Name G M Firoz Khan

Roll No. 520931217

Program MBA

SubjectFinancial Management [Set 2]

Code MB 0029

Learning Centre

Systems Domain –Indira Nagar, Bangalore [2779]

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1 Is Equity Capital Free of cost? Substantiate your statement.

Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and complex exercise. There are many approaches for estimating return – the dividend forecast approach, capital asset pricing approach, realized yield approach, etc. According to dividend forecast approach, the intrinsic value of an equity share is the sum of present values of dividends associated with it.

Ke = (D1/Pe) + g

This equation is modified from the equation Pe={D1/Ke-g}. Dividends cannot be accurately forecast as they may sometimes be nil or have a constant growth or sometime supernormal growth periods.

Equity Capital is not free of cost:

Some people are of the opinion that equity capital is free of cost for the reason that a company is not legally bound to pay dividends and also the rate of equity dividend is not fixed like preference dividends. This is not a correct view as equity shareholders buy shares with the expectation of dividends and capital appreciation. Dividends enhance the market value of shares and therefore equity capital is not free of cost.

Example:

Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth rate in dividends is expected to grow @ 10% p.a. The price of one share is currently at Rs. 110 in the market. What is the cost of equity capital to the company?

Solution:

Ke = (D1/Pe) + g

= (5/110) + 0.10

= 0.1454 or 14.54%

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2 a. What is the rate of return for a company if the β is 1.25, risk free rate of return is 8% and the market rate of return is 14%. Use CAPM model.

β = 1.25Risk free Rate of Return= 8%Market Rate of return = 14%Rate of return for a company is given by,Ke = Rf + β [Rm-Rf]

Ke = 0.08 + 1.25(0.14-0.08)

Ke = 0.08 + 0.275

= 0.155 or 15.5%

Therefore the rate of return for the company is 15.5%

b. Sundaram Transports has the following capital structure.

Equity capital Rs.10 par value 250 lakhs

12% preference share capital Rs.100 each

100 lakhs

Retained earnings 150 lakhs

12% Debentures (Rs.100 each) 350 lakhs

14% Term loan from SBI 150 lakhs

Total 1000 lakhs

The market price per equity is Rs 54. The company is expected to declare a dividend per share of Rs.2 per share and there will be a growth of 10% in the dividends for the next 5 years. The preference shares are redeemable at a premium of Rs.5 per share after 8 years. The current market price of preference share is Rs.92. Debenture redemption will take place after 7 years at a discount of 2% and the current market price is Rs.91 per debenture. The corporate tax rate is 40%. Calculate WACC.

Solution:

Market price per equity = PO = 54

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Expected dividend per share = D1 = Rs.2Rate of growth of dividend = g =0.1

Step I is to determine the cost of each component.

Cost of equity capital, Ke =( D1/P0) + g

= (2/54) + 0.1

= 0.137 or 13.7%

Preference dividend payable = D = 12Present value P =92Future Value F =105Period n =8

Cost of preference capital, Kp = [D + {(F—P)/n}] / {F+P)/2}

= [12 + (105—92)/8] / (105+92)/2

=13.625/98.5

= 0.1383 or 13.83%

Cost of retained earnings, Kr = Ke this is 13.7%

Annual interest payable per unit debenture = I = 12%Corporate tax rate = T = 40%Redemption price per debenture = F = 105Net amount realized per debenture = P= 92Maturity period = n = 7

Cost of debentures, Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}

= [12(1—0.4) + (105—92)/7] / (105+92)/2

= [7.2 + 1.857] / 98.5

= 0.09195 or 9.2%

Cost of term loans, Kt = I (1–T)

= 0.14(1–0.4)

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= 0.084 or 8.4%

Step II is to calculate the weights of each source.

We = 250/1000 = 0.25

Wp = 100/1000 = 0.1

Wr = 150/1000 = 0.15

Wd = 350/1000 = 0.35

Wt = 150/1000 = 0.15

Step III Multiply the costs of various sources of finance with corresponding weights and WACC calculated by adding all these components.

WACC = WeKe + WpKp +WrKr + WdKd + WtKt

= (0.25*0.137) + (0.1*0.1383) + (0.15*0.137) + (0.35*0.092) + (0.15*0.084)

= 0.03425 + 0.01383 + 0.021 + 0.0322 + 0.0126

= 0.1139 or 11.39%

3 The effective cost of debt is less than the actual interest payment made by the firm. Do you agree with this statement? If yes/no substantiate your views.

The effective cost of debt is less than the actual interest payment made by the firm. Any organization requires funds to run its business. These funds may be acquired from short-term or long-term sources. Long-term funds are raised from two important sources – capital (owners’ funds) and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not desirable as debt-holders attach many conditions which may not be possible for the companies to adhere to. It is therefore desirable to have a combination of both debt and equity which is called the ‘optimum capital structure’. Optimum capital structure refers to the mix of different sources of long term funds in the total capital of the company.

Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period. When we

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combine Capital with budget we get Capital budget. Capital budget is a blue print of planned investments in operating assets. Therefore, Capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the Capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are Strategic because they change the profile of the organizations. Successful organizations have created wealth for their shareholders through Capital budgeting decisions. Investment of current funds in long-term assets for generation of cash flows in future over a series of years characterizes the nature of Capital Budgeting decisions.

Designing of capital structure requires a number of factors to be considered such as:

Return: The capital structure of a company should be most advantageous. It should generate maximum returns to the shareholders for a considerable period of time and such returns should keep increasing.

Risk: As already discussed in the previous chapter on leverage, use of excessive debt funds may threaten the company’s survival. Debt does increase equity holders’ returns and this can be done till such time that no risk is involved.

Flexibility: The company should be able to adapt itself to situations warranting changed circumstances with minimum cost and delay.

Capacity: The capital structure of the company should be within the debt capacity. Debt capacity depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay creditors’ interests, principal and also to shareholders to some extent.

Control: An ideal capital structure should involve minimum risk of loss of control to the company. Dilution of control by indulging in excessive debt financing is undesirable.

With the above points on ideal capital structure, raising funds at the appropriate time to finance firm’s investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect. A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds. The cost of capital is the minimum rate of return a company must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures, equity and preference shares. A company not being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy. Loans and debentures come with a pre-determined interest rate, preference shares also have a fixed rate of dividend while equity holders expect a minimum

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return of dividend based on their risk perception and the company’s past performance in terms of pay-out of dividends.

Cost of debentures

The cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows – interest and principal repayments.

The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm.

4 Why capital budgeting decision very crucial for finance managers?

Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardize the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economize the use of their funds and adapt to the changing conditions.

There are many reasons that make the Capital budgeting decisions the most crucial for finance managers

These decisions involve large outlay of funds now in anticipation of cash flows in future. For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes had declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions.

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b. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology creating wealth for shareholders. The best example is the Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capital expenditure can significantly affect the firm. An upward bias may lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness.

d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its competitors. Both are risky fraught with grave consequences.

A long term investment of funds sometimes may change the risk profile of the firm. A FMCG company with its core competencies in the business decided to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investor’s perception of risk of the new business to be taken up by the company will change his required rate of return to invest in the company. In this connection it is to be noted that the power pricing is a politically sensitive area affecting the profitability of the organization. Therefore, Capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want.

Most of the Capital budgeting decisions involve huge outlay. The funds requirements during the phase of execution must be synchronized with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost overrun. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a company’s operations unproductive. But the major challenge that the management of a firm faces in managing the uncertain future cash inflows and out flows associated with the plan and execution of Capital budgeting decisions.

Capital budgeting decisions involve assessment of market for company’s products and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realize after committing itself considerable sums of money in the process of implementing the Capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialized costly equipments. Therefore, Capital budgeting decisions are irreversible.

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The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs Capital expenditure to build up capacity in anticipation of the expected boom in the demand for its products. The timing of the Capital expenditure decision must match with the expected boom in demand for company’s products. If it plans in advance it may effectively manage the timing and the quality of asset acquisition. But many firms suffer from its inability to forecast the future operations and formulate strategic decision to acquire the required assets in advance at the competitive rates.

All Capital budgeting decisions have three strategic elements. These three elements are cost, quality and timing. Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing the products of required quality for customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of Capital expenditure decision taken, will strategically affect the firm’s profitability.

Liberalization and globalization gave birth to economic institutions like World Trade organization. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell its products in India at a rate less than the rate at which Indian Companies sell cannot be ignored. Therefore, the growth and survival of any firm in today’s business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging Capital budgeting decisions for growth. Therefore, Capital budgeting decisions for growth have become essential characteristics of successful firms today.

The social, political, economic and technological forces generate high level of uncertainty in future cash flows streams associated with Capital budgeting decisions. These factors make these decisions highly complex.

Capital expenditure decisions are very expensive. To implement these decisions, firm’s will have to tap the Capital market for funds. The composition of debt and equity must be optimal keeping in view the expectation of investors and risk profile of the selected project.

5. A road project require an initial investment of Rs.10,00,000. It is expected to generate the following cash flow in the form of toll tax recovery.

Year Cash Inflows1 4,50,000

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2 4,25,0003 3,00,0004 3,50,000

What is the IRR of the project?

Step I:

Compute the average of annual cash inflows

YearCash inflows

1 4500002 4250003 3000004 350000

Total 1525000

Average = 1525000 /4

= Rs. 381250

Step II:

Divide the initial investment by the average of annul cash inflows:

= 1000000/381250

= 2.62

Step III:

From PVIFA table for 4 years, the annuty factor very near 2.62 is 19%. Therefore the first initial rate is 19%

Year

Cash flows

PVIF factor @ 19%

PV of cash flows

1 450000 0.84 3780002 425000 0.706 3000503 300000 0.593 1779004 350000 0.499 174650

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Total 1030600Since the initial investment of Rs. 10,00,000 is less than computed value at 19% of Rs. 1030600 the next trail rate is 20%

Year

Cash flows

PVIF factor @ 20%

PV of cash flows

1 450000 0.833 3748502 425000 0.694 2949503 300000 0.579 1737004 350000 0.482 168700

Total 1012200

The next trail is 21%

Year

Cash flows

PVIF factor @ 21%

PV of cash flows

1 450000 0.826 3717002 425000 0.683 2902753 300000 0.564 1692004 350000 0.467 163450

Total 994625Since the investment of Rs.10,00,000 lies between 21% and 20%, the IRR by interpolation is,

20+(1000000−1012200 )(1000000−994625)

x1

IRR = 20.7%

6. What is sensitivity analysis? Mention the steps involved in it.

Sensitivity Analysis:

There are many variables like sales, cost of sales, investments, tax rates etc which affect the NPV and IRR of a project. Analysing the change in the project’s NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis. It is a technique that shows the change in NPV given a change in one of the variables that determine cash flows of a project. It measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.

The reliability of the NPV depends on the reliability of cash flows. If forecasts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost. Therefore, forecasts are made under different

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economic conditions viz pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions.

Following steps are involved in Sensitivity analysis:

1. Identification of variables that influence the NPV & IRR of the project.2. Examining and defining the mathematical relationship between the

variables.3. Analysis of the effect of the change in each of the variables on the NPV of

the project.

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