Chapter 1 Introductory

Transcription

1 Chapter 1 Introductory 1. Introduction Finance is the strength of all economic activities. It is the supply of funds, which regulates the activities and operations of the industry. Adequate finance is required besides the requirement of fixed and working capital for undertaking the program of extension, reorganization or expansion. Proper provision of finance is pre- requisite for overall growth of a firm. It is related to the study of money management dealing with the ways in which businessmen, investors, governments, financial institutions and individuals handle the monetary provisions. The financial needs of the industry, therefore, require proper attention. Adequate finance is mandatory for meeting fixed and working capital requirements as well as to maintain sustainable growth of the firm. In fact, the existing industrial units as well as new industrial projects require substantial amount of the capital to meet their financial appetite arose in the context of reconstruction, modernization, expansion and diversification programme. During last two decades the finance function has been considered as foremost important managerial function. Now a day the policy statement of any business concern invariably includes four activities; production, personnel, marketing and finance. Finance provides necessary stimulus for continued

2 Chapter: 1 Introductory 2 business operation of all types. Generally, appropriate volume of investment both in fixed and working capital as determined by the firm s financial policies ensures success for the firm in the hyper competitive milieu. As a matter of fact, financial decision is extensively intertwined in all business activities. Finance has, therefore, been rightly called a binding force and emerged as key area of management. Finance Manager, Chief Finance Officer (CFO), treasury officer as the case be are entrusted with managing the organizational funds for greater interest of the stakeholders. Management of finance is the important task of business concern and financial decision holds a prominent position in entire managerial decision-making process. Generally, it encompasses on financing decision, investment decision, dividend decision and management of assets decision. The financing decision is the major decision of the financial manager concerned with determination of best financing mix in the capital structure of the organization. On the other hand, investment decision is concerned with effective utilization of funds in one or the other activities. Urgency is felt for careful estimation of all requirements of long as well as short-term fund. The fund commitment of various fixed assets is estimated through the techniques of capital budgeting. Budgetary control, on the other hand, a technique ensures long range planning of funds. Before taking any final decision in regard to procurement of funds, it is necessary to assess the relative profitability of each of the investment avenues, while dividend decisions constitute a crucial area of financial management. Shareholders are particularly interested in capital gain from their

3 Chapter: 1 Introductory 3 equity holding besides appropriate dividend from the organization. However, dividend payment has necessary impact on firm s liquidity. Again, assets management decision is concerned with the management of different types of assets, particularly in the current assets that usually changes its shape frequently. Thus, it is well-recognized fact that finance is necessary for every business concern. It can be raised through issue of shares, debenture/bond from domestic as well as international capital market in the form of GDR (Global Deposit Receipts), ADR (American Deposit Receipts) and FCCB (Foreign Currency Convertible Bonds) and from the wide range of financial institutions. However, the finance is not free of cost. The suppliers of various sources of funds have a charge on the income of organization, like; dividend for shareholders, interest for bond/debenture holders; dividend /interest for non-banking financial companies, foreign investors and so on. This charge on each source of capital is known as cost of capital. Bhattacharya (1970) investigated that the term cost of capital is used in different senses. In the past it was frequently used to refer to the costs of specific sources of capital such as the cost of debt, cost of equity etc. When used in this sense, the term carried the implication that in order to accept or reject the projects, their profitability should be evaluated on different cost basis depending on the specific sources of funds used to finance particular projects. It has been, however, recognized recently that the position contained a basic fallacy. A firm s decision to use more debts in future by proportionately lowering its equity base creates

4 Chapter: 1 Introductory 4 risks to the shareholders. Such risk in turn will influence the cost of equity. Similarly, a firm s decision to use equity capital to finance its projects would widen its scope for borrowings in the future. Because of this relationship between the method of financing and their costs, it has been now agreed that the term cost of capital should be used in the composite sense of weighted average cost of capital. Cost of capital plays a crucial role in capital budgeting decision. It provides useful guidelines in determining optimum capital structures of a company. It indicates the discount rate on which firm s cash flows are discounted to find out the present value. It is used as guideline in rising of finance from different sources. If company fails to earn minimum rate of return then it will land to a peculiar environment leading to insolvency. Thus, cost of capital is critically important for three reasons. Firstly, every cost of inputs should be minimized in order to maximize the value of firm. Secondly it acts as a cut off rate or hurdle rate in case of capital budgeting decision. Thirdly, it is used as a basic of many other types of investment decisions related to public utility, organization, leasing, bond refunding, and short-term assets management. Further, in foreign capital budgeting decision, cost of capital is used as a minimum required rate of returns which to be earned by the proposed investment. Moreover, it is regarded as one of the most important factors in evaluating and assessment of capital proposals pertaining to investment decision of the firm.

5 Chapter: 1 Introductory 5 Therefore in this treatise, with the help of latest financial data pertaining to Indian corporate sector a modest attempt was made to study the influence of capital structure decision on cost of capital and also to examine the nature of relationship between cost of capital and companies performance measured in terms of widely used parameters like; growth, size, profitability and liquidity. Moreover, the nature of capital structure of Indian industry and the relationship between the aforesaid parameters relating to the companies financial performance are to be assessed. 2. Statement of the problem Studies in Indian context revealed that irrespective of nature of industries, cost of capital does not hold a prime factor in the financial decision making process in true sense and most of Indian companies have not considered the cost of capital as pre-requisite for capital structure decisions and financial managers are only emphasizing on available sources of finance in the market. However, optimum capital structure is sine- qua -non for sustainable growth of any industry. It is therefore, argued that optimum capital structure helps to maximize the market value of the firm as well as to minimize the overall cost of capital (Pandey: 1999). It has also been observed from a number of research investigations undertaken in abroad that cost of capital has an impact on capital structure decision. But literature in this respect in Indian context is in the nascent stage. Here lies therefore, an essence of investigating the interrelationship

6 Chapter: 1 Introductory 6 between costs of capital and financing decision of the firms with reference to India. 3. Objective of the study The present study was focused on to examine the asset financing pattern (debt-equity mix) of the Indian companies and the influence of the various factors affecting the capital structure decisions. Further, an attempt was made to assess the impact of overall cost of capital on the performance of firms. However, the specific objectives of the study were outlined as under: i. To analyse the pattern of capital structure and to identify the determinants of capital structure of Indian industry ii. To examine the factors affecting the financial performance of Indian industry iii. To assess the influence of cost of capital on the performance as well as on capital structure of the firms and the industry as a whole. 4. Hypotheses formulated: To attain aforesaid objectives, the following major hypotheses were H 1 : There is no significant influence of financing decision on overall cost of capital

7 Chapter: 1 Introductory 7 H 2 : Average cost of capital is not influenced by the performance of the company measured in terms size of companies, growth of companies, profitability, liquidity, and dividend payout of the firm. 5. Conceptual frame Work The basic terms formulating the premises of the present treatise need certain explanation which is made hereunder 5.1 Cost of capital Chandra P. (1984) viewed that the cost of capital to a company is the rate of return that the company must earn on its investment in order to satisfy the expectations of investors who has provided long- term funds to it. Kulkarni. P.V. (1981) articulated that a rate of return on investment of the project, which is necessary to restrict flight of such capital and keep, unchanged the market price of a firm s stock. It is merely a hurdle rate that a firm must earn whether it operates at a zero risk level or at some business or financial risk. Weston (1963) viewed that it is a concept which should be expressed in quantitative terms, and defined as one of the following. (a) the minimum required rate of return on investment for proposals for using capital funds (b) the cut off rate for which the capital is available for the organization (c) the target rate of return on investment, which must be serviced if the capital used, is to be justified. Sharma R.K. and Gupta S.K. (1982) hold that it is weighted average cost of various sources of finance used by a firm in the form of debenture, preference capital, retained earnings and equity

8 Chapter: 1 Introductory 8 shares. According to Khan M.Y. and Jain P.K. (2004) cost of capital is the discount rate which is used in determining the present value of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not. In this sense, it is defined as the minimum rate of return that a firm earns on its investment for the market value of a firm to retain unchanged. Kishore Ravi. M (2002) holds similar opinion that cost of capital is a maximum rate of return that firm must earn on its investment so that market value per share remains unchanged. Van Horne Wachowiz (2003) observed that firms should have a single hurdle rate, which will be used to evaluate each of the investment proposals, and that rate will not be changed unless the underlined business and financial market condition changed. 5.2 Opportunity Cost of Capital When an organization faces shortage of capital and it has to invest capital in more than one project, then the company will meet the problem by rationing the capital to projects whose returns are estimated to be more. The firm might decide to estimate the opportunity cost of capital in other projects. Another approach to opportunity cost of capital concept is that the expected rate of return that equates to the market interest rate for investments of a similar risk profile. While discounting the risk cash flows at different rates, the companies will take into consideration different risk premium for different types of investments depending on the nature of investments. This is usually in the form of premium on what is

9 Chapter: 1 Introductory 9 considered the basic company cost of capital. The opportunity cost of funds can be analysed from the following two angles: Opportunity cost of equity funds If a company cannot earn sufficient profits, shareholders will be dissatisfied. The company will not be able to raise funds from new issue of shares, because investors will not be attracted. Existing shareholders who wish to sell their shares will find that buyers, who can invest in whatever securities they choose, will offer a comparatively low price, and the market price of the shares will be depressed. Since investors have a wide range of shares available to them there is a market opportunity cost of equity funds. Opportunity cost of debt funds Financial manager is concerned with obtaining funds for investments, and investing those funds profitability as to maximize the value of the firm. It is not enough to invest at a profit, it is necessary to invest so that the profits are sufficient to pay lenders a satisfactory amount of interest. If a company can not pay interest at the market rate demanded by lenders, the lender will prefer to invest elsewhere on the capital market, where they can get this rate. There is a market opportunity cost of debt funds which a company must expect to pay for new finance.

10 Chapter: 1 Introductory Performance According to oxford dictionary, performance means ability to operate efficiently. In this treatise, the term performance has been used to indicate financial performance of the concern, which measures whether the activities are running according to the pre- plan goal of the business. In other words, financial appraisal is known as the technique of evaluation of the financial performance of any business concern. Financial appraisal is also the process of scientifically making a proper and comparatively evaluation of the profitability and financial health of a given concern on the basis of summarized and analysis data that is the output of financial analysis. The following tools of financial appraisal are considered for the purpose of present study to measure the financial performance of the concern. i) Growth of business. ii) Size of business. iii) Profitability iv) Liquidity v) Dividend Payout (i) Growth (G): Growth is an important dimension of measuring firms performance that affects its market valuation. A review of empirical literature (Dess & Robinson, 1984) shows that the mostly used measures for growth are compounded annual growth rate (CAGR) of sales, net profit and market capitalization. In this treatise, we used compounded annual growth rate of net profit and growth rate of market capitalisation to measure the growth of the firm.

11 Chapter: 1 Introductory 11 (ii) Size: Size of the firm is included in the study as one of the determinants of performance of the organization in the sense that larger size firms are expected to have higher market value. The reason behind is that the investors prefer to invest their funds in the securities of the large size firms because (a) these firms provide wide market profitability of the shares, (b) they are better known in the capital markets, (c) being more diversified, they are less risky and (d) larger firms, in general, tend to have greater ingenuity to use more expensive and efficient techniques of production and labour saving devices, and thereby, they have less cost of production. The capital employed at the balance sheet value is used as a measure of the firm size. Capital employed = Share Capital + Reserves & Surplus + Long-term debt + Short-term Loans This measure is preferred over other measures of size, viz, total assets, fixed assets, sales or employment, because it represents firm s investment, and also, its magnitude indicates the confidence and attitude of investors towards the firm in providing long term financial resources. In other words, a firm can grow only when investors provide finance to it on a sustainable basis. (iii) Profitability: Profitability implies profit-making ability of business unit. Howard (1961) articulated that the term profitability is a combination of two terms profits and ability. Profitability may be defined as the ability of a given investment to earn a return from its use. According to McAlphine (1967) the profit cannot be ignored since it is a measure of the success of the business and the means of its survival and growth. In other words, profit is the engine that drives

12 Chapter: 1 Introductory 12 the business enterprise to achieve its objectives and is the reward for entrepreneurship. Different researchers in different perspective viewed the term profit. For example, from the point of view of financial management, profit is the test of efficiency and a measure of control, to the owners; a measure of growth of their investment; to the creditors; the margin of safety; to the employees, source of fringe benefits; to the government; the measure of taxable capacity and the basis of legislative action; to the customers; demand for price cut; and finally, to the country it is the economic progress, national income generated and rise in the standard of living (Kulshrestha : 1996). A business enterprise is, thus expected to discharge its obligations to the various interested segments of society only through profits. It is therefore, imperative that profit should be the basic thing for which the business undertaking should strive for its all round development. Thus, meeting the requirement of various stakeholders in right perspective makes one of the important yardsticks for assessing the financial performance of the organization. Interest of different groups of a firm makes it one of the determinants of financial performance. The term profitability is expressed in the absolute terms of gross profits and net profits earned during a particular period and in the relative terms; return on assets, return on equity, earning per share, dividend per share. The nitty-gritty of each term is explained as under. a) Gross profit margin The gross profit margin measures the percentage of sales remaining after the firm has incurred all relevant expenses. The gross profit represents the excess

13 Chapter: 1 Introductory 13 of sales proceeds during the period under observation over their cost, before taking into account the expenses related to administration, selling and distribution and financing charges. The ratio measures the efficiency of the company s operations and this can also be compared with the previous year results to ascertain the efficiency. A stable gross profit margin is the normal and any variation from it, needs careful investigation. A reason of variation may be due to the (i) price cuts- a company needs to reduce its selling price to achieve the desired increase in sales (ii) cost increases- the price which a company pays its suppliers during period of inflation, is likely to rise and this reduces the gross profit margin unless an appropriate adjustment is made to the selling price (iii) change in mix- a change in the mix of products sold causes the overall gross profit margin, assuming individual product lines earn different gross profit percentages (iv) valuation of stocks- if closing stocks are undervalued, cost of goods sold is inflated and profit is understated. The higher the gross profits margin, the better the firm s performance. The gross profit margin is calculated as under: Gross profit margin= x 100 Where, Gross profit= (Closing Stock+ Sales) - (Opening Stock+ Purchases+ Cost of goods sold), Sales = Cash and credit sales of goods during the year.

14 Chapter: 1 Introductory 14 b) Net profit margin The ratio is designed to focus attention on the net profit margin arising from the business operations before interest and tax is deducted. The convention is to express profit after tax and interest as a percentage of sales. A drawback is that the percentage which results varies depending on the source employed to finance business activity; interest is charged above the line while dividends are deducted below the line. It is for this reason that the net profit that is earning before interest and tax (EBIT) is used. This ratio reflects net profit margin on the total sale after deducting all expenses but before deducting interest and taxation. The ratio measures the efficiency of operation of the company. The net profit is arrived at from gross profit after deducting administration, selling and distribution expenses. The non-operating incomes and expenses are ignored in computation of net profit before tax, depreciation and interest. This ratio could be compared with that of the previous years and with that of the competitors to determine the trend in net profit margins of the company and its performance in the industry. This measure will depict the correct trend of performance where there are erratic fluctuations in the tax provisions from year to year. The net profit margin is calculated as under: Net proit margin = Net profit before interest and taxes Sales 100 Where, net profit means gross profit minus operating and administrative charges but before interest and tax; and Sales equal to cash and credit sales of goods in the year.

15 Chapter: 1 Introductory 15 c) Return on Assets The return on total assets, often called the return on investment, measures the overall effectiveness of management in generating profits with its available assets. The higher the firms return on total assets, the better. The return on total assets is calculated as follows: Return on Total Assets Net Profit after Taxes 100 Assets Where, Net profit after tax arrived at from gross profit after deducting administration, selling and distribution expenses, depreciation and interest; Total Assets is the summation of fixed assets and intangible assets such as machinery, building, land & building, copy right, trade mark, goodwill, patent. d) Return on Capital The return on capital employed is similar to the return on assets except in one aspect. Here the profits are related to the total capital employed. The term capital employed refers to long term funds supplied by the lenders and owners of the firm. This ratio is also called as return on investment. The strategic aim of a business enterprise is to earn a return on capital. Return on capital analysis provides a strong incentive for optimum utilization of the assets of the company. This encourages managers to obtain assets that will provide a satisfactory return on capital and to dispose of assets that are not providing an acceptable return.

16 Chapter: 1 Introductory 16 Thus, the ratio provides a test of profitability related to the sources of long-term funds. The following formula is used for the study purpose Return on Capital = 100 Where, Net profit arrived at from gross profit after deducting administration, selling and distribution expenses, depreciation but before interest and taxes; Total capital constitute of equity paid-up capital plus free reserve excluding revaluation reserve plus preference capital and total debt capital such as debenture, loan from banks and financial institutions minus capital work-inprogress, investment outside the business, preliminary expenses, debit balance of profit and loss account. e) Return on Net- Worth (RONW) The profitability of a firm from the owner s (equity shareholders) point of view may be assessed in terms of the return to the ordinary shareholders (Khan & Jain 1981). The following formula used for the study. Return on Net Worth = 100 Where, Net profit after tax arrived at from gross profit after deducting administration, selling & distribution expenses, depreciation and interest & taxes.

17 Chapter: 1 Introductory 17 f) Earning Per Share (EPS) The objective of financial management is wealth or value maximization of a corporate entity. The value is maximized when market price of equity shares is maximized. The use of wealth maximization objective or net present value maximization objective has been advocated as an appropriate and operationally feasible criterion to choose among the alternative financial actions. In practice, the performance of corporation is better judged in terms of its earning per share. The earning per share (EPS) is calculated by dividing the profit after taxes by the total number of ordinary shares outstanding. For the study purpose, the following formula is used. EPS= Face Value of Share Where, Net profit arrived at from gross profit after deducting administration, selling and distribution expenses, depreciation but before interest and taxes; EPS calculations made over the years indicate whether or not the firms earning power on per share basis had changed over that period. EPS simply shows the profitability of the firm on a per share basis; it does not reflect how much is paid as dividend and how much is retained in the business. But as a profitability index, it is a valuable and widely used ratio. g) Dividend per Share (DPS) The net profit after taxes belongs to shareholders. But the income, which they really receive, is the amount of earnings distributed as cash dividends.

18 Chapter: 1 Introductory 18 Therefore, a large number of present and potential investors may be interested in DPS, rather than EPS. DPS is the earning distributed to ordinary shareholders dividend by the number of ordinary shares outstanding. DPS = Face Value of Share h) Book Value per Share Book Value per Share represents the equity claim of the equity shareholders on a per share basis. The ratio is sometimes used as a benchmark for comparisons with the market price per share. However, the book value per share has a serious limitation as a valuation tool as it is based on the historical costs of the assets of a firm. The following formula has been used for our study purpose. Book Value per Share = Face Value of Share Where, Net worth means equity paid-up capital and free reserve excluding revaluation reserve. (iv) Liquidity: Liquidity plays a significant role in the successful functioning of a business unit. Liquidity refers to the ability of a concern to meet its current obligation as and when these become due. The short-term obligation is met by realizing amounts from current, floating, or circulating assets. The current assets should either be liquid or near liquidity. These should be convertible in to cash for paying obligations for short-term nature. Therefore, to account for the short-term risk of the firms, liquidity ratio has been included in the models.

19 Chapter: 1 Introductory 19 (a) Current ratio It is generally used for measuring liquidity position of the business. Current Ratio = For the study purpose, we use total inventory, debtors, cash, loan & advances as current assets and short term liabilities and current portion of long term debts constitute current liabilities. (b) Debtors Turnover Ratio It indicates the velocity of debts collection of a firm. The purpose of this ratio is to measure the liquidity of the receivables. It finds out the period over which receivables remain uncollected. Higher ratio implies more efficiency in the debts management. It may be noted that excessive high debtor turnover ratio indicates a more conservative credit sales policy which may reduce profit. The following formula is used for calculating purpose. Debtors Turnover Ratio = Where, Sales includes credit sales of goods during the year and Sundry debtors imply goods sold on credit to the customers. (c)inventory Turnover Ratio This ratio indicates the number of times the stock has been turned over during a period and evaluates the efficiency with which a firm is able to manage

20 Chapter: 1 Introductory 20 its inventory. A high inventory ratio indicates better inventory management as a result fewer funds are needed in inventory. The following is the widely used formula. Inventory Turnover Ratio = (v) Dividend Decision From the shareholders perspective, dividend decision is important to analyze the financial position of the business. For the purpose of study, dividend payout ratio is considered. The ratio measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them. Dividend Payout Ratio = 100 Where, total net profit belonging to shareholders implies profit after tax minus preference dividend minus dividend tax. 6. RESEARCH METHODOLOGY 6.1 Collection of data The study is based on data collected from secondary sources. They are Capital line Database 2007, Bombay Stock Exchange Directory and Financial Statement of Indian Companies. Further, the website like registered site of Financial Consultancy Firm containing relevant articles and reports, a registered site of financial consultancy firm containing annual reports of companies and.htt://indiainfo.com are also used. In this treatise we

21 Chapter: 1 Introductory 21 investigate companies listed in BSE. The reason of such selections is attributed to BSE maintains harmonious rules for submissions of annual statement of the companies and ease of access to the data. The study covered a period of five years from 2003 to To avoid the impact of global financial crisis on companies performance the periods of 2008 and 2009 have been excluded. 6.2 Sampling design The sample units have been chosen from the BSE, Directory comprising of all listed companies. We have selected top 500 companies on the basis of market capitalization as on end March All the companies are classified under different industrial groups. The final sample frame considering availability of data for all years considered for the study constitutes 151 numbers of companies pertaining to 13 industrial groups. The industries are classified on the basis of Capitalline database. Table 1.1 delineates the nature of sample companies covered in the study. 6.3 Data Coverage The study covered a period of five years from 2003 to 2007 to analyze the financial performance of the firms and industries. Correlation and regressions are also run for the pooled data of the cross-sections years. The virtue of pooling from statistical point of view is that it leads to larger samples and therefore, to more reliable results. The pooling is done on an industry basis for two reasons: (a) it can generally be expected that the accounting practices of the firms within the same

22 Chapter: 1 Introductory 22 industry would be similar than inter-industry firms; (b) the firms within the same industry are not expected to differ in respect of their financial pattern. Table- 1.1 Classification of Companies on the basis of Rank of Market capitalization as on 31 st March 2007 Name of Industry Range of M cap No of Companies No of companies not included Final Sample Energy , & Above I T , & Above Construction , & Above Pharmaceutical , & Above Cement , & Above Electricity , & Above Engineering , & Above Steel , & Above Finance & Investment , & Above Diversified , & Above Automobile , & Above Chemical , & Above Personal Care , & Above Companies are classified under different industry on the basis of Capitalline Database

23 Chapter: 1 Introductory Tools and Techniques The study includes both financial and statistical tools and techniques to evaluate the relationship between cost of capital and performance of sample units measured on the basis of different parameters. The different techniques of financial management like ratio analysis, method of calculation of specific cost of capital, leverage, WACC and several statistical tools such as Mean, Variance Analysis, correlation, regression analysis and relevant significance of test like t- test, F-test, etc are employed. Different techniques were used to analyse the data. Correlation and regressions analyses were used among the pooled data of the cross-sections years. The pooling is done on an industry basis for two reasons: (a) it can generally be expected that the accounting practices of the firms within the same industry would be similar than inter-industry firms; (b) the firms within the same industry are not expected to differ in respect of their financial pattern. 7. Methodology of Computation of Cost of Capital With a view to analyze the influence of cost of capital on the performance of the firm expressed in terms of profitability and value creation for both the firm and shareholders, it is imperative to compute the cost of each source of funds along with overall cost of capital over the years. From the available literature in this respect it has been observed that there are different methods used for finding

24 Chapter: 1 Introductory 24 out the cost of each source of capital (specific costs). The process of computing cost of each source of capital used in the treatise is enumerated as under Cost of Debt Capital Generally debt capital raised in the form of debentures or bonds, term loans from financial institutions and banks etc. To calculate the explicit cost of debt, we need data regarding (i) the net cash proceeds/inflows (the issue price of debentures/amount of loan minus all floatation costs) from specific source of debt and (ii) the net cash outflows in terms of the amount of periodic interest payments and repayment of principal in installments or in lump sum on maturity. The interest payments made by the firm on debt issue qualify for tax deduction in determining the taxable income. Therefore, the effective cash outflows is less than the actual payment of interest made by the firm to the debt holders by the amount of tax shield on interest payment. The debt can be perpetual/ irredeemable or redeemable. a) Cost of Perpetual debt It is the rate of return which the lenders expect. The debt carries a certain rate of interest. The coupon interest rate or the market yield on debt can be said to represent an approximation of the cost of debt. The nominal/coupon rate of interest on debt is the before tax cost of debt. Since the effective cost of debt is the tax adjusted rate of interest, the before tax of cost of debt need to be adjusted for the tax effect. Finally, the bonds and debentures can be issued at par, discount

25 Chapter: 1 Introductory 25 or at premium. The coupon rate requires adjustment to derive the true cost of debt. Symbolically, K i = (1.1) K d = (1-t) (1.2) Where, K i = Before-tax cost of debt K d = Tax-adjusted cost of debt I = Annual interest payment SV = Sale proceeds of the bond/debenture t = Tax rate b) Cost of Redeemable debts It is the discount rate at which net cash proceeds equates with present value of cash outflow in form of interest paid and repayment of principal amount. The working formula will be as under: CI o = () + () (1.3) Where, CIo = Net cash proceeds from issue of debentures or from raising debt COI 1 + COI COI n = Cash outflow on interest payments in time period 1, 2 and so on up to the year of maturity after adjusting tax savings on interest payment.

26 Chapter: 1 Introductory 26 COPn = Principal repayment in the year of maturity K d = Cost of debt If the repayment of debt is in a number of installments instead of one lump sum payment, the used equation would be: CI o = () (1.4) c) Cost of Floating Debt Sometimes, the companies raised debt on a rate of interest that varies from year to year and that type of loan or debt is called floating debt. Similarly, the rate is called floating debt rate. In floating debt rate, a certain percentage of total interest will be of fixed in nature and remaining part varies time to time depending on the money market and policy of the economy. The company requires paying a rate of interest on its loan equal to whatever rate is plus an extra charge which is variable one depending on nature of economy is called cost of floating debt. K d = Fixed rate of interest + Extra rate of interest (1-tax rate) (1.5) 7.2 Cost of Preference Capital In case of preference share payment of a specific amount of dividend is legal commitment on the part of the firm. There is no such obligation in regard to preference dividend. Although, a fixed dividend rate is stipulated on preferences shares but the holder of such shares have a preferential right as regard to payment

27 Chapter: 1 Introductory 27 of dividend as well as return of principal as compared to the ordinary shareholder. But unlike debt, there is no risk of legal bankruptcy if the firm does not pay the dividends due to the holders of such shares. Nevertheless, firms can be expected to pay the stipulated dividend, if there are sufficient profits, for a number of reasons. First, the preference shareholders, as already observed, carry a prior right to receive dividends over the equity shareholders. Unless, therefore, the firm pays out the dividend to its preference shareholders, it will not be able to pay anything to its ordinary shareholders. Moreover, the preference shares are usually cumulative which means that preference dividend will get accumulated till it is paid. As long as it remains in arrears, nothing can be paid to the equity holders. Further, non payment of preference dividend may entitle their holders to participate in the management of the firm as voting rights are conferred on them in such cases. Above all, the firm may encounter difficulty in raising further equity capital mainly because the non payment of preference dividend adversely affects the prospects of ordinary shareholders. Therefore, the stipulated dividend on preference shares like the interest on debt constitutes the basis for calculation of the cost of the preference shares. The cost of preference capital may be defined as the dividend expected by the preference shareholders. However, unlike interest payments on debt, dividend payable on preference shares is not tax-deductible because preference dividends are not a charge on earnings or an item of expenditure; it is an appropriation of earnings. In other words, they are paid out of after-tax earnings of the company. Therefore, no adjustment is required for taxes while computing the cost of preference capital.

28 Chapter: 1 Introductory 28 There are two types of preference shares: (i) Irredeemable and (ii) redeemable. The first category is a kind of perpetual security in that the principal is not to be returned for a long time or is likely to be available till the life of the company. The redeemable preference shares are issued with a maturity date so that the principal will be repaid at some future date. Accordingly, the cost of preference shares is calculated separately for these situations. i) Perpetual Security calculated by The cost of preference shares which has no specific maturity date is K p = () ()... (1.6) Where, K p = Cost of preference share, D p = Constant annual dividend payment P o = Expected sales price of preference shares, f = Flotation costs as a percentage of sales price, D t = Tax on preference dividend ii) Cost of Redeemable Preference Capital The explicit cost of preference shares in such a situation is the discount rate that equates the net proceeds of the sale of preference shares with the present

29 Chapter: 1 Introductory 29 value of the future dividends and principal repayment. The formula for calculating cost of preferences shares is P o (1-f) = () () () ()... (1.7) Where, P o = Expected sale price of preference shares f = Floatation cost as percentage of P 0 D p = Dividends paid on preference shares P n = Repayment of preference capital amount 7.3 Cost of Equity Capital The fund raised by issuing equity shares is basically permanent in nature. These funds generally need not be repayable during the life time of the organization. Hence, it is a permanent source of funds. The equity share holders are considered to be the owners of the company. The main objective of the firm is to maximize the wealth of the equity shareholders. Equity share capital is the risk capital of the company. If the company s business is doing well the ultimate beneficiaries are the equity share holders who will get the return in the form of dividends from the company and the capital appreciation for the investment. If the company comes for liquidation due to losses, the ultimate and worst sufferers are the equity shareholders. Sometimes they may not get their investment back during the liquidation process. Profits after taxation less preference dividends paid out to the preference shareholders are funds that belong to the equity shareholders which are reinvested in the company and therefore, those retained funds should be

30 Chapter: 1 Introductory 30 included in the category of equity. The cost of equity capital (K e ) defined as the minimum rate of return that a firm must earn on the equity-financed portion of an investment project in order to leave un-changed the market price of the shares (Khan & Jain: 2004). The cost of equity capital generally calculated in the following ways: a) Dividend Yield Method The dividend per share is expected on the current market price per share. As per this method, the cost of capital is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale of a share. This method is based on the assumption that the market value of equity shares is directly related to the future dividends on those shares. Another assumption is that the future dividend per equity share is expected to be constant and the company is expected to earn at least this yield to keep the equity shareholders content. Where, K e = (1.8) K e = Cost of equity capital, D 1 = Annual dividend per share on equity capital in period 1 P o = Current market price of equity share. But in practice, a shareholder expects the return from his equity investment to grow over time.

31 Chapter: 1 Introductory 31 b) Dividend Growth Model Equity shareholders will normally expect dividend to increase year after year and not to remain constant in perpetuity. In this method, an allowance for future growth in dividend is added to the current dividend yield. It is recognized that the current market price of a share reflects expected future dividends. This model is also called as Gordon Growth Model. Where, K e = + g... (1.9) D 1 = Expected dividend per equity share, P o = Current market price per equity share, g = Growth rate by which dividends are expected to grow per year at a constant compound rate. c) Capital Assets Pricing Model Approach Another technique that sometimes used to estimate the cost of equity is the Capital Asset Pricing Model (CAPM) approach. The CAPM explains the behavior of security prices and provides a mechanism whereby investors could assess the impact of proposed security investment on their overall portfolio risk and return. In other words, it formally describes the risk-return trade off for securities. It is based on certain assumptions. The basic assumptions of CAPM are related to (a) the efficiency of the security market and (b) investor preferences.

32 Chapter: 1 Introductory 32 The efficiency market assumption implies that (i) all investors have common expectations regarding the expected returns, variances, and correlation of returns among all securities; (ii) all investors have the same information about securities; (iii) there are no restrictions on investments; (iv) there are no taxes; (v) there are no transactions costs; and (vi) no single investor can affect market price significantly. The risk to which security investment is exposed falls into two groups: (i) diversifiable/ unsystematic, and (ii) non-diversifiable/systematic. The first represents that portion of the total risk of an investment that can be eliminated through diversification. The factors that cause such risks vary from firm to firm. The risks include the factors such as strikes, government regulations competition, and level of operating and financial leverage of the firm and so on. The systematic / non diversifiable risk is attributable to factors that affect all firms. The risks include interest rate changes, inflation or purchasing power change and so on. An unsystematic risk can be eliminated by an investor through diversification. Therefore, an investor should be concerned, according to CAPM, solely with the non diversifiable risks. Systematic risks can be measured in relation to the risks of a diversified portfolio which is commonly referred to as the market portfolio. According to CAPM the non diversifiable risks of an investment/ security/ asset is assessed in terms of the beta coefficient. Beta is a measured of the volatility of a security s return relative to the returns of a broad based market portfolio. The beta for the market portfolio as measured by the broad based market index. Beta coefficient indicates that the risk of the specified securities is equal to the market;

33 Chapter: 1 Introductory 33 the interpretation in zero coefficients is that there is no market related risks to the investment. A negative coefficient would indicate a relationship in the opposite direction. With reference to the cost of capital, the CAPM describes the relationship between the required rates of return, or the cost of equity capital and the non diversifiable or relevant risks of the firm as reflected in its index of non diversifiable risks, that is, beta. Symbolically, K e = R f + β (K m R f )... (1.10) Where, K e = cost of equity capital R f = the rate of return required on a risk free asset/ security K m = the required rate of return on the market portfolio of assets that can be viewed as the average rate of return on all assets. β = the beta coefficient d) Price Earning Method This method takes into considerations the earning per share (EPS) and the market price of the share. It is based on assumption that the investors capitalized the stream of future earnings of the share and the earnings of a share need not be in the form of dividend and also it need not be distribute to the shareholders. It is based on the argument that even if the earnings are not distributed as dividends, it is kept in the organization in form of retained earnings which accelerate the future

34 Chapter: 1 Introductory 34 growth in the earnings of the company as well as the increase in the market price of the share. Under this method, the cost of equity capital is calculated, K e =... (1.11) Where, EPS = earning per share, MPS = market price per share 7.4 Cost of Retained Earnings Retained earnings as a source of finance for investments proposal, differ from other sources like debt, preference share and equity. The use of debt is associated with a contractual obligation to a fixed rate of interest to the suppliers of the firms and often, repayment of principal at some pre determined date. In the case of ordinary shares, although there is no provision for any pre determined payment to the shareholders, yet a certain expected rate of dividend provides a starting point for the competition of cost of equity capital. In case of retained earnings, there is no obligation, formal or implied, on a firm to pay a return on retained earnings. Retained earnings may appear to carry no cost since they represent funds which have not been raised from outside. Although, a firm does not require paying a return on retained earnings but retention of earnings does have implications on the shareholders value of the firms. If earnings were not retained, they would have been paid out to the ordinary shareholders as dividends. When earnings are retained, shareholders are therefore, forced to forgo dividends. The dividends forgone by the equity-holders are, in

35 Chapter: 1 Introductory 35 fact, and opportunity cost. Thus, retained earnings involved opportunity costs. In other words, the firm is implicitly required to earn on the retained earnings at least equal to the rates that would have been earned by the shareholders if they were distributed to them. This is the cost of retained earnings. Therefore, the cost of retained earnings may be defined as opportunity cost in terms of dividends forgone by / withheld from the equity shareholders (Khan & Jain: 2004). Therefore, the cost of retained earnings represents an opportunity cost in terms of the return on their investment in another enterprise by the firm whose cost of retained earnings is being considered. The opportunity cost given by the external-yield criterion which can be consistently applied can be said to measure the K r which is likely to be equal to the K e. 7.5 Weighted Average Cost of Capital (WACC) Once the components of cost of capital (i.e. the equity and debts) have been calculated, they are multiplied by the respective weights of various sources of capital to obtain a Weighted Average Cost of Capital (WACC). The composite or overall Cost of Capital is the weighted average of the costs of various sources of funds, weights being the proportion of each source of fund in the capital structure. It is very important to know that it is the weighted average concept and not the simple average, which is relevant in calculating the overall Cost of Capital.

36 Chapter: 1 Introductory 36 The simple average cost of capital is not appropriate to use because firms hardly use various sources of funds equally in the capital structure. The underlying principle of using a weighted average cost of capital is that by financing in the proportions specified and accepting projects yielding more than the weighted average required return, the firm is able to increase the market price of its stocks. This increase occurs because of the investment projects are expected to yield return more on their equity finance than the cost of equity capital. Once these expectations are met, the market price of stocks should raise, other things remaining the same. 7.6 Computation: Following are the steps that are used in evaluating the Cost of Capital (WACC) for the companies taken for study Estimation of the cost of the specific sources of funds. Then, their respective proportions in the capital structure are multiplied by these costs of sources. By adding the weighted component costs to get the WACC. However, the following equation used for calculating the WACC of a firm E V K e D V K d R V K r (1.12)