Cost of Capital of a Company| Essay | Accounting

Read this essay to learn about:- 1. Long Term Source of Finance 2. Weighted Average Cost of Capital.

Essay # 1. Long Term Source of Finance:

What type of long term finance a company uses to fund its capital requirement?

1. Long-term debt – secured and unsecured loans;

2. Preference shares; and

3. Equity Shares.

Given below are the Sources of Funds of Tata Tea Ltd. 2001-03 which we shall use as company example while computing cost of capital.

Out of total long term fund deployed 18.81 % was raised by Tata Tea (in 2002-03) using debt and balance through equity (meaning share capital and reserves and surplus). This was 18.12 % in 2001-02 signifying minor changes in declining interest rate regime.

Computation of Cost of Debt:

In the simplest form this is given by:

K_d = Cost of Debt = Interest rate × (1 – Tax rate)

Interest is the cash outflow arising out of debt. However, interest is regarded as a deductible expense for computing taxable income under the Income-tax Act, 1961. Thus interest creates tax benefit. Cost to the company for raising debt is cash outflow arising out of interest payment net of tax saving.

Illustration 1:

X Ltd. raised 10% Debentures of Rs.100 each at par. The company is in 30% tax bracket. Find cost of debenture.

Solution:

10% × (1 – 30%) = 7%.

However, debts may be raised at a discount but repaid at par. Let us see how to approximate cost of debt in such a case.

K_d = Cost of Debt

Illustration 2:

X Ltd. raised 10% Debentures of Rs.100 each at Rs.98 repayable at par after 5 years. The company is in 30% tax bracket. Find out cost of debenture.

Solution:

Illustration 3:

X Ltd. raised 10% Debentures of Rs.100 each at Rs.98 repayable after 5 years at Rs.101. The company is in 30% tax bracket. Find cost of debenture.

Solution:

However, this formula makes an approximation about the cost of debt. The best approach should be to apply Internal Rate of Return concept.

Illustration 4:

Applying Excel Function, find out cost of debt using data given in Illustration 3.

Illustration 5:

A company issued 10% Debentures of Rs.100 each at Rs.98. Interest is payable at the end of every year during its tenure of 5 years. Corporate tax rate is 35% and surcharge is 5%. Expenses of debenture issue is 0.5% on the par value. The company is entitled to get tax benefit on discount on debenture issue and issue expense in the year in which such expenses are incurred. Find out cost of debentures.

Solution:

Tax rate = 35% + 5% of 35% = 36.75%

Issue Expenses & Discount = Rs.100 – Rs.97.5 = Rs.2.5

Illustration 6:

A company issued 10% Debentures of Rs.100 each at Rs.98. Interest is payable at the end of every year during its tenure of 5 years. Corporate tax rate is 35% and surcharge is 5%. Expenses of debenture issue is 0.5% on the par value. The company is entitled to get tax benefit on discount on debenture issue and issue expense in the year in which such expenses are incurred. Find out cost of debentures. Principal is repayable in two equal instalments from the end of 4th year, i.e. Rs.50 at the end of fourth year and Rs.50 at the end of fifth year.

Cost of Debt of Tata Tea:

Now let us take financial information from the Balance Sheets and Profit and Loss Accounts of Tata Tea to apply the theoretical framework for computing cost of debt of Tata Tea Ltd. for the year 2002-03:

Illustration 7:

Average Cost of Debt of Tata Tea: 

To find out average cost of debt of Tata Tea Ltd follow the steps given below:

i. Find out average interest rate. Collect data of interest from profit and loss account.

Find out average interest:

ii. Find out effective tax rate of Tata Tea?

This is given by Tax/Profit Before tax % = 29.30%

iii. Cost of debt = 12.69% × (100 – 29.30) % = 8.97%.

Cost of Preference Shares:

Preference shares as source of corporate funds enjoys preference for dividend and repayment of capital over equity shares. Dividend on preference shares is not deductible for tax purpose, these are treated as appropriations. Also dividend on preference shares is subject to dividend tax under section 105-0 of the Income-tax Act, 1961. Dividend is taxable @ 12.5% plus surcharge. A domestic company has to pay 5% surcharge.

Illustration 8:

Find out cost of 10% Preference Shares of Rs.100.

Solution:

Dividend + Dividend tax + Surcharge on Dividend tax

= 10% + 10% × 12.5%+ 10% × 12.5% × 5% = 11.31%

Comparative Cost of Debenture and Preference Shares:

In Illustration 1 we have found that cost of 10% debentures works out to be 7%.

In Illustration 8 we have found that cost of 10% preference shares is 11.31%.

Preference shares proves to be a costlier option as compared to deben­tures because of the differential arising out of tax treatment. For this reason, preference shares as a source of corporate finance has become obsolete.

Are preference shares more or less risky to investors than debt?

Yes, it is riskier to debt. A company not required to pay preference dividend. However, unless it pays preferred dividend, it cannot pay common dividend, and it is difficult to raise additional funds, and also because of failure to pay preference dividend allows the preference shareholders to have voting right.

Cost of Equity Share Capital:

Equity stands for both equity share capital and reserves and surplus.

Return to equity shareholders is dividend and capital gains that share­holders can get through capital market.

Accordingly, the best approach to find out cost of equity is given by Capital Asset Pricing Model (CAPM). CAPM is based on opportunity cost approach which means the return stockholders could earn from alter­native investments of equal risk.

CAPM: R_i = R_f + (R_m – R_f) β

R_i = return on equity

R_f = Risk free rate

R_m = Market return

β = Slope of the regression line of stock return on market return

CAPM model explains that return of particular equity can be estimated from risk free rate and market return.

Illustration 9:

Find out cost of equity of Tata Tea Ltd. 2002-03 take its beta 1.10 from Table 13.1, Risk free rate is 6.97% and Market return 14.06%

Ke = 6.97% + (14.06% – 6.97%) × 1.1 = 14.77%.

Now let us see the CAPM cost of equity S&P CNX NIFTY 50 companies:

Dividend Growth Model:

An alternative approach of computing cost of equity is the presumption that “price of equity share is given by discounted value of future dividend”. This model is also called Dis­counted Cash Flow Model.

P₀ = Current market price, D₀ = Current dividend, g = Expected dividend growth

Given present dividend and its expected growth and current market price, cost of equity can be estimated applying the equation given above.

Illustration 10:

Current market price of equity share of Rs.10 each Y Ltd. is Rs.300. The company paid dividend @ 200% in the current period. As per the current forecast the dividend of the company will rise @ 1% p.a. because of the business growth which the company is expected to achieve. Find out the cost of equity of Y Ltd.

Would you like this approach?

Shortcomings of this approach are:

1. There are many companies which do not pay dividend. It cannot be presumed that in such cases cost of equity is zero. Opportunity cost of the equity should be computed.

2. There are companies which pay low dividend and retain a maximum portion of its profit for reinvestment. In such cases cost of equity may even work out to be lower than risk free rate. This situation is also not acceptable under risk – return approach.

3. Sometimes company may payout at a very high rate. That may not reflect true cost of equity as that is not sustainable dividend.

Essay # 2. Weighted Average Cost of Capital:

Each company uses equity or debt instruments in different propor­tion for financing its capital requirement. Also cost of debt and equity will vary from company to company.

The simple reasons for such cost differences are:

(i) Differences in borrowing rates,

(ii) Differences in effective tax rate, and

(iii) Beta of the company.

In any case all companies would strategise to strike a balance between debt and equity to achieve lowest possible cost of capital.

Overall cost of capital is given by “weighted average cost of capital”, WACC. Book value or market value debt and/or equity are taken as weights. Since corporate debts are mostly unlisted in India, getting market value of all debts is unrealistic.

Also equity market is highly volatile, and therefore, using market capitalisation of the company of a particular date may lead to over- or under- estimation equity weight. More stable approach should be to take book value of equity and debt as weights, or average market capitalization of equity and book value of debts as weights.

Illustration 11:

Given below is a simple capital structure comprising of debt and equity.

The company pays tax @ 36.75%. Beta of the company is 1.4, market return is 14% and risk free rate is 6.5%. Find out weighted average cost of capital of the company.

Solution:

(1) WACC using book value as weight:

WACC = 14.1%

(2) WACC using book value as weight:

WACC = 16%

Since the objective is to maximize value of the equity shareholders, using market value of equity as weight should be a better approach. Then the company would target to earn at rate higher than 16%.

Illustration 12:

Find out WACC of Tata Tea for 2002-03.

Solution:

WACC of Tata tea

WACC = 13.68%

Marginal Cost of Capital versus WACC:

Reconsider Illustration 12. If Tata Tea plans to invest Rs.100 cr. in a project, What minimum return would make the project acceptable? Assume that the new project is entirely debt financed @ 10%. Effective tax rate is 36.75%.

The most sensible analysis should be to compare marginal cost with the marginal return. The marginal cost of investment in the new project is only 6.325%. So any return above that rate is acceptable. Marginal return > Marginal cost. This will create value to the shareholders. There is no need to ensure that all projects should earn @ WACC. But as whole WACC should be less than or equal to Return on Capital Employed.

Illustration 13:

Given below is the WACC of the company. It earns @ 20% on capital employed after payment of corporate tax , i.e., PBIAT = Rs.148 lacs.

So, ROCE > WACC.

Now the company considering to invest in a new project: Initial invest­ment Rs.500 lacs. It is to be financed using 10% debentures. Tax rate 35% plus 5% surcharge. The new project will generate PBIAT of 10% on Capital Employed. Should the company reject the new project as its PBIAT to Capital Employed 10% is less than its present WACC 14.1%? Should the company work out new WACC and compare the return? Should the company ignore WACC and go by marginal cost of capital?

Solution:

There is a classical debate as regards choice between marginal cost and WACC while evaluating new investments. Eugene F. Brigham and Michael C. Ehrhardt have argued in “Financial Management Prac­tice and Theory” that “We are primarily inter­ested in obtaining a cost of capital for use in the capital budgeting, and for this purpose the cost of the new money that will be invested is the relevant cost. So WACC of the marginal dollars raised is the target cost of capital.”

New WACC of the company after the investment is made:

WACC (New) = 10.97%

So the new project has added value to the equity shareholders. This proves that marginal cost of capital should be used for evaluating new investments.