UNIT-V

Transcription

1 UNIT-V

2 LESSON 20 COST OF CAPITAL CONTENTS 20.0 Aims and Objectives 20.1 Introduction 20.2 Meaning and Assumptions of Cost of Capita 20.3 Measurement of Cost of Debt 20.4 Cost of Preference Share Capita 20.5 Cost of Retained Earnings 20.6 Weighted Average of Cost of Capita 20.7 Let us Sum up 20.8 Lesson-end Activity 20.9 Keywords Questions for Discussion Suggested Readings 20.0 AIMS AND OBJECTIVES The purpose of this esson is to discuss about the cost of capita which is used as a phenomenon for the decision criterion in the case of studying the worth of ong-term assets. After studying this esson you wi be abe to: (i) understand meaning and assumptions of cost of capita (ii) describes measurement of cost of debt (iii) sove probems on cost of debt (iv) sove probems on cost of preference share of capita (v) describe cost of retained earnings INTRODUCTION It is imperative to study the importance of cost of capita to the tune of financing decision of the firm. The financing decision of the firm normay faciitates the firm to raise the financia resources to the requirements of the firm. The raising of the financia resources shoud be carried out not ony to the tune of financia requirements but aso it shoud mind about the cost of avaiing the resource; which means that the cost of raising and appying the resources in and of the organization. The cost is the most imiting factor of infuence for the success of the firm, the reason is that the cost of capita is the major determinant of success of the business firm. The firm must be faciitated to raise the financia resources at cheaper cost in order to earn more and more.

3 Accounting and Finance for Managers The cost of capita is used as a phenomenon for the decision criterion in the case of studying the worth of ong-term assets, which have got greater importance in the success of the firm. The cost of capita is instrumented in the Net present vaue method and Interna rate of return method of studying the worth of ong-term assets under the capita budgeting decisions of the enterprise MEANING AND ASSUMPTIONS OF COST OF CAPITAL It is the Minimum rate of return which the firm shoud or must earn ony in order to maintain the vaue of the sharehoders. Cassification of the cost of capita: The cost of capita can be cassified into two categories viz specific cost of capita and weighted cost of capita. 282 Assumptions It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing but determinant of infuence is Fixed Cost of Operations. The cost of capita is subject to the voume of fixed cost of operations of the firm. On the basis of Financia Risk i.e., with reference to Financia Commitments of the firm which in other words as financia Risk. The Interest on debenture, Preference Dividend on Preference share capita shoud be paid without fai irrespective of the firms' earnings according to the terms and conditions of the issue. The greater the fixed financia commitments require the firm to earn more and more in order to retain the interest of the sharehoders of the firm. Operationa Terms - capita structure remain unchanged; uness the cost of capita of the firm woud change. For new projects, funds are raised ony at same proportion. How the cost of capita is to be denominated in terms? Whether the cost of capita is to be denominated in terms of after tax or before tax. Why it has to be expressed in terms of after tax? Why not the before tax cost shoud be taken into consideration? For appraising the projects, the return of the investments are considered for comparison which are nothing but the resutant of earnings of the firm immediatey after the payment of tax. To study the quaity of the projects, both factors must be at common at parance for comparison. Whie computing the cost of capita, the cost of specific sources shoud be to the tune of after tax ony in order to have an effective comparison. v Then, the cost of capita is further bifurcated into two categories viz Expicit cost of capita and Impicit cost of capita. v Expicit cost of capita: The discount rate that equates the present vaue of the cash infows that are incrementa to the taking of the financing opportunity with the present vaue of its incrementa cash outfows. It is further expained that rate of return of cash fow of the financing opportunity. It normay takes pace ony at the moment of raising of financia resources. Impicit cost of capita: It is nothing but the Opportunity cost of capita of the firm to earn through investing esewhere by the sharehoders themseves or by the company itsef. It is rate of return which is associated with the best investment opportunity for the firm and its sharehoders that woud have to be forgone, which were presenty considered by the firm. Specific cost of specific source of capita: Each source of capita has its own cost at the moment of raising which form part of the computation of tota cost of capita of the firm.

4 MEASUREMENT OF COST OF DEBT Cost of Capita The cost of the perpetua debt is nothing but the cost of raising the debt financia resource, in which the time period of repayment of the principa is not known. This particuar specific source has two different cassifications viz cost of interest and cost of debt. Cost of interest (Ki) = Interest Sae vaue Tax adjusted Interest Cost of Debt (Kd) = Sae vaue Probem on Cost of Debt A company has 10 percent perpetua debt of Rs.1,00,000. The tax rate is 35 per cent. Determine the cost of capita (before tax as we as after tax) assuming the debt is issued at i) at par ii) at 10% discount iii) at 10% premium. Cost of Interest Ki= Rs.10,000/Rs.1,00,000=10% Cost of Interest Ki=Rs.10,000/ Rs.90,000= 11.11% Cost of Interest Ki= Rs.10,000/Rs.1,10,000=9.09% At par At Discount At Premium Cost of Debt Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5% Cost of Debt Kd= Rs.6,500/90,000= 7.22% Cost of Debt Kd=Rs 6,500/Rs.1,10,000=5.90% Check Your Progress 1. A company is considering raising Rs 100 akh by one of the two aternative methods. viz 14 percent institutiona term oan and 13 percent non - convertibe debentures. The term oan option woud attract no major incidenta cost. The debentures woud have to be issued at a discount of 2.5 per cent and woud invove Rs. 1 akh as cost of issue. Advise the company as to the better option based upon the effective cost of capita in each case. Assume tax rate of 35 per cent. The next method of computing the cost of debt is ony for the debt finance which knows the repayment period of the principa and the payment of the interest periodicas. This process of computation coud be divided into two categories First one is the periodica repayment of the principa aong with the periodica payment of interest periodicas. COIt + COPn CIo = t (1 + kd) The second one is the ump sum repayment of the principay ony at the end of the term of the debenture. 283

5 Accounting and Finance for Managers COIt CIo = + t (1+kd) COPn (1+Kd) n Probem on cost of debt A company issues a new 10 percent debentures of Rs.1,000 face vaue to be redeemed after 10 years. The debenture is expected to be sod at 5 percent discount. It wi aso invove fotation cost of 5 per cent of face vaue. The company s tax rate is 35 per cent what woud be the cost of debt be? Iustrate the computations i) tria and error approach and ii) shortcut method. Tria Error approach: The first step is to determine the cash fows invoved in the process of the debentures issue Years Particuars 0 Rs.900 at the moment of raising i.e., cash in fow during the issue of debenture Rs.1,000 Rs.50 Rs Reguar fow interest payment The interest outfow which is subject to the adjustment of taxation Rs100(1 0.35)=Rs Fina repayment of the principa The ast payment is nothing but the repayment of the principa Rs.1,000 Rs. 900 = 10 T = 1 Rs 65 Rs. 1,000 + (1+kd) t (1+Kd) n The present vaue of the future cashfows shoud be found out one after the another. The determination of present vaue at 7% and 8% Years Cash Present vaue Tota Present @ 8% 1-10 Rs.65(Annuity Tabe) Rs Rs ,000(Singe fow tabe) Rs Rs The vaue of Cost of debt is 8% The short cut method is as foows 284 I(1 t) + (f + d + pred - pi)/n Kd = (RV + SV)/2 I=Annua interest payment T=tax rate F=Fotation cost d=discount on debentures pred=premium on redemption pi=premium on issue of debentures RV=Reaisabe vaue SV=Sae vaue Kd= 7.9%

6 Check Your Progress Cost of Capita A company issues 11 percent debentures of Rs.100 for an amount aggregating Rs.1,00,000 at 10 percent premium, redeemabe at par after five years. The company s tax rate is 35 per cent. Determine the cost of debt using the shortcut method COST OF PREFERENCE SHARE CAPITAL The next specific source of cost is cost of preference share capita Cost of preference share capita - From the ange of interest on the amount of debentures it is aso ike a fixed in charge but not contractua obigation, but the interest payment is contractua in obigation in accordance with the terms and conditions of the issue agreement reached earier with the company, irrespective of the profits earned. Preference dividend is to be paid ony with reference to avaiabiity of profits. Normay the Expectations of the preference sharehoders are nothing but the preference dividends. The preference shares are cassified into two categories viz Redeemabe and Irredeemabe Let us discuss at first about the Irredeemabe preference shares during the issue The first one is the methodoogy for the computation of the cost of irredeemabe preference share Kp = Dividend preference share P0 (1 f) The second methodoogy incorporates the dividend taxation which is normay borne by the company during the moment of decaration. Kp = Kp=Dividend prefernce(1+dt) P0 (1 f) ABC company issues 11 percent irredeemabe preference shares of the face vaue of Rs. 100 each. Fotation costs are estimated at 5 per cent of the expected sae price a) par vaue b) 10% premium c) 5% discount and aso compute the Dividend tax at % At par Cost of Preference share capita Kp= Rs11./Rs 95.=11.57% Cost of preference share with dividend tax Kp = Rs.11( ) = 13.09% Rs.95 At Discount Cost of Preference share capita Kp=Rs.11/ Rs.110(.95).= 10.5% Cost of preference share with dividend tax Kp = Rs.11( ) = 13.81% Rs 110(.95) At Premium Cost of Preference share capita Ki= Rs.11/Rs.95(.95)=12.2% Cost of preference share capita with dividend tax Kd = Rs.11( ) = 13.78% Rs 95(.95) The next methodoogy under the preference share capita is the cost computation for redeemabe preference share capita. Under this the period of payment of capita is known aong with the payment periodica preference dividends. 285

7 Accounting and Finance for Managers Po (1-f) = Dp + (1+kp) Pn (1+kp) t n Probem on the preference share capita Xion Ltd has issued 11% preference shares of the face vaue of Rs.100 each to be redeemed after 10 years. Foatation cost is expected to be 5% Determine the cost of preference shares Kp Rs. 95 = 10 T = 1 Rs 11 Rs. 1,000 + (1+kp) t (1+Kd) 10 The vaue of the Kp is ying in between the two rates of discounts viz 11% and 12% Determination of present vaue in between 11% and 12% Year Cash outfow Present Tota Present Rs 1 to 10 years Rs th yr competion Rs Cost of preference share capita is Kp= 11.9% The next important cost to be determined is that cost of equity share capita: Equity dividends is not at par with Interest and Preference dividends, these two are subject to fixed in principe. The payment of dividends are subject to the avaiabiity of earnings and the future prospects of the firm in the future to grow. Equity sharehoders are the ast caimants of the company not ony in sharing the profits of the company at the end of every year immediatey after anything paid to the preference sharehoders. It never carries any fixed rate of dividends subject to the avaiabiity of profits to disburse. Market vaue of shares are determined by the Equity dividends which are nothing but the return expect to get. Ke= a minimum rate of return which the firm shoud earn from the equity portion of financing of the project in order to maintain the vaue of the share prices. There are many more modes in the computation of cost of equity i) Dividend vauation mode ii) Capita Asset Pricing Mode Dividend vauation mode: The Cost of equity capita Ke is in terms of required rate of return to the tune of future dividends to be paid to the investors. v It is discount rate which equates the present vaue of future dividends per share with sae proceeds of a share (after adjusting the expenses of fotation of a share) v Po = Dividend of the first year1 Ke g 286 Ke = Dividend of the first year1 + G Po

8 Probem: Cost of Capita Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25 What woud be market price of a share after 1 year and 2 year Ke= Re.1/25+ 6%= 4%+ 6%= 10% The market price at the end of 1 year P1 = Rs %-6% = Rs.26.5 The market price at the end of 2nd year P2 = Rs %-6% = Rs.28 Capita Asset Pricing Mode approach: The cost of equity share capita is computed by registering the Beta with reference to the non diversifiabe risk in addition to the diversifiabe risk of the equity share with reference to market responsiveness. The basic assumptions of the CAPM approach (i) (ii) The efficiency of the security markets Investor preferences The efficiency of the security markets is embedded with the foowing assumptions: (a) (b) (c) (d) (e) A investors are common expectations about the expected returns, variances and correation of the expected returns among the various securities in the market A investors have equivaent amount of information A investors are rationa No transaction costs No singe investor infuence the market The investors' preference with reference to two different types of returns (i) (ii) Highest eve return at minimum eve risk or Lowest eve of risk for given eve of return The above aternatives are subject to two different type of risk viz Systematic and Unsystematic risk. Systematic risk which cannot be reduced i.e., undiversifiabe risk for which aowances are given to the investors. Unsystematic risk which can be reduced to the eve of minimum for which no other aowances are given to the investors. The aowances are given to the investors ony subject to the market responsiveness Beta coefficient Ke= Rf+ b(km Rf) Probem The hypothetica td wishes to cacuate the cost of equity capita using the CAPM approach. From the information that the risk free rate of return equas 10% ; the firms beta equas 1.50 and the return on the market portfoio equas 12.5% Compute the cost of equity capita Ke= 10% (12.5%-10%)=13.75% 287

9 Accounting and Finance for Managers 20.5 COST OF RETAINED EARNINGS The next important cost of specific source of capita is cost of retained earnings. The cost of retained earnings is to be computed on the basis of opportunity cost. It does not have any direct cost, instead, the amount of retained earnings oses the opportunity of the investors to earn in the form of dividends due to retained earnings; which are foregone by them one side and on the other side the earnings which are retained are invested in some other investments, woud be in a position to yied the return, is the cost of retained earnings. It coud be defined as "cost of retained earnings is the opportunity cost in terms of dividends foregone by with hed from the equity sharehoders." The cost of retained earnings is nothing but the externa criterion which is equa to the Ke. Practicay speaking, Ke is more than the Kr due to the foatation cost invoved in the process of issue of shares WEIGHTED AVERAGE OF COST OF CAPITAL 288 The term cost of capita is nothing but the overa cost of capita which is to be computed to the tune of the proportion of the funds in the mixture; shoud computed ony to the tune of assignment of weights. The weight average cost of capita has its own steps to foow during the process of computation. Assigning the weights Mutipying the weights with the specific cost of the fund Dividing the tota cost immediatey after adding them together by the summation of weights It is denominated by Ko The weights are normay cassified into two major cassification viz Margina weights Historica weights Margina weights: Assignment of weights to the specific cost by the proportion of the each fund to be raised to the tota fund Historica weights: The weights are assigned to the specific source of fund to the tune of the proportion of the fund in the existing capita structure. This type of historica weight is further cassified into two different categories viz: Book vaue weights and Market vaue weights. Book vaue weights are assigned to the tune of book vaues to measure the proportion of each type of capita. Market vaue weights are assigned to the tune of market vaue to measure the proportion of each type of capita. Probem A company has on its books the foowing amounts and specific cost of each type of capita. Type of capita Book vaue Market vaue Specific cost Rs Debt Rs.4,00,000 3,80,000 5 Preference 1,00,000 1,10,000 8 Equity 6,00, Retained earnings 2,00,000 12,00, ,00,000 16,90,000

10 Determine the weighted average cost of capita using (a) Book vaue weights and (b) Market vaue weights. The determination of the weighted average cost of capita using book vaue weights Cost of Capita Type of capita Market vaue Specific cost Rs Tota costs BV* K Debt 3,80,000 5 Rs.20,000 Preference 1,10, ,000 Equity 9,00, ,000 Retained earnings 3,00, ,000 16,90,000 1,44,000 Rs.1,44,000 Ko = 100 = 11.1% Rs.13,00,000 The determination of Market vaue weights Type of capita Book vaue Specific cost Rs Tota costs BV* K Debt Rs.4,00, ,000 Preference 1,00, ,000 Equity 6,00, ,35,000 Retained earnings 2,00, ,000 13,00,000 2,01,000 Rs.2,01,000 Ko = 100=11.9% Rs.13,00, LET US SUM UP The cost is the most imiting factor of infuence for the success of the firm, the reason is that the cost of capita is the major determinant of success of the business firm. The cost of capita is used as a phenomenon for the decision criterion in the case of studying the worth of ong-term assets. Cost of capita is the minimum rate of return which the firm shoud or must earn ony in order to maintain the vaue of the sharehoders. The cost of the perpetua debt is nothing but the cost of raising the debt financia resource, in which the time period of repayment of the principa is not known. This particuar specific source has two different cassifications viz cost of interest and cost of debt. The term cost of capita is nothing but the overa cost of capita which is to be computed to the tune of the proportion of the funds in the mixture; shoud computed ony to the tune of assignment of weights. The weight average cost of capita has its own steps to foow during the process of computation LESSON-END ACTIVITY A company has issued 15% preference shares of the face vaue of Rs.100 each to be redeemed after 20 years. Fotation cost is expected to be 5% of the expected saes price. Determine the cost of preference shares KEYWORDS Cost of capita: It is the minimum rate of return to be earned at which the capita is raised Impicit cost of capita: It is the minimum rate of return to be earned by the firm, at the moment of retaining the earnings, towards the investment decision 289

11 Accounting and Finance for Managers Expicit cost of capita: It is the cost incurred by the firm at the moment of raising Specific cost of capita: It is the cost incurred at every moment for raising the specific resource of capita Book vaue weights: Weights assigned to the tune of the book vaue of the capita Weighted average cost of capita: The aggregate of the weighted specific resources cost of capita is weighted average cost of capita QUESTIONS FOR DISCUSSION 1. Define cost of capita. 2. Expain the various types of cost of capita. 3. Expain the methodoogy invoved in the process of computing the weighted average cost of capita. 4. Expain the meaning of assigning the weights on the specific sources of capita SUGGESTED READINGS R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goya, Financia Accounting, Exce Books, New Dehi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. M.P. Pandikumar Accounting & Finance for Managers, Exce Books, New Dehi. S. Bhat Financia Management, Exce Books, New Dehi. Prasanna Chandra, Financia Management Theory and Practice, Tata McGraw Hi, New Dehi (1994). I.M. Pandey, Financia Management, Vikas Pubishing, New Dehi. Nitin Bawani, Accounting & Finance for Managers, Exce Books, New Dehi. 290