FINANCIAL MANAGEMENT

ASSIGNMENT -1

TOPIC-: COST OF CAPITAL

SUBMITTED ON -: 11/01/2016

SUBMITTED TO-: SUBMITTED BY-:

PROF. JEEVAN NAGARKAR 1) ANKIT GOSWAMI(15020241023)

HOD , DEPT OF FINANCE, 2) ABHISHEK GUPTA(15020241004)

SYMBIOSIS INSTITUTE OF INTERNATIONAL BUSINESS, 3)ABHISHEK SINGH(15020241006)

PUNE 4) ADITI MANDOWARA(15020241009) 5) NAMRATA MANGLIK(15020241133)

6) AASHNA GUPTA(15020241001)

COST OF CAPITALINTRODUCTION

Investment decision is major decision for an organization. Under investment decision process, the cost and benefit of prospective projects is analyzed and the best alternative is selected on the basis of the result of analysis. The benchmark of computing present value and comparing the profitability of different investment alternatives is cost of capital. Cost of capital is also known as minimum required rate of return, weighted average cost of capital, cut off rate, hurdle rate, standard return etc. Cost of capital is determined on the basis of component cost of financing and proportion of these sources in capital structure. Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure represents how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness.

Significance of Cost of Capital

Cost of capital is considered as a standard of comparison for making different business decisions. Such importance of cost of capital has been presented below.

1. Making Investment Decision

Cost of capital is used as discount factor in determining the net present value. Similarly, the

actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost of capital has a significant role in making investment decisions.

2. Designing Capital structure

The proportion of debt and equity is called capital structure. The proportion which can minimize the cost of capital and maximize the value of the firm is called optimal capital structure. Cost of capital helps to design the capital structure considering the cost of each sources of financing, investor's expectation, effect of tax and potentiality of growth.

3. Evaluating the Performance

Cost of capital is the benchmark of evaluating the performance of different departments. The department is considered the best which can provide the highest positive net present value to the firm. The activities of different departments are expanded or dropped out on the basis of their performance.

4. Formulating Dividend Policy

Out of the total profit of the firm, a certain portion is paid to shareholders as dividend. However, the firm can retain all the profit in the business if it has the opportunity of investing in such projects which can provide higher rate of return in comparison of cost of capital. On the other hand, all the profit can be distributed as dividend if the firm has no opportunity investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

MEANING

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profit abilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability.

From the view point of return, cost of capital is the minimum required rate of return to be earned on investment. In other words, the earning rate of a firm which is just sufficient to satisfy the expectation of the contributors of capital is called cost of capital. Shareholders and debenture holders are the contributors of the capital. For example, a firm needs $ 5, 00,000 for investing in a new project. The firm can collect $3,00,000 from shares on which it

must pay 12% dividend and $ 2,00,000 from debentures on which it must pay 7% interest. If the fund is raised and invested in the project, the firm must earn at least $50,000 which becomes sufficient to pay $36,000 dividend (12% of $3, 00,000) and $14000 interest (7% of $2, 00,000). The required earning $50,000 is 12% of the total fund raised. This 12% rate of return is called cost of capital.In this way, cost of capital is only minimum required rate of return to earn on investment and it is not the actual earning rate of the firm. As per above example, if the firm is able to earn only 10%. All the earnings will go in the hands of contributors of capital and nothing will be left in the business. Therefore, any business firm should try to maximize the earning rate by investing in the projects that can provide the rate of return which is more than the cost of capital.

Internal Rate of Return

The cost of capital serves as a benchmark in financial decision-making. The cost of capital can be compared to the internal rate of return (IRR) of a project or investment. IRR is the rate of return that makes the net present value of all cash flows from an investment equal zero. Since IRR measures the efficiency of investments, as opposed to magnitude, IRRs are commonly used to evaluate the desirability of investments or projects. If the IRR of an investment exceeds its cost of capital, the project should be undertaken.

Equation used to determine net present value, and therefore internal rate of return. DPV =

discounted net present value, N = total number of periods in which a cash flow occurs, t =

the specific period of the cash flow, FV = the value of the future cash flow, and i = internal

rate of return.

IRR calculation can be very complex. Unless using a computer or financial calculator, IRR must be calculated using trial and error using the above equation.

Source: Boundless. “Defining the Cost of Capital.” Boundless Finance. Boundless, 21 Jul. 2015. Retrieved 10 Jan. 2016 from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/the-basics-of-the-cost-of-capital-87/defining-the-cost-of-capital-372-8286/

What impacts the cost of capital?

RISKINESS OF EARNINGS

INTEREST RATE

LEVELS IN THE

US/GLOBAL THE DEBT TO EQUITY MIX OF THE FIRM

FINANCIAL SOUNDNESS OF THE FIRM

The cost of capital becomes a guideline for measuring the profit abilities of different investments.

Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor’s opportunity cost), investors will not invest in the firm’s debt and equity. As a result, the firm’s value (both their debt and equity) will decline.

Controllable Factors Affecting Cost of Capital: These are the factors affecting cost of capital that the company has control over:

Capital Structure Policy: A firm has control over its capital structure, and it targets an optimal capital

structure. As more debt is issued, the cost of debt increases, and as more equity is

issued, the cost of equity increases.

Dividend Policy: Given that the firm has control over its pay-out ratio, the breakpoint of the

marginal cost of capital schedule can be changed. For example, as the pay-out ratio

of the company increases, the breakpoint between lower-cost internally generated

equity and newly issued equity is lowered.

Investment Policy: It is assumed that, when making investment decisions, the company is making

investments with similar degrees of risk. If a company changes its investment policy

relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors Affecting the Cost of CapitalThese are the factors affecting cost of capital that the company has no control over:

Level of Interest Rates: The level of interest rates will affect the cost of debt and, potentially, the cost of

equity. For example, when interest rates increase the cost of debt increases, which

increases the cost of capital.

Tax RatesTax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt

decreases, decreasing the cost of capital.

WEIGHTED AVERAGE COST OF CAPITAL(WACC)

The firm’s WACC is the cost of Capital for the firm’s mixture of debt and stock in their capital structure.

WACC = wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. stock)

wd = weight of debt (i.e. fraction of debt in the firm’s capital structure)

ws = weight of stock

wp = weight of preferred stock

COST OF DEBT (Kd)

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1 – tax rate)

EXAMPLE

If the cost of debt for ABC Energy Services is 10% (effective rate) and its tax rate is 40% then:

Kd after taxes = Kd (1 – tax rate)

= 10 (1 – 0.4) = 6.0 %

We use the effective annual rate of debt based on current market conditions (i.e. yield to maturity on debt). We do not use historical rates (i.e. interest rate when issued; the stated rate).

Cost of Preferred Stock (Kp)

Preferred Stock has a higher return than bonds, but is less costly than common stock.

In case of default, preferred stockholders get paid before common stock holders. However, in the case of bankruptcy, the holders ofPreferred stock get paid only after short and long-term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and usually cannot vote on the firm’s affairs.Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the full market cost of financing by issuing preferred stock. In other words, the firm cannot deduct dividends paid as an expense, like they can for interest expenses.

Example

If ABC Energy Services is issuing preferred stock at $100 per share, with a stated dividend of $12, and a flotation cost of 3%, then:

Preferred stock dividend Kp = market price of preferred stock (1 – flotation cost)

$12 = $100 (1-0.03) = 12.4 %

Cost of Equity (i.e. Common Stock & Retained Earnings)

The cost of equity is the rate of return that investors require to make an equity investment in a firm. Common stock does not generate a tax benefit as debt does because dividends are paid after taxes.

Retained earnings are considered to have the same cost of capital as new common stock. Their cost is calculated in the same way, EXCEPT that no adjustment is made for flotation costs.

3 Ways to Calculate

1. Use CAPM2. (GORDON MODEL) The constant dividend growth model – same as DCF method3. Bond yield – plus – risk premium

Determining the Weights to be used :

The firm’s balance sheet shows the book values of the common stock, preferred stock, and long-term bonds. You can use the balance sheet figures to calculate book value weights, though it is more practicable to work with market weights. Basically, market value weights represent current conditions and take into account the effects of changing market conditions and the current prices of each security. Book value weights, however, are based on accounting procedures that employ the par values of the securities to calculate balance sheet values and represent past conditions. The table on the next page illustrates the difference between book value and market value weights and demonstrates how they are calculated.

VALUE DOLLAR AMOUNT

WEIGHTS OR % OF TOTAL VALUE

ASSUMED COST OF CAPITAL

(%)Book ValueDebt 2,000 bonds at par, or $1000

2,000,000 40.4 10

Preferred stock 4,500 shares at $100 par value

450,000 9.1 12

Common equity 500,000 shares outstanding at $5.00

par value

2,500,000 50.5 13.5

Total book value of capital 4,950,000 100 11.24 is the WACC

Market Value

Debt 2,000 bonds at $900 current market

price

1,800,000 30.2 10

Preferred stock 4,500 shares at $90 current market

price

405,000 6.8 12

Common equity 500,000 shares outstanding at $75

current market price

3,750,000 63.0 13.5

Total market value of capital 5,955,000 100 What is the WACC?

Note that the book values that appear on the balance sheet are usually different from the market values. Also, the price of common stock is normally substantially higher than its book value. This increases the weight of this capital component over other capital structure components (such as preferred stock and long-term debt). The desirable practice is to employ market weights to compute the firm’s cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities – stocks as well as bonds – to finance projects, and that these securities are issued at market value, not at book value.

Target weights can also be used. These weights indicate the distribution of external financing that the firm believes will produce optimal results. Some corporate managers establish these weights subjectively; others will use the best companies in their industry as guidelines; and still others will look at the financing mix of companies with characteristics comparable to those of their own firms. Generally speaking, target weights will approximate market weights. If they don’t, the firm will attempt to finance in such a way as to make the market weights move closer to target weights.

Hurdle rates :

Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firm’s WACC. Projects the firm is considering must “jump the hurdle” exceed the firm’s borrowing costs (i.e. WACC). If the project does not clear the hurdle, the firm will lose money on the project if they invest in it – and decrease the value of the firm. The hurdle rate is used by firms in capital budgeting analysis (one of the next topics we will be studying). Large companies, with divisions that have different levels of risk, may choose to have divisional hurdle rates.

Divisional hurdle rates are sometimes used because firms are not internally homogeneous in terms of risk. Finance theory and practice tells us that investors require higher returns as risk increases.

Breakpoints (BP) in the WACC :

Breakpoints are defined as the total financing that can be done before the firm is forced to sell new debt or equity capital. Once the firm reaches this breakpoint, if they choose to raise additional capital their WACC increases.

For example, the formula for the retained earnings breakpoint below demonstrates how to calculate the point at which the firm’s cost of equity financing will increase because they must sell new common stock. (Note: The formula for the BP for debt or preferred stock is basically the same, by replacing retained earnings for debt and using the weight of debt.)

BPRE = Retained earnings Weight of equity

COST OF DEBT

The primary meaning of cost of capital is simply the cost an entity must pay to raise funds. The term can refer, for instance, to the financing cost (interest rate) a company pays when securing a loan.

The cost of raising funds, however, is measured in several other ways, as well, most of which carry a name including "Cost of".

Very briefly, these similar-sounding terms are defined as follows:

Cost of capital is the cost an organization pays to raise funds, e.g., through bank loans or issuing bonds. Cost of capital is expressed as an annual percentage.

Cost of borrowing simply refers to the total amount paid by a debtor to secure a loan and use funds, including financing costs, account maintenance, loan origination, and other loan-related expenses. A cost of borrowing sum will most likely be expressed in currency units such as dollars, pounds, euro, or yen.

Cost of debt is the overall average rate an organization pays on all its debts, typically consisting primarily of bonds and bank loans. Cost of debt is expressed as an annual percentage.

An organization's cost of debt is the effective rate (overall average percentage) that it pays on all its debts, the major part of which typically consist of bonds and bank loans. Cost of

debt is a part of a company's capital structure. (along with preferred stock, common stock, and cost of equity).

Cost of debt is expressed as a percentage in either of two ways: Before tax or after tax. In cases where interest expenses are tax deductible, the after tax approach is generally considered more accurate or more appropriate. The after-tax cost of debt is always lower than the before-tax version.

For a company with a marginal income tax rate of 35% and a before tax cost of debt of 6%, the after tax cost of debt is found as follows:

After tax cost of debt = (Before tax cost of debt) x (1 – Marginal tax rate) = (0.06) x (1.00 – 0.35) = (0.06) x (0.65) = 0.039 or 3.9%

As with cost of capital, cost of debt tends to be higher for companies with lower credit ratings—companies that the bond market considers riskier or more speculative. Whereas cost of capital is the rate the company must pay now to raise more funds, cost of debt is the cost the company is paying to carry all debt it has acquired.

Cost of debt becomes a concern for stockholders, bondholders, and potential investors when a company is highly leveraged (i.e., debt financing is large relative to owner equity). A highly leveraged position becomes riskier and less profitable in a poor economy (e.g., recession), when the company's ability to service its large debt load may be questionable.

The cost of debt may also weigh in management decisions regarding asset acquisitions or other investments acquired with borrowed funds. The additional cost of debt that comes with the acquisition or investment reduces the value of investment metrics such as return on investment (ROI) or internal rate of return (IRR).

Debt -:

Any money owed to an individual, company, or other organization. One acquires debt when one borrows money. Generally speaking, one acquires debt for a specific purpose, such as funding a college education or purchasing a house. In business and government, debt is often issued in the form of bonds, which are tradeable securities entitling the bearer to repayment at the appropriate time(s). Occasionally, especially for personal loans, debt is issued without interest or other compensation; one simply pays back what was lent. This is exceedingly rare in business and a debtor almost always compensates a creditor with a certain amount of interest, representing the time value of money. However, some areas of finance, especially Islamic banking, do not allow debt with interest.

Interest-:

Interest is the fee charged by the creditor to the debtor. Interest is generally calculated as a percentage of the principal sum per year, which percentage is known as an interest rate, and is generally paid periodically at intervals, such as monthly or semi-annually.

Many conventions on how interest is calculated exist – day count convention for some while a standard convention is the annual percentage rate (APR), widely used and required by regulation in the United States and United Kingdom, though there are different forms of APR.

Interest rates may be fixed or floating. In floating-rate structures, the rate of interest that the borrower pays during each time period is tied to a benchmark such as LIBOR or, in the case of inflation-indexed bonds, inflation.

For some loans, the amount actually loaned to the debtor is less than the principal sum to be repaid. This may be because upfront fees or points are charged, or because the loan has been structured to be sharia-compliant. The additional principal due at the end of the term has the same economic effect as a higher interest rate. This is sometimes referred to as a banker's dozen, a play on "baker's dozen" – owe twelve (a dozen), receive a loan of eleven (a banker's dozen). Note that the effective interest rate is not equal to the discount: if one borrows $10 and must repay $11, then this is ($11–$10)/$10 = 10% interest; however, if one borrows $9 and must repay $10, then this is ($10–$9)/$9 = 11 1/9% interest.[3]

Repayment

There are three main ways repayment may be structured: the entire principal balance may be due at the maturity of the loan; the entire principal balance may be amortized over the term of the loan; or the loan may partially amortize during its term, with the remaining principal due as a "balloon payment" at maturity. Amortization structures are common in mortgages and credit cards.

Collateral and recourse

A debt obligation is considered secured if creditors have recourse to specific collateral. Collateral may include claims on tax receipts (in the case of a government), specific assets (in the case of a company) or a home (in the case of a consumer). Unsecured debt comprises financial obligations for which creditors do not have recourse to the assets of the borrower to satisfy their claims.

Types of Borrowers

Individuals

Common types of debt owed by individuals and households include mortgage loans, car loans, and credit card debt. For individuals, debt is a means of using anticipated income and future purchasing power in the present before it has actually been earned. Commonly, people in industrialised nations use consumer debt to purchase houses, cars and other things too expensive to buy with cash on hand.

People are more likely to spend more and get into debt when they use credit cards vs. cash for buying products and services. This is primarily because of the transparency effect and consumer’s “pain of paying.” The transparency effect refers to the fact that the further you are from cash (as in a credit card or another form of payment), the less transparent it is and the less you remember how much you spent. The less transparent or further away from cash, the form of payment employed is, the less an individual feels the “pain of paying” and thus is likely to spend more. Furthermore, the differing physical appearance/form that credit cards have from cash may cause them to viewed as “monopoly” money vs. real money, luring individuals to spend more money than they would if they only had cash available.

Besides these more formal debts, private individuals also lend informally to other people, mostly relatives or friends. One reason for such informal debts is that many people, in particular those who are poor, have no access to affordable credit. Such debts can cause problems when they are not paid back according to expectations of the lending household. In 2011, 8% of people in the European Union reported their households has been in arrears, that is, unable to pay as scheduled "payments related to informal loans from friends or relatives not living in your household".

Businesses

A company may use various kinds of debt to finance its operations as a part of its overall corporate finance strategy.

A term loan is the simplest form of corporate debt. It consists of an agreement to lend a fixed amount of money, called the principal sum or principal, for a fixed period of time, with this amount to be repaid by a certain date. In commercial loans interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date, or may be paid periodically in the interval, such as annually or monthly. Such loans are also colloquially called "bullet loans", particularly if there is only a single payment at the end – the "bullet" – without a "stream" of interest payments during the life of the loan.

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan. A syndicated loan is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers. Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity.

A company may also issue bonds, which are debt securities. Bonds have a fixed lifetime, usually a number of years; with long-term bonds, lasting over 30 years, being less common. At the end of the bond's life the money should be repaid in full. Interest may be added to the end payment, or can be paid in regular installments (known as coupons) during the life of the bond.

A letter of credit or LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in

international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and travellers. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and a document proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

Companies also use debt in many ways to leverage the investment made in their assets, "leveraging" the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier.

Governments

Governments issue debt to pay for ongoing expenses as well as major capital projects. Government debt may be issued by sovereign states as well as by local governments, sometimes known as municipalities.

The overall level of indebtedness by a government is typically shown as a ratio of debt-to-GDP. This ratio helps to assess the speed of changes in government indebtedness and the size of the debt due.

BOND -:

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity date. Interest is usually payable at fixed intervals (semi-annual, annual, sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market. This means that once the transfer agents at the bank medallion stamp the bond, it is highly liquid on the second market.

Thus a bond is a form of loan or IOU: the holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or short

term commercial paper are considered to be money market instruments and not bonds: the main difference is in the length of the term of the instrument.

Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e. they are investors), whereas bondholders have a creditor stake in the company (i.e. they are lenders). Being a creditor, bondholders have priority over stockholders. This means they will be repaid in advance of stockholders, but will rank behind secured creditors in the event of bankruptcy. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks are typically outstanding indefinitely. An exception is an irredeemable bond, such as a consol, which is a perpetuity, i.e. a bond with no maturity.

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process for issuing bonds is through underwriting. When a bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the entire issue of bonds from the issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The book runner is listed first among all underwriters participating in the issuance in the tombstone ads commonly used to announce bonds to the public. The book runners' willingness to underwrite must be discussed prior to any decision on the terms of the bond issue as there may be limited demand for the bonds.

In contrast, government bonds are usually issued in an auction. In some cases both members of the public and banks may bid for bonds. In other cases only market makers may bid for bonds. The overall rate of return on the bond depends on both the terms of the bond and the price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is determined by the market.

In the case of an underwritten bond, the underwriters will charge a fee for underwriting. An alternative process for bond issuance, which is commonly used for smaller issues and avoids this cost, is the private placement bond. Bonds sold directly to buyers and may not be tradable in the bond market.

Historically an alternative practice of issuance was for the borrowing government authority to issue bonds over a period of time, usually at a fixed price, with volumes sold on a particular day dependent on market conditions. This was called a tap issue or bond tap.

IMPORTANT TERMS WITH RESPECT TO BOND -:

Principal

Nominal, principal, par, or face amount is the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets.

Maturity

The issuer has to repay the nominal amount on the maturity date. As long as all due payments have been made, the issuer has no further obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Some bonds have been issued with terms of 50 years or more, and historically there have been some issues with no maturity date (irredeemables). In the market for United States Treasury securities, there are three categories of bond maturities:

short term (bills): maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments)

medium term (notes): maturities between six to twelve years;

long term (bonds): maturities greater than twelve years.

Coupon

The coupon is the interest rate that the issuer pays to the holder. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name "coupon" arose because in the past, paper bond certificates were issued which had coupons attached to them, one for each interest payment. On the due dates the bondholder would hand in the coupon to a bank in exchange for the interest payment. Interest can be paid at different frequencies: generally semi-annual, i.e. every 6 months, or annual.

Yield

The yield is the rate of return received from investing in the bond. It usually refers either to

the current yield, or running yield, which is simply the annual interest payment divided by the current market price of the bond (often the clean price),

the yield to maturity or redemption yield, which is a more useful measure of the return of the bond, taking into account the current market price, and the amount and timing of all remaining coupon payments and of the repayment due on maturity. It is equivalent to the internal rate of return of a bond.

Credit quality

The quality of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.

Market price

The market price of a tradable bond will be influenced amongst other things by the amounts, currency and timing of the interest payments and capital repayment due, the quality of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets.

The issue price at which investors buy the bonds when they are first issued will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees. The market price of the bond will vary over its life: it may trade at a premium (above par, usually because market interest rates have fallen since issue), or at a discount (price below par, if market rates have risen or there is a high probability of default on the bond).

TYPES OF BONDS -:

Corporate Bonds A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond has a maturity of less than five years, intermediate is five to 12 years and long term is more than 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Convertible BondsA convertible bond may be redeemed for a predetermined amount of the company's equity

at certain times during its life, usually at the discretion of the bondholder. Convertibles are sometimes called "CVs."

Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity should the company continue to do well.

From the investor's perspective, a convertible bond has a value-added component built into it: it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock.

Callable BondsCallable bonds, also known as "redeemable bonds," can be redeemed by the issuer prior to maturity. Usually a premium is paid to the bond owner when the bond is called.

The main cause of a call is a decline in interest rates. If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate. In this case, the company will call its current bonds and reissue new, lower-interest bonds to save money.

Term BondsTerm bonds are bonds from the same issue that share the same maturity dates. Term bonds that have a call feature can be redeemed at an earlier date than the other issued bonds. A call feature, or call provision, is an agreement that bond issuers make with buyers. This agreement is called an "indenture," which is the schedule and the price of redemptions, plus the maturity dates.

Some corporate and municipal bonds are examples of term bonds that have 10-year call features. This means the issuer of the bond can redeem it at a predetermined price at specific times before the bond matures.

A term bond is the opposite of a serial bond, which has various maturity schedules at regular intervals until the issue is retired.

Amortized BondsAn amortized bond is a financial certificate that has been reduced in value for records on accounting statements. An amortized bond is treated as an asset, with the discount amount being amortized to interest expense over the life of the bond. If a bond is issued at a discount - that is, offered for sale below its par (face value) - the discount must either be treated as an expense or amortized as an asset.

Amortization is an accounting method that gradually and systematically reduces the cost value of a limited life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing allows bond issuers to treat the

bond discount as an asset until the bond's maturity.

Adjustment BondsIssued by a corporation during a restructuring phase, an adjustment bond is given to the bondholders of an outstanding bond issue prior to the restructuring. The debt obligation is consolidated and transferred from the outstanding bond issue to the adjustment bond. This process is effectively a recapitalization of the company's outstanding debt obligations, which is accomplished by adjusting the terms (such as interest rates and lengths to maturity) to increase the likelihood that the company will be able to meet its obligations.

If a company is near bankruptcy and requires protection from creditors , it is likely unable to make payments on its debt obligations. If this is the case, the company will be liquidated, and the company's value will be spread among its creditors. However, creditors will generally only receive a fraction of their original loans to the company. Creditors and the company will work together to recapitalize debt obligations so that the company is able to meet its obligations and continue operations, thus increasing the value that creditors will receive.

DEBENTURES -:

In corporate finance, a debenture is a medium- to long-term debt instrument used by large companies to borrow money, at a fixed rate of interest. The legal term "debenture" originally referred to a document that either creates a debt or acknowledges it, but in some countries the term is now used interchangeably with bond, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not become share capital. Senior debentures get paid before subordinate debentures, and there are varying rates of risk and payoff for these categories.

Debentures are generally freely transferable by the debenture holder. Debenture holders have no rights to vote in the company's general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the rights to the debentures. The interest paid to them is a charge against profit in the company's financial statements.

Debentures have no collateral. Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. An example of a government debenture would be any government-issued Treasury bond (T-bond) or Treasury bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at worst, can print off more money or raise taxes to pay these type of debts.

Features of debentures -:

A movable property.

Issued by the company in the form of a certificate of indebtedness.

It generally specifies the date of redemption, repayment of principal and interest on specified dates.

May or may not create a charge on the assets of the company.

1.Types Of Debentures On The Basis Of Record Point Of View

a. Registered DebenturesThese are the debentures that are registered with the company. The amount of such debentures is payable only to those debenture holders whose name appears in the register of the company.

b. Bearer DebenturesThese are the debentures which are not recorded in a register of the company. Such debentures are transferable merely by delivery. Holder of bearer debentures is entitled to get the interest.

2. Types Of Debentures On The Basis Of Security

a. Secured Or Mortgage DebenturesThese are the debentures that are secured by a charge on the assets of the company. These are also called mortgage debentures. The holders of secured debentures have the right to recover their principal amount with the unpaid amount of interest on such debentures out of the assets mortgaged by the company.

b. Unsecured DebenturesDebentures which do not carry any security with regard to the principal amount or unpaid interest are unsecured debentures. These are also called simple debentures.

3. Types Of Debentures On The Basis Of Redemption

a. Redeemable DebenturesThese are the debentures which are issued for a fixed period. The principal amount of such debentures is paid off to the holders on the expiry of such period. These debentures can be redeemed by annual drawings or by purchasing from the open market.

b. Non-redeemable DebenturesThese are the debentures which are not redeemed in the life time of the company. Such debentures are paid back only when the company goes to liquidation.

4. Types Of Debentures On The Basis Of Convertibility

a. Convertible DebenturesThese are the debentures that can be converted into shares of the company on the expiry of pre-decided period. The terms and conditions of conversion are generally announced at

the time of issue of debentures.

b. Non-convertible DebenturesThe holders of such debentures can not convert their debentures into the shares of the company.

5. Types Of Debentures On The Basis Of Priority

a. First DebenturesThese debentures are redeemed before other debentures.

b. Second DebenturesThese debentures are redeemed after the redemption of first debentures.

Cost of Equity

Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.

Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest and equity investors seek dividends and/or appreciation in the value of their investment (capital gain). From a firm's perspective, they must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two kinds of capital sources.

The Capital Asset Pricing Model - Definition and Underlying Assumptions

In finance, one of the most important things to remember is that return is a function of risk. This means that the more risk you take, the higher your potential return should be to offset your increased chance for loss.

One tool that finance professionals use to calculate the return that an investment should bring is the Capital Asset Pricing Model (CAPM from now on). CAPM calculates a required

return based on a risk measurement. To do this, the model relies on a risk multiplier called the beta coefficient, which we will discuss in the next section.

Like all financial models, the CAPM depends on certain assumptions. Originally, there were nine assumptions, although more recent work in financial theory has relaxed these rules somewhat. The original assumptions were:

1. Investors are wealth maximises who select investments based on expected return and standard deviation.

2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.3. There are no restrictions on short sales (selling securities that you don't yet own) of

any financial asset.4. All investors have the same expectations related to the market.5. All financial assets are fully divisible (you can buy and sell as much or as little as you

like) and can be sold at any time at the market price.6. There are no transaction costs.7. There are no taxes.8. No investor's activities can influence market prices.9. The quantities of all financial assets are given and fixed.

Overview:

CAPM is a mathematical model which is used to determine required rate of return of a particular asset, if that asset is to be added to an already diversified portfolio. Beauty of this model is that it takes into account asset’s sensitivity to non-diversifiable risk(Mostly known as systematic risk or market risk) which is known as β (Beta) and also takes into account the expected return if market of risk-free asset(theoretical).

CAPM suggests that an investor’s cost of equity capital is determined by beta or risk that he undertakes while making an investment. CAPM is still very popular due to its simplicity and utility for very different situations. There does exist some flaws due to the certain assumptions made while deriving the theory and that paves the way for other theories as arbitrage pricing theory and Merton’s portfolio theory.

The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.Risk and the Capital Asset Pricing Model FormulaTo understand the capital asset pricing model, there must be an understanding of the risk on an investment. Individual securities carry a risk of depreciation which is a loss of investment to the investor. Some securities have more risk than others and with additional risk, an investor expects to realize a higher return on their investment.

How it works:

The CAPM formula is:

ra = rrf + Ba (rm-rrf)

where:

rrf = the rate of return for a risk-free security

rm = the broad market's expected rate of return

Ba = beta of the asset

Market return (rm) – Your input of market rate of return, rm, can be based on past returns or projected future returns. Economist Peter Bernstein famously calculated that over the last 200 years, the stock market has returned an average of 9.6% per year. Whether or not you want to use this as your projection of future stock market returns is up to you as an analyst.

Risk-free return (rrf): U.S. Treasury bills and bonds are most often used as the proxy for the risk-free rate. Most analysts try to match the duration of the bond with the projection horizon of the investment. For example, if you're using CAPM to estimate Stock XYZ's required rate of return over a 10 year time horizon, you'll want to use the 10-year U.S. Treasury bond rate as your measure of rrf.

Beta (Ba): The risk premium is beta times the difference between the market return and a risk free return. In the capital asset pricing model formula, by subtracting the market return from a risk free return, the risk of the overall market can then be determined. By multiplying beta times this risk of the market, the risk of the individual stock can then be determined. As previously stated, beta is the risk of an individual security relative to the market. A beta of 2 would be twice as risky as the market. In practice, risk is synonymous with volatility. A stock with a beta larger than the market beta of 1 will generally see a greater increase than the market when the market is up and see a greater decrease than the market when the market is down.

The risk premium is beta times the difference between the market return and a risk free return. In the capital asset pricing model formula, by subtracting the market return from a risk free return, the risk of the overall market can then be determined. By multiplying beta times this risk of the market, the risk of the individual stock can then be determined. As previously stated, beta is the risk of an individual security relative to the market. A beta of 2 would be twice as risky as the market. In practice, risk is synonymous with volatility. A stock with a beta larger than the market beta of 1 will generally see a greater increase than the market when the market is up and see a greater decrease than the market when the market is down.

SML:The straight line is known as Security market line (SML) which signifies that even at zero beta means at zero risk even there does exist some return which is known as risk-free rate of return. .

SML is also used in relating expected return and systematic risk which shows how market prices individual securities relative to their security class.

The X-axis represents risk (beta) and Y-axis represents expected return. The market risk premium can be determined by slope of SML. The intercept on Y-axis is nominal risk free rate available in the market.

SML is very useful in deciding whether an investment should be considered for expected rate of return. If for particular investment if expected return line is plotted below SML then that particular investment is considered to be overvalued as investor will receive less return compared to risk that is being put.

If for particular investment if expected return line is plotted above SML then that particular investment is considered to be undervalued as investor will receive higher return for inherent risk.

ADVANTAGES OF THE CAPM

The CAPM has several advantages over other methods of calculating required return, explaining why it has remained popular for more than 40 years: It considers only systematic risk, reflecting a reality in which most investors have

diversified portfolios from which unsystematic risk has been essentially eliminated. It generates a theoretically-derived relationship between required return and

systematic risk which has been subject to frequent empirical research and testing. It is generally seen as a much better method of calculating the cost of equity than the

dividend growth model (DGM) in that it explicitly takes into account a company’s level of systematic risk relative to the stock market as a whole.

It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

Ease-of-use: CAPM is a simplistic calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return.

Diversified Portfolio: The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk.

Problems with CAPM: It is assumed that variance of returns are adequate measures of risk and assumes that

they are normally distributed which actually depends upon shareholder’s preference and potential.

So, risk in financial proximity is not variance but probability of losing on investment.

This model also assumes that all the investors have perfect knowledge about market in which they are investing.

This model also assumes that all the investors expect the same as beta for that particular investment remains the same despite of their proportion of investment. But, exposure and capacity to consume risk varies with each investor.

This model in free use also assumes that there are no taxes or transaction costs.

This model does not include all the assets while calculating portfolio diversification of particular investment.

Market portfolio consists of all type of assets & model assumes that all the customer will consider their all assets and will optimize and enhance their portfolio. But, Individual investors mainly have fragmented portfolios according to their needs.

EXAMPLE 1:

The current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the return that Joe's Oyster Bar Inc (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB's beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

Rf = 5%

Rm = 12%

Β = 1.9

Re = Rf + β (Rm-Rf)

= 5% + (12% - 5%)*1.9

=18.3%

Solution: What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment.

EXAMPLE 2:

Find the beta on a stock given that its expected return is 16%, the risk-free rate is 4%, and the expected return on the market portfolio is 12%.

Rf = 4%

Rm = 12%

Re = 16%

Re = Rf + β (Rm-Rf)

β = 16% - 4% / 12% - 4%

β = 1.5

EXAMPLE 3:

Suppose CAPM works, and you know that the expected returns on ABC and XYZ are estimated to be 12% and 10%, respectively. You have just calculated extremely reliable estimates of the betas of ABC and XYZ to be 1.30 and 0.90, respectively. Given this data, what is a reasonable estimate of the risk-free rate (the return on a long-term government bond)?

Re = Rf + β (Rm-Rf)

Now for company ABC–

0.12= Rf + 1.3(Rm-Rf)

Now for company XYZ:-

Re = Rf + β (Rm-Rf)

0.10= Rf + 0.9(Rm-Rf)

Now since Rf is going to be the same over both the business we will replace (Rm-Rf) of XYZ into the equation.

0.12 = Rf + 1.3[(0.1-Rf)/0.9]

0.12 = Rf + 0.144-1.444 Rf

Rf =0.0540 = 5.4%

There are two main components of the risk suffered by equity shareholders:

1 The nature of the business. Businesses that provide capital goods are expected to show relatively risky behaviour because capital expenditure can be deferred in a recession and these companies’ returns will therefore be volatile. You would expect ßi > 1 for such companies. On the other hand, a supermarket business might be expected to show less risk than average because people have to eat, even during recessions. You would expect ßi < 1 for such companies as they offer relatively stable returns.

2 The level of gearing. In an ungeared company (ie one without borrowing), there is a straight relationship between profits from operations and earnings available to shareholders. Once gearing, and therefore interest, is introduced, the amounts available to ordinary shareholders become more volatile.

The Dividend Growth Model

According to the model, the cost of equity is a function of current market price and the future expected dividends of the company. The rate at which these two things are equal is the cost of equity.

It is the simple phenomenon of ‘what is the cost of buying equity’ and ‘what will I get from it’. Here, ‘what is the cost of buying equity’ represents the current market price of that equity share and ‘what will I get from it’ is represented by the expected future dividends of the company. By comparing the two, we can get the actual rate of return which an investor will get as per the current situations. That rate of return is the cost of equity. The underlying assumption here is that the current market price is adjusted as per the required rate of return by the investor in that share.

Formula :

P0 = the current market price

D = the dividend year wise

Ke = the cost of equity

AdvantagesJustification: The primary advantage of the dividend discount model is that it is grounded in theory. The justifications are rock solid and indisputable. The logic is simple. A business is a perpetual entity. When an investor buys a share of the business, they are basically paying a

price today which entitles them to enjoy the benefits of all the dividends that the corporation will pay throughout its lifetime. Hence, the value of the firm is basically the value of a perpetual never ending stream of dividends that the buyer intends to receive later with the passage of time. Hence, many analysts believe that there is absolutely no subjectivity involved in this model and the logic is crystal clear.

Consistency: A second advantage of the dividend discount model is the fact that dividends tend to stay consistent over long periods of time. Companies experience a lot of volatility in measures like earnings and free cash flow. However, companies usually ensure that dividends are only paid out from cash which is expected to be present with the company every year. They do not set up unnecessarily high dividend expectations because not living up to those expectations makes the stock price plummet at a later date. Companies are very specific and announce any additional dividend as a one-time dividend.

No Subjectivity: There is no ambiguity regarding the definition of dividends. Whereas there is subjectivity as to what constitutes earnings and what constitutes free cash flow. Therefore, even if different analysts are asked to come up with a valuation for a company using a discounted dividend model, it is likely that they will come up with more or less the same valuation. This lack of subjectivity makes the model more reliable and hence more preferred.

No Requirement of Control: Dividends are the only measure of valuation available to the minority shareholder. While institutional investors can acquire big stakes and actually influence the dividend pay-out policies, minority shareholders have no control over the company. Thus, the only thing that they can be sure about is that fact that they will receive dividend year on year because they have been receiving it consistently in the past. Hence, as far as minority shareholders are concerned, dividends are really the only metric that they can use to value a corporation.

Mature Businesses: The regular payment of dividends is the sign that a company has matured in its business. Its business is stable and there is not much expectation of turbulence in the future unless something drastic happens. This information is valuable to many investors who prefer stability over possibility of quick gains. Thus, from a valuation point of view, it is far easier to arrive at a discount rate. Since consistency eliminates risk, dividends are generally discounted at a lower rate as compared to other metrics that can be used in valuation.

To sum it up, dividend discount models are preferred by two kinds of investor groups. One investor group consists of retail investors who prefer it because of their lack of control to influence the payout policies. The other investor group consists of risk averse investors who prefer it because of the stability and risk aversion which are built into this model.

Disadvantages

Limited Use: The model is only applicable to mature, stable companies who have a proven track record of paying out dividends consistently. While, prima facie, it may seem like a good thing, there is a big trade-off. Investors who only invest in mature stable companies tend to miss out high growth ones.

May Not Be Related To Earnings: Another major disadvantage is the fact that the dividend discount model implicitly assumes that the dividends paid out are correlated to earnings. This means that higher earnings will translate into higher dividends and vice versa. But, in practice, this is almost never the case. Companies strive to maintain stable dividend payouts, even if they are facing extreme variations in their earnings. There have been instances where companies have been simultaneously borrowing cash while maintaining a dividend payout. In this case, this is a clear incorrect utilization of resources and paying dividends is eroding value. Hence, assuming that dividends are directly related to value creation is a faulty assumption until it is backed by relevant data.

Too Many Assumptions: The dividend discount model is full of too many assumptions. There are assumptions regarding dividends which we discussed above. Then there are also assumptions regarding growth rate, interest rates and tax rates. Most of these factors are beyond the control of the investors. This factor too reduces the validity of the model.

Tax Efficiency: In many countries, it may not be efficient to pay dividends. The tax structures are created in such a way that capital gains may be taxed lower than dividends. Also, many tax structures may encourage repurchase of shares instead of paying out dividends. In these countries most of the companies will not pay out dividends because it leads to dilution of value. Any investor who only strictly believes in dividend discount model will have no option but to ignore all the shares pertaining to that particular country! This is one more reason why dividend discount model fails to guide investors.

Control: Lastly, the dividend discount model is not applicable to large shareholders. Since they buy a big stake in the corporation, they have some degree of control and can influence the dividend policy if they want to. Thus, for them, at least, dividends are an irrelevant metric.

EXAMPLE 1:

The dividend just about to be paid by a company is $0.24. The current market price of the share is $2.76 cum div. The historical dividend growth rate, which is expected to continue in the future, is 5%. What is the estimated cost of capital?

Solution

re = D0(1 + g) + g = 0.24(1 + 0.05) + 0.05 = 15%

P0 2.52

P0 must be the ex-dividend market price, but we have been supplied with the cum-dividend price.

The ex-dividend market price is calculated as the cum-dividend market price less the impending dividend. So here:

P0 = 2.76 - 0.24 = 2.52

The cost of equity is, therefore, given by:

re = D0(1 + g) + g

EXAMPLE 2:

Let's assume XYZ Company intends to pay a $1 dividend per share next year and you expect this to increase by 5% per year thereafter. Let's further assume your required rate of return on XYZ Company stock is 10%. Currently, XYZ Company stock is trading at $10 per share. Using the formula above, we can calculate that the intrinsic value of one share of XYZ Company stock is:

$1.00/ (.10-.05) = $20

According to the model, XYZ Company stock is worth $20 per share but is trading at $10; the Gordon Growth Model suggests the stock is undervalued.

The stable model assumes that dividends grow at a constant rate. This is not always a realistic assumption for growing (or declining) companies, which gives way to the multistage growth model.

WACCWeighted average cost of capital, defined as the overall cost of capital for all funding sources in a company, and is used as commonly in private businesses as it is in public businesses.

A company can raise its money from three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. It is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others.

It has also been explained as the minimum return a company can make to repay capital providers.

A company raises capital from various sources namely: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, each category of capital is proportionately weighted. Options, pension liabilities, executive stock options, governmental subsidies etc. While calculating WACC, each category of capital is proportionately weighted.

WACC is commonly used by companies internally to arrive at meaningful investment decisions. It is often used as a hurdle rate for capital investment. It also acts as a measure to find the optimal capital structure for the company and is a key factor in choosing the mixture of debt and equity used to finance a firm.

WACC is calculated by multiplying the cost of each source of capital for a project—which may include loans, bonds, equity, and preferred stock by its percentage of the total capital, and then adding them together.

Expected return on a portfolio of all a firm's securities. Used as a hurdle rate for capital investment. Often the weighted average of the cost of equity and the cost of debt the weights are determined by the relative proportions of equity and debt in a firm's capital structure.

The WACC calculation is a calculation of a company’s cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let’s say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company’s return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

Weighted Average Cost of Capital Formula

The most popular method to calculate cost of capital is through using the Weighted Average Cost of Capital formula.

WACC = Ke *(E/ (D+E+PS)) + Kd*(D/ (D+E+PS))*(1-T) + Kps*(PS/ (D+E+PS))

Where:Ke = cost of equityKd = cost of debtKps= cost of preferred stockE = market value of equity

D = market value of debtPS= market value of preferred stockT = tax rate

Ke reflects the riskiness of the equity investment in the company. Kd reflects the default risk of the company, and Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

EXAMPLE

Example: a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.

Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.

Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).

WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%

Corporation ABC's weighted average cost of capital is 4.9%.

This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return.

Also in terms of weights we can say

WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)

Cost of equity

In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn

to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).

After-tax cost of debt

In the WACC formula, r(D) × (1 – t) represents the after-tax cost of debt i.e. the after-tax rate of return which the debt-holders need to earn till the maturity of the debt. Cost of debt of a company is based on the yield to maturity of the relevant instruments. If no yield to maturity is available, the cost can be estimated using the instrument's current yield, etc. After-tax cost of debt is included in the calculation of WACC because debt offers a tax shield i.e. interest expense on debt reduces taxes. This reduction in taxes is reflected in reduction in cost of debt capital.

Weights

w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt.

w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.

Ideally, WACC should be estimated using target capital structure, which is the capital structure the company’s management intends to maintain in the long-run. For practical purposes, market values are usually used and where the market values are not available, book values may be used to find out the weight.

Example

Sanstreet, Inc. went public by issuing 1 million shares of common stock @ $25 per share. The shares are currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in 20 years. The bonds are currently trading at $950.

The tax rate is 30%. Calculate the weighted average cost of capital.

Solution:

First we need to calculate the proportion of equity and debt in Sanstreet, Inc. capital structure.

Current Market Value of Equity = 1,000,000 × $30 = $30,000,000Current Market Value of Debt = 50,000 × $950 = $47,500,000Total Market Value of Debt and Equity = $77,500,000Weight of Equity = $30,000,000 / $77,500,000 = 38.71%Weight of Debt = $47,500,000 / $77,500,000 = 61.29%, orWeight of Debt = 100% minus cost of equity = 100% − 38.71% = 61.29%

Now, we need estimates for cost of equity and after-tax cost of debt.

We can estimate cost of equity using either dividend discount model (DDM) or capital asset pricing model (CAPM).

Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rateCost of equity (CAPM) = risk free rate + beta coefficient × market risk premium

In the current example, the data available allow us to use only CAPM to calculate cost of equity.Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%

Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%. It is calculated using hit and trial method. We can also estimate it using MS Excel RATE function.

For inclusion in WACC, we need after-tax cost of debt, which is 7.427% [= 10.61% × (1 − 30%)].

Having all the necessary inputs, we can plug the values in the WACC formula to get an estimate of 9.82%.

WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%

It is called weighted average cost of capital because as you see the cost of different components is weighted according to their proportion in the capital structure and then summed up.

Weighted average cost of capital is the discount rate used in calculation of net present value (NPV) and other valuations models such as free cash flow valuation model. It is the hurdle rate in the capital budgeting decisions.

WACC represents the average risk faced by the organization. It would require an upward adjustment if it has to be used to calculate NPV of projects which are riskier than the company's average projects and a downward adjustment in case of less risky projects. Further, WACC is after all an estimation. Different models for calculation of cost of equity may yield different values.

Applying the Cost of capital to capital Budgeting and Security Valuation

• The investment opportunity schedule (IOS) is a representation of the returns on

investments. We assume that the IOS is downward sloping: the more a company invests, the lower the additional opportunities.

• That is, the company will invest in the highest-returning investments first, followed by lower-yielding investments as more capital is available to invest

• The marginal cost of capital (MCC) schedule is the representation of the costs of raising additional capital. We generally assume that the MCC is upward sloping: the more funds a company raises, the greater the cost.

Marginal cost of capitalInvestment opportunity schedule

Amount of New Capital

Cost or

Return

Optimal CapitalBudget

In capital budgeting, we use the WACC, adjusted for project-specific risk, to calculate the net present value (NPV).Using a company’s overall WACC in evaluating a capital project assumes that the project has risk similar to the average project of the company.

In analysis, Analysts can use the WACC in valuing the company by discounting cash flows to the firm.

NUMERICALS

Question 1

Suppose a company uses only debt and internal equity to finance its capital budget and uses CAPM to compute its cost of equity. Company estimates that its WACC is 12%. The capital structure is 75% debt and 25% internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%. Risk free rate is rRF = 6% and market risk premium (rm - rRF) = 8%: What is the beta of the company.

Solution:

WACC = WD*rd*(1 T) + we*re

0.12=0.75*(0.125)*(1-0.20) +0.25*re

0.12=0.075+0.25*re

re= 18%

18%=6% + Beta (8%)

Beta=1.5

Question 2

A company finances its operations with 50 percent debt and 50 percent equity. Its net income is I = $30 million and it has a dividend payout ratio of x = 20%. Its capital budget is B = $40 million this year. The interest rate on company’s debt is rd = 10% and the company’s tax rate is T = 40%. The company’s common stock trades at P0 = $66 per share, and its current dividend of D0 = $4 per share is expected to grow at a constant rate of g = 10% a year.

The flotation cost of external equity, if issued, is F = 5% of the dollar amount issued.

a) Will the company have to issue external equity?

Solution:

We B = 0:50(40M) = 20M

I (1- x) = $30(1 0:2) = 24M

Since I (1- x) > we B =) Internal Equity

b) What is the company’s WACC?

r e = D0(1 + g) P0 + g = 4(1 + 0:10) 66 + 0:10 = 16:66%

WACC = WD*rd (1 - T) + we*re internal

= 0:50(0:10)*(1 0:40) + 0:50(0:166) = 11:3%

Question 3:

A company finances its operations with 40 percent debt and 60 percent equity. Its net income is I = $16 million and it has a dividend payout ratio of x = 25%. Its capital budget is B = $15 million this year. The annual yield on the company’s debt is rd = 10% and the company’s tax rate is T = 30%. The company’s common stock trades at P0 = $55 per share, and its current dividend of D0 = $5 per share is expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if it is issued, is F = 5% of the dollar amount issued. What is the company’s WACC?

We B = 0:60(15M) = 9M

I*(1 x) = $16(1 0:25) = 12M

Since I*(1 x) > weB =) Internal Equity

b) What is the company’s WACC?

r internal e = D0*(1 + g) P0 + g = 5(1 + 0:10) 55 + 0:10 = 20%

WACC = WD*rd (1-T) + we*r internal

= 0:40(0:10)*(1 - 0:30) + 0:60(0:20)

= 14:8%

Types of Weighted Average Cost of Capital:

Marginal Weighted Average Cost of Capital: The Marginal WACC is calculated taking marginal costs of all types of capital. The reason is simple. We calculate WACC to evaluate the current projects where old cost of capital is not important and only the cost of acquiring capital at the time of that project is relevant.

Optimal Weighted Average Cost of Capital: Optimum WACC is the lowest cost of capital possible due to the optimum mix of capital. There are various theories for explaining the effect of capital structure or mix on WACC. Such as Net Income Theory, Net Operating Income Theory, Traditional Theory and Modigliani and Miller Approach.

Conditions / Assumptions for Use of WACC as Hurdle Rate

The use of WACC for evaluating the projects assumes some conditions. One, all the projects undertaken by the company are of same risk profile. Second, the source and mix of financing the new projects is same as the current capital mix of the company.

Advantages and Limitations of Weighted Average Cost of Capital as the Hurdle Rate for Project Evaluation

The main advantage of using WACC for evaluation of projects is its simplicity. Same rate can be used for all the projects which will obviate all the individual project wise different calculations.

The main limitation of using WACC is that it does not take into consideration the floatation cost of raising the marginal capital for new projects. Another problem with WACC is that it is based on an impractical assumption of same capital mix which is very difficult to maintain.

Importance and Use of Weighted Average Cost of Capital (WACC)

The importance and usefulness of weighted average cost of capital (WACC) as a financial tool for both investors and the companies is well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. Calculation of important metrics like net present values and economic value added requires WACC. It is equally important for investors for arriving at valuations of companies.

WACC can be looked at from two angles – the investor and the company. From the company’s angle, it can be defined as the blended cost of capital which the company has to pay for using the capital of both owners and debt holders. In other words, it is the minimum rate of return a company should earn to create value for the investors. From investor’s angle, it is the opportunity cost of their capital. If the return offered by company is less than its WACC, it is destroying value and hence the investors may discontinue their investment in the company.

The following points will explain why WACC is important and how it is used by investors and the company for their respective purposes:

1. Investment Decisions by Company: WACC is widely used for making investment decisions in the corporate by evaluating their projects. Let us categorize the investments in projects in the following 2 ways:

a. Evaluate of Projects with Same Risk: When the new projects are of similar risk like existing projects of the company, it is an appropriate benchmark rate to decide the acceptance or rejection of these projects. For example, a furniture manufacturer wishes to expand its business in new locations i.e. establishing new factory for same kind of furniture in different location. To generalize it to some extent, a company entering new projects in its own industry can reasonably assume similar risk.

b. Evaluation of Projects with Different Risk: WACC is appropriate measure to be used to evaluate a project provided two underlying assumptions are true. The assumptions are ‘same risk’ and ‘same capital structure’. What to do in this situation? Still, WACC can be used with certain modification with respect to the risk and target capital structure. Risk adjusted WACC, adjusted present value etc. are the concepts to circumvent the problems of WACC assumptions.

2. Discount Rate in Net Present Value Calculations: Net present value (NPV) is widely used method of evaluating projects to determine the profitability of the investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and terminal values are discounted using the WACC.

3. Calculate Economic Value Added (EVA): EVA is calculated by deducting the cost of capital from the net profits of the company. In calculating the EVA, WACC serves as the cost of capital of the company. This is how WACC may also be called a measure for value creation.

4. Valuation of Company: Any rational investor will invest time before investing money in any company. The investor will try to find out the valuation of the company. Based on the fundamentals, the investor will project the future cash flows and discount them using the WACC and divide the result by no. of equity shareholders. He will get the per share value of the company. He can simply compare this value and the current market price (CMP) of the company and decide whether it is investable or not. If the valuations are more than the CMP, the scrip is underpriced and if it is less than CMP, it is overpriced. If the value is $25 and CMP is 22, the investor will invest at 22 expecting the prices to rise till 25 and vice versa.

5. Important Inferences from WACC: Some important inferences from WACC can be drawn to understand various important issues that the management of the company should address.

a. Effect of Leverage: Considering the Net Income Approach (NOI) by Durand, the effect of leverage is reflected in WACC. So, the WACC can be optimized by adjusting the debt component of the capital structure. Lower the WACC, higher will be the valuations of the company. Lower WACC also widens the scope of the company by allowing it to accept low return projects and still create value.

b. Optimal Capital Budgets: The increase in the magnitude of capital tends to increase the WACC as well. With the help of WACC schedule and project schedule, an optimal capital budget can be worked out for the company.

WACC is an important metric used for various purposes but it has to be used very carefully. The weights of the capital components should be expressed in market value terms. The market values should be determined carefully and accurately. Faulty calculations of WACC will result in faulty investment decisions as well. There are issues such as no consideration given to floatation cost which are not worth ignoring. The complications increase if the capital consists of callable, puttable or convertible instruments, warrants etc.

 

CAPITAL STRUCTURE

The capital structure concerns the proportion of capital that is obtained through debt and equity. There are tradeoffs involved: using debt capital increases the risk associated with the firm's earnings, which tends to decrease the firm's stock prices. At the same time, however, debt can lead to a higher expected rate of return, which tends to increase a firm's stock price. As Brigham explained, "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."

Capital structure decisions depend upon several factors. One is the firm's business risk—the risk pertaining to the line of business in which the company is involved. Firms in risky industries, such as high technology, have lower optimal debt levels than other firms. Another factor in determining capital structure involves a firm's tax position. Since the interest paid on debt is tax deductible, using debt tends to be more advantageous for companies that are subject to a high tax rate and are not able to shelter much of their income from taxation.

A third important factor is a firm's financial flexibility, or its ability to raise capital under less than ideal conditions. Companies that are able to maintain a strong balance sheet will generally be able to obtain funds under more reasonable terms than other companies during an economic downturn. Brigham recommended that all firms maintain a reserve borrowing capacity to protect themselves for the future. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.

SOURCES OF CAPITAL

DEBT CAPITAL

Small businesses can obtain debt capital from a number of different sources. These sources can be broken down into two general categories, private and public sources. Private sources of debt financing, according to W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.

There are many types of debt financing available to small businesses—including private placement of bonds, convertible debentures, industrial development bonds, and leveraged buyouts—but by far the most common type of debt financing is a regular loan. Loans can be classified as long-term (with a maturity longer than one year), short-term (with a maturity shorter than two years), or a credit line (for more immediate borrowing needs). They can be endorsed by co-signers, guaranteed by the government, or secured by collateral—such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds, or the item purchased with the loan.

When evaluating a small business for a loan, Jennifer Lindsey wrote in her book The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow, and an ability to obtain short-term financing from other sources as a supplement to the loan. Most lenders will require a small business owner to prepare a loan proposal or complete a loan application. The lender will then evaluate the request by considering a variety of factors. For example, the lender will examine the small business's credit rating and look for evidence of its ability to repay the loan, in the form of past earnings or income projections. The lender will also inquire into the amount of equity in the business, as well as whether management has sufficient experience and competence to run

the business effectively. Finally, the lender will try to ascertain whether the small business can provide a reasonable amount of collateral to secure the loan.

EQUITY CAPITAL

Equity capital for small businesses is also available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs).

There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or startup firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.

In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for startup firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.

Relationship Between Capital Structure and Cost of Capital

The cost of debt is higher than the cost of share capital and retained earnings and the behaviour of the weighted-average-cost of capital is influenced by the proportion of debt in the capital.

What is the nature of the relationship between capital structure and the cost of capital?

The relationship between the capital structure and the overall cost of capital is that the overall cost of capital increases as the proportion of debt in the capital structure increases. But as the proportion of debt increases, the overall cost of capital also starts rising. The association between these two variables is tested by simple correlation.

First, the use of debt in capital structure affects the overall cost of capital and thus the cost of capital is a function of leverage.

Second, there is a direct relationship between capital structure and cost of capital.

Why does the overall cost of capital increase, as the proportion of debt in capital structure increases ?

Suppose the cost of debt is higher, though constant and the other two components of capital structure namely the share capital and the retained earnings are less costly and they do not bear any cost, whenever dividend is not paid. Thus when high-cost debt is introduced in the capital structure, the overall cost of capital increases and the latter decreases when debt is repaid. In brief with a change in leverage, a relatively high-cost source of funds replaces a source of funds which involves relatively a lower cost. This obviously causes a rise in the overall cost of capital.

Factors Influencing the Relationship between Capital Structure and Cost of Capital

The focus of the preceding section is on examining the nature of relationship between capital structure and cost of capital. The overall cost of capital increases as the proportion of debt or leverage increases and decreases with a fall in the proportion of debt or leverage. Thus, the use of debt leads to high cost of capital which is detrimental to the sound growth of a cooperative organization. A higher proportion of debt may lead to financial distress which includes a broad spectrum of problems ranging from the relatively minor liquidity shortage to the extreme case of bankruptcy. It also reduces commercial profitability. All these may in turn deter the cooperatives in fulfilling their very objective of rendering service to their members at a reasonable cost. Leverage, thus, is detrimental to a cooperative organization.

A cooperative organization, therefore, should try to bring down the proportion of debt and should augment equity to such an extent that it could bring down its overall cost of capital. Theoretically it may sound good. In practice it is a formidable task. As we have seen, there is no set capital structure for cooperativesThere are significant inter-intra industry variations in respect of capital structures.

This is because of the influence of a host of factors, both quantitative and qualitative on the capital structure.

'Need for Funds' and the 'Internal Financing' are the two immediate factors which have influence over the leverage. The 'need for funds' depends on required initial investment, growth rate and social cost, whereas 'internal financing' and profitability are interdependent. The influence of 'need for funds' and 'internal financing' and the factors behind each of these two variables are briefly stated here.

Need for funds:

The need for funds is the first factor which has a direct influence on the capital structure of a firm. A firm requires for initial investment to start its manufacturing operations. The amount of initial investment depends upon the proposed installed capacity and social

investments when the firm is established. Initially, a cooperative firm may not be able to mobilize adequate equity capital from its members because of their poor socio-economic background. Therefore, it has to rely on debt for financing its assets. The need for additional funds arises when a firm has steady growth rate. When a firm takes up expansion or modernization, it involves a huge capital outlay. This could not entirely be met out of owned funds. Hence a firm has to resort to debt to meet the additional investment.

Apart from this a firm has its social obligations. The cost of welfare measures such as education, health care facilities for members and employees and housing for employees, etc. is called social cost. Social cost is unproductive in nature.

Internal Financing:

Yet another factor which has a direct bearing on the capital structure is internal financing. A firm with steady profitability could easily meet and settle its fixed obligations at a quicker pace and could generate its own internal funds. This would not only help such firms to reduce the proportion of debt in their capital structure but also, would obviate the need for external financing. Further a cooperative which anticipates a stable profitability can boldly resort to debt capital to finance its assets, for it may not have any difficulty in honouring its future fixed obligations. Thus, profitability enables a cooperative to generate its own internal funds and therefore it can modify its capital structure to its best advantage. Profitability of a cooperative, in turn, depends on its degree of operating profit to changes in sales. The profit of a highly leveraged (operating) firm is likely to increase at a faster rate than the increase in sales. But if sales fall, it will suffer a greater loss. Thus the degree of operating leverage represents a firm's business risk. A cooperative with a high degree of operating leverage resorting to debt capital to finance its assets will expose itself to greater risk .This has an impact on the profitability.

The degree of operating leverage is influenced by several factors. One major determinant of operating leverage is the variability of sales revenue. The variability in sales generally depends on the characteristics of industry, effectiveness of market efforts, technological developments and general economic condition.

Another major determinant of operating leverage is the variability in operating expenses. An increase in "supply-price" of raw material and labour contributes to the variability of operating expenses. The extent of the firm's fixed costs in operation also influences the degree of operating leverage. The Capacity Utilization plays a crucial role in determining the profitability of a firm. A firm with higher capacity utilization tends to increase its production and productivity and this would contribute towards higher profitability.

On the other hand, under-utilization of capacity leads to locking up of resources, high cost of production and therefore low profitability. The Operating efficiency, yet another determinant of profitability, implies the efficiency with which capital employed is rotated in the process of doing business. Effective rotation of capital would lead to higher profitability. The operating efficiency of the firm can be determined by the efficiency in utilising the total assets, fixed assets and inventory.

The Gross Operating Margin is also a measure of profitability. It is an indicator of the efficiency of the operation of production. A firm with a fairly higher percentage of gross margin is well on the way to higher percentage of operating profit. The gross operating margin is influenced by rate of change in cost of production and rate of change in selling price. A stable or declining trend in the rate of change in cost of production would help a firm to achieve a higher gross operating margin.

On the other hand, an increasing trend in cost of production would cause a reduction in gross operating margin. The variability in sales may also affect gross operating margin. If the sales revenue is fairly stable, then the firm's profit would be stable. Such stability paves the way either for going in for a higher level of debt or for lessening the proportion of debt in the capital structure. From the foregoing analysis it is clear that the "need for funds" and the "internal financing" are the two factors which directly influence the leverage.

CAPITAL STRUCTURE THEORIES

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure

This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value

of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share.

High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.

2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure

Name of Theory = Traditional Theory of Capital Structure

This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:

Ist Stage

In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm.

2nd Stage

In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure.

3rd Stage

Company can get loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of

capital.

4th Theory of Capital Structure

Name of theory = Modigliani and Miller

MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital.

Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.

CAPITAL STRUCTURE IN A PERFECT MARKET

Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment returns are not affected by financial uncertainty. Modigliani and Miller made two findings under these conditions.

Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, risk is shifted between different investor classes, while total firm risk is constant, and hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt.

CAPITAL STRUCTURE IN THE REAL WORLD

If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model

TRADE-OFF THEORY

The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure

An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc.). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

(As the Debt equity ratio (i.e. leverage) increases, there is a trade-off between the interest tax shield and bankruptcy, causing an optimum capital structure, D/E*)

PECKING ORDER THEORY

Pecking order theory starts with asymmetric information as managers know more about their companies prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. There therefore exists a pecking order for the financing of new projects.

Asymmetric information favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the board and that they feel the share

price is over-valued. An issue of equity would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible

The pecking order theory explains the inverse relationship between profitability and debt ratios:

1. Firms prefer internal financing.2. They adapt their target dividend payout ratios to their investment opportunities,

while trying to avoid sudden changes in dividends.3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment

opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends.

4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt.

AGENCY COSTS

There are three types of agency costs which can help explain the relevance of capital structure.

Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside.

Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.

Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Capital Structure Theory – Modigliani and Miller (MM) Approach

Modigliani and Miller approach to capital theory, devised in 1950s advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component, it has no bearing on its market value. Rather, the market value of a firm is dependent on the operating profits of the company.

Capital structure of a company is the way a company finances its assets. A company can finance its operations by either debt or equity or different combinations of these two sources. Capital structure of a company can have majority of debt component or majority of equity, only one of the 2 components or an equal mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories, trying to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach.

Modigliani and Miller Approach

This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble to that of Net Operating Income Approach. Modigliani and Miller advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component in the financing mix, it has no bearing on the value of a firm.

Modigliani and Miller Approach further states that the market value of a firm is affected by its future growth prospect apart from the risk involved in the investment. The theory stated that value of the firm is not dependent on the choice of capital structure or financing decision of the firm. If a company has high growth prospect, its market value is higher and hence its stock prices would be high. If investors do not see attractive growth prospects in a firm, the market value of that firm would not be that great.

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1: With the above assumptions of “no taxes”, the capital structure does not influence the valuation of a firm. In other words, leveraging the company does not increase the market value of the company. It also suggests that debt holders in the company and equity share holders have the same priority i.e. earnings are split equally amongst them.

Proposition 2: It says that financial leverage is in direct proportion to the cost of equity. With increase in debt component, the equity shareholders perceive a higher risk to for the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction here is that proposition 2 assumes that debt share holders have upper-hand as far as claim on earnings is concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of Leverage)

The Modigliani and Miller Approach assumes that there are no taxes. But in real world, this is far from truth. Most countries, if not all, tax a company. This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the same is not the case with dividends paid on equity. To put it in other words, the actual cost of debt is less than the nominal cost of debt because of tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts, until a given threshold value will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that a change in debt equity ratio has an effect on WACC (Weighted Average Cost of Capital). This means higher the debt, lower is the WACC. This Modigilani and Miller approach is one of the modern approaches of Capital Structure Theory.

Proposition

where

is the value of an unlevered firm = price of buying a firm composed only of equity, and is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile than the firm.

Proposition II

Proposition II with risky debt. As leverage (D/E) increases, theWACC (k0) stays constant.

here

is the required rate of return on equity, or cost of equity. is the required rate of return on borrowings, or cost of debt.

is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true under the following assumptions:

no transaction costs exist, and individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes

Proposition I

where

is the value of a levered firm. is the value of an unlevered firm. is the tax rate ( ) x the value of debt (D) the term assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition II

where:

is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.

is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).

is the required rate of return on borrowings, or cost of debt.

is the debt-to-equity ratio. is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula, however, has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%.

The following assumptions are made in the propositions with taxes:

corporations are taxed at the rate on earnings after interest, no transaction costs exist, and individuals and corporations borrow at the same rate.

Modigliani and Miller's Capital-Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.

Modigliani and Miller's Tradeoff Theory of Leverage

The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds effectively reduces a company's tax liability. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax be recognised.

In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the company's WACC.

Bankruptcy Costs

M&M II might make it sound as if it is always a good thing when a company increases its proportion of debt relative to equity, but that's not the case. Additional debt is good only up to a certain point because of bankruptcy costs.

Bankruptcy costs can significantly affect a company's cost of capital. When a company invests in debt, the company is required to service that debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow.

For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender.

The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly.

Optimal Capital StructureIs there an optimal debt-equity relationship? In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expenses and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments.

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

What Is the Optimal Capital Structure?

As we have seen, some debt is often better than no debt, but too much debt increases bankruptcy risk. In technical terms, additional debt lowers the weighted average cost of capital. Of course, at some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:

First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property and equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally use more long-term debt.

Second, capital structure tends to track with the company's growth cycle. Rapidly growing

startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns. These companies are considered growth stocks. High-growth companies do not need to give these shareholders cash today; however lenders would expect semi-annual or quarterly interest payments.

In summary, the optimal capital structure is the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this optimal capital structure.

Extended Pie Model

The extended pie model draws upon Modigliani and Miller's capital structure irrelevance theory. This model considers both corporate taxes and bankruptcy costs to be a claim on the firm's cash flows and illustrates the proportion of each entity's claim on the company's cash flows using pie charts. These pie charts also show how an increase or decrease in the company's debt relative to its equity increases or decreases each entity's claim. Under the extended pie model, stockholders, bondholders, the government, bankruptcy courts, lawyers and other entities are each considered to have a partial claim on the company's cash flows. The size of each slice of the pie represents each entity's percentage claim.

The extended pie model helps illustrate the relationship between the value of the firm and its cash flows. It is an extension of Modigliani and Miller's theory because it attempts to show a way in which capital structure does not affect the firm's value.

Observed Capital Structures

Observed capital structure refers to the real-life capital structures of various industries as a whole as well as the individual businesses within those industries. Different industries have different proportions of debt and equity because they require varying levels of investment in plant, property and equipment. For example, capital-intensive industries tend to have more debt because banks are willing to make loans against fixed assets. Within the same industry, firms may have similar capital structures because similar businesses may have similar assets and liabilities. However, within the same industry, a given business's capital structure may differ from industry norms because of factors such as firm size, technology requirements and growth stage.

The Ibbotson Cost of Capital Yearbook, which as of February 2012 is published annually and updated quarterly, is a comprehensive and authoritative source of business valuation statistics, including cost of equity, cost of debt and weighted average cost of capital. According to the 2008 yearbook, the industries with the lowest debt levels were computers

(5.61%) and drugs (7.25%). The industries with the highest debt levels were cable television (162.03%) and airlines (129.04%).

These numbers can change significantly in even a short amount of time. The same survey in 2004 also found that the industries with the lowest debt levels were drugs (6.38%) and paper and computers (10.24% to 10.68%), but the industries with the highest debt levels were airlines (64.22%) and electric utilities (49.03%). Notice the dramatic increase in the debt levels of the high-debt industries from 2004 to 2008.

Large capital outlays are also a fact of life for most telecom industry players. To finance their CAPEX initiatives, they often rely on debt financing. Department stores and steel companies have also historically had relatively high levels of debt. On the whole, however, U.S. corporations generally prefer equity financing over debt financing and therefore have low debt-to-equity ratios.

Long-Term Financing under Financial Distress/Bankruptcy

Financial distress is a condition in which a company cannot meet or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has high fixed costs, illiquid assets or revenues that are sensitive to economic downturns.

A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise much-needed funds. In an effort to satisfy short-term obligations, management might forego profitable longer-term projects. Employees of a distressed firm usually have higher stress, lower morale and lower productivity caused by the increased chance of the company's bankruptcy, which would force them out of their jobs.

Bankruptcy is a legal proceeding involving a person or business that is unable to repay outstanding debts. The bankruptcy process begins with a petition filed by the debtor (most common) or on behalf of creditors (less common). All of the debtor's assets are measured and evaluated, whereupon the assets are used to repay a portion of outstanding debt. Upon the successful completion of bankruptcy proceedings, the debtor is relieved of the debt obligations incurred prior to filing for bankruptcy.

Bankruptcy offers an individual or business a chance to start fresh by forgiving debts that simply can't be repaid while offering creditors a chance to obtain some measure of repayment based on what assets are available.

Bankruptcy filings in the United States can fall under one of several chapters of the Bankruptcy Code, such as Chapter 7 (which involves liquidation of assets), Chapter 11 (company or individual "reorganizations") and Chapter 13 (debt repayment with lowered

debt covenants or payment plans). Bankruptcy filing specifications vary widely among different countries, leading to higher and lower filing rates depending on how easily a person or company can complete the process.

Some firms are at greater risk of financial distress than others. Any firm with volatile earnings has an increased risk of financial distress. For example, a retail company might be considered at greater risk of financial distress because many retail companies have dramatically higher sales in the fourth quarter than in other quarters. Firms whose value largely derives from intangible assets are also at higher risk of financial distress since they have little that can be sold off to repay debt.

Firms with a higher risk of financial distress are well advised to issue bonds with caution since they may struggle to repay the debt. Financial distress does not just harm bondholders and stockholders who stand to lose their investments; it also harms the firm in ways that make a bad situation worse. As we mentioned above, a firm in financial distress will find it more difficult and more expensive to borrow. Difficulty in borrowing or in obtaining credit from suppliers can diminish inventory and make it harder to make sales and to retain and attract customers. Existing and potential customers may seek alternatives with companies that have better inventories and that they are confident they can return to for repeat business. Financial distress can also cause the firm to lose key talent to more stable job opportunities. Finally, filing for bankruptcy requires expensive legal assistance.

The costs of financial distress and bankruptcy thus illustrate once again why choosing an optimal capital structure and not taking on too much long-term debt are crucial to a firm's vitality and longevity.