Sources & Cost Of Capital

Sources & Cost of Capital Sreejith S FIMS

SS Fims March 2009

• • • • • • • • •

Sources of capital Cost of Capital; Concept Different Sources Short Term & Long Term Sources International Sources; ADR,GDR,ADS Money Market instruments Leasing, Factoring, Hire purchase, Installments Securitisation Commercial Paper Venture Capital SS Fims March 2009

Sources of Capital • Long Term Sources • Short Term Sources

SS Fims March 2009

Cost of Capital • The Minimum Required rate of return • Financing Cost • It is the discount rate for project appraisal

SS Fims March 2009

Cost of Capital • It is useful for - Evaluate investment decision - Designing a firms debt policy - Appraising the financial performance

SS Fims March 2009

Investment Evaluation • Cut off rate/hurdle rate • Discount Rate

SS Fims March 2009

Designing the Debt Policy • Tax Saving • Financial Risk • Maximising the share holder value

SS Fims March 2009

Performance Appraisal • Compare the actual with Proposed • Exibits the future requirements • It is useful in dividend decision

SS Fims March 2009

Investment’s Risk & Return Risk

EQUITY Preference Shares Other Debt instrument s

Debentur es Risk Free Security 5

10

15

20

25

30

35

Target Return % p.a.

SS Fims March 2009

Opportunity Cost • • • •

Shareholder’s View Next best option Depend on the business risk Considering Creditors Claims

SS Fims March 2009

Cost of Capital • Weighted average cost of Capital • Specific Cost of Capital

SS Fims March 2009

WACC • Combined Cost • Consider all Cost of capital • Weight age is given for each element

SS Fims March 2009

Specific Cost of Capital • Cost of Capital for each element • Cost of each sources is calculated separately

SS Fims March 2009

Determinants of Cost of Capital • Investors Required rate of return • Cost of Debt • Tax shield

SS Fims March 2009

Components ; Cost of Capital • Cost of Debt • Cost of Preference capital • Cost of Equity

Cost of Debt • Cost of Debentures • Cost of loans

Two Factors - Net cash Inflow - Net Cash Outflow

Cost of Perceptual Debt • • • • •

It is the rate of return Lender’s Expected rate of return Debt Carries interest/Coupon rate Before Tax Cost Tax Adjusted Cost

Cost Before Tax A. Debentures/Bonds Issued @ Par B. Debentures/Bonds Issued @ Discount C. Debentures/Bonds Issued @ Premium

Cost Before Tax Ki = i . SV Ki = Before Tax Cost of Debt SV= Sales Proceeds i = Annual Interest Payment

Find out The cost of Capital (Before Tax) •

A Company Has 10% Debentures of Rs 100,000 a) Issued at Par b) Issued at Discount 10% c) Issued at Premium 10%

Tax Adjusted Cost A. Debentures/Bonds Issued @ Par B. Debentures/Bonds Issued @ Discount C. Debentures/Bonds Issued @ Premium

Tax Adjusted Cost

Kd = Ki(1-T) Kd = Tax Adjusted Cost Ki = Before Tax Cost T= Tax Rate

Find out The cost of Capital (Tax Adjusted) •

A Company Has 10% Debentures of Rs 100,000 • Tax Rate 35% a) Issued at Par b) Issued at Discount 10% c) Issued at Premium 10%

Trial & Error Method

SV = I(PVFA n, Kd) + RV(PVF n,Kd) I =Annual Interest payment RV = Redemption Value

SS Fims March 2009

Find out Cost of Debt • Rs 15 Interest per year • No of Years 7 • Face Value Rs 100 Three Cases a)Maturity @ par b)Maturity @ a discount of Rs 6 c)Maturity @ a premium of Rs 10

SS Fims March 2009

Cost of Preference Shares • Irredeemable Preference Shares • Redeemable Preference Shares

Irredeemable Preference Shares Kd = PDIV SV PDIV :- Dividend SV = Sales Value

Find out The cost of Capital •

A Company Has 10% Irredeemable Preference Shares of Rs 100,000

a) Issued at Par b) Issued at Discount 10% c) Issued at Premium 10%

Redeemable Preference Shares Trial & Error Method SV = PDIV(PVFA n, Kd) + RV(PVF n,Kd)

RV = Redemption Value

SS Fims March 2009

Find out Cost of Preference Shares • 15 % Dividend • No of Years 7 • Face Value Rs 100; Three Cases a)Issued @ par b)Issued @ a discount of Rs 6 c)Issued @ a premium of Rs 10

SS Fims March 2009

Find out Cost of Preference Shares • 15 % Dividend • No of Years 7 • Face Value Rs 100; Three Cases a)Redeemed @ par b) “ “ @ a discount of Rs 6 c) “ “ @ a premium of Rs 10

SS Fims March 2009

Cost of Equity • Zero Growth • Constant Growth • Supernormal Growth

SS Fims March 2009

Zero Growth

Ke = Div MV DIV = Dividend MV = Market Value SS Fims March 2009

Constant Growth

Ke = Div + G MV G = Growth

SS Fims March 2009

Find out Cost of Equity • Market Price of Share is Rs 90 • Expected Dividend is Rs 4.5 • Dividend is expected to grow @ 8% rate

Supernormal Growth Trial & Error Method MV = n ∑DIV(1+g)^t (PV t, ke) + t 1

DIV x (ke-gn)

(1+ke)^n SS Fims March 2009

Find out cost of Equity • Market Value of Share : Rs 134 • Current Dividend : Rs 3.5 • Expected growth : 15% (next 6 years), Then 8%

SS Fims March 2009

Assuming that a firm pay tax at a Rs 50%, Calculate cost of Capital

Cases 1.A 8.5 % preference shares sold at par 2.Issue of 7% bond at par 3.Equity share price @ market Rs 120; Dividend Rs 9; Expected Growth 8%

SS Fims March 2009

Weighted Average Cost of Capital • Calculate The specific Cost of Capital • Multiply it with the proportion in the capital Structure • Add the weighted cost

Calculate WACC Capital Structure

Tax Adjusted Cost

Share Capital

450,000

Share Capital

18%

Reserve

150,000

Reserve

18%

Preference 100,000 Share

Preference 11% Share

Debt

Debt

300,000

8%

Floatation Cost • The present day business entities incur costs of flotation in a variety of forms. A few of them may be mentioned as below:  • • • •

Charges of the underwriters Legal Fees Commission to be paid to brokers Costs of Administration

Calculate cost of Equity A company plans to issue some new equity shares to raise additional funds. The net proceeds per share will be the market price share (Which is Rs 120) less floatation cost (which is 5% of the share price). If the company plans to pay a dividend of Rs 6 per share and the growth in dividend is expected to be 8%.

Sources of Capital

Internal Sources of Finance and Growth •

•

•

•

‘Organic growth’ – growth generated through the development and expansion of the business itself. Can be achieved through: Generating increasing sales – increasing revenue to impact on overall profit levels Use of retained profit – used to reinvest in the business Sale of assets – can be a double edged sword –

reduces capacity?

External Sources of Finance • Long Term – may be paid back after many years or not at all! • Short Term – used to cover fluctuations in cash flow • ‘Inorganic Growth’ – growth generated by acquisition

'Inorganic Growth' • •

Acquisitions The necessity of financing external inorganic growth – Merger/Joint Venture: • firms agree to join together – both may retain some form of identity

– Takeover: • One firm secures control of the other, the firm taken over may lose its identity

Sources of Capital • Long Term Sources • Short Term Sources

SS Fims March 2009

Long Term Sources • Equity • Preference • Debt

Long Term •

Shares (Shareholders are part owners of a company) – Ordinary Shares (Equities): • • • •

Ordinary shareholders have voting rights Dividend can vary Last to be paid back in event of collapse Share price varies with trade on stock exchange

– Preference Shares: • Paid before ordinary shareholders • Fixed rate of return • Cumulative preference shareholders – have right to dividend carried over to next year in event of non-payment

– New Share Issues – arranged by merchant or investment banks – Rights Issue – existing shareholders given right to buy new shares at discounted rate – Bonus– change to the share structure – increases number of shares and reduces value but market capitalisation stays the same

Equity • IPO • Private Placements • Euro Issues

IPO • Public issue of securities • New firms • First Time

Terms - IPO • • • • • •

Authorized Capital Issued Capital Subscribed Capital Paid-up Capital Par Value Share Premium

Features of Equity • • • •

Claim on Income Residual Ownership Voting right Right to Control etc

Private Placement • • • •

Issue of Shares Privately Less Compliance than Public Issue Time Effective Cost effective

Euro Issues • • • •

Public issue of Shares In Foreign Stock Exchanges ADR GDR

Debt Fund • • • •

Bond Debentures Term Loans Asset Based Financing

SS Fims March 2009

Bond/Debentures • • • •

A long term promissory note Tool for raising Loan Capital Stipulated Interest and time Public Sec Instruments- Bonds

SS Fims March 2009

Bond/Debenture Features • • • • •

Interest rate Maturity Redemption Secured/Unsecured Yield to Maturity

SS Fims March 2009

Types of Debentures • Non-Convertible Debentures • Fully Convertible Debentures • Partly Convertible Debentures

SS Fims March 2009

Pros & Cons • • • •

Less Costly No ownership dilution Fixed payment of interest Reduced real obligation •

Obligatory Payment Financial Risk • Redemption •

SS Fims March 2009

Terms & Loans • Long term debt • More Than one Year • From banks/Fis

SS Fims March 2009

Features • • • •

Maturity Direct Negotiation Security Convertibility

SS Fims March 2009

Leasing • Lease is a contractual arrangement/ transaction • in which a party (lessor) owning an asset/equipment provides • the asset for use to another party/ transfer the right to use the equipment to the user (lessee) • over a certain/for an agreed period of time for consideration in form of / in return for periodic payments / rental with or without a further payment (premium). • At the end of the contract period (lease period) the asset/equipment is returned to the lessor

Leasing • Parties to Contract: -financer (or owner - Lessor) -user (lessee)

• there could be lease-broker who works as an intermediary in arranging lease finance deals

Leasing • Ownership - Ownership vests with Lessor - Procession (Uses) is allowed to the lessee

On the Expiry date of the lease tenure; the asset revert to the lessor

Leasing • Lease Rentals - The consideration lessee pays • Term Lease - The period for of lease agreement

Classification of Leasing • A lease contract can be classified on various characteristics in following categories: . Finance Lease and Operating Lease . Sales & Lease back and Direct Lease . Single investor and Leveraged lease .Domestic and International lease

Finance Lease • A Finance lease is mainly an agreement for just financing the equipment/asset, through a lease agreement. • The owner /lessor transfers to lessee substantially all the risks and rewards incidental to the ownership of the assets (except for the title of the asset). The lessor is only a financier and is usually not interested in the assets. Economic life is normally utilized by one user – i.e. Ships, aircrafts etc. Generally a finance lease agreement comes with an option to transfer of ownership to lessee at the end of the lease period.

Operating Lease • the lessor does not transfer all risks and rewards • such assets which can be used by different users • without major modification • The lessor provides all the services associated with the assets, and the rental includes charges for these services. •

The lessor is interested in ownership of asset/equipment as it can be lent to various users, during its economic life.

• Examples of such lease are Earth moving equipments, computers, automobiles etc.

Sale and Lease Back • Sale and Lease Back: In this type of lease, the owner of an equipment/asset sells it to a leasing company (lessor) which leases it back to the owner (lessee).

Sale and Lease Back

Direct Lease: • Direct Lease: In direct lease, the lessee and the owner of the equipment are two different entities. A direct lease can be of two types: Bipartite and Tripartite lease.

Single Investor Lease • This is a bipartite lease in which the lessor is solely responsible for financing part. The funds arranged by the lessor (financier) have no recourse to the lessee.

Leveraged Lease • This is a kind of tripartite lease • the lessor arranges funds from another party. • the equipment is part financed by a third party (normally through debt) • a part of lease rental is directly transferred to such lender • towards the payment of interest and installment of principal.

Leveraged Lease

Domestic Lease • Domestic Lease: A lease transaction is classified as domestic if all the parties to such agreement are domiciled in the same country

International Lease • Import Lease • Cross Border Lease

Regulatory Framework of Leasing in India • The Indian Contract Act,1872 are applicable to all lease contracts. • Motor Vehicles Act are also applicable to specific lease agreements. • Indian Stamp Act: • RBI NBFCs Directions:

A lease agreement includes • • • • • •

i. Nature of lease: ii. Description of equipment iii. Delivery and re-delivery of asset iv. Lease Period & Lease Rentals v. Uses of assets allowed vi. Title: Identification and ownership of equipment • vii. Repairs and maintenance • viii. Alteration and improvements • ix. Possession:

Structure of Leasing Industry • over 400 private and public limited leasing companies. • Private Sector Leasing First Leasing Co of India Ltd. (FLGI), The Twentieth Century Finance Corporation Ltd. (TGFL), The Grover Leasing Ltd

Adapted Companies • Sundaram Finance Ltd (SFL), • Mercantile Commercial and Credit Corporation ltd. (MCCL), • Motor and General Finance Ltd. (MGF).

Subsidiaries of Manufacturing Group Companies

• Swadeshi Leasing Ltd was floated by the Hindustan Motors Ltd. • Classic Leasing by ITC Ltd • Ashok Leyland • Finance Ltd. of Ashok Leyland Ltd

Subsidiaries of Commercial Banks • • • • •

SBI Capital Markets Ltd. Canbank Financial Services Ltd. BOB Fiscal Services Ltd BOI Financial Services Ltd PNB Capital Services Ltd

Public Sector Organisations • State Industrial Investment Corporation of Maharashtra (SICOM) • Gujarat Industrial and Investment Corporation (GIIC) • FIs

Performance of Lease till 1990

Hire Purchase

Hire Purchase • The goods to be sold on a future date • The goods are let on hire • price is to be paid in installments

Hire Purchase Act,1972 • a. Payments to be made in installments over a specified period. • b. The possession is delivered to the hirer at the time of entering into the contract. • c. The property in goods passes to the hirer on payment o the last installment. • d. Each installment is treated as hire charges so that if default is made in payment of any installment, the seller becomes entitled to take away the goods, and • e. The hirer/ purchase is free to return the goods without being required to pay any further installments falling due after the return.

National Small Industries Corporation (NSIC)

Features of Hire Purchase Agreement • the buyer takes possession of goods immediately and agrees to pay price in installments • Each installment is treated as hire charges. • The ownership of the goods passes from the seller to the buyer on the payment of the last installment • In case the buyer makes any default in the payment of any installment the seller has right to repossess the goods from the buyer and forfeit the amount already received treating it as hire charges • The buyer can terminate the payment at any point of time

Installment • the contract of sale is entered into the goods are delivered and the ownership is transferred to the buyer • but the price is paid in specified installments over a period of time. • It is not possible to terminate the contract by the buyer.

Hire purchase Vs Leasing Hire Purchase

Leasing

Ownership is transferred on final installment

Ownership is never transferred

Hirer is entitled to claim depreciation

Lessor is entitled to claim Depreciation

Maintenance is Hirer’s Responsibility

Lessor is doing Maintanance

Hirer will get Tax benefit

Lessor will get tax benefit

Magnitude is Low

Magnitude is High

Less than 100% Finance extention 100% Finace Extention

Factoring

FACTORING • it is the conversion of credit sales into cash

• a financial institution (factor) buys the accounts receivable of a company (Client) • pays up to 80%(rarely up to 90%) of the amount immediately on agreement

Characteristics of factoring • Usually the period for factoring is 90 to 150 days • Factoring is considered to be a costly source of finance compared to other sources • Bad debts will not be considered for factoring • The cost of factoring vary from 1.5% to 3% per month • Indian firms offer factoring for invoices as low as 1000Rs

Classification of Factoring • Disclosed and Undisclosed • Recourse and Non recourse

Disclosed Factoring • In disclosed factoring client's customers are notified of the factoring agreement

Undisclosed Factoring •  Client's customers are not notified of the factoring arrangement • ledger administration and collection of debts are undertaken by the client 

• Client has to pay the amount to the factor irrespective of whether customer has paid or not

Recourse • client undertakes to collect the debts from the customer • If the customer don't pay the amount on maturity, factor will recover the amount from the client • lower interest rate since the risk by the factor is low

Non recourse factoring • factor undertakes to collect the debts from the customer

• Balance amount is paid to client at the end of the credit period or when the customer pays the factor whichever comes first

• factoring will eliminate the need for credit and collection departments

Factoring In India •

Canbank Factors Limited

•

SBI Factors and Commercial Services Pvt. Ltd

•

The Hongkong and Shanghai Banking Corporation Ltd: 

•

Foremost Factors Limited:

•

Global Trade Finance Limited: 

•

Export Credit Guarantee Corporation of India Ltd: 

•

Citibank NA, India: 

•

Small Industries Development Bank of India (SIDBI):

•

Standard Chartered Bank:

Forfaiting

Forfaiting • The forfaiting owes its origin to a French term ‘forfait’ • which means to forfeit (or surrender) one’s rights on something to some one else. • Under this mode of export finance, exporter forfaits his rights to the future receivables and the forfaiter loses recourse to the exporter in the event of non-payment by the importer.

Methodology • Forfeiting is generally extended for export of capital goods, commodities and services

where the importer insists on supplies on credit terms.

Mechanism • 1. 2. 3. 4. 5.

There are five parties in a transaction of forfaiting. These are : Exporter Exporter’s bank Importer Importer’s bank and Forfaiter

Mechanism • The exporter and importer negotiate • The exporter approaches the forfaiter • The forfaiter collects all the relevant details of the proposed transaction, viz., details about the importer, supply and credit terms, documentation, etc., in order to ascertain the country risk and credit risk involved in the transaction..

Mechanism • Depending upon extent of these risks the forfaiter quotes the discount rate. • Discount rate must be reasonable and would be acceptable to his buyer. • He will then quote a contract price by loading the discount rate, commitment fee, etc. • If the deals go through, the exporter and forfaiter sign a contract.

Mechanism takes place against • Export guaranteed by the importer’s bank.

documents

• The exporter discounts the bill with the forfaiter • The forfaiter presents the same to the importer for payment on due date or even can sell it in secondary market.

Documentation and cost • Forfaiting transaction is usually covered either by a promissory note bill of exchange. it has to be guaranteed by a bank or, bill of exchange may be ‘avalled’ by the importer’ bank. • The forfeiting cost ‘commitment fee’,

FACTORING & 1.Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange. 2. Usually provides financing for shortterm credit period of upto 180 days.

FORFAITING 1.

Oriented towards single transactions backed by LC or bank guarantee. 2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorterm credit of 30–180 days is also available for large transactions.

FACTORING &

FORFAITING

3.Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor. 4. Factor assumes responsibility for collection, helps client to reduce his own overheads.

3. Seller need not route or commit other business to the forfaiter. Deals are concluded transactionwise. 4. Forfaiter’s responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected.

FACTORING & FORFAITING 5. Separate charges are applied for —  financing —  collection —  administration —  credit protection and —  provision of information.

5. Single discount charges is applied which depend on —  guaranteeing bank and country risk, —  credit period involved and —  currency of debt. Only additional charges is commitment fee, if firm commitment is required prior to draw down during delivery period.

FACTORING & FORFAITING 6. Service is available for domestic and export receivables. 7.Financing can be with or without recourse; the credit protection collection and administration services may also be provided without financing.

6. Usually available for export receivables only denominated in any freely convertible currency. 7.It is always ‘without recourse’ and essentially a financing product.

DIFFERENCE BETWEEN FACTORING AND FORFAITING 8. Usually no restriction on minimum size of transactions that can be covered by factoring . 9. Factor can assist with completing import formalities in the buyer’s country and provide ongoing contract with buyers.

8. Transactions should be of a minimum value of USD 250,000. 9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries

Venture Capital

IMPERATIVES OF VENTURE CAPITAL (VC) •

Technological progress is the key driver of economic growth

•

Technological progress involves: –

Improvement in skills

–

Better capital equipment

–

New products, processes & business methods

•

Technological progress in emerging economies will emerge from enterprises catch-up

•

Technology capacity is necessary to adopt technologies to local conditions

•

VC encourages technological progress via research & development

•

VC converts research & development into new ventures

FINANCING STAGES DURING LIFE- CYCLE OF INITIATIVE • VC funding is special which enterprises tap at different stages of life cycle of initiative •

Seed - to prove concept

•

Start-up - product development & market testing

•

First stage - commercial production

•

Second stage - expansion to scale

•

Later stage - expansion of profitable enterprise

•

Bridge/ Mezzanine - preparation for going public

SNAPSHOT OF INDIAN VENTURE CAPITAL SCENARIO Snapshot of Indian Venture Capital Scenario 12000

10000

Total Invested ($ millions)

10000 8000 6000 4000 2000

20

80

250

500

1200

1100

1050

0

7 8 9 1 2 3 8 00 -9 -0 -9 -9 -0 -0 -0 0 6 7 8 0 1 2 7 2 9 9 9 900 00 00 00 19 19 19 9 2 2 2 2 Year 19

SOURCE: www.nishithdesai.com/Research-Papers/VCF-Xroads.pdf

Sector investment (2008)

Regulations • Securities & Exchange Board of India (SEBI) to: – preferential offering – Permit investment /surplus funds in bank deposits etc. – Substantial Acquisition & Takeover Regulations

• Reserve Bank of India (RBI) to: – Grant general permission under FEMA – Allow banks to value VCF investments on cost basis – Allow investment in real estate

• Government of India: – Revisit tax issues for greater participation – Allow investments in pension funds – Streamline regulations under companies act including winding up & valuation guidelines