Cost of Capital

Explicit and Implicit cost of capital

Explicit cost of capital of any source is the discount rate that equates the present value of cash inflows that are incremental to the taking of the financing oppurtunity with the prsent value of its incremental cash outflows.It is the internal rate of return cash inflows and outflows.

Implicit cost of capital is also known as the opportunity cost of capital.It is rate associated with best investment oppurtunity .

Eg. Mr X has a choice of investing Rs 1000 in the shares or bank deposits.at 12%.If he invests 1000 in shares  implicit cost of capital is 12%

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Cost of Debt

Debentures ,Bonds,Fixed deposits,Term loans ets..Debt may be issues and redeemed at par premium or discount.

1.Debt issued at par and redeemed at par/Cost of perpetual debt(irreedeemable debt.)

The before tax cost of debt(BTCD) is simply the interest offerd to the suppliers of money.

BTCD= Interest/Net proceeds.

Eg. A company issues 3years debentures of Rs 100 at 15% coupon rate .Calculate BTCD.

BTCD=15/100=15%

2.Debt issued and redeemped at discount or at a premium & Cost of existing debt.

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Cost of Preference Capital

These shares carry preferential rights with regard to payment of dividend and repayment of capital at the time of winding up.The measurement of the cost of preference capital poses some conceptual difficulty.

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Irredeemable Preference Share & Redeemable Preference Share

Irredeemable Preference Share

The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation (for a perpetuity):

kp = DIV+RV-NP/N/RV+NP/2

where kp is the cost of preference share, DIV is the expected preference dividend, Rv is redeemable value,NP is net proceeds now and N is number of years for maturity.

Redeemable Preference Share

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Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than the internal equity.

Is Equity Capital Free of Cost?

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Stability of Dividend

There may be three types of dividend policy

Strict or Conservative dividend Policy which envisages the retention of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company; (2) Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the current earing of the company. Under such policy company retains the minimum possible earnings; (3) Stable Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend policy, the market price of tis shares shall be higher. There are reasons why investors prefer stable dividend policy. Main reasons are:- 1. Confidence Among Shareholders. 2. Income Conscious Investors. 3. Stability in Market Price of Shares. 4. Encouragement to Institutional Investors.   for details visit- http://www.mbachannel.blogspot.in/2014/05/stability-of-dividend.html

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Factors Affecting Dividend Policy

A number of considerations affect the dividend policy of company. The major factors are

1. Stability of Earnings. 2. Age of corporation. 3. Liquidity of Funds. 4. Extent of share Distribution. 5. Needs for Additional Capital. 6. Trade Cycles.  7. Government Policies.  8. Taxation Policy. 9. Legal Requirements. 10. Past dividend Rates.  11. Ability to Borrow. 12. Policy of Control. 13. Repayments of Loan. 14. Time for Payment of Dividend. 15. Regularity and stability in Dividend Payment.

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Different types of Dividend

The profits of a company when made available for the distribution among its shareholders are called dividend. The dividend may be as a fixed annual percentage of paid up capital as in the case of preference shares or it may vary according to the prosperity of the company as in the case of ordinary shares.

Dividend may be of different types. It can be classified according to the mode of its distribution as follows

(1) Regular Dividend.  (2) Interim Dividend. (3) Stock-Dividend.  (4) Scrip Dividend.  (5) Bond Dividends.  (6) Property Dividend.  For details please visit- http://www.mbachannel.blogspot.in/2014/05/different-types-of-dividend.html.

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Dividend Relevance: Walter’s Model

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions:

1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued.

2. Constant return and cost of capital: the firm’s rate of return, r , and its cost of capital, k , are constant.

3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately.

4. Infinite time: the firm has infinite life

Valuation Formula: Based on the above assumptions, Walter put forward the following formula:

P = DIV + (EPS-DIV) r/k

k

P = market price per share

DIV= dividend per share

EPS = earnings per share

DIV-EPS= retained earnings per share

r = firm’s average rate of return

k= firm’s cost o capital or capitalisation rate

The above equation is reveals that the market price per share is the sum of two components:

The first component k

b. The second component (EPS-DIV) r/k is the present value of an infinite stream of

k returns from retained earnings.

Let’s apply the theoretical formula to a practical illustration to improve our understanding. We will take three models, one of a growth firm, the other normal firm and a declining firm. The financial data of all the three firms is given as follows:

Growth firm for details please visit- http://www.mbachannel.blogspot.in/2014/05/dividend-relevance-walters-model.html

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Gordon’s Model

Gordon proposed a model of stock valuation using the dividend capitalization approach. His model is based on the following assumptions:

1. All-equity firm: The firm is an all-equity firm, and it has no debt

2. No external financing: Retained earnings would be used to finance any expansion.

3. Constant return: The internal rate of return, r, of the firm’s investment is constant.

4. Constant cost of capital: The appropriate discount rate k for the firm remains       

constant and is greater than the growth rate.

5. No taxes: Corporate taxes do not exist.

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Modigliani-Miller (MM) supports irrelevance in dividend, how?

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm. They argue that the value of the firm depends on the firm’s earnings, which results from its investment policy. Thus, when investment decision of the firm is given, dividend decision –the split of earnings between dividends and retained earnings- is of no significance in determining the value of the firm

M-M constructed their arguments on the following assumptions:

• Perfect capital markets: The firm operates in perfect capital markets where investors behave rationally, information is freely available to all and transactions and flotation costs do no exist. Perfect capita; markets also imply that no investor is large enough to affect the market price of a share.

• No taxes: taxes do no exist or there are no differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains.

• Investment opportunities are known: the firm is certain with its investment opportunities and future profits.

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Long Term Sources of Finance

Long term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance.

Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

Shares

Venture Capital

Government Grant

Bank Loans

Mortgage

Owner's Capital

Retained Profit

Selling Assets

Lottery Funding

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Sources of short term finance

1) Trade creditors

2) Factoring

Factoring involves raising funds on the security of the company’s debts, so that cash is received earlier than if the company waited for the debtors to pay. Most factoring companies offer these three services:

3) Invoice Discounting

4) Bank Overdraft

5) Counter Trade

Composition of Short-Term Financing

The best mix of short-term financing depends on:

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Financial Management

Meaning of Financial Management

Financial management is broadly concerned with the acquisition of and use of funds by the business firm. Its scope may be defined in terms of the following questions.

<!--How large should the firm be and how fast should it grow?

<!--What should be the composition of firm’s assets?

<!--What should be the mix of firms financing?

<!--How should the firm analyze, plan and control its financial affairs?

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Objectives of Financial management

They can be classified into two heads.

1. Basic Objectives 2. Other Objectives

   Basic Objectives:
  Traditionally they areMaintenance of liquid assets 

   Maximization of profitability of the firm 

   Shareholders wealth maximization rather than profit maximization.

Maintenance of liquid assets:FM aims at maintenance of adequate liquid assets with the firm. The finance manager has to maintain a balance between liquidity and profitability.

Maximization of Profit: 

Wealth Maximization: 

Other Objectives:

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Methods Of Financial management

The term Financial method or Financial tool refers to any logical method technique to be employed for accomplishing the following goals:

    1.Measuring of effectiveness of firms actions and decisions.

    2.Measuring the validity of the decisions regarding accepting or rejecting the projects.

Following are the important financial tools used.

    1.Cost of capital-

    2.Trading on Equity: 

    3.Capital Budgeting appraisal-

    4.Ratio analysis: 

    5. ABC Analysis: 

   6. Fund flow analysis and cash flow analysis: 

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Financial Forecasting

It is, therefore, necessary for a new concern to estimate its requirements of funds properly. The financial requirements of a new company may be outlined under the following heads:

1. Cost of fixed assets including land and buildings, plant and machinery, furniture, etc. The amount invested in these items is called fixed capital.

2. Cost of current assets including cash, stock of goods (also called inventory of merchandise), book debts, bills, etc.

3. Cost of promotion including 

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Under-Capitalization

Under-Capitalization -Under-capitalization is just the reverse of over-capitalization. Sometimes a company, on the face of it, may have an insufficient capital but it may have large secret reservesThus, in case of well-established companies, there is a very large appreciation in the value of assets specially of buildings, plant and goodwill. Such appreciation is generally not brought into the books. Nevertheless these assets do bring profits and, therefor, the profits in such a company would appear to be much larger than are warranted by the book figures of the capital. In such a case, the dividends will be high and the market quotations of the shares of such companies will be higher than the par value of the shares of other similar companies. It is in this sense that an under-capitalized company pays high rates of dividend and the value of the shares is higher than the par value. A company is under-capitalized when its actual capitalization (i.e., total long-term resources) is lower than its proper capitalization as warranted by its earning capacity. Such a company will earn considerable more than the prevailing rate on its outstanding securities.

The possible corrections for under-capitalisation may be outlined as under:

             (i)Splitting-up of shares.
(ii) Increase in par value of shares. 
(iii) Issue of bonus shares.

Disadvantages of Under-Capitalization

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Factors determining working capital requirements

• Nature of business
• Size of business
• Production policy

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