Cost
Cost Of Capital AOf Capital And Capital Structurend Capital Structure Capital of a
Capital of a company consists company consists of of ::
1. Equity ( equity share capital + reserves & surpluses ) 1. Equity ( equity share capital + reserves & surpluses ) 2. Preference share capital
2. Preference share capital 3. Loan capital i.e. Debenture 3. Loan capital i.e. Debenture EBIT-EPS Chart
EBIT-EPS Chart
Falcon Limited plans to raise additional capital of Rs. 10 mln for financing an expansion project. In this Falcon Limited plans to raise additional capital of Rs. 10 mln for financing an expansion project. In this context, it is evaluating two alternative financing plans: (i) issue of equity shares (1 mln equity shares at context, it is evaluating two alternative financing plans: (i) issue of equity shares (1 mln equity shares at Rs. 10 per share), and (ii) issue of debentures carrying 14 per cent interest.
Rs. 10 per share), and (ii) issue of debentures carrying 14 per cent interest. What will be the EPS under the two alternative financing plan
What will be the EPS under the two alternative financing plans for two levels of s for two levels of EBIT, say Rs. 4 mln and Rs. 2 EBIT, say Rs. 4 mln and Rs. 2 mln?mln? Following table shows the value of EPS for these two levels of EBIT under the alternative financing plans.
Following table shows the value of EPS for these two levels of EBIT under the alternative financing plans.
Calculate the indiference EBIT. Calculate the indiference EBIT.
In general, the relationship between EBIT and EPS is as follows : In general, the relationship between EBIT and EPS is as follows :
(EBIT - I) (1 – t) (EBIT - I) (1 – t) EPS = ———————— EPS = ———————— n n The EBIT inifference point between two
The EBIT inifference point between two alternative plans can be alternative plans can be obtained mathemobtained mathemetecally by solving the etecally by solving the followingfollowing equation
equation
( EBIT – I
( EBIT – I11 ) ) ( 1 ( 1 – – t ) t ) = = ( ( EBIT EBIT – – II22 ) ( 1 – t )) ( 1 – t ) n
n11 nn22
w
weerree EEPPSS = = eeaarrnniinnggs s ppeer r sshhaarree EB
EBIT =IT = eaearnrninings bgs befeforore ine intetererest ast and tnd taxaxeses II == iinntteerreesst t bbuurrddeenn
tt == ttaax x rraattee n
n == nnuummbbeer r oof f eeqquuiitty y sshhaarreess wh
whereere EBEBIT* = inIT* = indidifferfferencence poie point bent betwetween then the two ale two alterternanativtive finae financncing ping planlanss II11, I, I22 = interest expenses before taxes under financing plans 1 and 2= interest expenses before taxes under financing plans 1 and 2
t
t = iin= nccoommee--ttaax x rraattee n
n11, n, n22= number of equity shares outstanding after adopting financing plans 1 and 2.= number of equity shares outstanding after adopting financing plans 1 and 2.
Risk Considerations Risk Considerations
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So far we looked at the impact of alternative financing plans on EPS. What is the effect of leverage on So far we looked at the impact of alternative financing plans on EPS. What is the effect of leverage on risk? A precise answer to this question is not possible with the help of EBIT-EPS analysis. However, a risk? A precise answer to this question is not possible with the help of EBIT-EPS analysis. However, a broad indication may be obtained with reference to it.
broad indication may be obtained with reference to it.
The finance manager may do two things : (i) compare the expected value of EBIT with its indifference The finance manager may do two things : (i) compare the expected value of EBIT with its indifference value, and (ii) assess the probability of EBIT falling below its indifference value. If the most likely value of value, and (ii) assess the probability of EBIT falling below its indifference value. If the most likely value of EBIT exceeds the indifference value of EBIT, the debt financing option, prima facie, may be advantageous. EBIT exceeds the indifference value of EBIT, the debt financing option, prima facie, may be advantageous. The larger the difference between the expected value of EBIT and its indifference value, the stronger the The larger the difference between the expected value of EBIT and its indifference value, the stronger the case for debt financing, other things being equal.
case for debt financing, other things being equal.
Given the variability of EBIT, arising out of the business risk of the company, the probability of EBIT falling Given the variability of EBIT, arising out of the business risk of the company, the probability of EBIT falling below the indifference level of EBIT may be assessed. If such probability is negligible, the debt financing below the indifference level of EBIT may be assessed. If such probability is negligible, the debt financing option is advantageo
option is advantageous. On the us. On the other hand, if such probability is high, other hand, if such probability is high, the debt financing alternative is risky.the debt financing alternative is risky. The notion may be illustrate
The notion may be illustrated graphically as shown in d graphically as shown in where two probabiliwhere two probability distributions of EBIT (A and B)ty distributions of EBIT (A and B) are superimpose
are superimposed on the EBIT-EPS chart. Distribution A is d on the EBIT-EPS chart. Distribution A is relatively safe, as there is hardly any probabilityrelatively safe, as there is hardly any probability that EBIT will fall below its indifference level. With such a distribution, the debt alternative appears to be that EBIT will fall below its indifference level. With such a distribution, the debt alternative appears to be advantageous. Distribution B, on the other hand, is clearly risky because there is a significant probability advantageous. Distribution B, on the other hand, is clearly risky because there is a significant probability that EBIT will decline below its indifference value. In this
that EBIT will decline below its indifference value. In this case, the debt alternative may not be regarded ascase, the debt alternative may not be regarded as desirable.
desirable. ROI-ROE ANALYSIS ROI-ROE ANALYSIS
In the preceding section we looked at the relationship between EBIT and EPS under alternative financing In the preceding section we looked at the relationship between EBIT and EPS under alternative financing plans. Pursuing a similar line of analysis, we may
plans. Pursuing a similar line of analysis, we may look at the relationship between the return on investmentlook at the relationship between the return on investment (ROI) and the return on
(ROI) and the return on equity (ROE) for different levels of equity (ROE) for different levels of financing leveragfinancing leverage.e.
Suppose a firm, Korex Limited, which requires an investment outlay of Rs. 100 mln, is considering two Suppose a firm, Korex Limited, which requires an investment outlay of Rs. 100 mln, is considering two capital structures.
capital structures.
C
Caappiittaal l SSttrruuccttuurre e AA CCaappiittaal l SSttrruuccttuurre e BB E
Eqquuiittyy 110000 EEqquuiittyy 5500
D
Deebbtt 00 DDeebbtt 5500
While the average cost of debt is fixed at 12 per cent, the ROI (defined as EBIT divided by total assets) may vary While the average cost of debt is fixed at 12 per cent, the ROI (defined as EBIT divided by total assets) may vary widely. The tax rate of the firm is 50 per cent.
widely. The tax rate of the firm is 50 per cent.
Based on the above information, the relationship between ROI and ROE (defined as equity earnings divided by net Based on the above information, the relationship between ROI and ROE (defined as equity earnings divided by net worth) under the two capital structures, A and B, would be as shown in Table 13.2. Graphically the relationship is worth) under the two capital structures, A and B, would be as shown in Table 13.2. Graphically the relationship is shown as below shown as below ROE ROE B B AA ROI ROI
So far we looked at the impact of alternative financing plans on EPS. What is the effect of leverage on So far we looked at the impact of alternative financing plans on EPS. What is the effect of leverage on risk? A precise answer to this question is not possible with the help of EBIT-EPS analysis. However, a risk? A precise answer to this question is not possible with the help of EBIT-EPS analysis. However, a broad indication may be obtained with reference to it.
broad indication may be obtained with reference to it.
The finance manager may do two things : (i) compare the expected value of EBIT with its indifference The finance manager may do two things : (i) compare the expected value of EBIT with its indifference value, and (ii) assess the probability of EBIT falling below its indifference value. If the most likely value of value, and (ii) assess the probability of EBIT falling below its indifference value. If the most likely value of EBIT exceeds the indifference value of EBIT, the debt financing option, prima facie, may be advantageous. EBIT exceeds the indifference value of EBIT, the debt financing option, prima facie, may be advantageous. The larger the difference between the expected value of EBIT and its indifference value, the stronger the The larger the difference between the expected value of EBIT and its indifference value, the stronger the case for debt financing, other things being equal.
case for debt financing, other things being equal.
Given the variability of EBIT, arising out of the business risk of the company, the probability of EBIT falling Given the variability of EBIT, arising out of the business risk of the company, the probability of EBIT falling below the indifference level of EBIT may be assessed. If such probability is negligible, the debt financing below the indifference level of EBIT may be assessed. If such probability is negligible, the debt financing option is advantageo
option is advantageous. On the us. On the other hand, if such probability is high, other hand, if such probability is high, the debt financing alternative is risky.the debt financing alternative is risky. The notion may be illustrate
The notion may be illustrated graphically as shown in d graphically as shown in where two probabiliwhere two probability distributions of EBIT (A and B)ty distributions of EBIT (A and B) are superimpose
are superimposed on the EBIT-EPS chart. Distribution A is d on the EBIT-EPS chart. Distribution A is relatively safe, as there is hardly any probabilityrelatively safe, as there is hardly any probability that EBIT will fall below its indifference level. With such a distribution, the debt alternative appears to be that EBIT will fall below its indifference level. With such a distribution, the debt alternative appears to be advantageous. Distribution B, on the other hand, is clearly risky because there is a significant probability advantageous. Distribution B, on the other hand, is clearly risky because there is a significant probability that EBIT will decline below its indifference value. In this
that EBIT will decline below its indifference value. In this case, the debt alternative may not be regarded ascase, the debt alternative may not be regarded as desirable.
desirable. ROI-ROE ANALYSIS ROI-ROE ANALYSIS
In the preceding section we looked at the relationship between EBIT and EPS under alternative financing In the preceding section we looked at the relationship between EBIT and EPS under alternative financing plans. Pursuing a similar line of analysis, we may
plans. Pursuing a similar line of analysis, we may look at the relationship between the return on investmentlook at the relationship between the return on investment (ROI) and the return on
(ROI) and the return on equity (ROE) for different levels of equity (ROE) for different levels of financing leveragfinancing leverage.e.
Suppose a firm, Korex Limited, which requires an investment outlay of Rs. 100 mln, is considering two Suppose a firm, Korex Limited, which requires an investment outlay of Rs. 100 mln, is considering two capital structures.
capital structures.
C
Caappiittaal l SSttrruuccttuurre e AA CCaappiittaal l SSttrruuccttuurre e BB E
Eqquuiittyy 110000 EEqquuiittyy 5500
D
Deebbtt 00 DDeebbtt 5500
While the average cost of debt is fixed at 12 per cent, the ROI (defined as EBIT divided by total assets) may vary While the average cost of debt is fixed at 12 per cent, the ROI (defined as EBIT divided by total assets) may vary widely. The tax rate of the firm is 50 per cent.
widely. The tax rate of the firm is 50 per cent.
Based on the above information, the relationship between ROI and ROE (defined as equity earnings divided by net Based on the above information, the relationship between ROI and ROE (defined as equity earnings divided by net worth) under the two capital structures, A and B, would be as shown in Table 13.2. Graphically the relationship is worth) under the two capital structures, A and B, would be as shown in Table 13.2. Graphically the relationship is shown as below shown as below ROE ROE B B AA ROI ROI
Looking at the relationship between ROI and ROE it is observed that : Looking at the relationship between ROI and ROE it is observed that :
1.The ROE under capital structure A is higher than the ROE under capital structure B when ROI is less than the cost of 1.The ROE under capital structure A is higher than the ROE under capital structure B when ROI is less than the cost of debt.
debt.
2.The ROE under the two capital structures is the same when ROI is equal to the cost of debt. Hence the indifference 2.The ROE under the two capital structures is the same when ROI is equal to the cost of debt. Hence the indifference (or breakeven) value of ROI is equal to the cost of debt.
(or breakeven) value of ROI is equal to the cost of debt.
3.The ROE under capital structure B is higher than the ROE under capital structure A when ROI is more than the cost 3.The ROE under capital structure B is higher than the ROE under capital structure A when ROI is more than the cost of debt.
of debt.
Mathematical Relationship Mathematical Relationship
The influence of ROI and financial leverage on ROE is mathematically as follows : The influence of ROI and financial leverage on ROE is mathematically as follows :
ROE = [ROI + (ROI – r) D/E] (1 – t) ROE = [ROI + (ROI – r) D/E] (1 – t) Wh
Wherere e ROROEE = re= retuturn rn on on eeququiityty ROI
ROI = = return return on on investmentinvestment rr ==ccoosst t oof f ddeebbtt
D/
D/EE = = dedebtbt-e-eqquiuity ty raratitioo tt = = ttaax x rraattee
ASSESMENT OF DEBT CAPACITY ASSESMENT OF DEBT CAPACITY
Employment of debt capital entails two kind of burden: interest payment and principal repayment. To assess a firm’s Employment of debt capital entails two kind of burden: interest payment and principal repayment. To assess a firm’s debt capacity we look at its ability to meet these committed payments. This may be judged in terms of:
debt capacity we look at its ability to meet these committed payments. This may be judged in terms of:
••
Coverage ratiosCoverage ratios••
Probability of cash insolvencyProbability of cash insolvency••
Inventory of resourcesInventory of resources Coverage RatiosCoverage Ratios
A coverage ratio shows the relationship between a committed payment and
A coverage ratio shows the relationship between a committed payment and the source for that payment. The the source for that payment. The coveragecoverage ratios commonly used are: interest coverage ratio, cash flow coverage ratio, and debt service coverage ratio.
ratios commonly used are: interest coverage ratio, cash flow coverage ratio, and debt service coverage ratio. This may be derived as follows:
This may be derived as follows:
P PAATT ROE = ——— ROE = ——— E E (EBIT – I) (1 – t) (EBIT – I) (1 – t) ROE = ———————— ROE = ———————— E E (TA
(TA
××
ROI – I) (1 – t)ROI – I) (1 – t) ROE = ——————————— ROE = ——————————— E E [(E + D) ROI – rD] (1 – t) [(E + D) ROI – rD] (1 – t) ROE = ———————————— ROE = ———————————— E EROE = [ROI + (ROI – r) D/E] (1 – t) ROE = [ROI + (ROI – r) D/E] (1 – t) Interest Coverage Ratio
Interest Coverage Ratio : The : The intereinterest coverage ratio (also referred to st coverage ratio (also referred to as the as the times interetimes interest earned ratio) is st earned ratio) is simplysimply defined as:
Earnings before interest and taxes ————————————————
Interest on debt
To illustrate, suppose the most recent earnings before interest and taxes (EBIT) for Vitrex Company were Rs. 120 million and the interest burden on all debt obligations were Rs. 20 million. The interest coverage ratio, therefore, would be 120/20 = 6. What does it imply? It means that even if EBIT drops by 831/
3percent, the earnings of Vitrex Company
cover its interest payment.
Though somewhat commonly used, the interest coverage ratio has several deficiencies: (i) It concerns itself only with the interest burden, ignoring the principal repayment obligation. (ii) It is based on a measure of earnings, not a measure of cash flow. (iii) It is difficult to establish a norm for this ratio. How can we say that an interest coverage ratio of 2,3,4, or any other is adequate?
Cash Flow Coverage Ratio This may be defined as:
EBIT + Depreciation + Other non-cash charges Loan repayment installment Interest on debt +
—————————————--(1 – Tax rate) To illustrate, consider a firm :
Depreciation Rs. 20 mln
EBIT Rs.120mln
Interest on debt Rs. 20 mln
Taxrate 50%
Loan repayment installment Rs. 20 mln
Calculate the cash flow coverage ratio for this firm .
Debt Service Coverage Ratio Financial institutions which provide the bulk of long-term debt finance judge the debt capacity of a firm in terms of its debt service coverage ratio. This is defined as:
n PATi+ DEPi+ INTi
DSCR =
∑
—————————— nt INT
i+ LRIi
where DSCR = debt service coverage ratio PATi = profit after tax for year I
DEPi = depreciation for year I
INTi = interest on long-term loan for year I
LRIi = loan repayment instalment for year I
n = period of loan
In determination of best capital structure , share- holder prefers higher E.P.S. ( i.e. earning per share ) or EPS volatility
EPS volatility refers to the magnitude or the extent of fluctuation of earnings per share of a company in various years as compared to the mean or average earnings per share. In other words, EPS volatility shows whether a company enjoys a stable income or not. It is obvious that higher the EPS volatility, greater would be the risk attached to the company. A major cause of EPS volatility would be the fluctuations in the sales volume and the operating levarage. It is obvious that the net profits of a company would greatly fluctuate with small fluctuations in the sales figures specially if the fixed cost content is very high. Hence, EPS will fluctuate in such a situation. This effect may be heightened by the financial leverage.
E.P.S. = Profits available to equity. Share holders number of equity shares
Where, PBIT = Profit before tax. ; I = Interest.; t = Tax rate of the firm. At point of Indifference : (EPS)1 = (EPS ) 2
Calculation of costs for each Elements
Costs of Capitals are of two types
1. One Time Cost Or Flotation Cost 2. Annual Costs e.g. Interest, Dividend
Cost of Debt (Cd) a) When date of redemption is not given in the problem.
Cost of Debt. (after tax ) or Cd = ( 1-t ) x I Where, i = Effective rate of Interest .
T = Tax rate .
Effective rate of interest = Interest amount p.a. x 100 Net Proceeds
Net proceeds = Face value – discount + premium –flotation cost . You can calculate on per debenture basis . b) Cost of redeemable debt :
When Redemption is made at the end of its life or project . Cost of debt (after tax ) I + RV - NP
Cd= , n , (1 - t )
RV + NP 0 2
Where, I = Fixed Interest charges p.a. or interest per debenture. RV = Redeemable value i.e. face value + premium
NP = Net proceeds or Cash Inflow. n = Life of the debt.
c) When DEBENTURES are redeemed during its life:
Apply the principle of EXPLICIT COST i.e. the rate of return at which the initial cash inflow equates the discounted future cash outflows . This method is opposite to I.R.R.
SEBI Guidelines
Uptil early 1992, matters like a company’s capital structure, its pricing of capital issues,
dividend and interest rates, capitalisation of reserves, etc. were governed by the Capital
issues (Control) Act, 1947. The system had certain drawbacks like the under pricing of
equity issues, delays in getting clearances, etc. So the Act was abolished and
companies are now required to conform to the disclosure and investor protection
guidelines issued by the Securities and Exchange Board of India (SEBI). The important
guidelines are :
1. A new company set up by existing companies with a five-year track record of consistent profitability can freely price its capital issues, provided the promoting companies’ participation is at least 50 percent. Other new companies must price their issues at par.
2.
Closely held companies and private companies going public can price their issues
Cost of Preference Share Capital (Cp ) a) Cost of irredeemable preference Share .
Cp = Preference Dividend 100 NOTE : Tax on Dividend may be
charged
Net Proceeds (NP ) or Market Value( MP ) b) Cost of redeemable preference Share
i. Redemption at the end
RV - NP
Cp = D + n , D= preference dividend
RV + NP 2
ii. Pref. sh. Redeemed intermittently -- Apply Explicit Cost principle as before.
Cost of Equity Share Capital (Ce)
a. Dividend Price Approach ( D/P ) with growth model
Ce = Dividend 100 + g
Net Proceeds or Market value.
Where, g = growth rate or expected growth in dividend from coming year. b) Earning/ Price Approach ( E / P ):
Ce = Current Earning per Share 100 Current Market Price per share
c) Realised yield Approach :- It is that rate of return where investor’s initial investment = Total discounted cash Inflow in form of dividend and sales realisation at the end of the period.
d) Earning growth Model
Ce = EPS x 100 + g NP
e ) Estimating growth rate (g )
1) Dn = Do ( 1+ g ) n ; Dn = div / share in current year ; n = no of years Do = div / share in first year ; g = growth rate 2) GORDON’S MODEL :
g = br ; g = growth rate ; b = constant proportion of net profit retained each year ; r = average return of the firm .
where , b = Net profit - dividends THIS METHOD IS ONLY APPLICABLE
Net profit TO FIRMS WHICH HAVE
ALL EQUITY CAPITAL STRUCTURE r = net profits
Book value of capital employed
1.
Theoretical Post Right Price = { market price no. of old share + no. of right share subscription price } total no. of shares2. Theoretical value of rights = Post right price – subscription price 3. Bond Yield Plus Risk Premium Approach
According to this approach the rate of return required by the equity investors of a firm is equal to Yield on the long-term bonds of the firm + Risk premium
The logic of this approach is simple. Equity investors bear a higher degree of risk than bond investors and, hence, their required rate of return should include a premium for this higher risk. The problem with this approach is how to determine the risk premium. Should it be 1 percent, 2 percent, or n percent ? There is no theoretical basis for estimating the risk premium. Most analysts look at the operating risk and financial risk characterising the business and arrive at a subjectively determined risk premium figure which varies normally between 2 percent and 6 percent. This is added to the yield on the firm’s long-term bonds to estimate the rate of return required by equity investors.
THE CAPITAL ASET PRICING MODEL (CAPM)
The previous chapter on portfolio theory dealt with how to measure the risk and expected return of a portfolio or collection of assets; so far we have not attempted to bring the two together, that is to specifically link risk with return.
In the chronological development of modern financial management, portfolio theory came first with Markowitz in 1952. It was not until 1964 that William Sharpe derived the capital Asset Pricing Model (CAPM)1 based on
Markowitz’s portfolio theory. For example, a key assumption of the CAPM is that investors hold highly diversified portfolios and thus can eliminate a significant proportion of total risk.
The CAPM was a breakthrough in modern finance because for the first time a model became available which enable academic, financiers and investors to link the risk and return for an asset together, and which explained the underlying mechanism of asset pricing in capital markets.
TYPES OF INVESTMENT RISK
In the preceding chapter we have seen how the total risk (as represented by the standard deviation,
σ
) of a two-security portfolio can be significantly reduced by combining securities whose returns are negatively correlated, or at least havelow positive correlation – the principle of diversification.
According to the CAMP, the total risk of a security or portfolio of securities can be split into two specific types, systematic risk andunsystematic risk . This is sometimes referred to asrisk partitioning , as follows :
Total risk = Systematic risk + Unsystematic risk
Systematic (or market) risk cannot be diversified away : it is the risk which arises from market factors and is also frequently referred to as undiversifiablerisk. It is due to factors which systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of payments, inflation and interest rates). It may help you remember which type is which if you think of systematic risk as arising from risk factors associated with the general economic and financial system.
Unsystematic (or specific) risk can be diversified away by creating a large enough portfolio of securities : it is also often called diversifiable risk or company-unique risk. It is the risk which relates, or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the discovery of a new
technology or product would contribute to unsystematic risk.
The relationship btween total portfolio risk,
σ
p, and portfolio size can be bshon diagramatically as in Figurebelow . Notice that total risk diminshes as the number of assets or securities in the portfolio increases, but also observe that unsystematic risk does not disappear completely and that systematic risk remains unaffected by portfolio size.
Total risk
Portfolio risk Unsystematic risk
σ
p1 5 10 15 20
Number of securities in portfolio THE CAPM MODEL
We have previously described the CAPM as a method of expressing the risk-return relationship for a security or portfolio of securities: it brings together systematic (undiversifiable) risk and return. After all, for any rational, risk-averse investor it is only systematic risk which is relevant, because if the investor creates a sufficiently large portfolio of securities, unsystematic or company-specific risk can be virtually eliminated through diversification.
It is therefore the measurement of systematic risk which is of primary importance for rational investors in identifying those securities which possess the most desired risk-return characteristics. It is the measurement of systematic risk which becomes critical in the CAPM because the model relies on the assumption that investors will only hold well diversified portfolios, so only systematic risk matters.
The CAPM is quite a complex concept so if you find it difficult to grasp at first do not become disillusioned, stick with it. For reasons of presentation and ease of understanding we will approach our study of the CAPM by breaking it down into five key components as follows:
1. The beta coefficient, ( ); 2. The CAPM equation;
3. the CAPM graph—the security market line (SML);
4. Shifts in the SML—inflationary expectations and risk aversion; 5. Comments and criticisms of the CAPM.
Let us examine each component in turn, beginning with the key concept of beta,
β
, The beta coefficient ( )Recall that the standard deviation,
σ
, is used to measure an asset or share’s total risk, while the beta coefficient,β
, in contrast is used to measure only part of a share or portfolio’s risk, namely the part that cannot be reduced by diversification, that is the systematic or market risk of an individual share or portfolio of shares.Systematic risk can be further subdivided into business risk and financial risk. Business risk arises from the nature of the firm’s business environment and the particular characteristics of the type of business or industry in which it operates. For example the competitive structure of the industry, its sensitivity to changes in macroeconomic variables such as interest rates and inflation and the stability of industrial relations all combine to determine a firm’s business risk. The level of business risk in some industries, for example catering and construction, is higher than in others and is a variable which lies largely outside management’s control.
Shares or securities can be broadly classified as aggressive, average or defensive according to their betas. Shares with a beta>1.0 are described as aggressive; they are more risky than the market average, although they will tend to perform well in a rising or bull market. Consequently investors would require a rate of return from the share which is greater than the market average.
Shares with a beta = 1.0 are described as average or neutral as their rate of return moves in exact harmony with movements in the stock market average return; they are of average risk and yield average returns. In contrast, shares with a beta < 1.0 are classed as defensive. A defensive share does not perform well in a bulk market but conversely it does not fall as much as the average share in a falling or bear market.
How are betas determined?
A share’s beta is determined from the historical values of the share’s return relative to market returns. It is important to appreciate therefore that beta is a relative, not an absolute, measure of risk. As each individual beta is derived from a common base, that is, the return on the market portfolio or a suitable stock index substitute, then beta is a standardised risk measure, i.e. this makes the beta of one share directly comparable with the beta of another.
One way of determining the beta for a share is to plot on a graph the historic (ex post) relationship between the movement in the share’s returns and the market (or stock index) returns over a defined period of time. For example, if a stock market analyst considers that the share’s actual performance over the past five years also gives a fair indication of the share’s likely future performance, then deriving its beta is a matter of:
1. Computing both the average individual share’s return and the average market return (utilising an appropriate stock market index) for each month of the five-year period. Sometimes betas are also computed using daily averages.
2. Plotting on a graph the co-ordinates for each monthly set of returns. Conventionally the market’s or index’s returns are platted on the horizontal (x) axis and the individual share’s returns on the vertical (y) axis. The results will probably appear in the form of a scattergram and the statistical technique called regression analysis can then be used to derive the regression or characteristic line of the data.
Derivation of beta Return on Share
•
Market ReturnThe characteristic line is
the straight line that best represents or fits the relationship between the share’s return and the return from the market over the period. Beta is the slope of this characteristic line for the share as illustrated in Figure above. Shares with high betas will have steeper the slope of the line the more volatile (risky) are the returns from the sahre in relation to the returns from the market.
Figure below illustrates the respective characteristic line for two different risk securities, A and B. Security A has a beta of 1.5 and is represented by the steeper sloped line, compared with Security B which has a beta of 0.7. Security A’s higher beta suggests that its return is more sensitive to changes in the market return: it is thus a more risky investment than Security B.
Figure below Characteristic lines for two different risk securities, A and B
Security return ( % )
A
aaa
Market return ( % ) Alternative derivation of beta
Using past data on individual share and market returns over a sufficiently lengthy period, say, the most recent four to five years, betas can also be calculated statistically. For example the beta (
β
)of a share (S) is equal to the covariance between the share’s returns and the market’s returns (COVsm) divided by the variance of the market’s returns (Var m)—which in turn isthe standard deviation of the market’s returns squared, that is:
Covariancesm COVsm COVsm
Beta,
β
s = ——————— = ———— = ————Variancem Var m
σ
2mThe returns on a suitable stock market index can be used as a proxy for the market returns. For example, substituting the FTSE 100 Share Index, the beta (
β
) of a share (S) would be calculated as:COVs,FTSE100 COVs,FRSE100
Beta,
β
s = —————— = ——————Var FRSE100
σ
2FTSE100As the covariance of each individual share is divided by a common denominator, the variance of the market (Var m) or
a suitable surrogate market index, we end up with a standardised measure of risk, that is, the share’s beta. Being a standardised measure we are able to directly compare the beta of one share with the beta of another.
Portfolio betas
As it is learned that a share’s beta represents only part of a share’s risk, namely the element of systematic or market risk, which is the risk element that cannot be diversified away. When it comes to including a share in a portfolio we are only concerned with the impact of that share’s market risk on the portfolio risk. In a portfolio context market risk is also the only relevant risk and beta is the best measure. The portfolio beta measures the portfolio’s responsiveness to macroeconomic variables such as inflation and interest rates.
To determine the systematic risk for a portfolio, that is the portfolio beta, we simply calculate a weighted average of the betas of the individual securities making up the portfolio, as follows:2
Portfolio beta,
β
p = w1β
1+ w2β
2+ w3β
3… + wnβ
nwhere,
β
p = the portfolio beta (i.e. risk of the portfolio relative to the market)wi = portfolio weightings of the individual securities (where I = 1, 2, … n)
β
i = beta of the individual security (where i = 1,2,…n)n = number of securities in the portfolio Obtaining and interpreting betas
Betas can be obtained from published sources e.g. the London Business School (LBS) and through brokerage firms. The LBS published
β
values and other data for UK and Irish companies listed on the London Stock Exchange every quarter in its Risk Measurement Service publication.Individual betas are produced for all companies listed in the Financial Times (FT) All-Share Index. The individual betas are calculated from the monthly returns over the most recent five-year period related to the monthly returns from FT
All-Share Index using a standard least squares regression computer programme.
Most investment firms and analysts utilise
β
books which give beta values for all the major companies listed on the stock market although different investment firms may give varying beta estimates for the same company due to the differentmethods and timings used in their calculations.
In the United States beta value are commonly obtained from Value Line Investment Survey and from brokerage and investment firms such as Merrill Lynch.
The CAPM equation
We will now examine the actual equation for the capital asset pricing model. It is one of the most famous equations in financial management. The CAPM equation links together risk and the required return for a share. It shows, for example, that the return a rational investor would require on a particular share, R(r i), is a function of the share’s market or systematic risk
(beta),
β
i, and a risk premium to compensate for investing in the risky market. Thus the higher the risk, the higher the return theinvestor will require a vice-versa.
Simply stated, the underlying precept of the CAPM is that the expected return on a security is composed of two elements as follows:
Expected return, E(r) = a risk-free interest rate + a risk premium
Using the capital asset pricing model (CAPM) this relationship is expressed more formally as: E(r i) = r f +
β
i(ER m– R f )where,
E(r I) = required return on asset/share I
R f = risk-free rate of return
β
i = beta coefficient for asset/share iER m = expected market return, that is the return expected on the market portfolio of share.
As it is seen above, the CAPM equation can be split into two segments: 1. the risk-free rate of return, R f ; and
2. The risk premium,
β
i(ER m– R f )We will discuss the risk-free rate of return R f , first.
The CAPM graph – the security market line (SML)
Having now had some practice in using the CAPM to calculate the expected returns you will have noticed that the CAPM equation is in fact a straight line equation. Conventionally the equation for a straight line is usually given as: y = ax + c.
When the CAPM equation is shown in graph form, the resultant straight line is referred to as the security market line (SML). It is the line which exhibits the positive relationship (correlation) between the systematic risk of a security and its expected return.
On the security market line (SML) the risk-free rate, R f , is a constant and represents the vertical intercept, i.e. the point
where the SML crosses the vertical axis; it is equivalent to the constant c in the straight line equation above.
The co-ordinate x represents the systematic or market risk of the share as measured by its beta,
β
i, and co-ordinate yrepresents the expected market return. Observe that the slope or gradient of the line, a, is represented by the market risk premium (ER m– R f ), not jbeta and indicates the level of risk aversion in the economy.
The SML represents the level of return expected in the market for each level of the share’s beta (market risk), thus the risk-return trade-off for the share can be plainly seen as in Figure 7.4.
Interpreting the security market line (SML)
A few comments about the SML will facilitate its interpretation. First, notice that the beta associated with the risk-free security is 0, reflecting the security’s freedom from risk and its immunity from changes in the market return.
Second, point M on the SML represents the market portfolio. The return on the market portfolio (i.e. the average return from all securities on the entire market or a proxy index) is given by ER mand its corresponding level of risk is shown by
β
m, whereβ
= 1.0.SML Expected return, E(r), %
ER m M
Risk-free rate (R t)
0 0.5 1.0 1.5 2.0
β
mMarket risk,
β
Security market line (SML)Expected return E(r), % Share A
ν
SML Erm M Share B
ν
Risk-free rate (Rf) 0 0.5 1.0 1.5 2.0β
m Market risk,β
Fig. Expected return and required return and required return
Shifts in the security market
We noted above that the slope of the SML is given by the market risk premium (ER m– R f ), not beta and that it reflects
the general level of risk aversion in the economy.
The security market line is not static, it is an expression or snapshot of the risk-return relationship at a particular point in time. In dynamic capital markets, which are constantly responding to new information, risk-return factors change continually, thus the SML can and does shift over time. Here we will explore the impact of two specific major change effects on the SML—(1) inflation and (2) risk aversion.
The inflation shift
The risk-free rate of return is composed of several elements: a real interest rate, a liquidity or maturity premium and an inflation premium (IP). However, as we are primarily concerned with understanding inflation effects, we will simplify matters by assuming that any liquidity premium is subsumed within the real interest rate, which we will denote r*. Thus the risk-free interest rate is made up as follows:
R f = r* + IP
When expectations in the financial markets about the future rate of inflation change, this will essentially move the risk-free rate, R f , up or down depending on the market’s expectations about the direction of inflation. As t he risk-free rate is the
base line ingredient for all rates of return, any change in the risk-free rate as a result of changes in inflation expectations will be applied to all required rates of return as implied by the CAPM.
ERm2, 11%
Erm1 , 9%
M1 Increase inexpected inflation.
∆
IP = 2% New risk-free (r12) 9%Original risk-free rate (Rf1) 7%
0 0.5 1.0 1.5 2.0
β
mThe risk aversion shift
As we have explained, the slope of the SML represents the market risk premium, the steeper the slope, the greater the risk premium in the market. This reflects the extent to which investors in the market are risk-averse, that is for an increase in risk they require a commensurate increase in return as indicated by the upward slope of the SML. If market risk did not exist there would be no risk premium and the SML would be a flat line extending from the R f vertical intersection.
However, in reality market risk does exist and it is a variable which can change, primarily as a result of economic, political and social factors such as general strikes, widespread civil unrest, stock market crashes, wars or greater political or
economic uncertainty and instability.
Should market risk increase, for example because investors perceive greater economic uncertainty or i nstability ahead, then this will be reflected in a rise in the slope of the SML. Note that in this instance the risk-free rate remains unchanged, it is the risk premium which now changes. Observe also how the increase in the risk premium becomes more prominent as the riskiness of the security (its
β
) increases. The increase in the risk premium is significantly greater for a security with a beta of 1.5 (an aggressive share) than it is in relation to a security with a beta of 0.5 (a defensive share). The effect of an increase in risk aversion on the SML is illustrated in Figure belowExpected return E(r)% SML2
ER m2 12% M2
ER m19% M1
Additional market risk premium
(ER m2 -ER m1 )
If we adopt the same figures as before, that is Ff1equals 7 percent and ER m1equals 9 per cent the original market risk
premium was ER m1 – R f1 = 9% - 7% = 2%. If we assume that ER m2 has now moved to 12%, the new market risk premium is
ER m2– R f1 = 12% - 7% = 5%. Thus the market risk premium has increased by an additional 3 per cent; ER m2 – ER m1 = 12%
-9% = 3%: the risk-free rate remains unaffected.
Underlying assumptions and limitations of the CAPM
The CAPM is a mathematical mode, and like any model it is merely a representations of reality. All models (business economic and financial, etc. are constructed from a set of underlying assumptions about the real world; they inevitably have their limitations. The CAPM is built on the following set of assumptions and limitations:
1. Historic data.CAPM is a future-oriented model yet it essentially relies on historic data to predict future returns. Betas, for example, are calculated using historic data; consequently they may or may not be appropriate predictors of the variability or risk of future returns. Thus the CAPM is not a deterministic model, the required
returns suggested by the model can only be viewed as approximations.
2. Investor expectations and judgements. The models includes the expectations and subjective judgements of investors about future asset or security returns and these are very difficult to quantify. In addition the model also assumes that investor expectations and judgements are homogenous, i.e. identical. If investors have heterogeneous (i.e. varied) expectations about future returns they will essentially have different SMLs, rather than a common SML as implied by the model.
3. A perfect capital market. CAPM assumes an efficient or perfect capital market. An efficient capital market is one where all securities and assets are always correctly priced and where it is not possible to outperform the market consistently except by luck. An efficient capital market implies that there are many small investors (all are price-takers), all of whom are rational and risk-averse; they each possess the same information and the same future expectations about securities. It also assumes that in the financial markets there are no transaction costs, no taxes and no limitations on investment.
4. Investors fully diversified. The CAPM also assumes that investors are fully diversified. In practice many investors, particularly small investors, do not hold highly diversified asset portfolios.
5. Practical data measurement problems. There are also practical problems associated with the model such as difficulties with specifying the risk-free rate, measuring beta and measuring the market risk premium.
6. One-period time horizon.CAPM assumes investors adopt a one-period time horizon. In practice investors are likely to have differing time horizons and again this would imply varying SMLs.
7. Single factor model.CAPM is a single factor model: it relies on the market portfolio to explain security returns. The rate of return on a security is a function of the security’s beta times a risk premium, that is
β
(ER m– R f ). Bothbeta and the risk premium are determined in relation to the market portfolio. Recall that each security’s beta (risk factor) is derived by linear regression, plotting its return against the return from the market portfolio—the characteristic line.
Rules of CAPM
:---E ( R p ) = R f + p [:---E ( R m ) - R f ]
E (R p) = Expected return of the portfolio R f = Risk free rate of Return
p = Portfolio Beta i.e. market sensitivity index
= change in expected rate of return change in market rate of return E(R m) = Expected Return on market portfolio
[E (R m) – R f ] = Market risk premium.
Portfolio Beta ( p) = (R sm) (S.D. s ) S.D.m Where,
R sm = Correlation Coefficient with market . S.D.s = Standard deviation of an asset .
S.D.m = Market Standard deviation . E(R m) = ( DIV + Cap. Gain ) Total Investment Capital Gain = Market Value - Value of Original Investment .
COST OF RETAINED EARNINGS ( Cr ) Cost of Retained Earnings
Two basic approach have been suggested for determining the cost of retained earnings : (i) tax adjusted rate of return approach, and (ii) external yield approach.
Tax-adjusted Rate of Return Approach The cost of retained earnings is calculated as the post-tax rate of return available to the investor. This means that k shas to be adjusted for ordinary and long-term capital gains tax. One way to
do it is as follows :
k r = k s 1 – t p
1 – tg
where k r = cost of retained earnings
k s = rate of return required by equity investors
t p = ordinary personal income tax rate
tg = personal long-term capital gains tax rate.
This approach is riddled with two problems : (i) The ordinary personal income tax rate and the personal long-term capital gains rate may vary widely across the shareholders of a company. Hence it may be impossible to establish a minimum rate of return that ensures that all the shareholders benefit if the company reinvests its cash flows instead of paying dividends. (ii) The alternative investment opportunities of the company are not considered.
External Yield Approach The basic premise of this approach is that the company should evaluate the possibility of buying shares of other companies with similar risk characteristics by using retained earnings. Hence the opportunity cost of retained earnings is deemed equal to the rate of return that can be earned on such investment. Since that rate of return is equal to k s, the cost of retained earnings is simply equal to k s. This approach appears to be superior
to the earlier approach. Hence in our subsequent discussion we will adopt this approach. Cr = Ce ( 1- b ) ( 1 - t )
Where b = rate of brokerage; t = marginal tax rate applicable to share holder If rate brokerage is not given , Cr = Ce
Overall Cost of Capital or Weighted Average of Capital
Cost of Capital or cut off rate ( Cw or Co ) = (Capital mix ratio x cost of each ingredients ) x 100 : Alternatively, Cw or Co = Total cost x 100
total capital MIX are taken on 4 different
1. Book value Basis 3. Marginal Basis
2. Market value Basis 4. Expected Cap. Structure basis
Market Value Of The Firm 1. Net Income Approach :
Value = { ( EBIT –I ) ( 1-t ) } market Capitalisation rate + value of debt
2. Net Operating Income Approach :
Value of equity = { ( EBIT market Capitalisation rate) - value of debt } ( 1- t ) Value of the firm = value of equity + value of debt
3. MODIGLIANI MILLER APPROACH
1. Value of the firm = EBIT Ce 2. Po = ( D1 + P1 ) ( 1 + Ce )
Where, Po = Market price per share of time 0 D1 = Dividend per share at that time. P1 = Market price per share at time 1. Ce = Market capitalisation rate.
3. In case of new financing : mp1 = I - (NP – nD1 )
where, m = no. of share to be issued, at time 1. I = new investment.
P = Price. NP = Net profit.
D1= Dividend per share at time 1.
4. Traditional Approach = interest Cd + Dividend Ce as there is no tax.
Financial BEP = Required PBIT to pay the fixed charges on capital .
EXPLAINING FINANCING CHOICES
Two theories are commonly advanced to explain real-world corporate financing behaviour, viz. The tradeoff theory and the pecking order theory.
Tradeoff Theory
While choosing the debt-equity ratio, financing managers often look at the tradeoff between the tax shelter provided by debt and the cost of financing distress. Figure 13.4 shows the nature of this tradeoff.
According to the trade-off theory, profitable firms with stable, tangible assets would have higher debt-equity ratios. On the other hand, unprofitable firms with risky, intangible assets tend to have lower debt-equity ratio.
Inventory of Resources
Available for use within:
Resources
One
quarter
One
year
Three
years
Uncommited reserves
Instant reserves
Surplus
cash
$
Unused line of credit
$
Negotiable reserves
Additional bank loans
Unsecured
$
Secured
$
Additional
long-term
debt
$
Issue
of
new
equity
$
Reduction of planned outflows
Volume-related
Change in production schedule
$
Scale-related
Marketing programme
$
R
&
D
budget
$
Administration
overhead
$
Capital
expenditures
$
Value-related
Dividend
payments
$
Liquidation of assets
How well does the tradeoff theory explain corporate financing behaviour? It explains reasonably well some industry differences in capital structures. Fore example, power companies and refineries use more debt as their assets are tangible and safe. High-tech growth companies, on the other hand, borrow less because their assets are mostly intangible and somewhat risky.
The trade-off theory, however, cannot explain why some profitable companies depend so little on debt. Fore example, Hindustan Lever Limited and Colgate Palmolive India Limited, two highly profitable companies, use very little debt. They pay large amounts by way of income tax which they can possibly save by using debt without causing any concern about their solvency.
Packing Order Theory
There is an alternative theory which explains why profitable firms use little debt. According to this theory, there is a pecking order of financing which goes as follows:
•
Internal finance (retained earnings)•
Debt financing•
External equity financeA firm first taps retained earnings. Its primary attraction is that it comes out of profits and not much effort is required to get it. Further, the capital market ordinarily does not view the use of retained earnings negatively.
When the financing needs of the firm exceed its retained earnings, it seeks debt finance. As there is very little scope for debt to be mispriced, a debt issue does not ordinarily cause concern to investors. Also, a debt issue prevents dilution of control.
Value of tax shelter Value of
The firm
Value with tax shelter & cost of Financial distress
Leverage Trade off Theory
External equity appears to be lest choice. A great deal of effort may be required in obtaining external equity. More important, while retained earnings is not regarded by the capital market as a negative signal, external equity is often perceived as ‘bad news’. Investors generally believe that a firm issues external equity when it considers its stock overpriced in relation to its future prospects.
Thus, according to the pecking order theory, there is no well-defined target debt-equity ratio, as there are two kinds of equity, internal and external. While the internal equity (retained earnings) is at the top of the pecking order, the external equity is at the bottom. The pecking order theory explains why highly profitable firms generally use little debt. They borrow less as they don’t need much external fi nance and not because they have a low target debt-equity ratio. On the other hand, less profitable firms borrow more because their financing needs exceed retained earnings and debt finance comes before external equity in the pecking order.
Proposition II of MM
M-M argue that the cost of equity, ko, is equal to a constant average cost of capital, ko, plus a risk premium
that depends on the degree of leverage. That is — ko = ko + Risk premium
The premium for financial risk equals to the difference between the pure equity capitalisation rate, ko, and
cost of debt, kd, times the ratio D/S, that is —
ke = ko(ko – kd) (D/S)
In short, Proposition II states that the firm’s cost of equity, ke, increases in a manner to offset exactly the
use of chapter debt capital. In other words, as the firm’s use of debt increase, its cost of equity also rises. Proposition II of M-M Hypothesis implies a linear relationship between keand the debt-equity ratio (D/S).
The M-M Hypothesis with corporate taxes
With introduction of corporate taxes, M-M change their position. They now recognize that the value of the firm will increase or the cost of capital will decrease with increase in leverage as interest on debt is a deductible expense.1 Between two firms, levered and unlevered, the levered firm will have a higher value
for the same reason. More specifically, the value of levered firm (L) will exceed that of unlevered firm (U) by an amount equal to L’s debt multiplied by the tax rate. That is —
VL= Vu = tD
Where, VL = value of the levered firm ;
Vu = value of the unleverd firm ;
t = corporate tax rate ; D = amount of debt in L. Proof
The proof of the above equation is given below :
Two firms are considered identical in all respects except capital structure. Assume that firm U (unlevered) finances by equity only while firm L (levered) employs debt. EBIT are identical in each firm. Under these assumptions, the operating cash flows (CF) available to investors firms U and L are computed as follows :
CFu = EBIT (1–t) … … (1) and CFL = (EBIT – I )(1 –t) + I … … (2) or CFL = (EBIT – kd.D) (1 – t) + kd.D = EBIT – kd.D – EBIT (t) + tkd+ kdD = EBIT – EBIT (t) + tkdD = EBIT (1 – t) + tkdD
where EBIT = earnings before interest and taxes I = interest on debt capital = kd.D
D = amount of debt in L t = corporate tax rate.
It may be mentioned that in equation (2) the first term to the right of the equation sign, i.e., (EBIT – I ) represents the income available to the shareholders ; the term ‘I’ or ‘kd.D’ is that available to the providers of debt capital. CFL is thus the total income available to all investors (equity plus debt ).
Firm U does not use debt capital. Its value, Vu, may, therefore, be determined by discounting its net
earnings after tax, i.e., EBIT (1 – t), by its equity capitalisation rate of cost of equity, ke. That is —
Vu = EBIT (1 – t) … … (3)
ke
The value of the levered firm is determined by capitalising1 both parts of its after-tax earnings. Thus —
VL = EBIT (1 – t) + tkd.D = EBIT (1 – t) + tD … (4)
ke kd ke
∴
VL = Vu + tD asVu = EBIT (1 – t)ke
Thus, M-M state that the value of a levered firm is equal to its value without leverage plus the present value of the interest tax shelter, which is equal to the tax rate times the value of the debt.
From equation (3) the cost of equity, ke, in the unlevered firm can be ascertained as follows :
ke(u) = EBIT (1 – t) … … (5)
Vu
Since it is financed by equity only, its average cost of capital, ko, is equal to its cost of equity, ke.
The cost of equity in the levered firm is the net earnings after tax divide by the value of the equity. That is —
ke(L) = ( EBIT – I ) (1–t ) … … (6)
S
The weighted average cost for the levered firm would be :
ko(L) = (D/V) (kd) (1 – t) + (S/V) (ke) … … (7)
M-M state that that, in a world with corporate taxes, the value of the firm increases and cost of capital decreases continuously with financial leverage. Thus, to achieve optimum capital structure the firm should use the maximum amount of debt.
Problems
1. X Ltd. , a widely held company is considering a major expansion of its production facilities and the following alternatives are available :
Alternatives (Rs. In lakhs)
A B C
SharesCapital 50 20 10
14%Debentures -- 20 15
Loan from a Financial Institution
@ 18% p.a. Rate of Interest -- 10 25
Expected rate of return before tax is 25%. The rate of dividend of the company is not less than 20%. The company at present has low debt. Corporate taxation 35%. Which of the alternatives you would choose ? 2. EXE Limited is considering three financing plans. The key information is as
Plans of Financing Proportion
Plans Equity Debt Preference Shares
A 100% -
-B 50% 50%
-C 50% - 50%
Cost of debt 8%
Cost of preference shares 8%
Tax rate 35%
Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share. Expected PBIT is Rs. 80,000.
Determine for each
plan:-1) Earnings per share (EPS)and 2) The financial break even point.
3) Indicate if any of the plans dominate and compute the PBIT range among the plans for indifference. 3. Aries Limited wishes to raise additional Finance of Rs. 10 lakhs for meeting its investment plans. It has Rs. 2,10,000
in the from of retained earnings available for investment purposes. The following are the further details:
1) Debt/equity mix 30% : 70%
2) Cost of debt
upto Rs. 1,80,000 10% (before tax)
beyond Rs. 1,80,000 16% (before tax)
3) Earnings per share Rs.4
4) Dividend pay out 50% of earnings
5) Expected growth rate in dividend 10% 6) Current market price per share Rs. 44
7) Tax rate 35%
You are required:
a) To determine the pattern for raising the additional finance. b) To determine the post-tax average cost of additional debt.
c) To determine to cost of retained earnings and cost of equity, and
d) Compute the overall weighted average after tax cost of additional Finance.
4. A B Limited provides you with following figures:- Rs.
Profit 3,00,000
Less Interest on Debentures @ 12% 60,000
2,40,000
Income tax @ 50% 1,20,000
1,20,000
Number of Equity Shares (Rs. 10 each 40,000
E.P.S (Earning Per Share) 3
Rulings price in market 30
PE ratio (Price/EPS) 10
The company has undistributed reserves of Rs. 6,00,000. The company needs Rs.2,00,000 for expansion. This amount will earn at the same rate as funds already employed. You are informed that a debt equity ratio (Debt/Debt+Equity) higher than 35% will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14%. You are required to ascertain the probable price of the share
1) If the additional funds are raised as debt; and 2) If the amount is raised by issuing equity shares.
5. The abridged Balance Sheet as at 31st March, 1999 of a company is as under :
Liabilities Rs. Assets Rs
Shares capital Fixed Assets 1,80,000
equity shares of Rs. 10 each 1,00,000 Current assets:
Revenue Reserves 1,50,000 Stocks 70,000
Trade Creditors 50,000 Debtors 50,000
The company in the next year plans to undertake a major capital investment which will, by 31st March 2000, increase the fixed assets by Rs. 70,000. Turnover for the year expected to go up by 50% and the profits before interest and taxes also are anticipated to increase by the same percentage, as will the creditors, stock and debtors.
The earnings before tax for the year ended 31st March, 2000 were Rs. 60,000 and the rate of company taxation was 50% Dividends at the rate of Re. 1 per share were paid at the end of that year. Dividends per share for the year 99-00 will be at the same rate per share. Tax rate is not expected to change.
The company needs large funds for the expansion programme and the finance division is examining the following alternatives for implementation.
a) issue of 10% convertible debentures for Rs. 2 lakhs: each Rs. 1,000 debenture is convertible into 80 equity shares; b) issue of debentures for Rs. 2 lakhs with interest warrants attached. Interest rate is to be fixed at 10% p.a. and each
Rs. 1,000 debentures will enable the holder to purchase 50 equity shares at Rs. 15 each.
c) making a rights issue, which would allow shareholders to buy 8 new shares at Rs. 12.50 each for every five shares presently held.
You are required to consider each of the alternatives separately. You are requested to indicate the effect of each financing method on the Balance Sheet as at 31st March, 1991 and also indicate the underlying per share (earnings per share based on the number of shares that have been issued as at 31st March, 1999). You are to assume that the debentures and rights issue will be made on 1st April, 1999. In the case of convertible debentures, assume that all the debentures are converted on 1st October, 1999. If funds are raised in excess of the needs of the company for 1999-00, you can assume that they will be held in the form of cash.
6. The stock of Tetratronix Ltd. is currently fairly priced by the market at Rs.50. It has paid a dividend of Rs.2 per share for the financial year ending March 31, 1999. The company is in the advertising business and the order book of the company for the current year is full. The prospects that some big multinational companies will become part of their clientele in near future and high. The dividend per share paid by the company is expected to grow at a rate of 25% for the next three years. After that, the growth rate is expected to drop to a stable level, determine the expected growth rate of the dividends after three years. Cfa I-2000q-5 7. Mr. X, an investor, purchases an equity share of a growing company Y for Rs. 210. He expects the company to pay dividends of Rs. 10.5, Rs. 11.025 and Rs. 11.575 in years 1, 2 and 3, respectively, and he expects to sell the shares at a price of Rs. 243.10 at the end of three years.
(i) Determine the growth rate in dividends
(ii) Calculate the current dividend yield.
(iii)What is the required rate of return of Mr. X on his equity investment? Kj 8. The capital structure of Swan & Co. comprising of 12% debentures, 9% preference shares and equity shares of Rs.100
each is in the proportion of 3: 2: 5.
The company is contemplating to introduce further capital to meet the expansion needs by seeking 14% term loan from financial institutions. As a result of this proposal, the proportions of debentures, preference shares and equity would get reduced by 1/10. 1/15 and 1/6 respectively.
In the light of above proposal calculate the impact on weighted average cost of capital assuming 35% tax rate, expected dividend of Rs. 9 per share at the end of the year and growth rate of dividends 5% No change in the dividend, growth rate and market price of share is expected after availing the proposed term loan.
9. The following items have been extracted from the of the Balance Sheet of XYZ Company as at 31 / 12 / 1998
:-Paid up Capital: Rs.
4,00,0000 Equity Shares of Rs. 10 each 40,00,000
Reserves and Surplus 60,00,000
Loans:
15% Non convertible Debentures 20,00,000
14% Institutional Loans 60,00,000
