ACKNOWLEDGEMENT A large number of individual has contributed to this project.

I am thankful to all of them for their help and encouragement. Like other reports, this report is also drawn from the work of large number of researchers and author in the field of finance. I would like to express my gratitude to Mr. N.C. Jain S.G.M. (finance) for giving me the opportunity and enough of support to undergo training in their organization, SHREE CEMENT LTD, BEAWER (RAJ) I shall like to thanks SHREES finance department for their able guidance, support, supervision and care during the whole training programme and to whom words can never express my feeling of gratitude and reverence. I would like to give my sincere thanks to officers, managers and employees of SHREE CEMENT LTD, BEAWER (RAJ) for providing valuable information, reports and data that were require for the study. The successful completion of my project has been carried out under the table guidance of Mr. N.C Jain S.G.M (finance). I take upon this opportunity to thank them for encouragement and guidance in completion of project. Their knowledge and expertise was of great help for the project study. Last but not least, I would like to express my deep sense of gratitude to my parents and friends for their unflinching moral support. Their towering presence instilled in me the carving to the work harder and completes this daunting task timely with a sufficient degree of in depth study. I have tried to give credit to all sources form where I have drawn material in this project still I fell obliged if they are brought to my notice.
1

PREFACE About three decade ago, the scope of financial management was confined to the raising of funds, whenever needed and little significance used to be attached to financial decision-making and problem solving. As a consequence, the traditional finance texts were structured around this theme and contained description of the instruments and institutions of raising funds and of the major events, such as promotion, reorganization, Readjustment, merger, consolidation etc. When funds were raised. In the mid fifties, the emphasis shifted to the judicious utilization of funds. The modern thinking in financial management accords a far greater importance to management decision-making and policy. Today, financial management donot perform the passive role of scorekeepers of financial data and information, and arranging funds, whenever directed to do so. Rather, they occupy the key position in top management areas and play a dynamic role in solving complex management problems. They are now responsible for the fortune of the enterprises and are involved in the most vital management decision of allocation of capital. It is their duty to insure the funds are raised most economically and used in the most efficient and effective manner. Because of this change in emphasis, the descriptive treatment of the subject of financial management is being replaced by growing analytical content and sound theoretical underpinnings.

COST OF CAPITAL The main objective of a business firm is to maximize the wealth of its shareholders in the long-run, the Management Should only invest in those projects which give a return in excess of cost of fund invested in the project of the business. The difficulty will arise in determination of cost of funds, if is raised from different sources and different quantum. The various sources of funds to the company are in the form of equity and debt. The cost of capital is the rate of return the company has to pay to various suppliers of fund in the company. There are main two sources of capital for a company shareholder and lender. The cost of equity and cost of debt are the rate of return that need to be offered to those two groups of suppliers of the of capital in order to attract funds from them. The primary function of every financial manager is to arrange adequate capital for the firm. A business firm can raise capital from various sources such as equity and or preference shares, debentures, retain earning etc. This capital is invested in different projects of the firm for generating revenue. On the other hand, it is necessary for the firm to pay a minimum return to each source of capital. Therefore, each project must earn so much of the income that a minimum return can be paid to these sources or supplier of capital. What should be this minimum return? The concept used to determine this minimum return is called Cost of Capital. On the basis of it the management evaluates alternative sources of finance and select the optimal one. In this chapter, concepts and
3

implications of firms cast of capital, determination of cast of difference sources of capital and overall cost of capital are being discussed. DEFINING THE COST OF CAPITAL The cost of capital is the cost of obtaining funds, through debt or equity, in order to finance an investment.

NET PRESENT VALUE EQUATION 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. CONCEPT OF COST OF CAPITAL Cost of capital is the measurement of the sacrifice made by investors in order to invest with a view to get a fair return in future on his investments as a reward for the postponement of his present needs. On the other hand form the point of view of the firm using the capital, cast of capital is the price paid to the investor for the use of capital provided by him. Thus, cost of capital is reward for the use of capital. Author Lutz has called itBORROWING AND LANDING RATES. The borrowing rates means the rate of interest which must be paid to obtained
4

and use the capital. Similarly, landing rate is the rate at which the firn discounts its profits.It may also the opportunity cost of the funds to the firm i.e. what the firm would earn by investing these funds elsewhere. In practice the borrowing rates used indicate the cost of capital in preference to landing rates. Technically and Operationally, the cost of capital define as the minimum rate of return a firm must earn on its investment in order to satisfy investors and to maintain its market value. I.e. it is the investors required rate of return. Cost of capital also refers to the discount rate which is used while determining the present value of estimated future cash flows. In the other word of John J. Hampton, The cost of capital is the rate of return in the firm requires from investment in order to increase the value of firm in the market place . For example if a firm borrows Rs. 5 crore at an interest of 11% P.A., then the cost of capital is 11%. Hear its the essential for the firm to invest these Rs. 5 Crore in such a way that it earn at least Rs. 55 lacks i.e. rate of return at 11%. If the return less then this, then the rate of dividend which the share holder are receiving till now will go down resulting in a decline in its market value thus the cost of capital is the reward for the use capital. Solomon Ezra, has called It the minimum required rate of return or the cut of rate for capital expenditure.

DETERMINATION OF COST OF CAPITAL Problems in determination It has already been stated that the cost of capital is one of the most crucial factors in most financial management decisions. However, the determination of the cost of capital of a firm is not an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems can briefly be summarized as follows: 1. Controversy regarding the dependence of cost of capital upon the method and level of financing There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing. In other words, according to them, a firm can change its overall cost of capital by changing its debtequity mix. On the other hand, the modern theorists such as Modigliani and Miller argue that the firm's total cost of capital is independent of the method and level of financing. In other words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.

2. Computation Of Cost Of Equity The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. In other words, it is the rate of return which the equity shareholders expect from the shares of the company which will maintain the present market price of the equity shares of the company. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares of accompany on the basis of a large number of factors, financial as well as psychological. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. Their methods andcalculations differ.

3. Computation of cost of retained earnings and depreciation funds The cost of capital raised through these sources will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.

4. Future costs versus historical costs It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds. 5. Problem of weights The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case. It is clear from the above discussion that it is difficult to calculate the cost of capital with precision. It can never be a single given figure. At the most it can be estimated with a reasonable range of accuracy. Since the cost of capital is an important factor affecting managerial decisions, it is imperative for the finance manager to identify the range within which his cost of capital lies.

PROBLEMS IN DETERMINATION OF COST OF CAPITAL It has already been stated that the
financial management decisions

cost of capital

is

one of the most crucial factors

in most

. However, the determination of the cost of capital of a firm is not

an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems can briefly be summarized as follows:

1. Controversy regarding the dependence of cost of capital upon the method and level of financing There is a, major controversy whether or not the dependent upon the

cost of capital

method and level of financing by the company. According to the traditional theorists, the cost of capital of a firm depends upon the method and level of financing. In other words, according to them, a firm can change its overall cost of capital by changing its
debt-equity mix

. On the other hand, the modern theorists

such as Modigliani and Miller argue that the firms total cost of capital is independent of the method and level of financing. In other words, the change in the debt-equity ratio does not affect the total cost of capital. An important assumption underlying MM approach is that there is perfect capital market. Since
perfect capital market

does not exist in practice, hence the approach is not of much practical utility. 2. Computation of cost of equity The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is
equity capital financed by

so that the market price of the shares of the company remains

unchanged. In other words, it is the rate of return which the equity shareholders expect from the shares of the company which will maintain the present market price of the equity shares of the company. This means that determination of the cost

of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders
shares value the equity

on the basis of a large number of factors, financial as well as

psychological. Different authorities have tried in different ways to quantify the expectations of the equity shareholders. Their methods and calculations differ. 3. Computation of cost of retained earnings and depreciation funds The cost of capital raised through these sources will depend upon the approach adopted for
computing the cost of equity capital

. Since there are different views, therefore,

a finance manager has to face difficult task in subscribing and selecting an appropriate approach. 4. Future costs versus historical costs It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider
marginal cost of capital

, i.e., cost of additional funds or

the average cost of capital

i.e., the cost of total funds.

5. Problem of weights

10

The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case. It is clear from the above discussion that it is difficult to calculate the cost of capital with precision. It can never be a single given figure. At the most it can be estimated with a reasonable range of accuracy. COMPUTATION OF COST OF CAPITAL Computation of cost of capital involves: (i)Computation of cost of each specific source of finance-termed as computation of specific costs and (ii)Computation of composite cost termed as weighted average cost.

COST OF DEBT Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained later. it is imperative for the finance manager to identify the range within which his cost of capital lies. Cost of each specific source of finance, viz., debt, preference capital and equity capital, can be determined as follows: Cost of Debt

11

Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained later.

(a) DEBT ISSUED AT PAR: The computation of cost of debt issued at par is comparatively an easy task. It is the explicit interest rate adjusted further for the tax liability of the company. It may be computed according to the following formula: Kd = (l-T)R where Kd = Cost of debt; T = Marginal tax rate;R = Debenture interest rate.

(b) DEBT ISSUED AT PREMIUM OR DISCOUNT: In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realized on account of issue of such debentures or bonds. Such cost may further be adjusted keeping in view the tax applicable to the company.

(c) COST OF REDEEMABLE DEBT In the preceding pages while calculating cost of debt we have presumed that debentures/bonds are not redeemable during the lifetime of the company. However, if the debentures are redeemable after the expiry of a fixed period the

12

effective cost of debt before tax can be calculated by using the following formula: I + (P - NP)/nKd(before tax) = (N + NP)/2whereI = Annual interest payment,P = Par value of debentures, NP = Net proceeds of debentures,n = Number of years to maturity.

ZERO COUPON BOND VALUE

A zero coupon bond, sometimes referred to as a pure discount bond or simply discount bond, is a bond that does not pay coupon payments and instead pays one lump sum at maturity. The amount paid at maturity is called the face value. The term discount bond is used to reference how it is sold originally at a discount from its face value instead of standard pricing with periodic dividend payments as seen otherwise. As shown in the formula, the value, and/or original price, of the zero coupon bond is discounted to present value. To find the zero coupon bond's value at its original price, the yield would be used in the formula. After the zero coupon

13

bond is issued, the value may fluctuate as the current interest rates of the market may change. Example of Zero Coupon Bond Formula A 5 year zero coupon bond is issued with a face value of $100 and a rate of 6%. Looking at the formula, $100 would be F, 6% would be r, and t would be 5 years.

After solving the equation, the original price or value would be $74.73. After 5 years, the bond could then be redeemed for the $100 face value. FLOATING OR VARIABLE RATE DEBT Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money
market reference rate

, like LIBOR or federal funds rate, plus a quoted spread (a.k.a. quoted margin).

The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.

VARIATIONS Some FRNs have special features such as maximum or minimum coupons, called "capped FRNs" and "floored FRNs". Those with both minimum and maximum coupons are called "collared FRNs". "Perpetual FRNs" are another form of FRNs that are also called irredeemable or unrated FRNs and are akin to a form of capital.

14

FRNs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. This combination is known as an Asset Swap.

Perpetual Notes (PRN) Variable Rate Notes (VRN) Structured FRN Reverse FRN Capped FRN Floored FRN Collared FRN Step up recovery FRN (SURF) Range/corridor/accrual notes Leveraged/Deleveraged FRN

A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN. Deleveraged FRN = Long Pure FRN + Short (1 - Leverage factor) x Swap A leveraged or super floater gives the investor increased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative. Leveraged FRN = Long Pure FRN + Long (Leverage factor - 1) x Swap + Long (Leverage factor) x Floor.

15

COST OF PREFERENCE CAPITAL The computation of the cost of preference capital however poses some conceptual problems. In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of preference shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share capital do not constitute cost. However, this is not true. This is because, though it is not legally binding on the company to pay dividends on preference shares, it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be better of serious concern from the point of view of equity shareholders. They may even lose control of the company because of the preference shareholders getting the legal right to participate in the general meetings of the company with equity shareholders under certain conditions in the event of failure of the company to pay them their dividends. Moreover, the accumulation of arrears of preference dividends may adversely affect the right of equity shareholders to receive dividends. This is because no dividend can be paid to them unless the arrears of preference dividend are cleared. On account of these reasons the cost of preference capital is also computed on the same basis as that of debentures. The method of its computation can be put in the form of the following equation: DpKp = NPwhere Kp == Cost of preference share capitalDp = Fixed preference dividend Np = Net proceeds of preference shares.

16

COST OF REDEEMABLE PREFERENCE SHARES In case of redeemable preference shares, the cost of capital is the discount rate that equals the net proceeds of sale of preference shares with the present value of future dividends and principal repayments. Such cost can be calculated according to the same formula which has been given in the preceding pages for calculating the cost of redeemable debentures.

COST OF EQUITY CAPITAL The computation of the cost of equity capital is a difficult task. Some people argue, as observed in case of preference shares, that the equity capital does not involve any cost. The argument put forward by them is that it is not legally binding on the company to pay dividends to the equity shareholders. This does not seem to be a correct approach because the equity shareholders invest money in shares with the expectation of getting dividend from the company. The company also does not issue equity shares without having any intention to pay them dividends. The market price of the equity shares, therefore, depends upon the return expected by the shareholders. Conceptually cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment in a project in order to leave unchanged the market price of such shares. For example, in case the required rate of return on equity shares is 16% and cost of
17

debt is 12%,and the company has the policy of financing with 75%equity and 25% debt, the required rate of return on the project could be estimated as follows: 1 6 % x . 7 5 = 1 2 % 1 2 % x . 2 5 = 3 % 15% This means that if the company accepts a project involving an investment of Rs.l0,000, and giving an annual return of Rs. l,500, the project would provide a return which is just sufficient to leave the market value unchanged of the company's equity shares.

FEATURES OF COST OF CAPITAL It is not a cost in reality the cost of capital is not a cost as such, but its rate of return which it requires on the projects.

MINIMUM RATE OF RETURN Cost of capital is the minimum rate of return a firm is required in order to maintain the market value of its equity shares. COST OF RETAINED EARNINGS The companies do not generally distribute the entire profits earned by them by way of dividend among their shareholders. Some profits are retained by them for future expansion of the business. Many people feel that such retained earnings are absolutely cost free. This is not the correct approach because the amount retained by company, if it had been distributed among the shareholders
18

by way of dividend, would have given them some earning. The company has deprived the shareholders of this earnings by Retaining a part of profit with it. Thus, the cost of retained earnings is the earning forgone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of the retained earnings. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments. For example, if the shareholders could have invested the funds in alternative channels, they could have got a return of 10%. This return of 10% has been forgone by them because of the company is not distributing the full profits to them. The cost of retained earnings may, therefore, be taken at 10%. 16% x .75 =12%12% x .25 = 3 % 15%

The above analysis can also be understood in the following manner. Suppose the earnings not retained by the company is passed on to the shareholders, and are invested by the shareholders in the new equity shares of the same company, the expectation of the shareholders from the new equity shares would be taken as the opportunity cost of the retained earnings. In other words, if earnings were paid as dividends and simultaneously an offer for the right shares was made, the shareholders would have subscribed to the right shares on the expectation of certain return. This expected return can be taken as the cost of retained earnings of the company.

19

TAX ADJUSTED RETURN In the example given above, we have presumed that the shareholders will have with them the amount of retained earnings available when distributed by the company. In actual practice, it does not happen. The shareholders have to pay tax on the dividends received, incur brokerage cost for making investments, etc. The funds available with the shareholders are, therefore, less than what they would have been with the company, had they been retained by it. On account of this reason, the cost of retained earnings to the company would be always less than the cost of new equity shares issued by the company (see illustration).The following adjustments are made for ascertaining the cost of retained earnings:

(I) INCOME TAX ADJUSTMENT The dividends receivable by the shareholders are subject to income tax. Hence, the dividends actually received by them are not the amount of gross dividends but the amount of net dividend, i.e., gross dividends less income tax.

(II) BROKERAGE COST ADJUSTMENT Usually, the shareholders have to incur some brokerage cost for investing the dividends received. Thus, the funds available with them for reinvesting will be reduced by this amount. The opportunity cost of retained earnings to the shareholders is, therefore, the rate of return that they can obtain by investing the

20

net dividends (i.e., after tax and brokerage) in alternative opportunity of equal quality. The computation of the cost of retained earnings, after making adjustment for tax liabilities, is a difficult process because personal income tax rates will differ from shareholder to shareholder. Thus, it will be necessary to find out the personal income-tax rates of the different shareholders of the company in case cost of retained earnings it to be calculated according to the above approach. In case of a widely held public company, there are a large number of shareholders of varying means and incomes. It is, therefore, almost impossible to determine a single tax rate that would correctly reflect the opportunity cost of retained earnings to every shareholder. Even computation of a weighted average tax would also not give satisfactory results. Some authorities have, therefore, recommended the use of another approach termed by them as external yield criterion. According to this approach the opportunity cost of retained earnings is the rate of return that can be earned by investing the funds in another enterprise by the firm. Thus, according to this approach, the cost of retained earnings is simply the return on direct investment of funds by the firm and not what the shareholders are able to obtain on their investments. The approach represents an economically justifiable opportunity cost that can be applied consistently. Moreover, the need for determining the marginal tax rate for investors will not arise in case the approach is follows. The "External Yield Criterion", suggested above, has not yet been universally accepted. In the absence of a universally
21

acceptable and practically feasible method for determining separately the cost of retained earnings, many accountants calculate the cost of retained earnings on the same pattern as that of equity shares. Moreover, when the cost of funds raised by equity shares, the need for determining the separate cost for retained earnings does not at all arise. Some calculate it on the Dividend Payout Basis.

WEIGHTED AVERAGE COST OF CAPITAL After calculating the cost of each component of capital, the average cost of capital is generally calculated on the basis of weighted average method. This may also be termed as overall cost of capital. The computation of the weighted average cost of capital involves the following steps:

1. CALCULATION OF THE COST OF EACH SPECIFIC SOURCE OF FUNDS: This involves the determination of the cost of debt, equity capital, preference capital, etc., as explained before. This can be done either on "before tax" basis or "after tax" basis. However, it will be more appropriate to measure the cost of capital on "after tax basis". This is because the return to the shareholders is an important figure in determining the cost of CapitaLand they can get dividends only after the taxes have been paid.

22

2. ASSIGNING WEIGHTS TO SPECIFIC COSTS This involves determination of the proportion of each source of funds in the total capital structure of the company. This may be done according to any of the following method.

(a) MARGINAL WEIGHTS METHOD: In case of this method weights are assigned to each source of funds, in the proportion of financial inputs the firm intends to employ. The method is based on the logic that our concern is with the new or incremental capital and not with capital raised in the past. In case the weights are applied in a ratio different than the ratio in which the new capital is to be raised, the weighted average cost of capital so calculated may be different from the actual cost of capital. This may lead to wrong capital investment decisions. However, the method of marginal weighting suffers from one major limitation. It does not consider the long-term implications of the firm's current financing. A firm should give due attention to long-term implications while designing the firm's financing strategy. For example, a firm may accept a project giving an after-tax return of 6% because it intends to raise the funds required by issue of debentures having an after-tax cost of 5%. In case next year the firm intends to raise funds by issue of equity shares having a cost of 9%, it will have to reject a project which gives are turn of only 8%. Thus, marginal weighting method does not consider the fact that today's financing affects tomorrows cost.
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(B) HISTORICAL WEIGHTS METHOD According to this method the relative proportions of various sources to the existing capital structure are used to assign weights. Thus, in case of this method the basis of weights is the proportion of funds already employed by the firm. This is based on the assumption that the firm's present capital structure is optimum and it should be maintained in the future also. Weights under historical system may be either (i) book value or (ii) market value weights. The weighted average cost of capital will be different, depending upon whether book value weights are used or market value weights are used. The use of market value weights for calculating the cost of capital is theoretically more appealing on account of the following reasons: (i)The market values of the securities are closely approximate to the actual amount to be received from the sale of such securities. (ii)The cost of each specific source of finance which constitutes the capital structure is calculated according to the prevailing market price. However, the use of market value as weights is subject to the following practical difficulties:(i) The market values of the securities may fluctuate considerably.(ii) Market values are not readily available as compared to the book values. The book values can be taken from the published records of the firm.(iii)The analysis of the capital structure of the company, in terms of debtequity ratio, is based on the book values and not on the market-values. Thus, market value weights are operationally inconvenient as compared to book value
24

weights. However, market value weights are theoretically consistent and sound, hence they are a better indicator of the firm's cost of capital.3. Adding of the weighted cost of all sources of funds toget on overall weighted average cost of capital.

REWARDS FOR RISKS Cost of capital is the reward for the business and financial risk. Business risks is the measurement of variability in profits due to changes un sales, while financial risks depends on the capital structure.

SIGNIFICANCE OF CONCEPT OF COST OF CAPITAL The cost of capital is very important concept in the financial decision making. The progressive management always likes to consider the cost of capital while taking financial decisions as its very relevant in the following spheres:1. Designing the capital structure: the cost of capital is the significant factor in designing a balanced an optimal capital structure of a firm. While designing it, the management has to consider the objective of maximizing the value of the firm and minimising cost of capita. I comparing the various specific costs of different sources of capital, the financial manager can select the best and the most economical source of finance and can designed a sound and balanced capital structure.

25

2. Capital budgeting decisions: the cost of capital sources as a very useful tool in the process of making capital budgeting decisions. Acceptance or rejection of any investment proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of return is greater then the cost of capital. In various methods of discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines acceptability of all investment proposals by discounting the cash flows. 3. Comparative study of sources of financing: there are various sources of financing a project. Out of these, which source should be used at a particular point of time is to be decided by comparing cost of different sources of financing. The source which bears the minimum cost of capital would be selected. Although cost of capital is an important factor in such decisions, but equally important are the considerations of retaining control and of avoiding risks. 4. Evaluations of financial performance of top management: cost of capital can be used to evaluate the financial performance of the top executives. Such as evaluations can be done by comparing actual profitability of the project undertaken with the actual cost of capital of funds raise o finance the project. If the actual profitability of the project is more then the actual cost of capital, the performance can be evaluated as satisfactory. 5. Knowledge of firms expected income and inherent risks: investors can know the firms expected income and risks inherent there in by cost of
26

capital. If a firms cost of capital is high, it means the firms present rate of earnings is less, risk is more and capital structure is imbalanced, in such situations, investors expect higher rate of return. 6. Financing and Dividend Decisions: the concept of capital can be conveniently employed as a tool in making other important financial decisions. On the basis, decisions can be taken regarding dividend policy, capitalization of profits and selections of sources of working capital. CLASSIFICATION OF COST OF CAPITAL 1. Historical Cost and future Cost

Historical Cost represents the cost which has already been incurred for financing a project. It is calculated on the basis of the past data. Future cost refers to the expected cost of funds to be raised for financing a project. Historical costs help in predicting the future costs and provide an evaluation of the past performance when compared with standard costs. In financial decisions future costs are more relevant than historical costs. 2. Specific Costs and Composite Cost

Specific costs refer to the cost of a specific source of capital such as equity share. Preference share, debenture, retain earnings etc. Composite cost of capital refers to the combined cost of various sources of finance. In other words, it is a weighted average cost of capital. It is also termed as overall costs of capital. While evaluating a capital expenditure proposal, the composite cost of capital

27

should be as an acceptance/ rejection criterion. When capital from more than one source is employed in the business, it is the composite cost which should be considered for decision-making and not the specific cost. But where capital from only one source is employed in the business, the specific cost of those sources of capital alone must be considered. 3. Average Cost and Marginal Cost Average cost of capital refers to the weighted average cost of capital calculated on the basis of cost of each source of capital and weights are assigned to the ratio of their share to total capital funds. Marginal cost of capital may be defined as the Cost of obtaining another rupee of new capital. When a firm raises additional capital from only one sources (not different sources), than marginal cost is the specific or explicit cost. Marginal cost is considered more important in capital budgeting and financing decisions. Marginal cost tends to increase proportionately as the amount of debt increase. 4. Explicit Cost and Implicit Cost Explicit cost refers to the discount rate which equates the present value of cash outflows or value of investment. Thus, the explicit cost of capital is the internal rate of return which a firm pays for procuring the finances. If a firm takes interest free loan, its explicit cost will be zero percent as no cash outflow in the form of interest are involved. On the other hand, the implicit cost represents the rate of return which can be earned by investing the funds in the alternative investments. In other words, the opportunity cost of the funds is the implicit
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cost. Port field has defined the implicit cost as the rate of return with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted. Thus implicit cost arises only when funds are invested somewhere, otherwise not. For example, the implicit cost of retained earnings is the rate of return which the shareholder could have earn by investing these funds, if the company would have distributed these earning to them as dividends. Therefore, explicit cost will arise only when funds are raised whereas implicit cost arises when they are used.

ASSUMPTION OF COST OF CAPITAL While computing the cost of capital, the following assumptions are made: The cost can be either explicit or implicit. The financial and business risks are not affected by investing in new investment proposals. basis. Costs of previously obtained capital are not relevant for computing the cost of capital to be raised from specific source. The firms capital structure remains unchanged. Cost of each source of capital is determined on an after tax

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COMPUTATION OF SPECIFIC COSTS A firm can raise funds from different sources such as loan, equity shares, preference shares, retained earnings etc. All these sources are called components of capital. The cost of capital of these different sources is called specific cost of capital. Computation of specific cost of capital helps in determining the overall cost of capital for the firm and in evaluating the decision to raise funds from a particular source. The computation procedure of specific costs is explained in the pages that follow

COST OF DEBT CAPITAL Cost of Debt is the effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; however, because interest expense is deductible, the after-tax cost is seen most often. This is one part of the company's capital structure, which also includes the cost of equity. Much theoretical work characterizes the choice between debt and equity, in a trade-off context: Firms choose their optimal debt ratio by balancing the benefits and costs. Traditionally, tax savings that occur because interest is deductible while equity payout is not have been modeled as a primary benefit of debt. Large firms with tangible assets and few growth options tend to use a relatively large amount of debt. Firms with high corporate tax rates also tend to
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have higher debt ratios and use more debt incrementally. A company will use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea as to the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt. Example-: If a company issues 12% debentures worth Rs. 5 lacs of Rs. 100 each at par, then it must be earn at least Rs.60000(12% of Rs. 5 lacs) per year on this investment to maintain the income available to the shareholders unchanged. If the company earnws less than this interest rate (12%) than the income available to the shareholders will be redused and the market value of the share will go down. Therefore, the cost of debt capital is the contractual interest rate adjusted further for the tax liability of the firm. But, to know the real cost of debt, the relation of the interest rate is to be established with the actual amount realised or net proceeds from the issue of debentures. To get the after-tax rate, you simply multiply the before-tax rate by one minus the marginal tax rate. Cost of Debt = (before-tax rate x (1-marginal tax)) The before tax rate of interest can be calculated as below:

Interest Expense of the company 100 ---------------------------------------X

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Total Debt

Net Proceeds: 1. 2. 3. At par At premium At Discount = Par value Floatation cost = Par value + Premium Floatation cost = Par value Discount Floatation cost

COST OF PREFERENCE SHARE CAPITAL Preference share is another source of Capital for a company. Preference Shares are the shares that have a preferential right over the dividends of the company over the common shares. A preference shareholder enjoys priority in terms of repayment vis--vis equity shares in case a company goes into liquidation. Preference shareholders, however, do not have ownership rights in the company. In the companies under observation only India Cement has preference shares issued. Cost of Preference Capital = Preference Dividend/Market Value of Preference Shree Cement has not paid any dividend to the Preference Shareholders. Thus the Cost of Preference Capital is 0 (Zero).

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COST OF EQUITY SHARE CAPITAL The computation of cost of euity share capital is relatively diffiult because nether the rate of dividend is predetermind nor the payment of dividend is legally binding, therefore, some financial experts hold the opinion the p.s capital does not carry any cost but this is not true. When additional equity shares are issued, the new equity share holders get propranate share in future dividend and undistributed profits of the company. If reduces the earning per shares of excisting share holders resulting in a fall in marker price of shares. Therefore, at the time of issue of new equity shares, it is the duty of the management to see that the company must earn atleast so much income that the market price of its ecisting share remains unchanged. This expected minimum rate of return is the cast o equity share capital. Thus, cost of equity sahre capital may be define as the minimum rate of return that a firm must earn on the equity financed portion of a investment- project in order to leave unchanged the market price of its shares. The cost of equity can be computed by any of the following method: 1. Dividend yield method: Ke = DPS\mP*100 Ke= cost of equity capital Dps= current cash dividend per share Mp=current market price per share
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2. Earning yield method: Ke= EPS\mp*100 Eps= earning per share 3. Divideng yield plus growth in dividend method: While computing cost of capital under dividend yield(d\p ratio)method, it had been asumend that present rate of dividend will remail the same in future also. But, if the management astimates that companies prestnet dividend will increased continuisly for the year to come, then adjustment for this increase is essential to compute the cost of capital. The growth rate in dividend is assumed to be equal to the growth rate in earning per share. For example if the EPS increase at the rate of 10% per year, the DPS and market price per share would show an increase at the rate of 10%. Therefore, under this method, cost of equity capital is computed by adjusting the present rate of dividend on the basis of expected future increase in companys earning. Ke= DPS\MP*100+G G= Growth rate in dividend. 4. Realised yield methd: In case where future dividend and market price are uncertain, it is very difficult to estimate the rate of return on investment. In order to overcome this difficulty,
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the average rate of return actually relise in the past few year by the investors is used to determine the cost of capital. Unddr this method, the realised yield is discounted at the present value factor, and then compare with value of investment this method is based on these assumptions. The companys risk doe not change i.e. dividend and growth rate are stable. The alternative investment opportuinities, elsewhere for the investor, yield the return wshich is equal to realised yiels in the company, and The market of equity share of the company does not fluctuate widly.

COST OF NEWLY ISSUED EQUITY SHARES When new equityshare are issued by a company, it is not possible to realise the marlet price per share, because the company has to incur some expenses on new issue, including underwriting commission, brokerage etc. so, the amount of net proceeds is calculated by deducting the issue expenses form the expected marlet value or issue price. To acertain the cost of capital, dividend per share or EPS is divided by the amount of net proceeds. Any of the following formulae may be used for this purpose: Ke= DPS\NP*100 Or Ke= EPS\NP*100 Or Ke=DPS\NP*100+G
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COST OF RETAIN EARNINGS OR INTERNAL EQUITY Generally, compnays do not distribute the entire profits by way of dividend among their share holders. A part of such profit is reatianed for future expantion and development. Thus year by year, companies create sufficiat fund fior the fianancing thrugh internal sources. But , nether the company pays any cost nor incur any expenditure for such funds. Therefore, it is assumed to cost free capital that is not true. Though ratain earnings like retained earnings like equity funds have no explicit cost but do have opportunity cost. The opportunity cost iof retained earnings is the income forgone by the share holders. It is equal to the income what a share holders culd have earn otherwise by investing the same in an alternative investment, If the company would have distributed the earnings by way of dividend instead of retaining in the busieness. Therefore , every share holders expects from the company that much of income on ratined earnings for which he is deprived of the income arising o its alternative investment. Thus, income forgone or sacrifised is the cost of retain earnings which the share holders expects from the company.

WEIGHTED AVERAGE COST OF CAPITAL Once the specific cost of capital of the long-term sources i.e. the debt, the preference share capital, the equity share capital and the retained earnings have
36

been ascertained, the next step is to calculate the overall cost of capital of the firm. The capital raised from various sources is invested in different projects. The profitability of these projets is evaluated by comparing the exprcted rate of return with overall cost of apital of the firm. The overall cost of capital is the weighted average of the costs of the various sources of the funds, weights being the proportion of each sources of funds in the total capital structure. Thus, weighted average as the name implies, is an average of the cost of specific sources of capital employed in the business properly weighted by the proportion they held in firms capital structure. It is also termed as Composite Cost of Capital or Overall Cost of Capital or Average Cost of Capital.

WEIGHTED AVERAGE, How to calculate? Though, the concept of weighted average cost of capital is very simple. Yet there are many problems in its calculation. Its computation requires : 1. Assignment of Weights : First of all, weights have to be assigned to each source of capital for calculating the weighted average cost of capital. Weight can be either book value weight or market value weight. Book value weights are the relative proportion of various sources of capital to the total capital structure of a firm. The book value weight can be easily calculated by taking the relevant information from the capital structure as given in the balance sheet of the firm. Market value weights may be calculated on the
37

basic on the market value of different sources of capital i.e. the proportion of each source at its market value. In order to calculate the market value weights, the firm has to find out the current market price of each security in each category. Theoretically, the use of market value weights for calculating the weighted average cost of capital is more appealing due to the following reasons: The market value of securities is closely approximate to the actual amount to be received from the proceeds of such securities. The cost of each specific source of finance is calculated according to the prevailing market price. But, the assignment of the weight on the basic of market value is operationally inconvenient as the market value of securities may frequently fluctuate. Moreover, sometimes, no market value is available for the particular type of security, especially in case of retained earnings can indirectly be estimated by Gitmans method. According to him, retained earnings are treated as equity capital for calculating cost of specific sources of funds. The market value of equity share may be considered as the combined market value of both equity shares and retained earnings or individual market value (equity shares and retained earnings) may also be determined by allocating each of percentage share of the total market value to their respective percentage share of the total values.

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For example:- the capital structure of a company consists of 40,000 equity shares of Rs. 10 each ad retained earning of Rs. 1,00,000. if the market price of companys equity share is Rs. 18, than total market value of equity shares and retained earnings would be Rs. 7,20,000 (40,000* 18) which can be allocated between equity capital and retained earnings as followsMarket Value of Equity Capital = 7,20,000*4,00,000/5,00,000 =Rs. 5,76,000. Market Value of Retained Earnings= 7,20,000*1,00,000/5,00,000 =Rs. 1,44,000. 2. Computation of Specific Cost of Each Source : After assigning the weight; specific costs of each source of capital, as explained earlier, are to be calculated. In financial decisions, all costs are after tax costs. Therefore, if any source has before tax cost, it has to be converted in to after tax cost. 3. Computation of Weighted Cost of Capital : After ascertaining the weights and cost of each source of capital, the weighted average cost is calculated by multiplying the cost of each source by its appropriate weights and weighted cost of all the sources is added. This total of weighted costs is the weighted average cost of capital. The following formula may be used for this purpose : Kw = XW/W Here; Kw = Weighted average cost of capital
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X = After tax cost of different sources of capital W = Weights assigned to a particular source of capital Example: Following information is available with regard to the capital structure of ABC Limited : Sources of Funds E.S. Capital Retained Earning P.S. Capital Debentures Amount(Rs.) 3,50,000 2,00,000 1,50,000 3,00,000 After tax cost of Capital .12 .10 .13 .09

You are required to calculate the weighted average cost of capital. Computation of Weighted Average Cost of Capital Source Amount Rs. (1) (2) (3) E.S. Capital 3,50,000 .35 Retained Earning 2,00,000 .20 P.S. Capital 1,50,000 .10 Debentures 3,00,000 .09 Total 10,00,000 1.00 Weighted Average Cost of Capital (WACC) Weights After tax Weighted Cost (4) .12 .10 .13 .09 10.85% Cost (5)= (3) * (4) .0420 .0200 .0195 .0270 .1085 .10850 or

CALCULATION OF COST OF CAPITAL OF SHREE CEMENT LTD.

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Cost of Debt Capital: For the year 2008-09: Total Debt Capital = Term loan from Banks + Debts = 112573.18 + 800 = 113373.18 lacs Total Interest Paid = 9636.72 lacs Tax Rate = 30% Interest Expense of the company Kd (before tax) =-------------- X 100 Total Debt 113373.18 9636.72

Kd (before tax) = --------- X 100 = Kd (after tax) Kd (after tax) = =

8.50%

Interest Rate Before Tax Tax Rate ( 30%.) 8.50% - 30% = 5.95%

For the year 2007-08 Total Debt Capital = Term loan from Banks + Debts = 83427.02+1400 = 84827.02lacs Total Interest Paid = 6573.02 lacs Tax Rate = 30% 6573.02 Kd (before tax)=----------Kd (after tax) = X 100 =7.75% 7.75% - 30% 84827.0 = 5.42%

For the year 2006-07 Total Debt Capital = Term loan from Banks + Debts

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= 28617.33+2000= 30617.33lacs Total Interest Paid = 2143.21lacs Tax Rate Kd (before tax) Kd (after tax) = 30% =---------= X 100 = 2143.21 7% 30617.33

7% - 30%

= 4.90%

COMPARATIVE CALCULATION OF Kd FOR THREE YEAR Particular 2008-09 Total Debts (Term 112573.18+800 loan from =113373.18 9636.72 2007-08 83427.02+1400 =84824.02 6573.86 7.75% 5.42% 2006-07 28617.33+2000 =30617.33 2143.21 7% 4.90%

Bank+Debts) Total Interest paid Interest

Rate 8.50%

(Before Tax) Interest Rate (After 5.95% Tax)= Interest Rate Before Tax Tax Rate 30%.

COST OF EQUITY CAPITAL: EQUITY SHARE CAPITAL Particular 2008-09 2007-08 2006-07
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No. of Shares (In lacs) 348.37 DPS Given 8 Market Price (at the 1079.40 end of March) Earning per equity 74.74

348.73 6 921.85 50.81 Not given

348.73 5 893.50 NA NA

share of rs. 10(in Rs.) Proposed final 2786.98 dividend on equity

share (in lacs) Market Capitalisation 376033.01 321146.96 (in Lacs) 1. Dividend yield plus growth in dividend method:Ke = DPS\mP*100 + G Dps = Current cash dividend per share Mp = Current market price per share G = Growth rate Ke = ---------X 100+ 10% = 10.74%

311270.61

= 8 Rs. = 1079.40 Rs.

= 10% 1079.40

2. Earning yield method:Ke= EPS\mp*100 Eps = earning per share = 74.74 Rs. Mp = Market prise = 1079.40 Rs. 74.74 Ke=------X 100 = 6.92% 1079.40
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3. Dividend per share method:Ke = Proposed final dividend on Equity Share / No. of Equity Share Proposed final dividend on Equity Share = 2786.98 Lacs No. of Equity Share = 348.37 Lacs 2786.98 Ke = -------------------348.37 COST OF EQUITY SHARE CAPITAL (KE) Particular Dividend Per share method Earning Yeild Method Dividend yield plus growth method 2008-09 8 6.92 10.74 = 8

WEIGHTED AVERAGE COST OF CAPITAL (WACC) WACC = (We * Ke) + (Wd * Kd) Where... We = Weight of equity Wd = Weight of Debt. Ke = Cost of Equity Share capital Kd = Cost of Debt. Capital WACC = ( 0.768 * 10.74) +( 0.232 *5.95 ) = 9.628% WACC OF SHREE CEMENT LIMITED
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Source

Amount Rs.

Weight s

After tax Cost

Weighted Cost (5)= (3) * (4) 8.248 1.379 9.628

(1) E.S. Capital Debentures Total

(2) 376033.0 1 113373.1 8 489406.1 (3) .768 .232 1.00

(4) 10.74 5.95

9 Weighted Average Cost of Capital (WACC)

9.628%

MERITS OF WEIGHTED AVERAGE COST OF CAPITAL The WACC is widely used approach in determining the required return on a firms investments. It offers a number of advantages including the followings1. Straight forward and logical : It is the straightforward and logical approach to a difficult problem. It depicts the overall cost of capital as the some of the cost of the individual components of the capital structure. It employs a direct and reasonable methodology and is easily calculated and understood.

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2. Responsiveness to Changing Condition : Since, it is based upon individual debt and equity components, the weighted average cost of capital reflects each element in the capital structure. Small changes in the capital structure of the firm will be noted by small changes in overall cost of capital of the firm. 3. Accurate when Profits are Normal : During the period of normal profits, the weighted average cost of capital is more accurate as a cut-off rate in selecting the capital budgeting proposals. It is because the weighted average cost recognises the relatively low debt cost and the need to continue to achieve the higher return on the equity financed assets. 4. Ideal Creation for Capital Expenditure Proposals : With the help of weighted average cost of capital, the finance manager decides the cut-off rate for taking decisions relating to capital expenditure proposals. This cut-off rate determines the miimum limit for accepting an investment proposal. If an investment proposal is accepted below this limit, the firm incur a loss. Therefore, this cut-off rate is always decided above the weighted average cost of capital.

LIMITATION OF WEIGHTED AVERAGE COST OF CAPITAL The weighted Average cost approach also has some weaknesses, important among them are as follows :
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1. Unsuitable in case of Excessive Low-cost Debts : Short term loan can represent an important sources of fund for firm experiencing financial difficulties. When a firm relies on Zero cost (in the form of payables) or low cost short term debt, the inclusion of such debts in the calculation of cost of capital will result in a low WACC. If the firm accepts low-return projects on the basic of this low WACC, the firm will be in a high financing risk. 2. Unsuitable in Case of Low Profits : If a firm is experiencing a period of low profits, not earning profit as compared to other firms in the industry, WACC will be inaccurate and of limited value. 3. Difficulty in Assigning Weights : The main difficulty in calculating the WACC is to assign weight to different components of capital structure. Normally, there are two type of weights- (i) book value weights and (ii) market value weight. These two type of weights give different results. Hence, the problem is which type of weight should be assigned. Though, market value is more appropriate than book value, but the market value of each component of capital of a company is not readily available. When the securities of the company are unlisted, the problem becomes more intricate. 4. Selection of Capital Structure : The selection of capital structure to be used for determining the WACC is also not easy job. Three types of capital structure are there i.e. current capital structure, marginal capital
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structure and optimal capital structure. Which of these capital structure be selected. Generally, current capital structure is regarded as the optimal structure, but it is not always correct.

MARGINAL COST OF CAPITAL The Marginal Cost of Capital is the cost of the last dollar of capital raised. It is an important consideration the firm must take into account when making corporate decisions. The marginal cost of capital is calculated as being the cost of the last dollar of capital raised. Generally we see that as more capital is raised, the marginal cost of capital rises Figure 1. This happens due to the fact that marginal cost of capital generally is the weighted average of the cost of raising the last dollar of capital. Usually, we see that in raising extra capital, firms will try to stick to desired capital structure. Usually once sources are depleted they will have to issue more equity. Since the cost of issuing extra equity seems to be higher than other costs of financing, we see an increase in marginal cost of capital as the amounts of capital raised grow higher. The marginal cost of capital can also be discussed as the minimum acceptable rate of return or hurdle rate. The investment in capital is logically only a good decision if the return on the capital is greater than its cost. Also, a negative return is generally undesirable. As a result, the marginal cost of capital often becomes a benchmark number in the decision making process that goes into
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raising more capital. If it is determined that the dollars invested in raising this extra capital could be allocated toward a greater or safer return if used differently, according to the firm, then they will be directed elsewhere. For this we must look into marginal returns of capital, which can be described as the gains or returns to be had by raising that last dollar of capital.

The marginal cost of capital is calculated as being the cost of the last dollar of capital raised.

When raising extra capital, firms will try to stick to desired

capital structure

, but

once sources are depleted they will have to issue more equity. Since this tends to be higher than other sources of
financing

, we see an increase in

marginal cost of capital as capital levels increase.

BIBLIOGRAPHY BOOKS: 2008. MAGAZINES & JOURNALS: Accounting World Chartered Accountant M.R. Agarwal, Financial Management 1st Edition,

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 WEBSITES:

News Papers

www.shreecementltd.com

www.google.com

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