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PIM1

The document discusses various methods to calculate the cost of debt, preference shares, and equity for a company. It outlines formulas to calculate the before-tax and after-tax cost of debt depending on whether the debt was issued at par, at a discount, or at a premium. For preference shares, it provides formulas for the cost of irredeemable and redeemable preference shares. Finally, it discusses several models for calculating the cost of equity capital, including the dividend growth model for calculating internal and external equity costs, as well as approaches based on earnings like the Gordon and Walter models and price-earnings ratio.

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Rajat Goyal
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63 views19 pages

PIM1

The document discusses various methods to calculate the cost of debt, preference shares, and equity for a company. It outlines formulas to calculate the before-tax and after-tax cost of debt depending on whether the debt was issued at par, at a discount, or at a premium. For preference shares, it provides formulas for the cost of irredeemable and redeemable preference shares. Finally, it discusses several models for calculating the cost of equity capital, including the dividend growth model for calculating internal and external equity costs, as well as approaches based on earnings like the Gordon and Walter models and price-earnings ratio.

Uploaded by

Rajat Goyal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Module -3

Cost of Debt

Cost of Debt
Based on the interest/coupon rate Before tax cost of debt is the rate of return required by the lenders

1. Debt Issued At Par

INT kd i B0
where,
kd is the cost of debt I is the coupon rate of interest B0 is the issue price of the bond INT is the amount of interest
2

2. Debt Issued at Discount/Premium


`

The before tax cost of debt can be calculated using the following equation:

where, Bn is the repayment of debt on maturity B0 is the issue price of the bond

INTt Bn B0 t n t 1 (1 k ) (1 kd ) d
n

This equation can be solved for kd by trial & error & interpolation

Valuation of bonds

Using PVIF Tables I*PVIFkd,t + Bn * PVIFkd,n I*PVIFAkd,t + Bn * PVIFkd,n

Features of Debt instrument


Credit instrument Interest rates Collateral Maturity Date Voting Rights Face value and redemption value Priority in liquidation

Types of Debt Instrument


Secured and Unsecured debentures Convertible and Non-convertible debentures Zero Interest and fully convertible debentures Secured premium notes Callable and putable bonds Floating rates bonds(Bank rate +2%, Libor Libid, Limean) Deep discount bonds Junk bonds Inverse floaters(18%-1.5*T-Bill) Municipal bonds Indexed bond Government securities

Types of yield
Current yield or basic yield Weighted yield Yield to maturity YTM and default risk Yield to call Yield spread Holding period return Realised Compound yield and YTM

Risk analysis
Default Risk Market interest rate risk Liquidity Risk Inflation Risk Reinvestment Risk

Debt market Segments in India


Government Government sponsored Indian Corporate Banks Money market debt segment

Tax Adjustment
The interest paid on debt is tax deductible The higher the interest charges, lower would be the amount of tax payable by the firm As a result, the after-tax cost of debt to the firm will be substantially lower than the investors required rate of return After-tax-cost of debt = kd(1-T) Where T is the corporate tax rate Loss making firms will not have after tax cost of debt In Calculation of WACC after-tax-cost of debt is to be used

10

Cost of Preference Capital


In case of preference capital, payment of dividends is not legally binding The cost of preference capital is a function of the dividend expected by the investors

Irredeemable Preference Shares


If Preference shares are perpetual,
where, kp is the cost of preference shares PDIV is the expected preference dividend P0 is the issue price of preference shares
11

PDIV kp P0

Redeemable Preference Share


Cost of Redeemable Preference Shares can be computed as:
n

PDIVt Pn P0 t n (1 k p ) t 1 (1 k p )
The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid

Since interest is tax deductible & Preference dividend is not, the cost of preference is substantially higher than the after tax cost of debt

12

Cost of Equity Capital


Equity capital can be raised internally by retained earnings or the firm can distribute dividends & raise capital by new issue of equity shares In both the cases the shareholders are providing funds to the firms to finance their capital expenditures
Equity shareholders required rate of return would be same

Difference between cost of retained earnings & cost of external equity would be floatation costs
13

Cost of Internal Equity: Dividend Growth Model

The opportunity cost of retained earnings is the rate of return foregone by equity shareholders 1. Normal Growth: The cost of Equity is equal to the expected dividend plus capital gain rate

DIV1 ke g P0

Where,
ke = cost of equity DIV1 = DIV0(1+g) g= expected growth in dividends

14

Cost of Internal Equity: Dividend Growth Model Can be written as follows:

DIV1 P o ke g
These equations are based on the following assumptions:

Market price of shares is a function of expected dividends The Dividend is positive The dividends grow at a constant rate & g = ROE X Retention Ratio The dividend payout ratio is constant

Also called as GORDONs model Implies the opportunity cost for the shareholders, if these earnings were to be distributed as dividends
15

2. Supernormal Growth
When dividends grow at different rates, the dividend valuation model is used as follows:

DIV0 (1 g s ) DIVn1 1 P0 X t n ke g n (1 ke ) 1 ke t 1 Where, gs = super-normal growth rate for n years & gn is the growth rate beginning in the year n+1, perpetually
n t

3. Zero growth:

DIV1 ke P0

16

COST OF EXTERNAL EQUITY (No Flotation Cost) DIVIDEND GROWTH MODEL


Consists of funds raised externally through public or rights issue The minimum rate of return required by equity shareholders to keep the market price of share same is the cost of equity Firm can induce existing or potential shareholders to purchase new shares when it promises rate of return which is equal to

Where Div1 = Expected dividend = Div0 (1+g) P0 = Current market price g = Expected growth rate in dividend = RoE x Retention Ratio

ke = Div1 + g Po

COST OF EXTERNAL EQUITY (With Flotation Cost) DIVIDEND GROWTH MODEL(2)

New issues of ordinary shares are generally sold at a price less than the prevailing market price Hence cost of equity can be calculated as

ke = Div1 + g Pn
Where Div1 = Expected dividend = Div0 (1+g) Pn = Issue price of new equity = Issue Price Floatation cost g = Expected growth rate in dividend = RoE x Retention Ratio

Valuation Of Equity shares based on Earnings


Gordons Model
Po= EPS1(1-b) /(Ke br)

Walters Model
Po = (D/Ke) + (r/Ke)(E-D) /Ke

Earning Multiplier Approach or Price Earning Ratio


Value = EPS x P/E Ratio EPS = (PAT PDIV)/No of Equity Shares

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