Cost Of Capital 2

WEALTH MAXIMISATION (Value Creation) Company

MVA ($ Bn)

Capital ($ Bn)

ROIC %

WACC %

Spread %

Wealth Creators : Microsoft 219.2 Gen Electric 183.4 Walmart 182.8 Johnson & J 116.4 Merck 103.7 Coca-Cola 92.0 Proctor & G 89.7 Dell 63.6

25.6 99.4 73.6 47.5 37.5 24.1 41.8 7.2

17.7 14.5 13.0 15.0 19.1 17.5 13.0 17.6

13.6 8.1 8.8 9.0 8.7 6.9 8.0 12.5

4.2 6.4 4.2 6.0 10.4 10.6 4.9 5.1

Wealth Destroyers : Sears -8.2 Motorola -14.3 Gen Motors -15.5 Time Warner -83.0

51.7 45.9 119.8 183.0

6.1 0.0 1.8 -8.0

6.7 12.8 7.0 9.4

-0.6 -12.8 -5.3 -17.4

Source: Stern Stewart & Co.; data for year 2002. WACC varies from 6.7% to 13.6% & has inverse relationship with PE Ratio. MVA = Market Vaue Added (Market Value - Invested Capital) ROIC = Return on Invested Capital WACC = Weighted Average Cost of Capital

Four Factors Influence Shareholders' Wealth : Profitability, Growth, Capital Turnover (requirements) & WACC Recommended Book : Financial Management Theory & Practice by Brigham & Ehrhardt

Remarks

High Growth & High Return High Spread & Large Base Large Base & Turnover High Spread High Spread High Growth

Same business as Walmart!

ationship with PE Ratio.

ments) & WACC

ctice by Brigham & Ehrhardt

Price Earning (PE) Ratio PE Ratio ACC Bajaj Auto Colgate HDFC HDFC Bank Hindalco Hindustan ULever ICICI Bank Infosys L&T Nestle Reliance Comm Reliance Indusries Steel Authority SBI TCS Tata Motors Tata Steel (Eco Times dt. 23 Jun,09)

11.8 18.8 25.8 28.7 29.2 4.9 27.1 21.5 16.9 25.4 29.3 10.4 20.1 9.9 9.8 13.8 7.9 2.7

E/P % 8.47% 5.32% 3.88% 3.48% 3.42% 20.41% 3.69% 4.65% 5.92% 3.94% 3.41% 9.62% 4.98% 10.10% 10.20% 7.25% 12.66% 37.04%

Cost of Debt Company A issues 10% debentures and pays Income-tax @ 35%. Cost of Debt = 10% (coupon rate) x (1-tax saving @ 35%) 6.50% Why tax is deducted from interest payment ?

PBIT Less: Interest

Case A Case B 100 100 10

0

90

100

I. Tax @35%

31.5

35

PAT

58.5

65

PBT

Additional Cost of Interest

6.5

(difference between 65 & 58.5)

For cost of capital calculation for the entire project, the operating liabilities like Accounts Payable(suppl accruals and even short term funding are not considered as they are considerd as part of operating cos included in the investment requirements of a project.

s like Accounts Payable(suppliers,etc), iderd as part of operating cost. They are not

Debt with Floatation Cost Company X issues 12% bonds of Rs 1000 each repayable after 10 years with yearly interest payment. It collects Rs 980 per bond after meeting floatation cost like brokerage & other issue expenses. 980 = (present value)

120 + (1+r)

120 + (1+r)^2

120 + (1+r)^3

+ ……….

120 + (1+r)^9

1,120 (1+r)^10

Outflow over 10 years

Present Inflow

Pre Tax Calculation Year Flow Present Value 0 980 980.00 1 (120) (106.80) 2 (120) (95.05) 3 (120) (84.60) 4 (120) (75.29) 5 (120) (67.01) 6 (120) (59.64) 7 (120) (53.08) 8 (120) (47.24) 9 (120) (42.04) 10 (1,120) (349.25) 0.00 IRR (r) =12.3592% pre tax calculation

Growth Factor (106.80) x

1.123592 =

(120)

(349.25) x

3.206904 =

(1,120)

1 1.12 1.26 1.42 1.59 1.79 2.01 2.260790 2.54 2.85 3.21

Short Cut Approximate Method : Cost of issue of debentures = interest payment pa + floation cost, discount on issue or premium on r Life of debentures Net realisation on issue of debentures Rs120+Rs 20 10 Rs 980

Year 0 1 2 3 4 5 6 7 8 9 10

Cash Flow 980 (120) (120) (120) (120) (120) (120) (120) (120) (120) (1,120)

Accretion @ IRR 1101.12 1,102.38 1,103.79 1,105.38 1,107.17 1,109.17 1,111.43 1,113.96 1,116.80 1,120.00

Closing Balance 980.00 981.12 982.38 983.79 985.38 987.17 989.17 991.43 993.96 996.80 -

= 120+2 = 122 or 980 980

12.449%

980 @ IRR becomes 981.12 @ IRR becomes

1101.12 1102.38

996.80 @ IRR becomes

1120

Rate of Interest = Bond Value Rs

12% 1,000

Pre tax

on issue or premium on redemption fe of debentures

which is close to 12.359% calculated above.

after one year after one year

after one year

Debt with Floatation Cost Company X issues 12% bonds of Rs 1000 each repayable after 10 years with yearly interest payment. It collects Rs 980 per bond after meeting floatation cost like brokerage & other issue expenses. 980 = (present value)

120 + (1+r)

120 + (1+r)^2

120 + (1+r)^3

……….

980 = (present value)

120(1-t) + (1+r)

120(1-t) + (1+r)^2

120(1-t) + (1+r)^3

……….

Present Inflow

+

+

120 + (1+r)^9

1,120 (1+r)^10

120(1-t) + 1000+120(1-t) (1+r)^9 (1+r)^10

Outflow over 10 years

Pre Tax Calculation Year Flow Present Value 0 980 980.00 1 (120) (106.80) (106.80) x 2 (120) (95.05) 3 (120) (84.60) 4 (120) (75.29) 5 (120) (67.01) 6 (120) (59.64) 7 (120) (53.08) 8 (120) (47.24) 9 (120) (42.04) 10 (1,120) (349.25) (349.25) x 0.00 IRR (r) =12.3592% pre tax calculation

1.123592 =

(120)

3.206904 =

(1,120)

Post Tax Calculation @tax ra Year 0 1 2 3 4 5 6 7 8 9 10 IRR (r) = post tax calculation

Note : It is assumed that floation cost is fully tax deductible in Year 0.

Short Cut Approximate Method : Cost of issue of debentures = interest payment pa net of tax + floation cost, discount on issue or premi Life of debentures Net realisation on issue of debentures Rs78+Rs 20 *0.65 10 Rs 980+7

= 78+1.3 = 79.3 or 987 987

8.034%

erest payment.

Rate of Interest = Bond Value Rs Tax rate

12% 1,000 35%

Pre tax

1000+120(1-t)

Post Tax t=tax rate

Post Tax Calculation @tax rate 35% Growth Flow Present Value Factor 987 987.00 1 (78) (72.23) 78=120*(1-.35) 1.07994 (78) (66.88) 1.16626 (78) (61.93) 1.25949 (78) (57.35) 1.36017 (78) (53.10) 1.46890 (78) (49.17) 1.58632 (78) (45.53) 1.71312 (78) (42.16) 1.85006 (78) (39.04) 1.99795 (1,078) (499.61) 2.15766 0.00 7.994% post tax calculation (1,078) /

(499.61)

=

2.15766

ost, discount on issue or premium on redemption net of tax fe of debentures

which is close to 7.994% calculated above.

Since dividend on preference shares is not an admissible deduction while computing tax of a company, the formula explained for

pre-tax under the folder "debt&irrpreint" holds good.

ing tax of a company,

I. Under Capital Asset Pricing Model (CAPM): Re = Rrf Cost of Equity Risk free return

+ Rpm x Market risk premium

Beta Correlation between market & stock returns

e.g. Risk free return = 6% Market risk premium = 5% Beta = 1.1 Cost of Equity= 6% + 5%*1.1 =

11.50%

II. Dividend Yield plus Growth Rate Approach : Cost of Equity= Dividend per Share Price per Share

+

Expected Growth in Dividend

e.g. Rs 2 per share dividend Price per Share Rs 20

+

Expected growth 7%

10%

+

7% = 17%

III. Bond Yield plus Risk Premium Method : Not very popular. Cost of Equity= Bond Yield + 10% +

Bond Risk Premium ( i.e. risk premium for equity over own Bond yield) 4% =

14%

Normally, cost of retained earnings is not separately calculated as the market value of equity reflects equity capital and its reserves/ retained earnings. Cost of Equity= Dividend per Share + Price per Share t=tax rate of

Expected Growth in Dividend

x

(1-t) x

(1-f)

shareholders on dividend/ capital gains

f= floation cost (brokerage,publicity,etc) of equity issue e.g. Rs 2 per share dividend Price per Share Rs 20 =

10%

= 17% x 0.8 x .95

+

Expected growth 7%

+

or

7%

12.92%

x ( 1- shareholders' tax rate 20%)

x (1-0.2)

(1-0.05)

t value of equity

eholders' tax rate 20%) (1-floatation cost 5%)

Weighted Average Cost of Capital It is a weighted (or composite) average cost of each constituent of the company's capital. Company A has 40 lac equity shares whose value is Rs 25 each. Dividend per share is Rs 2. Expected growth 10%. 10% Debentures aggregating to Rs 4 crore. Tax rate 35%. 8% preference shares totalling Rs. 3 crore. Cost of equity = Dividend per Share Rs 2 + Expected growth 10% =8%+10% or 18% Price per share Rs 25 Structure Post tax Cost Product Total Equity Rs 100000000 18.00% 18000000 Total Debentures Rs

40000000

6.50%

2600000

Total Pref Shares Rs

30000000

8.00%

2400000

170000000 WACC=

Product Total Capital

=

23000000

13.5294%

If the Company raises new 11% Bonds totalling Rs 3 crore. This will result in increasing expected dividend to Rs 2.25 per share and share price falling to Rs 20 and expected growth increasing to 11%. Cost of equity = Dividend per Share Rs 2.25 + Expected growth11%=11.25%+11% or 22.25% Price per share Rs 20 Structure Post tax Cost 80000000 22.25%

Total Equity Rs Total Debentures Rs

40000000

6.50%

2600000

Total Pref Shares Rs

30000000

8.00%

2400000

Total Bonds

30000000

7.15%

2145000

180000000 WACC=

Product 17800000

Product Total Capital

=

13.8583%

24945000

Expected growth 10%.

cted dividend to

Optimum Capital Structutre Tax rate = 35% EBIT Rs = 30000000 Debt Interest 200 400 600 800 1000

Post Tax Interest 0% 0.00% 9% 5.85% 9.5% 6.18% 11% 7.15% 13% 8.45% 15% 9.75%

EBIT 300 300 300 300 300 300

(Rs in Lacs) Interest 18 38 66 104 150

EBT

Tax

300 282 262 234 196 150

105 99 92 82 69 53

EAT Cost of Equity 195 10.50% 183 10.75% 170 11% 152 13% 127 15% 98 18%

Optimum structure marked in bold when the Company's value is maximum.

Effects of Capital Structure on Value , Cost of Capital, Stock Price & EPS % After tax Cost of Equity financed cost of with debt debt 0% 0.00% 10.50% 10% 5.85% 10.75% 21% 6.18% 11.00% 34% 7.15% 13.00% 49% 8.45% 15.00% 65% 9.75% 18.00%

WACC

Share Market EPS Value of Price, Company assumed 10.50% 1,857.14 20 10.24% 1,905.12 22 10.01% 1,948.18 25 11.02% 1,770.00 21.5 11.82% 1,649.33 18.5 12.65% 1,541.67 15

No. of Shares 2.10 2.37 2.75 2.80 2.78 2.70

9,285,714 7,750,529 6,192,727 5,441,860 4,590,991 3,611,111

PE Ratio

9.52 9.30 9.09 7.69 6.67 5.56

Market Value of Equity

1,857.14 1,705.12 1,548.18 1,170.00 849.33 541.67

Market Value of Company 1,857.14 1,905.12 1,948.18 1,770.00 1,649.33 1,541.67

EPS lowest though PE Ratio highest

Though EPS highest, PE ratio deteriorates.

How should Finance Lease be treated for WACC calculation ?

What is 'Finance or Capital' Lease as against 'Operating Lease' ? e.g. Jet Airways acquiring aircrafts on 'Finance Lease' rather than buying Jaiprakash Associates acquiring specialised cement equipments installed in the factory on 'Financ Taking office on rental is an instance of 'Operating Lease'; risk & reward of property remains with l Treatment in financial statements 1. Capitalise as if it was a purchase : Company A's Balance Sheet Debt* 150 Curent Assets Equity 50 Fixed assets* 200

50 150 (*Fixed assets & debt include 100 of leased asset 200

2. Disclose only by Notes to Accounts : Company A's Balance Sheet Debt 50 Curent Assets 50 Equity 50 Fixed assets* 50 100 100 Notes indicate lease obligations over years.

Discussion on Enron scandal on 'Finance Lease'.

n the factory on 'Finance Lease' property remains with lessor (owner).

de 100 of leased assets)