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1. U N IT – III Financing Decision COST OF CAPITAL & LEVERAGE

2. Meaning of Cost of Capital : The cost of capital of a firm refers to the cost that a firm incurs in retaining the funds obtained from various sources (i.e. Equity shares, Preference shares, Debt, Retained Earnings). FINANCING DECISION Components of Cost of Capital / Cost of Specific Sources of Finance: Cost of debt capital i.e. debentures & loans from various institutions. Cost of Preference capital Cost of Equity Capital Cost of Retained Earnings Weighted Average cost of Capital It is weighted average of costs of various sources of funds where the weights are being the proportion of each source of funds in the capital structure. It is denoted as Ko

3. Capital budgeting decisions : It is used for discounting cash flows under Net Present Value method for evaluating investment proposals . So, it is very useful in capital budgeting decisions. Capital structure decisions : An optimal capital structure is that structure at which the value of the firm is maximum and cost of capital is the lowest . Evaluation of Financial Performance : The actual profitably is compared to the expected and actual cost of capital of funds and if profit is greater than the cost of capital the performance may be said to be satisfactory. Other financial decisions : It is also useful in making such other financial decisions as dividend policy , capitalization of profits , making the rights issue , etc. IMPORTANCE or SIGNIFICANCE OF COST OF CAPITAL

4. Business Capital Measurement of Specific Cost Measurement of Combined Cost Debenture Bonds Loans Equity Shares Preference shares Retained Earnings Interest Dividend

5. 1. Historical and Future Cost : Historical Cost is the cost which are already been incurred for financing a particular project. Future cost is the expected cost of financing in the proposed project. 2. Explicit and Implicit Cost : Explicit cost is the rate that the firm pay outsiders or procure financing ( Ex . Rent). Explicit cost is the cut-off rate or internal rate of return. The internal rate return the firm pays for financing. This cost arises when the funds are raised. IRR (Internal Rate of Return) is a common metric used to understand the profitability and earnings of a particular investment Implicit cost is which is not accounted as certain factor belongs to the producer. Implicit cost is the rate of return related to the best investment opportunity of the firm and its shareholders that will be foregone in order to take up a particular project. TYPES OF COST OF CAPITAL

6. 3.Specific and Composite Cost : The cost such as equity, debt, retained earnings and loans is called as specific cost . The composite cost is the combination of all sources of capital. 4.Average and Marginal Cost : Average cost of capital is the weighted average cost of each component of capital . Average cost is the combined cost of various sources of capital such as equity shares, debentures, preference shares. Marginal cost is the additional cost of capital when the company goes for further raising of finance.

7. 1. Measurement of specific costs Cost of Equity Capital (Ke) Cost of Preference Capital (Kp) Cost of Debt Capital (Kd) Cost of Retained Earnings (Kr) Measurement of overall cost of capital or combined cost of capital ( Weighted Average Cost of Capital – WACC). Book Value Weights Market Value Weights MEASUREMENT OF COST OF CAPITAL

8. COST OF DEBT Meaning : It may be defined as the returns expected by the potential investors of debt securities of a firm . The cost of debt is of two types i.e., Cost of irredeemable debt and cost of redeemable debt. The cost of debt is  the total interest expense owed on a debt . P e r p e t u a l o r Ir r e dee m a b l e – I rr e de e m a b l e o r P e r p et u a l d ebt i s t h e d e b t on which is not redeemable during the life time of the company. Redeemable - Redemption period is fixed in advance, say 5 or 7 or 10 years.

9. IRREDEEMABLE DEBT : Cost of debt before tax: Kdb = 𝑰 𝒏 𝒕 𝒆 𝒓 𝒆 𝒔 𝒕 𝑵𝒆𝒕 𝑷𝒓𝒐𝒄𝒆𝒆𝒅𝒔 × 100 Interest = Face value of debt × Rate of Interest Issued at Par : Net Proceeds = Face Value – Issue Expenses Issued at Premium : Net Proceeds = Face Value + Premium on issue - Issue Expenses Issued at discount : Net Proceeds = Face Value – Discount on issue - Issue Expenses Or Net Proceeds = Issue Price – Issue Expenses Cost of debt after tax: Kda = Kdb (1 - Tax) REDEEMABLE DEBT: i) Cost of Debt Before Tax: Kdrb = 𝑰+ (𝑷−𝑵𝑷) × 100 𝑷+𝑵𝑷 /𝟐 I = Annual Interest Payment P = Par Value (face value) of Debentures NP = Net Proceeds of debentures n= No. of Years to maturity ii) Cost of Debt After Tax (Kdra) = Kdrb (1-t)

10. Issues at par If, when a company issues a new bond, it receives the face value of the security , the bond is said to have been issued at par.  The term “at par” means “ at face value .” Bonds, preferred stocks, or other debt securities can be traded at par or at face value, below par, or above par. Issued at Premium The issue of shares at premium refers to  the issue of shares at a price higher than the face value of the share . In other words, the premium is the amount over and above the face value of a share. The issue of shares at a discount means  the issue of the shares at a price less than the face value of the share . F Issued at discount Cost of Capital is the rate the company must pay now to raise more funds, Cost of Debt is the cost the company is paying to carry all the debt it acquires .

11. Irredeemable Debt: AXL Ltd issued 10,000 irredeemable debentures at a face value of Rs.10 each carrying 8% interest. Issue expenses are Rs.5000. Calculate cost of debt before and after tax, Tax rate is 30%. A company raises Rs 1,00,000 by issuing 9% debentures of face value of Rs.100 each. Issue expenses are Rs.1000. Compute the cost of debentures (before tax) when they are issued at 10% premium. 10% discount. 3. S ltd issued 20,000, 8% debentures of Rs.100 each on 1 st April 2020. The cost of issue was Rs.50,000. the company's tax rate is 35%. Determine the cost of debentures (before as well as after tax) if they were issued (a) at par (b) at a premium of 10% and (c) at a discount of 10%. 4 . V l td i ssued R s . 30 00 , 8 % de b e n ture a t a premium of 10%. The flotation costs are 2%. The tax rate is 50%. You are required to ascertain cost of debt before tax and after tax. 5 . S l i m i ted i ssued 100 , 1 % de b e n tures of Rs.100 each. The tax rate is 50%. Calculate the before tax and after tax cost of debt if the debentures are issued (a) at Par (b) at a premium of 10% and (c) at a discount of 10% Redeemable Debt: 1. A company issues 10% debentures for Rs.1,00,000 redeemable at the end of the 10th und e r w r i t i n g c o st ( i ssue e x pen s es) is y ear f r o m the y ear o f the i r i ssue . T h e 5%. Calculate the effective cost of debt (debentures) before & after tax. Tax rate is 30%.

12. COST OF PREFERENCE SHARES Meaning : Dividend paid to the preference shareholders is the cost of preference share capital. Like debt capital, preference share are divided into tw o categories i.e., irredeemable and redeemable preference shares. COST OF IRREDEMABLE PREFERENCE SHARES: K p = 𝑫 𝑵𝒑 × 100 COST OF REDEMABLE PREFERENCE SHARES: p k = P −𝑁𝑃 𝐷+ 𝑛 P + 𝑁 𝑃 2 × 100

13. ( Sum – 4 ) A company issues 10 % irredeemable preference shares. The face value per share is Rs.100, but the issue price is Rs.95. What is the cost of a preference share? What is the cost if the issue price is Rs.105? ( Sum – 5 ) A preference share sold at Rs.100 with a 9 % dividend and a redemption price of Rs.110 if the company redeems it in five years.

14. COST OF EQUITY CAPITAL (Ko): The concept of equity capital (ke) defined as the “ Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares ”. Cost of equity capital can be divided in to 4 parts: Approaches to Calculate Cost of Equity : 1. Dividend price approach = Ke = 𝐷 𝑁 𝑝 × 100 2. Dividend price plus growth approach = Ke = 𝐷 𝑀 𝑝 +G × 100 Where as, Ke = Cost of equity, D = Dividend, G = Growth rate, Po = Market price of the share Earning price approach Realized yield approach

15. (Sum – 5) . A company issues 10000 equity shares of Rs.100 each at a premium of 10%. The company has been paying 25% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity shares is Rs.175. (Sum – 6) : a company plans to issue 10000 new shares of Rs.100 each at par. The flotation costs are expected to be 4% of the share price. The company pays a dividend of Rs.12 per share initially and growth in dividend is expected to be 5%. Compute the cost of new issue of equity shares. If the current market price of any equity share is Rs.120. calculate the cost of existing equity share capital.

16. C O S T OF R ETA I NED E A R NINGS The cost of retained earnings is the cost to a company of funds that it has generated internally. If funds were not retained internally they w ould be paid out to investors as dividend Cost of retained earnings (Kr) = Cost of equity(1 – b)(1-t) b = Brokerage/Floatation cost T = tax rate (Sum – 7 ) A company’s share are currently selling for Rs.120. The expected dividend and growth rate are Rs.5.20 and 6% respectively. Calculate the cost of retained earnings if the tax rate is 30% and brokerage costs are 1%.

17. WEIGHTED AVERAGE COST OF CAPITAL (WACC) It is defined as the average of the costs of each sources of funds employed by the firm, properly we ighted by the proportion they hold in the capital structure of the firm . It is denoted by Ko . The proportion or percentage or weight of each component may be determined based on either book value or market value of capital. Computation of Weighted Average Cost of Capital: Source of Capital Amount Proportion After Tax Cost(%) WACC (3*4) Equity Capital XX XX XX XX Reserve & Surplus XX XX XX XX Preference Capital XX XX XX XX Debt XX XX XX XX Total XXXX XXXX WACC XXXX

18. WEIGHTED AVERAGE COST OF CAPITAL / COMPOSITE COC Lohia Chemicals Ltd has the following book value capital structure on 31 March 2020: Find the weighted average cost of capital of Lohia Chemicals Ltd, based on the existing capital structure. Problem : Source of Capital Amount Proportion After Tax Cost(%) Equity Capital 4,50,000 45 8 Reserve & Surplus 1,50,000 15 18 Preference Capital 1,00,000 10 11 Debt 3,00,000 30 8

19. WEIGHTED AVERAGE COST OF CAPITAL – MARKET VALUES: Suppose Lohia Chemicals Ltd has 45,000 equity shares outstanding and that the current market price per share is Rs.20. Using market values of equity and the book values of debt and the preference share capital, compute WACC. Source of Capital Amount Proportion After Tax Cost(%) Equity Capital 45000 69 8 Preference Capital 1,00,000 7.7 11 Debt 3,00,000 23.1 8

20. CALCULATE WEIGHTED AVERAGE COST OF CAPITAL (BOOK VALUE): Source of Finance Amount After Tax Cost 12% Preference Capital 2,00,000 12% Equity Share Capital 4,00,000 16% Retained Earnings 1,50,000 15% 10% Debt 2,50,000 10%

21. L & T Capital Structure March ‘2019 L & T’s cost of equity is 21%. Cost of short-term is 12% and Long-term debt is 10%. Find out its cost of capital. All Values in Crores Book Value Weights Market Value MV Weights Net worth 291 1318.63 Total Debt: 80.06 80.06 Short term Debt 7.35 7.35 Long term Debt 72.71 72.71 Capital employed 371.49 100 1398.69 100

22. Kavin Corporation has the following book value of capital structure: Expected dividend is Rs.2 Per share. Calculate Weighted Average Cost of Capital. Securities Amount (Rs.) After tax Equity Capital:15 laksh shares @ Rs.10 each 1,50,00,000 - 12% preference share capital 50,00,000 12% Retained earnings 100,00,000 - 26% Debentures 60,00,000 13% Term loan at 24% 70,00,000 12% Total 43000000

23. The capital structure of Himalaya Traders Ltd, as on 31.0.2021 is as follows: Equity share capital: 100 lakhs shares of Rs.10 each Rs.10 crore Reserve and Surplus 14% Debenture of 100 each Rs. 2 Crore Rs.3 Crore For the year ended 31.03.2021 the company has paid equity dividend at 20%. As the company is a market leader with good future. Dividend is likely to grow by 5% every year. The equity shares are now traded at Rs.80 per share on the stock exchange. Income tax at 50%. Compute current weighted average cost of capital (WACC) The company has plan to raise in future Rs.5 Crore by way of floating long term loan at 16% interest. When then takes place the market value of the equity share is expected to fall to Rs.50 Per share. What will be the new WACC of the company?

24. The Smithra Ltd., has the following capital structure. The share of the company sells for Rs.20. It is expected that the company will pay dividend of Rs.2 per share, which will grow at 7% for ever. Assume the tax rated at 50%. Compute the WACC base on the existing capital structure. Compute the new WACC if the company raises on additional Rs.20,00,000 debt by issuing 15% debt. This would increase the expected dividend 3 per share and leave the growth unchanged, but price of share will fall to Rs.15. Sources of Capital Amount (Rs.) Common Share (200000 Shares) 40,00,000 10% Preference Share Capital 10,00,000 14% Debentures 30,00,000 Total 80,00,000

25. Solution : Cost of equity = 𝐷 𝑖 𝑣 𝑖 𝑑𝑒 𝑛 𝑑 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 × 100 2 . 5 Ke = × 100 = 3.125% 80 a) Calculation of WACC Solution : Cost of equity = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 × 100 2.5 Ke = × 100 = 3.125% 80 a) Calculation of WACC S o u r c e of capital Amount ( R s. I n c r ore ) Proportion A f t e r t a x ( % ) WACC

26. ASSIGNMENT QUESTION: The Kay Company has the following capital structure at 31 March 2020 which is considered to be optimum. The company’s share has a market price of Rs.23.60. The company pays a earnings per share of Rs.2.36. 50% of earnings are paid as dividend. The company has issued 16 % debentures. The company’s debenture is currently selling at Rs. 96 with a face value of Rs.100. The company’s marginal tax rate is 50 per cent. Calculate after tax cost of debt. The preference issue are sold at a net price of Rs.9.20, paying a dividend of Rs.1.1 per share. Assume preference shares are irredeemable. Calculate WACC. 14% Debentures 3,00,000 11% Preference Shares 1,00,000 Equity (1,00,000 Shares) 16,00,000 Total 20,00,000

27. LEVERAGE

28. LEVERAGE Meaning : Leverage refers to furnish the ability to use fixed cost assets to increase the return to its shareholders. According to Christy and Roden , “Leverage as the tendency for profits to change at a faster rate than sales. It is a relationship between equity share capital and securities and creates fixed interest and dividend charges. It is also known as “ gearing ”. The term gearing explains the relationship between the equity and fixed earing rated securities. Types of Leverage: Operating Leverage Financial Leverage and Combined leverage

29. Leverage or financial leverage is basically an investment where borrowed money or debt is used to maximise the returns of an investment, acquire additional assets or raise funds for the company.

30. Calculation of Leverage Profitability Statement Particulars Rs. Sales XX Less : Variable Cost XX Contribution XXX Less : Fixed Cost XX Operating Profit / EBIT XXX Less : Interest XX Earnings Before Tax (EBT) XXX Less : Tax XX Profit After Tax (PAT) XXX Less : Preference Dividend (if any) XX Net Earnings available to equity shareholders / Pat XXX No.of Equity Shares (N) XXX 𝑃𝐴𝑇 Earnings Per Share (EPS) = 𝑁 XXX Operating Leverage Financial Leverage Degree of Combined Leverage

31. TYPES OF LEVERAGE OPERATING LEVERAGE: [ Operating Leverage = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐸𝐵 𝐼𝑇 ] Operating cost may be defined as the firms ability to use fixed operating cost to magnify the effect of changes in sales on its earning before interest and taxes. FINANCIAL LEVERAGE: [ Formula = 𝐸𝐵 𝐼𝑇 𝐸𝐵𝑇 ] The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity . COMBINED LEVERAGE: = Operating leverage x Financial leverage

32. 1 . F r o m t h e f o l l o w i n g d a t a, c a l c ul a t e financ i al l e v e r a g e, operating leverage and combined leverage: Sales 10,000 units of Rs.25 per unit as the selling price Variable cost Rs.5 per unit Fixed cost Rs.30000 and Interest Cost Rs.15,000 2. VS corporation has sales Rs.40,00,000. Variable cost 27% of sales and fixed cost Rs.8,00,000. The firm has raised Rs.20,00,000 funds by increase of debenture @ 10%. Compute Operating Leverage and Combined leverage.

33. XYZ Ltd. decides to use two financial plans and they need Rs. 50,000 for total investment. The earnings before interest and tax are assumed at Rs.5000 and 12,500. the tax rate is 50%. Calculate the EPS Particulars Plan A Plan B Debentures (Interest @10%) 40,000 10,000 Equity Shares (Rs.10 each) 10,000 40,000 Total Investment Needed 50,000 50,000 Number of equity shares 1,000 4000

34. The company has some earning with different combination of capital structure in a given situation and examine the influence of financial leverage. Company A B C EBIT 200000 200000 200000 Capital Structure: ESC @ Rs.10 each 600000 400000 200000 12% Debt 200000 200000 8% Preference capital 200000 Total 600000 600000 600000