00,000 Debt fund (` 5,00,000) 10% debt ` 2,00,000 13% debt ` 3,00,000 Total ` 5,00,000 (i) K d Total Interest (1 t) / ` 5,00,000 [20, ,000] (1 0.3)/ 5,00,000 or (41,300 / 5,00,000) % (ii) Ke [EPS payout / mp] + g [12 (50%) / 60] + 10% 10% + 10% 20% Kr Ke (1 tp) 20(1 0.2) 16% (iii) Weighted average cost of capital Amount After tax Cost Equity Capital 11,00, % 2,20,000 Retained earning 4,00, % 64,000 Debt 5,00, % 41,300 Total 20,00,000 3,25,300 Ko (3,25,300 / 20,00,000) %

32 4.32 Financial Management Question 16 The capital structure of MNP Ltd. is as under: 9% Debenture ` 2,75,000 11% Preference shares ` 2,25,000 Equity shares (face value : ` 10 per share) ` 5,00,000 ` 10,00,000 Additional information: (i) (ii) (iii) ` 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market price per debenture is ` 105. ` 100 per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The market price per preference share is ` 106. Equity share has ` 4 floatation cost and market price per share of ` 24. The next year expected dividend is ` 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends. (iv) Corporate Income-tax rate is 35%. Required : Calculate Weighted Average Cost of Capital (WACC) using market value weights. Computation of Weighted Average Cost of Capital using Market Value Weights Cost of Equity (k e ) D K e 1 ` 2 + g + 5% 15% Po ` 24 ` 4 Cost of Debt (k d ) I(1 T) + (RV NP) / N K d (RV + NP) / 2 9(1 0.35) + (100 98) /10 ( ) / % Cost of Preference Shares (k p ) PD + (RV NP) /N K p (RV + NP) / 2

33 Financing Decisions (100 97) /10 ( ) / % Calculation of WACC using Market Value Weights Source of Capital Market Value (`) Weights to Total Capital Specific Cost Total Cost Debentures (` 105 per debenture) 2,88, Preference Shares (` 106 per preference share) 2,38, Equity Shares (` 24 per share) 12,00, WACC using market value weights 13.02% Question 17 17,27, Y Ltd. retains ` 7,50,000 out of its current earnings. The expected rate of return to the shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax bracket. Calculate the cost of retained earnings. Computation of Cost of Retained Earnings (K r ) K r k (1-T P ) (1-B) K r 0.10 (1-0.30) (1-0.03) 0.10 (0.70) (0.97) or 6.79% Cost of Retained Earnings 6.79% Question 18 SK Limited has obtained funds from the following sources, the specific cost are also given against them: Source of funds Amount (`) Cost of Capital Equity shares 30,00, percent Preference shares 8,00,000 8 percent Retained earnings 12,00, percent Debentures 10,00,000 9 percent (before tax)

34 4.34 Financial Management You are required to calculate weighted average cost of capital. Assume that Corporate tax rate is 30 percent. Calculation of Weighted Average Cost of Capital (WACC) Sources of Funds Amount (`) Weight Cost of Capital (after tax) % WACC % Equity Shares 30,00, Preference Shares 8,00, Retained Earnings 12,00, Debentures 10,00, * 1.05 Total 60,00, % *Cost of Debentures (Kd) (after tax) Kd (before tax) x (I T) 9% (1-0.3) 6.3% Weighted Average Cost of Capital 11.81% Question 19 PQR Ltd. has the following capital structure on October 31, 2010: Equity Share Capital (2,00,000 Shares of ` 10 each) Reserves & Surplus 12% Preference Shares 9% Debentures ` 20,00,000 20,00,000 10,00,000 30,00,000 80,00,000 The market price of equity share is ` 30. It is expected that the company will pay next year a dividend of ` 3 per share, which will grow at 7% forever. Assume 40% income tax rate. You are required to compute weighted average cost of capital using market value weights. Computation of Weighted Average Cost of Capital (WACC): Existing Capital Structure Calculation of Cost of Equity D Cost of Equity 1 + g P o

35 Financing Decisions 4.35 ` ` % After Tax Cost Weights Weighted Cost 9% Debentures (K d ) 0.054* % Preference Shares Equity Capital *K d rd* (1 T c ) 9% (1 0.4) 5.4% or Weighted Average Cost of Capital or 12.03% Question 20 Beeta Ltd. has furnished the following information: - Earning per share (ESP) ` 4 - Dividend payout ratio ` 25% - Market price per share ` Rate of tax 30% - Growth rate of dividend 8% The company wants to raise additional capital of ` 10 lakhs including debt of ` 4 lakhs. The cost of debt (before tax) is 10% upto ` 2 lakhs and 15% beyond that. Compute the after tax cost of equity and debt and the weighted average cost of capital. (i) Cost of Equity Share Capital (K e ) K e (after tax) DPS 100 MPS + G DPS 25% of ` 4 ` 1.00 K e K e 10.5% (ii) Cost of Debt (K d ) K d (After tax) Interest 100 (1 T) Net Proceeds Interest on ` 10% 20,000

36 4.36 Financial Management Interest on ` 15% 30,000 50,000 K d 50, (1 0.3) 4,00, % (iii) Weighted Average Cost of Capital (WACC) Source (1) Equity Debt Amount (2) In ` 6,00,000 4,00,000 Weights (3) Cost of Capital (4) Weighted Average Cost (5) (3)x(4) Weighted Average Cost of Capital or 9.8% [Note: Ke can be computed alternatively taking growth rate into consideration (D 0 (1+g)/P 0 +g). The values of Ke and WACC then would change accordingly as 10.7% and 9.92% respectively.] Question 21 RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost of equity K e 21%. The company wants to buyback equity shares worth ` 5,00,000 by issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model (with taxes), you are required to calculate: (i) (ii) (iii) Market value of RES Ltd. Cost of Equity K e Weighted average cost of capital and comment on it. Computation of Market Value, Cost of Equity and WACC of RES Ltd. Market Value of Equity 25,00,000 K e 21% Net income (NI) for equity - holders K e Market Value of Equity Net income (NI) for equity holders ,00,000 Net income for equity holders 5,25,000

37 Financing Decisions 4.37 EBIT 5,25,000/0.7 7,50,000 All Equity Debt and Equity EBIT 7,50,000 7,50,000 Interest to debt-holders - 75,000 EBT 7,50,000 6,75,000 Taxes (30%) 2,25,000 2,02,500 Income available to equity shareholders 5,25,000 4,72,500 Income to debt holders plus income available to shareholders 5,25,000 5,47,500 Present value of tax-shield benefits ` 5,00,000 x ,50,000 (i) Value of Restructured firm 25,00, ,50,000 26,50,000 (ii) Cost of Equity (K e ) Total Value 26,50,000 Less: Value of Debt 5,00,000 Value of Equity 21,50,000 K e 4,72, % 21,50,000 (iii) WACC Cost of Debt (after tax) 15% (1-0.3) 0.15 (0.70) % Components of Costs Amount Cost of Capital Weight Weighted COC Equity 21,50, Debt 5,00, ,50, WACC 19.8% Comment: At present the company is all equity financed. So, Ke Ko i.e. 21%. However after restructuring, the Ko would be reduced to 19.81% and Ke would increase from 21% to 21.98%. Reduction in Ko and increase in Ke is good for the health of the company.

38 4.38 Financial Management UNIT II : CAPITAL STRUCTURE DECISIONS Question 1 Explain in brief the assumptions of Modigliani-Miller theory. Assumptions of Modigliani Miller Theory (a) Capital markets are perfect. All information is freely available and there is no transaction cost. (b) All investors are rational. (c) No existence of corporate taxes. (d) Firms can be grouped into Equivalent risk classes on the basis of their business risk. Question 2 What is optimum capital structure? Explain. Optimum Capital Structure: Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases upto a certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consideration of all factors. Question 3 What is Net Operating Income (NOI) theory of capital structure? Explain the assumptions of Net Operating Income approach theory of capital structure. Net Operating Income (NOI) Theory of Capital Structure According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm. Assumptions (a) (b) The corporate income taxes do not exist. The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.

39 Financing Decisions 4.39 (c) The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders. (d) The overall cost of capital (K o ) remains constant for all degrees of debt equity mix. Question 4 Explain the principles of Trading on equity. The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm s earning and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is favourable, in the sense, increase in earnings per share more proportionately to the increased earnings before interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is said to be positive. Question 5 Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure of a company. Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital Structure of a Company The determination of optimum level of debt in the capital structure of a company is a formidable task and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest cost. Determination of optimum level of debt involves equalizing between return and risk. EBIT EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective of debt-equity mix. The indifference point for the capital mix (equity share capital and debt) can be determined as follows: ( EBIT I1)(1 T) ( EBIT I2)(1 T) E E 1 2 Question 6 What do you understand by Capital structure? How does it differ from Financial structure?

40 4.40 Financial Management Meaning of Capital Structure and its Differentiation from Financial Structure Capital Structure refers to the combination of debt and equity which a company uses to finance its long-term operations. It is the permanent financing of the company representing long-term sources of capital i.e. owner s equity and long-term debts but excludes current liabilities. On the other hand, Financial Structure is the entire left-hand side of the balance sheet which represents all the long-term and short-term sources of capital. Thus, capital structure is only a part of financial structure. Question 7 Discuss financial break-even and EBIT-EPS indifference analysis. Financial Break-even and EBIT-EPS Indifference Analysis Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e. interest and preference dividend. It denotes the level of EBIT for which firm s EPS equals zero. If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity would be preferred. EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen. Where, (EBIT I 1)(1 T) (EBIT I 2)(1 T ) E E 1 2 EBIT Indifference point E 1 Number of equity shares in Alternative 1 E 2 Number of equity shares in Alternative 2 I 1 Interest charges in Alternative Interest charges in Alternative 2 T Tax-rate Alternative 1 All equity finance Alternative 2 Debt-equity finance.

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