IILM-GSM

Corporate Finance
Project
Varun Maheshwari

2011-2013

COST OF CAPITAL:
The cost of capital of any investment (project, business, or company) is the rate of return the suppliers of capital would expect to receive if the capital were invested elsewhere in an investment (project, business, or company) of comparable risk The cost of capital reflects expected return The cost of capital represents an opportunity cost

Importance of Cost of Capital?

An investment can bring gains only when its rate of return is greater than the cutoff rate. It is also referred to as a hurdle rate because this is the minimum acceptable rate of return. It is important for capital budgeting decisions (accept & reject criteria). The wealth of shareholders will only be maximized when rate of return on proposal is greater than its cost of capital. Any investment which does not cover the firms cost of funds will reduce shareholder wealth. Just as if you borrowed money at 10% to make an investment which earned 7% would reduce your wealth.

Explicit cost & implicit cost

The explicit cost of capital of a particular source may be defined in terms of the interest or dividend that the firm has to pay to the suppliers of funds. These payments refer to the explicit cost of capital. There is one source of funds, which does not involve any payment or flow i.e., the retained earnings of the firm. Thus, the, implicit cost of retained earning is the return which could have been earned by the investor, had the profit been distributed to them. This is also called opportunity cost of capital.

Specific cost & overall cost

The cost of capital of each, source of capital is known as component or specific cost of capital. And when we take combined cost of all the components it is called overall cost of capital. The components are assigned certain weights & then the weighted average cost of capital (WACC) is determined.

Cost of DEBT
Rate of interest payable on debt is treated as its cost but thats not correct. This is bcoz interest is a tax deductible expense. Hence the actual cash outflow is less than interest paid to debt holders. Dividends payable to equity shareholders and preference shareholders is an appropriation of profit, whereas the interest payable on debt is a charge against profit. Therefore, any payment towards interest will reduce the profit and ultimately the companys tax liability would decrease.

Cost of Perpetual Debt

The cost of perpetual debt, rD is simply equal to the coupon payments (interest) divided by price of debt/debenture.

rD = I / P0
Cost of Preference shares
It may be dividend expected by preference shareholders. Like interest Preference Dividend is not a charge on earnings but appropriation of earnings since it is paid out of after tax profits. Hence no adjustment for tax is required.

Cost of Preference Capital

Irredeemable Preference Share The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation:

rP =Dp / P
where rp is the cost of preference share, Dp represents the fixed dividend per preference share and P is the price per preference share. Redeemable Preference Share

P0 =

D / (1+rP)t + F / (1+rP)n

The cost of preference capital is not adjusted for taxes, because dividends on preference capital are paid after taxes as it is not tax deductible.

Cost of equity
Most difficult cost to measure. The return on debt & preference shares is fixed. Moreover in case of repayment of capital, equity capital is last in priority list. It seems that they do not carry cost. But equity shares like others also carry a cost. It carries a cost in terms of dividends expected by the shareholders. The cost of equity is the highest among all, bcoz the shareholders bear the highest degree of financial risk, since they are paid after all other payments are made. Hence with higher risk, the return expected is higher & cost of capital is more.

APPROACHES TO ESTIMATE COST OF EQUITY

Dividend Growth Model Approach Capital Asset Pricing Model (CAPM) Price Earning Ratio

How to calculate SIP returns- ET wealth

Investments in mutual funds through systematic investment plans (SIPs) have become a favoured route for most investors. But one question dogs every investors mind: How are SIP returns calculated? It is very easy to calculate a funds return when the investments are made through the non-SIP (lump sum) route. This is because the entry date and exit date are known. However, in case of an SIP, although the exit date and the exit value is known, there are series of dates on which the investments are made, implying multiple entry dates. Moreover, there are possibilities of variations in the amount of investments made at different time intervals. For example, one may be investing Rs 2,500 every month that could be increased to Rs 4,500 per month or reduced to Rs 1,500 per month. How to estimate returns from such investments? IRR is useful not only for SIP returns but also for estimating returns from money back insurance policies and bond yields. This calculation method equates the discounted value of the stream of investments (also known as cash outflows) to the discounted exit value of the investment (cash inflows). The discount rate that equates the present value of cash outflows and the present value of cash inflows is the rate of return earned by an SIP.

There are two forms of Equity

Retained earnings or Internal equity Fresh Issue of Equity shares or External Equity

Types of Risks:
Systematic Risk This is the risk in return of securities due to market wide factors like Interest Rates, inflation, GDP, monetary & fiscal policies etc. Unsystematic Risk This risk is due to unique or company specific factors like such as expansion, product development, capital expenditure programme, competitive position, marketing policies, cost control, management change etc.

Capm:
It states that the returns on the equity are linearly related to the systematic risk of the project. There are three inputs required to compute the cost of equity the risk free rate of return, the market return, and the sensitivity of the stock to the systematic factors. The sensitivity of stock is measured by Beta. The value of Beta varies from 0 to 1. Beta of zero indicates no systematic risk in the project/security, while Beta of one means risk is equivalent to market risk.

Security Market Line (SML)

SML is a graphical line that shows a relationship between Beta (Market Risk) & expected returns of a stock at a given level of risk free rate. It is represented by equation:

rE = Rf + bE [E(RM) Rf ]
rE = required return on the equity of the company Rf = risk-free rate bE = beta of the equity of the company E(RM) = expected return on the market portfolio

WEIGHTED AVERAGE COST OF CAPITAL:

WACC = wErE + wprp + wDrD (1 tc)

wE = proportion of equity rE = cost of equity wp = proportion of preference rp = cost of preference wD = proportion of debt rD = pre-tax cost of debt tc = corporate tax rate

DETERMINING THE PROPORTIONS OR WEIGHTS

The appropriate weights are the target capital structure weights stated in market value terms. Book Value weights are easy to calculate, easily available & are more stable. Market values are superior to book values because in order to justify its valuation the firm must earn competitive returns for shareholders and debt holders on the current (market) value of their investments.

Concept of Capital Budgeting

Capital budgeting decision relates to acquisition of assets that have long term implications of the capacity of the enterprise for production, revenue and profits. Capital budgeting decision is often referred to as investment decision of the firm where allocation of capital among the different projects is decided.

Importance of Capital Budgeting

Capital budgeting is considered strategic in nature affecting the competitive position of the firm. Lack of capital budgeting proposals in any enterprise signals a bleak future of the firm because the existing projects would have some limited life as new products and competitors emerge.

These are important because of their following features:

Huge Outlay is involved Irreversible in nature Experience of the firms is less.

Types of Projects
Projects may relate to:- Mandatory Investments like medical dispensary, fire fighting equipments etc. Replacement Projects Expansion Projects Diversification Projects R & D Projects

Another Calssification of Projects is

Mutually Exclusive investments Independent Investments or Stand alone projects Contingent Investments

Types of Capital Budgeting Techniques

Discounted cash flow techniques:
NPV IRR MIRR Discounted Pay Back PI

Non - Discounted cash flow techniques:

Pay Back Period ARR

Discounted Cash flow (DCF)

The process of valuing an investment by discounting its future cash flows, including NPV, PI, and IRR Primary investment decision criteria as each of the three methods: Considers the time value of money, Examines all net Cash Flows, and Considers the required rate of return

Capital Budgeting TechniquesNPV

The NPV of an investment is the present value of proposals/projects net cash flows less the proposals initial cash outflow / initial investment.

 NPV = CF1 + CF2 + ..+CFn ICO (1 + k)1 (1 +k)2 (1+k)n NPV = {CFt / (1+k)t } - ICO t=1 A projects NPV is the net effect that undertaking a project is expected to have on the firms value A project with an NPV > (<) 0 should increase (decrease) firm value Since the firm desires to maximize shareholder wealth, it should select the capital spending program with the highest NPV Decision Rules Stand-alone Projects NPV > 0 accept NPV < 0 reject Mutually Exclusive Projects NPVA > NPVB choose Project A over B

Examples
Calculate the net present value of a project which requires an initial investment of $243,000 and it is estimated to generate a cash inflow of $50,000 each month for 12 months. Assume that the salvage value of the project is zero. The target rate of return is 12% per annum. Solution We have, Initial Investment = $243,000 Cash Inflow per Period = $50,000 Number of Periods = 12 Discount Rate per Period = 12% / 12 = 1% Net Present Value = $50,000 ( 1 - ( 1 + 1% )^-12 ) / 1% $243,000 = $50,000 ( 1 -1.1^-12 ) / 0.1 $243,000 $50,000 0.68137 / 0.1 $243,000 $50,000 6.8137 $243,000 $340,685 $243,000 $97,685

 Profitability Index (PI)

The profitability index is a variation on the NPV method It is a ratio of the present value of a projects inflows to the present value of a projects outflows Projects are acceptable if PI>1 Larger PIs are preferred Also known as the benefit/cost ratio Positive future cash flows are the benefit Negative initial outlay is the cost Decision Rules Stand-alone Projects If PI > 1.0 accept If PI < 1.0 reject Mutually Exclusive Projects PIA > PIB choose Project A over Project B

Formula: Profitability Index

Present Value of Future Cash Flows Initial Investment Required Net Present Value Initial Investment Required

= 1+

Example
Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows Initial Investment Rquired Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows:
Profitability Index = 1 + ( Net Present Value / Initial Investment Required ) Profitability Index = 1 + $15M/$65 = 1.3

Comparison with NPV

With mutually exclusive projects the two methods may not lead to the same choices

Internal Rate of Return (IRR)

It is the discount rate that equates the present value of net cash inflows during the life of the project with the initial cash outflow. Equation: PV of future CFs IC = 0 Solve the interest rate and the solved rate is IRR IRR is the required return that makes NPV = 0 when it is used as the discount rate. NPV = CF1 + CF2 + .. +CFn = 0 (1 + IRR)1 (1 +IRR)2 (1+IRR)n

{CFt / (1+r)t } ICO = 0 where, r = IRR t=1

Decision Rules
Stand-alone Projects If IRR > cost of capital (or k) accept If IRR < cost of capital (or k) reject Mutually Exclusive Projects IRRA > IRRB choose Project A over Project B

Example

Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first, second, third and fourth years are expected to be $65,200, $98,000, $73,100 and $55,400 respectively.

 Solution
Assume that r is 10%. NPV at 10% discount rate = $18,372 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $204 NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14%

Capital Budgeting Techniques-ARR

Accounting rate of return also known as ROI uses accounting profit and not CFAT ARR = average income/ average investment Where Average income = (PAT for each year/no. of years) (in case of annuity , any years profit can be considered) Average investment =(initial investment + salvage value)/2

Decision Rules
Stand-alone Projects ARR > REQUIRED RATE OF RETURN accept ARR < ROR reject Mutually Exclusive Projects ARRA >ARRB choose Project A over B

NPV Vs. IRR

NPV and IRR will generally give us the same decision Exceptions Non-conventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different(scale of project)

 Timing of cash flows is substantially different The projects may have different expected lives

What is Capital Structure?

The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, convertible bonds

Why is Capital Structure Important?

Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. The Optimal Capital Structure is the one that minimizes the firms cost of capital and maximizes firm value.

Business Risk
Uncertainty inherent in the firms operations if it used no debt. Firms have business risk generated by what they do. Total sales variability Total fixed operating expenses

Financial Risk
Financial Risk Additional risk incurred through the use of debt financing. Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

Employing Leverage
Leverage:
Use of fixed cost items in the process of magnifying earnings.

Perating Leverage:
Use of fixed operating costs in the process of magnifying operating income (EBIT) Fixed operating costsassets added to grow the firm Depreciation of PP&E Rent and utility costs Property taxes Salaried costs

Financial Leverage
Financial Leverage (also known as Trading on equity or Gearing) Use of fixed financial costs (e.g., debt and preferred stock financing) in the process of magnifying earnings per share EPS. Fixed capital costfunds the assets Interest charges Preferred dividends

Favorable and Unfavorable Financial Leverages

The effect of the financial leverage may be favorable or unfavorable. Positive, or favorable, financial leverage occurs when the earnings per share increase due to the use of debt in the capital structure. This happens when the rate of return on the companys assets is more than the cost of debt capital.

What is an optimal capital structure?

An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value.