Study
material
Cost
of capital
The
term cost of capital refers to the minimum rate of return a firm must earn on
its investments so that the market value of the company equity shares does not
fall. This is possible only when the
firm earns a return on the projects financed by the equity shareholders fund at
a rate at which is at a rate which is at leas equal to the rate of return
expected by them. If a firm fails to
earn return at the expected rate, the market value of the shard would fall and
thus result in reduction of overall wealth of the shareholders.
Definition
A
firm’s cost of capital may be defined, as “the rate of return the firm requires
form investment in order to increase the value of the firm in the firm in the
market place”.
Importance
of cost of capital:
The
determination of cost of capital is impotent from the point of vie of both
capital budgeting as well as capital planning decisions.
1.
Capital
budgeting decisions:
In capital budgeting decisions, the
cost of capital is often used as a discount rate on the basis of which the
firms’ future cash flows are discounted to find out their present values, thus
the cost of capital is the very basis of financial appraisal of new capital
expenditure proposals.
2. Capital
structure decisions:
The finance manager must raise capital
from different sources in a way that optimizes the risk and cost factors. The sources of funds, which have less cost,
involve high. Therefore, it is necessary
that cost of each source of funds is carefully considered and compared with the
risk involved in it.
Classification
of cost of capital
1. Explicit cost:
It is the discount rate that equates the
present value of the funds received by the firm net of underwriting costs, with
the present value of the expected cash outflows.
2. Implicit
cost:
It
is the rate of return associated with the best investment opp0ortunity for the
firm and its shareholders that will be foregone if the project presently under
consideration by the firm were accepted
3. Future
cost:
It
refers to the expected cost of funds to finance the project.
4. Historical
cost:
It
is the cost, which has been already incurred for financing a particular
project.
5.
Specific cost:
The
cost of each component of capital (i.e. Equality shares, preference shares,
debentured, loans etc) is known as specific source of capital
Combined or composite cost;
It is inclusive
of all cost of capital form all source, i.e., equity shares, reference shared,
debentures and other loans.
6. Average
cost:
It
is the weighted average of the costs of each component of funds employed by the
firm. The weights are in proportion of
the share of each component of capital in the total capital structure
7.
Marginal cost:
It
is the weighted average cost of new funds raised by the firm.
Computation
of cost of capital:
Computation
of cost of capital involves:
1. Computation
of cost of each source of finance
2. Computation
of composite cost(weighted average cost)
1.Computation
of specific costs:
Cost
of each sources of finance, viz, debt, preference capital, equity capital can
be determined as follows:
1.Cost
of debt:
Debt
may be issued at par, at premium or discount.
It my be perpetual or redeemable
a)
Debt issued at par:
The
computation of cost of debt issued at par is comparatively easy. It is the explicit interest rate adjusted
further for the tax liability of the company and is computed as follows
K db = I
──
P
Where, K db =
cost of debt before tax
I
= Interest
P =
Principal
b)
Debt issued at premium or discount:
In
case the debentures are issued at premium or discount, the cost of debt should
be calculated on the bases of net proceeds realized on account of issue of such
debentures or bonds. Such cost may further be adjusted with the tax rate
applicable to the company.
a)
If cost of debt raised at premium or discount (before tax):
K db = I
──
NP
Where NP = Net
proceeds
b)
Cost of debt after tax:
K da = K db
(1-t)
Where t= Rate of tax
Problems:
1.
(a) X Ltd issues Rs. 50,000
8% debentures at par. The tax rate applicable to the company is 50%. Compute
the cost of debt capital.
(b) Y Ltd issues
Rs. 50,000 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute cost of debt capital.
(c) A Ltd issues Rs. 50,000 8% debentures at a discount of 5%. The
tax rate is n50%, compute the cost
of debt capital
(d) B Ltd issues Rs. 1, 00,000 9 % debentures at a premium of 10%.
The costs of floatation are 2%. The tax rate applicable is 60%. Compute cost of
debt-capital.
Compute after tax
Solution:
(a) K da = I/NP (1-t)
= 4,000/50,000 (1-0.5)
= (4,000/50,000)x 100 x (0.5) = 4%
(b) K da = I/NP(1-t)
= (4,000/55,000) x 100 x (1-0.6) =
2.91%
(c) K da = (4,000/47,500) x 100 x (1-0.5) = 4.21%
(d) K da = (9,000/1,07,800) x 100 x (1-0.6) = 3.34%
c)Cost
of redeemable debt:
If the
debentures are redeemable after the expiry of a fixed period the cot of debt
before tax can be calculated as follows:
a)
Before tax cost of debt:
I + 1/n (P-NP)
K db =
1/2 (P+NP)
Where N=Number
of years in which debt is to be redeemed.
RV = Redeemable value of debts
b)
After tax cost of debt:
K da= K db
(1-t)
Problem:
1.
A company issues Rs. 10, 00,000
10% redeemable debentures at a discount of 5%. The costs of floatation amount
to Rs. 30,000. The debentures are redeemable after 5 yrs. Calculate before-tax
and after-tax of debt assuming a tax rate of 50%
Solution:
Before Tax:
K db = I + 1/n (P-NP)
1/2 (P+NP)
=
1, 00,000+ 1 /5 (10, 00,000-9, 20,000)
1/2 (10, 00,000 + 9,
20,000)
= 1, 16,000/9, 60,000 =
12.09%
After Tax:
K da = K db (1-t)
= 12.09 (1-0.5)
=12.09(0.5) = 6.045%
Cost of Redeemable debt at premium:
a)
Before tax cost of debt:
I + 1/n (RV-NP)
K db =
1/2 (RV+NP)
Where
RV=Redeemable Value of debt
b)
After tax cost of debt:
K da= K db (1-t)
Problems
1.
A 5 year Rs. 100 debenture of a
firm can be sold for a net price of Rs. 96.50. The coupon rate of interests is
14% per annum, and the debenture will be redeemed at 5% premium on maturity.
The firms’ tax rate is 40%. Compute the after-tax cost of debenture.
Solution:
a)
Before tax:
I + 1/n (RV-NP)
K db =
1/2 (RV+NP)
14+1/5 (105-96.50)
 |
1/2 (105+96.50)
= 15.58%
b)
After Tax:
K da= K db (1-t)
= 15.58 (1-0.4) = 9.35%
2.
Cost of preference capital:
Incase of borrowings, there is a legal
obligation on the firm to pay fixed interest while in case of preference
shares, there is no such legal obligation, but it cannot be concluded that
preference share capital does not involve cost as the preference dividend is
generally paid whenever the company earns sufficient profits.
The
failure to pay dividend may be serious concern as they have the first
preference and accumulation of arrears of preference dividend may adversely
affect the payment of dividend to the equity shareholders.
a)
K p = D/P
Where K p = Cost of preference capital
D = Annual preference Dividend
P = Preference share capital (Proceeds)
b)
If issued at premium or
discount:
K p = D/NP
c)
If redeemable share are issued:
K pr = D+1/n
(MV-NP)
 |
1/2 (MV+NP)
Where K pr = Cost of Redeemable preference
shares
MV = Maturity Value of preference shares
NP = Net proceeds
Problems:
1.
A company issues 10,000 10%
preference shares of Rs.100 each. Cost of issue is Rs. 2 per share. Calculate
cost of preference capital if these shares are issued (a) at par, (b) at a
premium of 10% and (c) at a discount of 5%
Solution:
(a)
K p = D/NP
K p =
1,00,000/10,00,000-20,000 x 100
= 1,00,000/9,80,000 x 100 = 10.2%
(b)
K p = D/NP
= 1,00,000 / 10,00,000 + 1,00,000 –
20,000 x 100
=
1,00,000 / 10,80,000 x 100 = 9.26%
(C) = 1,00,000/10,00,000-50,000-20,000 x
100
= 1,00,000/9,30,000 x 100 = 10.75%
2.
A company issues 1,000 7%
preference shares of Rs. 100 each at a premium of 10% redeemable after 5 yrs at
par. Compute the cost of preference capital.
Solution
K pr = D+1/n (MV-NP)
 |
1/2 (MV+NP)
= 7,000 + 1/5 (1, 00,000-1, 10,000)
½ (1, 00,000 + 1,
10,000)
= 7,000 -2,000
1, 05,000
= 5,000 / 1,05,000 x 100 = 4.76%
3. Cost
of equity capital:
The dividends are paid to; the equity
shareholders only if the company earns profits and so there is an argument that
the equity share capital does not involve and cost. But the is not correct. Because, the equity shareholders invest money
with the expectation of getting dividends and the market value of the share
depends on the return expected by the shareholders.
Moreover, the company issues equity shares
and pays dividend to increase the market value of the firm.
Therefore,
the cost of equity share capital can be 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 unchanged
the market price of such shares
In
order to determine the cost of equity capital, it may be divided into the following
two categories:
1.
The external equity or new issue of equity shares.
2.
The retained earnings
1.
The external equity or new issue of equity shares:
In order to determine the cost of equity
capital, the shareholders expectation from their investment has to be
determined first. The following are some
of the approaches for the computation of cost of equity capital
a)
Dividend
yield method or Dividend /price ratio method
According
to this approach, the investor arrives at the market price of an equity share
by capitalizing the expected dividends payments. Cost of equity capital has therefore defined
as “the discount rate that equated the present value of all expected future
dividends per share with the net proceeds of the sale of a share”
In other words, the cost of equity capital will be that rate of
expected dividends which will maintain the present market price of the equity
shares
Limitation:
This approach ignores the fact that retained earnings also have an
impact on the market price of the equity shares.
In case of existing
shares, it will be appropriate to calculate the Ke based on the market price of
the equity shares, it is computed as follows
K e = D/NP or D/MP
Where
K e = Cost of Equity capital
D = Expected dividend per share
NP
= Net proceeds per share
MP
= Market price per share.
1.
A company issues 1000 equity
chares of Rs.100 each at a premium of 10%. The company has been paying 20%
dividend to equity shareholders for the past 5 yrs and expects to maintain the
same in the future also. Compute the cost of equity capital. Will it make any
difference if the market price of equity share is Rs.160?
Solution:
K e = D/NP
= 20/110 x 100 = 18.18%
If the market
price of a equity share is Rs. 160
K e = D/MP
= 20/160 x 100 = 12.5%
b)
Dividend yield plus growth in dividend
method:
According
to this approach, the cost of equity capital is determined on the basis of the
expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is determined
on the basis of the amount of dividends paid by the company for the last few
years. The computation of cost of equity
capital is done as follows
K e = D 1 / NP + G = D 0 (1 + G) /
NP + G
K
e = Cost of equity capital
D
1 = Expected dividend per share at the end of the year
NP
= Net proceeds per share
G
= Rate of growth in dividends
D
0 = Previous year’s dividend
In
case cost of existing equity share capital is to be calculated, the NP should
be changed with MP in the above equation
K
e = D 1 / MP + G
Problem:
1.
(a) A company plans to issue
1000 new shares of Rs.100 each at par. The floatation costs are expected to be
5% of the share price. The company pays a dividend of Rs.10 per share initially
and the growth in dividend is expected to be 5%. Compute the cost of new issue
of equity shares.
(b)
It the current market price of
an equity share is Rs. 150, calculate the cost of existing equity share
capital.
Solution:
(a)
K e = D/NP + G
= 10/100-5 + 5% = 15.53%
(b)
K e = D/MP + G
= 10/150 + 5% = 11.67%
2.
The shares of a company are
selling at Rs. 40 per share and it had paid a dividend of Rs.4 per share last
year. The investor’s market expects a growth rate of 5% per year.
(a)
Compute the company’s equity
cost of capital
(b)
It the anticipated growth rate
if 7% per annum, calculate the indicated market price per share.
Solution:
(A)
K e = D 1 / NP + G
= D 0 (1 + G) / NP + G
= 4 (1.05) / 40 + 5%
=
4.20 / 40 + 5%
= 10.50% + 5% = 15.5%
(B)
K e = D 1 / MP + G
15.5% = 4 (1.07)
/ MP + 7%
15.5% - 7% =
4.28 / MP = Rs.50.35
c) Earning yield method
According
to this approach, it is the earning per share, which determines the market
price of the shares. T
his is based on the assumption that the
shareholders capitalize a stream of future earnings in order to evaluate their
shareholdings. Hence, the cost of equity
capital should be related to that earning percentage which would keep the
market price of the equity shares constant.
This approach takes into account both the dividends as well as retained
earnings.
The formula for calculating the cost of
equity capital is as follows:
K e = Earnings
per share / Net proceeds
= EPS / NP
For existing
capital
= EPS / MP
Problem:
1.
A firm is considering an
expenditure of Rs. 60 lakhs for expanding its operations. The relevant
information is as follows.
Number of
existing equity shares 10
Lakhs
Market value of
existing share 60
Net earnings 90
Lakhs
Compute the cost of existing equity share
capital and of new equity assuming that new shares will be issued at a price of
Rs.52 per share and the cost of new issue will be Rs. 2 per share.
Cost of existing equity share capital:
K e = EPS / MP
Earnings per
share = Rs. 90, 00,000 / 10, 00,000 = Rs. 9
K e = 9 / 60 x 100 = 15%
Cost of New equity capital:
K e = EPS / NP
= 9 / 52 – 2 x 100 = 18%
d)
Realized yield approach:
According
to this approach, the cost of equity
capital should be determined on the basis of return actually realized by
the investors in a company on their equity shares. Thus, according to this approach, the past
records in a given period regarding dividends as on the actual capital
appreciation in the value of equity shares held by the shareholders should be
taken to compute the cost of equity capital. This approach gives fairly goods
results in case of companies with stable dividends and growth records In case
of such companies; it can be assumed that the past behavior will be repeated in
the future also
2.Cost
of retained earnings:
The
companies do not generally distribute the entire profits earned by them by way
of dividend among their shareholders. They retain some profits fro future
expansion of the business. There is an
assumption that the retained earnings is absolutely cost free. This is not the correct approach because the
amount retained by the company, if it had been distributed by way of dividend,
would have given them some earning. The
company has deprived the shareholders of these earnings by retaining a part of
profit with it.
Thus,
the cost of retained earnings is the earning foregone by the shareholders i.e.,
the opportunity cost of retained earnings may be taken as their cost of
retained earnings. It is equal to the
income that the shareholders could have otherwise earned by placing these funds
in alternative investments.
For e.g.
If the shareholders have invested the funds in alternative channels,
they could have got a return (say10%) and this return has not earned by them as
the company has retained the earnings without distributing them. The cost of retained earnings may, therefore
be taken as 10%.
The
following adjustments are made for ascertaining the cost of retained earnings;
Income
tax adjustment:
The
dividends receivable by the shareholders are subject to income tax. Hence , the dividends actually received by
them are not the gross dividends but the amount of net dividends, i.e.,., gross
dividends less income tax.
Brokerage
cost adjustment:
Usually
the shareholders have to incur some brokerage cost for investing the dividends
received. Thus, the funds available with
them for reinvestment will be reduced by
this amount
The
opportunity cost of retained earnings to the shareholders is therefore
investing the funds in, the rate of return that they can obtain by investing
the net dividends (i.e. after tax and brokerage in alternative opportunity of
equal quality.
The cost of retained earnings after making
adjustment of income tax and brokerage cost payable by the shareholders can be
determined by the following formula;
The
computation of the cost of retained earnings, after making adjustments of tax
liabilities, is a difficult process because personal income tax will differ
from shareholder to shareholder. So in
order to avoid this, external yield criterion has been recommended by some
authorities. According to this approach
the opportunity cost of retained earnings is the rate of return that can be
earned by investing the funds in another enterprise by the fir. But this method is not universally
acceptable.
K
r = K e (1-t) (1-b)
K
r = Cost of retained Earnings
b
= Cost of purchasing new securities, or brokerage costs
Ke
= Rate of return available to shareholders
Problem:
1. A firm’s K (return available to
shareholders) is 15%, the average tax rate of shareholders is 40% and it is
expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of
retained earnings?
Solutions:
K r = K
e (1-t) (1-b)
= 15% (1-0.4)(1-.02)
= 15% x 0.6 x 0.98 = 8.82%
Weighted
average cost of capital
After
calculating the cost of each component of capital, the average cost of capital
is generally calculated on the basis of weighted average method. This may also be termed as the overall cost
of capital. The computation of the weighted average cost of capital involves
the following steps:
1.
Calcualtion of the cost of specific source of capital;
This involves the determination of cost of
debt, equity and preference capital.
This can be done either on “before tax” basis or “after tax” basis. But it will be appropriate to calculate on
the “after tax “basis. Because the
shareholders get dividends only after the taxes have been paid.
2.
Assigning weights to specific costs:
This involves the dete4rmination of the
proportion of each source of funds in the total capital structure of the
company and this done in any one of the following methods:
a)Marginal
weights method:
In this method weights are assigned
to each source of funds, in proportion of financing inputs the firm intends to
employ. However, this method is
suffering from the following limitations;
1. The
weight age is given only for the new capital and not for the already existing
capital and so the weighted average cost of capital so earned may be different
from the actual coat of capital.
2. A
firm should give due attention to long term implication while designing the
firms financial strategy. But this
method does not consider the long term implications of the firm’s current
financing.
b)
Historical weights method:
In
this method, the relative proportions of various sources to the existing
capital structure are used to assign weights.
This is based on the assumption that the firm’s present capital
structure is optimum and it should be maintained in the future also. Weights under this method may be either
·
Book value or
·
Market value weights
The weighted average cost of capital will
be different depending up0on whether book value weights are used or market
value weights are used.
The use of market value weights has the
following advantages and practical difficulties:
Advantages:
1. The
market values of the securities are closely approximate to the actual amount to
be received from the sale of such securities.
2. The cost of specific source of finance that
constitutes the capital structure is calculated according to the prevailing
market price.
3. Adding
of the weighted cost of all sources of funds to get and overall weighted
average cost of capital
Limitations:
o The
market value of the securities fluctuates considerably
o Market
values are not readily available as compared to the book values. The book values can be taken from he published records of the firm
o The
analysis of the capital structure of the company, in terms of debt equity
ratio, is based on the
book value and not on the market value.
K
w = ∑XW / ∑W
K
w = Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source
of finance.
1.
A firm has the following
capital structure and after-tax costs for the different sources of funds used.
Sources of funds Amount Rs. Proportion % After-tax
cost %
Debt 15, 00,000 25 5
Preference
shares 12, 00,000 20 10
Equity shares 18, 00,000 30 12
Retained
Earnings 15, 00,000 25 11
Total 60, 00,000 100
You are required
to compute the weighted average cost of capital
Solution:
Computation of weighted average cost of capital:
Sources of funds Proportion % (W) Cost % (X) Weighted cost % (XW)
Debt 25 5 1.25
Preference
shares 20 10 2.00
Equity shares 30 12 3.60
Retained
Earnings 25 11 2.75
 |
Weighted Average cost of capital 9.60%
Computation of market value weighted average cost of
capital:
Sources of funds Amount(Rs) Proportion%(W) Cost % (X) Weighted Cost (XW)
Debt 15,00,000 18.52 5 0.93
Preference
shares
12,00,000 14.81 10 1.48
Equity shares
54,00,000 66.67 12 8.00
(18000 shares @
Rs.300)
Weighted Average
cost of capital 10.41%
|
Cost
of Equity using Capital Asset Pricing Model (CAPM)
K e = R f +
B i (R m – R f)
Where K e =
Cost of equity capital
R
f = Risk free rate of return
R
m = Market return of d diversified portfolio
β
i = Beta co-efficient of the firm’s portfolio
1.
You are given the following
facts about a firm
(a)
Risk-free rate of return is 11%
(b)
Beta co-efficient, β i of the
firm is 1.25
Compute the cost of
equity capital using Capital Asset Pricing model (CAPM) assuming market return
of 15% next year. What would be the cost of equity if β I rises to 1.75
Solution:
When β i =
1.25
K e = 11% +
1.25 (15%-11%)
= 11% + 5%
= 16%
When β i =
1.75
K e = 11% +
1.75 (15%-11%)
= 11% + 5%
= 18%
Leverages
The term leverage refers to “an increased means for accomplishing
some purpose”. It is used to describe the firm’s ability to use fixed cost
assets or funds to magnify the return to its
owners.
James Horne has
defined leverage as “the employment of an asset or funds for which te firm pays
a fixed cost or fixed return”.
Types of leverages:
Leverages are of
three types:
a)Operating
leverage,
b) Financial
leverage
c) Composite
leverage
a) Operating leverage:
The operating leverage may be defined as
the tendency of the operating profit to vary disproportionately with sales. I is said to; exist when a firm has to pay
fixed cost regardless of volume of output or sales. The firm is said to have a high degree of
operating leverage if it employs a greater amount of fixed costs and a lesser
amount of variable costs and vice versa.
Thus, the degree of operating leverage depends on the amount of fixed
elements in the cost structure.
Operating
leverage is a function of three factors:
1. The
amount of fixed costs.
2. The
contribution margin
3. The
volume of sales.
There will be no operating
leverage if there are no fixed costs.
Computation: the operating
leverage can be calculated as follows:
Uses: The operating
leverage indicates the impact of change in sales on operating income. If a firm
has a high degree of operating leverage, small changes in sales will have large
effect on operating income i.e., the operating profits (EBIT) of such a firm
will increase at a faster rate than the increase in sales.
Similarly the operating profits of such a
firm will suffer a greater loss as compared to reduction in its sales.
Generally it is not advisable to have a
high degree of operating leverage
Operating Leverage =
Contribution / Operating profit
Contribution = Sales
– Variable cost
Operating profit =
Sales – Variable cost – Fixed cost
Operating profit =
Contribution – Fixed cost
Break Even point =
Fixed cost / P/V ratio
P/V ratio =
Contribution / sales.
Problem:
1. Following
information is taken from the records of a hypothetical company.
Installed
Capacity 1000
units
Operating capacity 800 units
Selling price per
unit Rs.
10
Variable cost per
unit Rs.
7
Fixed cost Rs
Situation A
800
Situation B 1,200
Situation C 1,500
Solution:
Situation
A Situation B Situation C
Sales 8,000 8,000 8,000
Less: Variable
cost 5,600 5,600 5,600
Contribution 2,400 2,400 2,400
Less: Fixed Cost 800 1,200 1,500
Operating Profit 1,600 1,200 900
Operating
Leverage (C/OP) 1.5 2.0 2.67
Break even Point
(F/C x S) 2,667 4,000 5,000
Margin of safety
ratio (OP/C) 66.7% 50% 37.5%
% of sales at
Break even point 33.3% 50% 62.5%
b) Financial leverage
Meaning
The
financial leverage may be defined as the tendency of the net income to very
disproportionately with the operating profit. It indicated the change that
takes place in the taxable income as a result of change in the operating income
It
signifies the existence of fixed interest dividend bearing securities in the
total capital structure of the company.
Thus, the use of debt capital, preference
capital along with the owner’s equity in the total capital structure of the
company is described as the financial leverage.
If the fixed interest dividend bearing securities are greater as
compared to the equity capital, the leverage is said to be larger. in a reverse
case the leverage will be said to be smaller.
Favourable and unfavorable financial leverage:
The leverage may be considered to be favorable
if the firm earns more on the assets purchased with the funds than the fixed
costs of their use. Unfavorable or negative leverage occurs when the firm does
not earn as much as the funds cost.
Trading on equity and financial leverage:
Financial leverage is also sometimes termed as
“trading on equity”
Computation:
It can be computed by the following
methods:
1. Where
the capital structure consists of equity shares and debt:
Financial
leverage measures the irresponsiveness of EPS
to changes in EBIT in this case, the financial leverage can be computed as follows:
2. Where
the capital structure consists of preference shares and equity shares:
The formula for computing computation of
financial leverage can also be applied to a financial plan having preference
shares. The amount of preference
dividends will have to be grossed up and then deducted from the earnings before
interest and tax
3.
Where the capital structure consists of equity shared, preference shares and
debt:
In this case, the financial leverage can be
computed after deducting from operating profit both interest and preference
dividend on a before tax basis.
Problem:
1. XYZ company
has currently an equity share capital of Rs. 40 Lakhs consisting of 40,000
equity shares of Rs.100 each. The management is planning to raise another Rs.30
lakhs to finance a major programme of expansion through one of the four
possible financing plans. The options are
a) Entirely
through equity shares.
b) Rs. 15 Lakhs
in equity shares of Rs.100 each and the balance in 8% debentures
c) Rs. 10 Lakhs
in equity shares of Rs.100 each and the balance through long-term borrowing at
9% interest p.a
d) Rs. 15 Lakhs
in equity shares of Rs. 100 each and the balance through preference shares with
5% dividend.
The company’s
expected earning before interest and taxes (EBIT) will be Rs. 15 lakhs.
Assuming corporate tax rate of 50%, you are required to determine the EPS and
comment on the financial leverage that will be authorized under each of the
above scheme of financing.
Calculation of EPS and
Financial leverage
|
||||
Plan 1
|
Plan II
|
Plan III
|
Plan IV
|
|
Equity shares
(Rs in lakhs)
Equity shares
(Number)
8% debentures
(Rs.in lakhs)
9% Long-term
borrowings (Rs in lakhs)
5% Preference
shares (Rs in lakhs)
|
40+30=70
70,000
-
-
-
|
40+15=55
55,000
15
-
-
|
40+10=50
50,000
-
20
-
|
40+15=55
55,000
-
-
15
|
Earnings before
interest & tax
Less: Interest on
debentures
Interest on
Long term borrowing
|
15,00,000
-
-
|
15,00,000
1,20,000
-
|
15,00,000
-
1,80,000
|
15,00,000
-
-
|
Earnings before
tax
Less: Tax @ 50%
|
15,00,000
7,50,000
|
13,80,000
6,90,000
|
13,20,000
6,60,000
|
15,00,000
7,50,000
|
Earnings after
tax (EAT)
Less:
Preference dividend
|
7,50,000
-
|
6,90,000
-
|
6,60,000
-
|
7,50,000
75,000
|
Earnings for
equity shareholders
|
7,50,000
|
6,90,000
|
6,60,000
|
6,75,000
|
Number of
equity shares
|
70,000
|
55,000
|
50,000
|
55,000
|
Earnings per
shares (EPS)
|
Rs. 10.71
|
12.55
|
13.20
|
12.27
|
Degree of
financial leverage (DFL)
(EBIT/ EBT-I)
|
1.00
|
1.087
|
1.136
|
1.00
|
p
Composite leverage:
Operating leverage measures the percentage
change in the operating profit due to percentage change in sales and it
explains the degree of operating risk.
Financial
leverage measures the percentage change in taxable profit on account of
percentage change in operating profit (EBIT) and it explains the financial
risk.
Both
these leverages are closely concerned with the firm’s capacity to meet its
fixed costs (both operating and financial) if both the leverages are combines,
the result obtained will disclose the effect of change in the sales over change
in taxable profit (CPS)
Composite
leverage thus explains the relationship between revenue on account of sales
(i.e., contribution or sales less variable cost) and the taxable income on
account of percentage change in sales.
Composite Leverage = Operating Leverage x
Financial Leverage
Significance of operating and financial leverages:
The
operating leverage and the financial leverage are the two important
quantitative tools used by the financial experts to measure the return to the
owners and the market price of the equity shares.
The financial leverage is superior of these
two tools as it focuses on the market price of the shares, which the management
always tries to increase by increasing the net worth of the firm.
When there is increase in EBIT, the price
of the equity shares also increase. If a firm goes on increasing the debt
capital, the marginal cost of debt also will increase as the lenders will
demand higher rate of interest.
A
company should try to have a balance of the two leverages because they have got
tremendous acceleration and deceleration effect on EBIT and EPS. it may be noted that a right combination of
these leverages is a very big challenge to for the management. A proper combination of both operating and
financial; leverages is a blessing for a firm’s growth while an improper
combination my prove to be curse.
A
high degree of operating leverage together either a high degree of financial
leverage makes the position every risky.
This is because on the one hand it is employing excessive assets for
which it has to pay fixed costs and at the same time it is also using a large
amount of debt capital. The fixed costs
towards using assets and fixed interest charges bring a greater risk, as the company
may not be able to meet incase of declined earnings.
The existence of operating leverage will
result in more than proportionate change even of a small change in sales. The presence of high degree of financial
leverage causes a more than proportionate change in EPS even on account of a
small change in EBIT
Thus
firm having a high degree of operating leverage and financial leverage has to
face the problems of liquidity or insolvency in one year or the other
year. It does not however mean that a firm
should opt for low degree of financial leverage. This may indicate the cautious policy of the
management, but the firm will be losing profit earning opportunities.
A
firm having high operating leverage should not have high financial
leverage. Similarly a firm having a low
operating leverage will gain profit by having a low operating leverage provided
it has enough profitable opportunities for the employment of borrowed funds.
Low
operating leverage and high financial leverage is considered to be an ideal
situation for the maximization of the profits with minimum risk. A firm should therefore, make all possible
efforts to combine the operating and financial leverage to maximize the risk an
minimize the risk
Capital
structure
Meaning
of capital structure
Capital structure is the permanent
financing of the company represented primarily by long term debt and
shareholders funds but excluding all shout term credit.
Capital
Structure is concerned with the qualitative aspect. It refers to the kinds of securities
and the proportionate amounts that make up capitalization. A decision about the
proportion among these types of securities refers to the capital structure of
an enterprise. The term capital structure differs form financial structure.
Financial
structure refers to the way the firm’s assets are financed. In other words, it
includes both, long term as well as short term sourced of funds. Thus a
company’s capital structure is only a part of its financial structure.
Patterns
of capital structure
In case of new company, the capital
structure may be of ay of the following four patterns.
1.
Capital structure with equity shares only.
2.
.Capital
structure with both equity and preference shares.
3.
Capital structure with equity shares and
debenture
4.
Capital structure with equity shares,
preference shares and debentures.
Factors
affecting capital structure:
Capital structure depends on a number of
factors such as,
v
The
nature of the business,
v
Regularity
of earnings
v
Conditions
of the money market,
v
Attitude
of the investor,
v
Debt
equity mix
There is a basic
difference between debt and equity. Debt is a liability on which interest has
to be paid irrespective of the company profits while equity consists of
shareholders or owners funds on which payments of dividend depends upon the
company’s profits. A high proportion of
the debt content in the capita structure increases the risk and many lead to
financial insolvency of the company in adverse times.
However, raising
funds through debt is cheaper as compared to raising funds through shares. This is because interest on debt is allowed
as an expense for tax purpose. Dividend is considered to be an appropriation of
profits and so payment of dividend does not result in any tax benefit to the
company. This means if a company, which is in 50% tax bracket, pays interest at
125 preference shares; the cost of raising the amount would be12%
Thus, rising of
funds by borrowing is cheaper result in higher availability of profits for
shareholder. This increases the earnings per equity share of the company, which
is to basic objective of a financial manager
Optimal
Capital Structure:
The optimum capital structure may be
defined as “that capital structure or combination of debt and equity that leads
to the maximum value of firm”. Optimal capital structure maximizes the value of
the company and hence the wealth of its owners and minimizes the company’s cost
of capital. Thus every firm should aim at achieving the optimal structure and
then to maintain it.
Considerations
The
following consideration will be greatly helpful for a finance manager in
achieving his goal of optimum capital structure.
·
If
the return on investment is higher than the fixed cost of funds, the company
should prefer to raise funds having a fixed cost, such as debentures, loans and
preference share capital. It will increase earnings per share and market value
of the firm. Thus, a company should, make maximum possible use of leverage.
·
When
debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of
tax. Hence, the effectiveness cost of debt is reduced, celled tax leverage. A
company should, therefore, take advantage of tax leverage.
·
The
firm should avoid undue financial risk attached with the use of increased debt
financing. If the shareholders perceive high risk in using further
debt-capital, it will reduce the market price of shares.
·
The
capital structure should be flexible
Factors
Influencing Capital structure:
The
factors influencing the capital structure are discussed as follows.
1.
Growth and stability of sales:
The
capital structure b of a firm is highly influenced by the growth and stability
of its sales. If the sales of a firm are expected to remain fairly stable, it
can raise a higher level of debt. Stability of sales ensures that the firm will
not face any difficulty in meeting its fixed commitments of interest payment
and repayments of debt.
2.
Cost of capital:
Cost
of capital refers to the minimum return expected by its suppliers. The capital
structure should provide for the minimum cost of capital. The main sources of
finance for a firm are equity, preference share capital and debt capital. Usually,
debt is a cheaper course of finance compared to preference and equity capital
due to fixed rate of interest on debt. On the other hand, the rate of dividend
is not fixed on equity capital. Preference capital is also cheaper than equity
because of lesser risk involved and a fixed rate of dividend payable to
preference shareholders. While formulating a capital structure, an effort must
be made to minimize the overall cost of capital
3.
Cash Flow ability to service debt:
A
firm which shall be able to generate larger and stable cash inflows can employ
more debt in its capital structure as compared to the one which has unstable
and lesser ability to generate cash inflows. Debt financing implies burden of
fixed charge due to the fixed payment of interest and the principal. Whenever a
firm wants to raise additional funds, it should estimate, project its future
cash inflows to ensure the coverage of fixed charges.
4.
Nature and size of a firm:
Nature
and size of a firm also influence its capital structure. All public utility
concern has different capital structure as compared to other manufacturing
concern. Public utility concerns may employ more of debt because of stability
and regularity of their earnings. On the other hand, a concern which cannot
provide stable earnings due to the nature of its business will have to rely mainly
on equity capital.
5.
Control:
Whenever
additional funds are required by a firm, the management of the firm wants to
raise the funds without any loss of control over the firm. In case the funds
are raised through the issue of equity shares, the control of the existing
shareholders is diluted. Hence, they might raise the additional funds by way of
fixed interest bearing debt and preference share capital. Preference
shareholders and debenture holders do not have the voting right. Hence, from
the point of view of control, debt fincancing is recommended.
6.
Flexibility:
Capital
structure of a firm should be flexible, i.e., it should be such as to be
capable of being adjusted according to the needs of the changing conditions. It
should be possible to raise additional funds, whenever the need be, without
much of difficulty and delay. A firm should arrange its capital structure in
such a manner that it can substitute one form of financing by another.
7.
Requirements of Investors:
The
requirements of investors are another factor that influences the capital
structure of a firm. It is necessary to meet the requirements of both
institutional as well as private investors when debt financing is used.
Investors are generally classified under three kinds, i.e. bold investors,
cautious investors and less cautious investors. For bold investors, equity
share will be suited, for over-cautious debentures will be suited, for less
cautious preference share capital will be suited.
8.
Capital Market conditions:
Capital
market conditions do not remain the same for ever. Sometimes there may be
depression while at other times there may be boom in the market. The choice of
the securities is also influenced by the market conditions. It the share market
is depressed and there are pessimistic business conditions, the company should
not issue equity shares as investors would prefer safety. But in case there is
boom period, it would be advisable to issue equity shares.
9.
Assets structure:
The
liquidity and the composition of assets should also be kept in mind while
selecting the capital structure. If fixed assets constitute a major portion of
the total assets of the company, it may be possible for the company to raise
more of long term debts.
10.
Purpose of Financing:
If funds are required for a productive purpose, debt
financing is suitable and the company should issue debentures as interest can
be paid out of the profits generated from the investment. However, if the funds
are required for unproductive purpose or general development on permanent
basis, we should prefer equity capital.
11.
Period of Finance:
The
period for which the finances are required is also an important factor to be
kept in mind while selecting an appropriate capital mix. If the finances are
required for a limited period of, say seven years, debentures should be
preferred to shares. Redeemable preference shares may also be used for a
limited period finance, if found suitable otherwise. However, in case funds are
needed on permanent basis equity share capital is more appropriate.
12.
Costs of Floatation:
Although not very significant, yet costs of
floatation of various kinds of securities should be considered while raising
funds, The cost of floating a debt is generally less than the cost of floating
an equity and hence it may persuade the management to raise debt financing. The
cost of floating as a percentage of total funds decrease with the increase in
size of the firm.
13.
Personal Considerations:
The
personal considerations and abilities of the management will have the final say
on the capital structure of a firm. Managements which are experienced and are
very enterprising do not hesitate to use more of debt in their financing as
compared to the less experienced and conservative management.
14.
Legal Requirements:
The
government has also issued certain guidelines for the issue of shares and
debentures. The legal restrictions are very significant as these lay down a
framework within which capital structure decision has to be made. For Ex: the
controller of capital issues, now SEBI grants his consent for capital issue
when (i) the debt-equity ration does not exceed 2:1 , (ii) preference capital
does not exceed 1:3.
Dividend:
The
term dividend refers to that part of the profits of a company, which is distributed
amongst the shareholders.
It
may be defined as the return that a shareholder gets from the company, out of
its profits, on his shareholdings.
According
to the Institute of Chartered accountants of India
Dividend
Policy:
The
term dividend policy refers to the policy concerning quantum of profits to be
distributed as dividend.
The
concept of dividend policy implies that companies through their Board of
Directors evolve a pattern of dividend payments, which has a bearing on future
action.
Classification
of Dividends:
The various
forms of dividends are as follows.
1.
Cash Dividend:
Payment of
dividend in cash is called cash dividend and this results in outflow of funds
from the firm
2.
Bond Dividend:
If
the company does not have sufficient funds to pay dividend in cash it may issue
bonds for the amount due to the shareholders by way of dividends. The purpose
of bond dividend is to postpone the payment of dividend in cash.
3.
Property Dividend:
In
this case, the dividend is paid in the form of assets other than cash. This may
be in the form of assets, which are not required by the company or in the form
of company’s products.
4.
Stock Dividend:
The
company issues its own shares to the existing shareholders in lieu or in
addition to cash dividend. Payment of stock dividend is known as “Issue of
bonus shares”.
Determinants
of Dividend Policy:
1.
Magnitude and trend of earnings:
The amount and trend of earnings is an important
aspect of dividend policy. It is rather the starting point of the dividend
policy. As dividends can be paid only out of present or past year’s profits,
earnings of a company fix the upper limits on dividends. The dividends should,
generally be paid out of current year’s earnings only as the retained earnings
of the previous years become more or less a part of permanent investment in the
business to earn current profits.
2.
Desire and Type of shareholders:
Although, legally, the discretion as to whether to
declare dividend or not has been left with the Board of Directors, the
directors should give the importance to the desires of shareholders in the
declaration of dividends as they are the representatives of shareholders. Desires
of shareholders for dividends depend upon their economic status. But a company
should adopt its dividend policy after taking into consideration the interests
of its various groups of shareholders.
3.
Nature of Industry:
Nature of industry to which the company is engaged
also considerably affects the dividend policy. Certain industries have a
comparatively steady and stable demand irrespective of the prevailing economic
conditions. Thus, industries with steady demand of their products can follow a
higher dividend payout ratio while cyclical industries should follow a lower
payout ratio.
4.
Age of the company:
The
age of the company also influences the dividend decision of a company. A newly
established concern has to limit payment of dividend and retain substantial
part of earnings for financing its future growth and development, while older
companies which have established sufficient reserves an afford to pay liberal
dividends
5.
Future Financial Requirements:
It
is not only the desires of the shareholders but also future financial
requirements of the company that have to be taken into consideration while
making a dividend decision. If a company has highly profitable investment
opportunities it can convince the shareholders of the need for limitation of dividend
to increase the future earnings and stabilize its financial position. But when
profitable investment opportunities, do not exist then the company may not be
justified in retaining substantial part of its current earnings.
6.
Government’s economic policy:
The
dividend policy of a firm has also to be adjusted to the economic policy of the
government as was the case when the Temporary Restriction on Payment of
Dividend Ordinance was in force. In 1974 and 1975, companies were allowed to
pay dividends not more than 33% of their profits or 12% on the paid-up value of
the shares, whichever was lower.
7.
Taxation Policy:
Taxation policy of the government also affects
the dividend decision of a firm. A high or low rate of business taxation
affects the net earnings of company and thereby its dividend policy. Similarly,
a firm’s dividend policy may be dictated by the income-tax status of its
shareholders. If the dividend income of shareholders is heavily taxed being in
high income bracket, the shareholders may forego cash dividend and prefer bonus
shares and capital gains.
8. Control Objectives:
When
a company pays high dividends out of its earnings, it may result in the
dilution of both control and earnings for the existing shareholders. As in case
of a high dividend pay-out ratio, the retained earnings are insignificant and
the company will have to issue new shares to raise funds to finance its future
requirements. The control of the existing shareholders will be diluted if they
cannot buy the additional shares issued by the company. Thus under these
circumstances to maintain control of the existing shareholders, it may be
desirable to declare lower dividends and retain earnings to finance the firm’s
future requirements.
9.
Requirements of Institutional investors:
Dividend
policy of a company can be affected by the requirements of institutional
investors such as financial institutions, banks insurance corporations etc.
These investors usually favor a policy of regular payment of cash dividends and
stipulate their own terms with regard to payment of dividend on equity shares.
10.
Stability of Dividends:
Stability
of dividends is another important guiding principle in the formulation of a
dividend policy. Stability of dividend simple refers to the payment of dividend
regularly and shareholders; generally prefer payment of such regular dividends.
Some companies follow a policy of constant dividend per share while others
follow a policy of constant payout ratio and while there are some other who
follows a policy of constant low dividend per share plus an extra dividend in
the years of high profits. A policy of constant dividend per share is most
suitable to concerns whose earnings are expected to remain stable
11.
Liquid Resources:
The
dividend policy of a firm is also influenced by the availability of liquid
resources. Although, a firm may have sufficient available profits to declare
dividends, yet it may not be desirable to pay dividends if it does not have
sufficient liquid resources. Hence the liquidity position of a company is an
important consideration in paying dividends.
Questions:
1. What is capital structure? What are
the major determinants of capital structure?
2. Explain the factors affecting capital
structure.
3. Discuss about the patterns of capital
structure
4. Discuss briefly about the Optimal
Capital Structure and its considerations.
5. Explain the meaning of dividend &
dividend policy and its classification.
6. “A firm should follow a policy of
very high dividend pay-out” Do you agree?
7. Explain the various factors which
influence the dividend decision of a firm
No comments:
Post a Comment