Sources & Cost of Capital

Sreejith S
FIMS

SS Fims March 2009

 Sources of capital
• Cost of Capital; Concept
• Different Sources
• Short Term & Long Term Sources
• International Sources; ADR,GDR,ADS
• Money Market instruments
• Leasing, Factoring, Hire purchase,
Installments
• Securitisation
• Commercial Paper
• Venture Capital
SS Fims March 2009
 Sources of Capital
• Long Term Sources
• Short Term Sources

SS Fims March 2009

 Cost of Capital

• The Minimum Required rate of return

• Financing Cost
• It is the discount rate for project
appraisal

SS Fims March 2009

 Cost of Capital
• It is useful for
- Evaluate investment decision
- Designing a firms debt policy
- Appraising the financial
performance

SS Fims March 2009

 Investment Evaluation
• Cut off rate/hurdle rate
• Discount Rate

SS Fims March 2009

 Designing the Debt Policy
• Tax Saving
• Financial Risk
• Maximising the share holder value

SS Fims March 2009

 Performance Appraisal
• Compare the actual with Proposed
• Exibits the future requirements
• It is useful in dividend decision

SS Fims March 2009

Investment’s Risk & Return

Risk
EQUITY

Preference
Shares
Other Debt
instrument
s

Debentur
es
Risk
Free
Security

5 10 15 20 25 30 35

Target Return
% p.a.

SS Fims March 2009

 Opportunity Cost
• Shareholder’s View
• Next best option
• Depend on the business risk
• Considering Creditors Claims

SS Fims March 2009

 Cost of Capital
• Weighted average cost of Capital
• Specific Cost of Capital

SS Fims March 2009

 WACC
• Combined Cost
• Consider all Cost of capital
• Weight age is given for each element

SS Fims March 2009

 Specific Cost of Capital
• Cost of Capital for each element
• Cost of each sources is calculated
separately

SS Fims March 2009

 Determinants of Cost of
Capital
• Investors Required rate of return
• Cost of Debt
• Tax shield

SS Fims March 2009

 Components ; Cost of
Capital
• Cost of Debt
• Cost of Preference capital
• Cost of Equity
 Cost of Debt
• Cost of Debentures
• Cost of loans

Two Factors
- Net cash Inflow
- Net Cash Outflow
 Cost of Perceptual Debt
• It is the rate of return
• Lender’s Expected rate of return
• Debt Carries interest/Coupon rate
• Before Tax Cost
• Tax Adjusted Cost
 Cost Before Tax
A. Debentures/Bonds Issued @ Par
B. Debentures/Bonds Issued @
Discount
C. Debentures/Bonds Issued @
Premium
 Cost Before Tax
Ki = i .
SV

Ki = Before Tax Cost of Debt

SV= Sales Proceeds
i = Annual Interest Payment
 Find out The cost of Capital
(Before Tax)
• A Company Has 10% Debentures of
Rs 100,000
a) Issued at Par
b) Issued at Discount 10%
c) Issued at Premium 10%
 Tax Adjusted Cost
A. Debentures/Bonds Issued @ Par
B. Debentures/Bonds Issued @
Discount
C. Debentures/Bonds Issued @
Premium
 Tax Adjusted Cost

Kd = Ki(1-T)

Kd = Tax Adjusted Cost

Ki = Before Tax Cost
T= Tax Rate
 Find out The cost of Capital
(Tax Adjusted)
• A Company Has 10% Debentures of
Rs 100,000
• Tax Rate 35%
a) Issued at Par
b) Issued at Discount 10%
c) Issued at Premium 10%
 Trial & Error Method

SV = I(PVFA n, Kd) + RV(PVF n,Kd)

I =Annual Interest payment

RV = Redemption Value

SS Fims March 2009

 Find out Cost of Debt
• Rs 15 Interest per year
• No of Years 7
• Face Value Rs 100

Three Cases
a)Maturity @ par
b)Maturity @ a discount of Rs 6
c)Maturity @ a premium of Rs 10

SS Fims March 2009

 Cost of Preference Shares
• Irredeemable Preference Shares
• Redeemable Preference Shares
 Irredeemable Preference
Shares

Kd = PDIV
SV

PDIV :- Dividend
SV = Sales Value
 Find out The cost of Capital

• A Company Has 10% Irredeemable

Preference Shares of Rs 100,000

a) Issued at Par
b) Issued at Discount 10%
c) Issued at Premium 10%
 Redeemable Preference
Shares
Trial & Error Method

SV = PDIV(PVFA n, Kd) + RV(PVF n,Kd)

RV = Redemption Value

SS Fims March 2009

 Find out Cost of Preference
Shares
• 15 % Dividend
• No of Years 7
• Face Value Rs 100;

Three Cases
a)Issued @ par
b)Issued @ a discount of Rs 6
c)Issued @ a premium of Rs 10

SS Fims March 2009

 Find out Cost of Preference
Shares
• 15 % Dividend
• No of Years 7
• Face Value Rs 100;

Three Cases
a)Redeemed @ par
b) “ “ @ a discount of Rs 6
c) “ “ @ a premium of Rs 10

SS Fims March 2009

 Cost of Equity
• Zero Growth
• Constant Growth
• Supernormal Growth

SS Fims March 2009

 Zero Growth

Ke = Div
MV

DIV = Dividend
MV = Market Value

SS Fims March 2009

 Constant Growth

Ke = Div + G
MV

G = Growth

SS Fims March 2009

 Find out Cost of Equity

• Market Price of Share is Rs 90

• Expected Dividend is Rs 4.5
• Dividend is expected to grow @ 8%
rate
 Supernormal Growth
Trial & Error Method

MV =
n
∑DIV(1+g)^t (PV t, ke) + DIV x
t
1
(ke-gn)
(1+ke)^n

SS Fims March 2009

 Find out cost of Equity
• Market Value of Share : Rs 134
• Current Dividend : Rs 3.5
• Expected growth : 15% (next 6
years), Then 8%

SS Fims March 2009

 Assuming that a firm pay
tax at a Rs 50%, Calculate
cost of Capital
Cases
1.A 8.5 % preference shares sold at
par
2.Issue of 7% bond at par
3.Equity share price @ market Rs 120;
Dividend Rs 9; Expected Growth 8%

SS Fims March 2009

 Weighted Average Cost of
Capital
• Calculate The specific Cost of Capital
• Multiply it with the proportion in the
capital Structure
• Add the weighted cost
 Calculate WACC
Capital Structure Tax Adjusted Cost
Share 450,000 Share 18%
Capital Capital

Reserve 150,000 Reserve 18%

Preference 100,000 Preference 11%

Share Share

Debt 300,000 Debt 8%

 Floatation Cost
• The present day business entities incur
costs of flotation in a variety of forms.

A few of them may be mentioned as below: 

• Charges of the underwriters

• Legal Fees
• Commission to be paid to brokers
• Costs of Administration
 Calculate cost of Equity
A company plans to issue some new equity shares to

raise additional funds. The net proceeds per share will be

the market price share (Which is Rs 120) less floatation

cost (which is 5% of the share price). If the company plans

to pay a dividend of Rs 6 per share and the growth in dividend

is expected to be 8%.
Sources of Capital
Internal Sources of Finance and
Growth

• ‘Organic growth’ – growth

generated through the
development and expansion
of the business itself. Can be
achieved through:
• Generating increasing
sales – increasing revenue
to impact on overall profit
levels
• Use of retained profit –
used to reinvest in the
business
• Sale of assets – can be a
double edged sword –
reduces capacity?
External Sources of Finance

• Long Term – may be paid back

after many years or not at all!
• Short Term – used to cover
fluctuations in cash flow
• ‘Inorganic Growth’ – growth
generated by acquisition
 'Inorganic Growth'
• Acquisitions
• The necessity of financing
external inorganic growth
– Merger/Joint Venture:
• firms agree to join together –
both may retain some form of
identity
– Takeover:
• One firm secures control of the
other, the firm taken over may
lose its identity
 Sources of Capital
• Long Term Sources
• Short Term Sources

SS Fims March 2009

 Long Term Sources
• Equity
• Preference
• Debt
 Long Term
• Shares (Shareholders are part owners of a company)
– Ordinary Shares (Equities):
• Ordinary shareholders have voting rights
• Dividend can vary
• Last to be paid back in event of collapse
• Share price varies with trade on stock exchange
– Preference Shares:
• Paid before ordinary shareholders
• Fixed rate of return
• Cumulative preference shareholders – have right to dividend carried
over to next year in event of non-payment
– New Share Issues – arranged by merchant or investment banks
– Rights Issue – existing shareholders given right to buy new
shares at discounted rate
– Bonus– change to the share structure – increases number of
shares and reduces value but market capitalisation stays the same
 Equity
• IPO
• Private Placements
• Euro Issues
 IPO
• Public issue of securities
• New firms
• First Time
 Terms - IPO
• Authorized Capital
• Issued Capital
• Subscribed Capital
• Paid-up Capital
• Par Value
• Share Premium
 Features of Equity
• Claim on Income
• Residual Ownership
• Voting right
• Right to Control etc
 Private Placement
• Issue of Shares Privately
• Less Compliance than Public Issue
• Time Effective
• Cost effective
 Euro Issues
• Public issue of Shares
• In Foreign Stock Exchanges
• ADR
• GDR
 Debt Fund
• Bond
• Debentures
• Term Loans
• Asset Based Financing

SS Fims March 2009

 Bond/Debentures
• A long term promissory note
• Tool for raising Loan Capital
• Stipulated Interest and time
• Public Sec Instruments- Bonds

SS Fims March 2009

 Bond/Debenture Features
• Interest rate
• Maturity
• Redemption
• Secured/Unsecured
• Yield to Maturity

SS Fims March 2009

 Types of Debentures
• Non-Convertible Debentures
• Fully Convertible Debentures
• Partly Convertible Debentures

SS Fims March 2009

 Pros & Cons
• Less Costly
• No ownership dilution
• Fixed payment of interest
• Reduced real obligation

• Obligatory Payment
• Financial Risk
• Redemption

SS Fims March 2009

 Terms & Loans
• Long term debt
• More Than one Year
• From banks/Fis

SS Fims March 2009

 Features
• Maturity
• Direct Negotiation
• Security
• Convertibility

SS Fims March 2009

 Leasing
• Lease is a contractual arrangement/ transaction

• in which a party (lessor) owning an

asset/equipment provides

• the asset for use to another party/ transfer the

right to use the equipment to the user (lessee)

• over a certain/for an agreed period of time for

consideration in form of / in return for periodic
payments / rental with or without a further
payment (premium).

• At the end of the contract period (lease period)

the asset/equipment is returned to the lessor
 Leasing
• Parties to Contract:
-financer (or owner - Lessor)
-user (lessee)

• there could be lease-broker who

works as an intermediary in
arranging lease finance deals
 Leasing
• Ownership
- Ownership vests with Lessor
- Procession (Uses) is allowed to the
lessee

On the Expiry date of the lease tenure;

the asset revert to the lessor
 Leasing
• Lease Rentals
- The consideration lessee
pays

• Term Lease
- The period for of lease
agreement
 Classification of Leasing
• A lease contract can be classified on
various characteristics in following
categories:

. Finance Lease and Operating Lease

. Sales & Lease back and Direct Lease
. Single investor and Leveraged lease
.Domestic and International lease
 Finance Lease
• A Finance lease is mainly an agreement for just financing the
equipment/asset, through a lease agreement.

• The owner /lessor transfers to lessee substantially all the risks

and rewards incidental to the ownership of the assets (except
for the title of the asset).

The lessor is only a financier and is usually not interested in the

assets.

Economic life is normally utilized by one user – i.e. Ships,

aircrafts etc.

Generally a finance lease agreement comes with an option to

transfer of ownership to lessee at the end of the lease period.
 Operating Lease
• the lessor does not transfer all risks and rewards

• such assets which can be used by different users

• without major modification

• The lessor provides all the services associated with the

assets, and the rental includes charges for these services.

• The lessor is interested in ownership of asset/equipment

as it can be lent to various users, during its economic life.

• Examples of such lease are Earth moving equipments,

computers, automobiles etc.
 Sale and Lease Back
• Sale and Lease Back:
In this type of lease, the owner of an
equipment/asset sells it to a leasing
company (lessor) which leases it
back to the owner (lessee).
Sale and Lease Back
 Direct Lease:

• Direct Lease:
In direct lease, the lessee and the
owner of the equipment are two
different entities. A direct lease can
be of
two types: Bipartite and Tripartite
lease.
 Single Investor Lease

• This is a bipartite lease in which the

lessor is solely responsible for
financing part. The funds arranged
by the lessor (financier) have no
recourse to the lessee.
 Leveraged Lease
• This is a kind of tripartite lease
• the lessor arranges funds from
another party.
• the equipment is part financed by a
third party (normally through debt)
• a part of lease rental is directly
transferred to such lender
• towards the payment of interest and
installment of principal.
Leveraged Lease
 Domestic Lease
• Domestic Lease:

A lease transaction is classified as

domestic if all the parties to such
agreement are domiciled in the same
country
 International Lease

• Import Lease
• Cross Border Lease
 Regulatory Framework of
Leasing in India
• The Indian Contract Act,1872 are
applicable to all lease contracts.
• Motor Vehicles Act are also
applicable to specific lease
agreements.
• Indian Stamp Act:
• RBI NBFCs Directions:
 A lease agreement includes
• i. Nature of lease:
• ii. Description of equipment
• iii. Delivery and re-delivery of asset
• iv. Lease Period & Lease Rentals
• v. Uses of assets allowed
• vi. Title: Identification and ownership of
equipment
• vii. Repairs and maintenance
• viii. Alteration and improvements
• ix. Possession:
 Structure of Leasing
Industry
• over 400 private and public limited leasing
companies.
• Private Sector Leasing
First Leasing Co of India Ltd. (FLGI),

The Twentieth Century Finance

Corporation Ltd. (TGFL),

The Grover Leasing Ltd

 Adapted Companies
• Sundaram Finance Ltd (SFL),
• Mercantile Commercial and Credit
Corporation ltd. (MCCL),
• Motor and General Finance Ltd.
(MGF).
 Subsidiaries of
Manufacturing Group
Companies
• Swadeshi Leasing Ltd was floated by
the Hindustan Motors Ltd.
• Classic Leasing by ITC Ltd
• Ashok Leyland
• Finance Ltd. of Ashok Leyland Ltd
Subsidiaries of Commercial
Banks
• SBI Capital Markets Ltd.
• Canbank Financial Services Ltd.
• BOB Fiscal Services Ltd
• BOI Financial Services Ltd
• PNB Capital Services Ltd
 Public Sector
Organisations
• State Industrial Investment
Corporation of Maharashtra (SICOM)
• Gujarat Industrial and Investment
Corporation (GIIC)
• FIs
Performance of Lease till
1990
Hire Purchase
 Hire Purchase
• The goods to be sold on a future date
• The goods are let on hire
• price is to be paid in installments
 Hire Purchase Act,1972
• a. Payments to be made in installments over a specified period.

• b. The possession is delivered to the hirer at the time of

entering into the contract.

• c. The property in goods passes to the hirer on payment o the

last installment.

• d. Each installment is treated as hire charges so that if default

is made in payment of any installment, the seller becomes
entitled to take away the goods, and

• e. The hirer/ purchase is free to return the goods without being

required to pay any further installments falling due after the
return.
National Small Industries
Corporation (NSIC)
 Features of Hire
Purchase Agreement
• the buyer takes possession of goods immediately and
agrees to pay price in installments
• Each installment is treated as hire charges.
• The ownership of the goods passes from the seller to the
buyer on the payment of the last installment
• In case the buyer makes any default in the payment of
any installment the seller has right to repossess the
goods from the buyer and forfeit the amount already
received treating it as hire charges
• The buyer can terminate the payment at any point of
time
 Installment
• the contract of sale is entered into the
goods are delivered and the ownership
is transferred to the buyer

• but the price is paid in specified

installments over a period of time.

• It is not possible to terminate the

contract by the buyer.
 Hire purchase Vs Leasing
Hire Purchase Leasing
Ownership is transferred on final Ownership is never transferred
installment

Hirer is entitled to claim Lessor is entitled to claim

depreciation Depreciation
Maintenance is Hirer’s Lessor is doing Maintanance
Responsibility
Hirer will get Tax benefit Lessor will get tax benefit

Magnitude is Low Magnitude is High

Less than 100% Finance extention 100% Finace Extention

Factoring
 FACTORING
• it is the conversion of credit sales into cash

• a financial institution (factor) buys the

accounts receivable of a company (Client)

• pays up to 80%(rarely up to 90%) of the

amount immediately on agreement
 Characteristics of
factoring
• Usually the period for factoring is 90 to 150 days

• Factoring is considered to be a costly source of

finance compared to other sources
• Bad debts will not be considered for factoring
• The cost of factoring vary from 1.5% to 3% per
month
• Indian firms offer factoring for invoices as low as
1000Rs
 Classification of Factoring
• Disclosed and Undisclosed
• Recourse and Non recourse
 Disclosed Factoring

• In disclosed factoring client's customers are

notified of the factoring agreement
 Undisclosed Factoring
•  Client's customers are not notified of the
factoring arrangement

• ledger administration and collection of debts are

undertaken by the client 

• Client has to pay the amount to the factor

irrespective of whether customer has paid or not
 Recourse
• client undertakes to collect the debts
from the customer

• If the customer don't pay the

amount on maturity, factor will
recover the amount from the client

• lower interest rate since the risk by

the factor is low
 Non recourse factoring
• factor undertakes to collect the debts from the
customer

• Balance amount is paid to client at the end of the

credit period or when the customer pays the
factor whichever comes first

• factoring will eliminate the need for credit and

collection departments
 Factoring In India
• Canbank Factors Limited

• SBI Factors and Commercial Services Pvt. Ltd

• The Hongkong and Shanghai Banking Corporation Ltd: 

• Foremost Factors Limited:

• Global Trade Finance Limited: 

• Export Credit Guarantee Corporation of India Ltd: 

• Citibank NA, India: 

• Small Industries Development Bank of India (SIDBI):

• Standard Chartered Bank:

Forfaiting
 Forfaiting
• The forfaiting owes its origin to a
French term ‘forfait’
• which means to forfeit (or surrender)
one’s rights on something to some one
else.
• Under this mode of export finance,
exporter forfaits his rights to the future
receivables and the forfaiter loses
recourse to the exporter in the event of
non-payment by the importer.
 Methodology

• Forfeiting is generally extended for

export of capital goods,
commodities and services

where the importer insists on supplies on

credit terms.
 Mechanism

• There are five parties in a transaction of

forfaiting. These are :
1. Exporter
2. Exporter’s bank
3. Importer
4. Importer’s bank and
5. Forfaiter
 Mechanism
• The exporter and importer negotiate

• The exporter approaches the forfaiter

• The forfaiter collects all the relevant

details of the proposed transaction,
viz., details about the importer, supply and
credit terms, documentation, etc., in order
to ascertain the country risk and credit
risk involved in the transaction..
 Mechanism
• Depending upon extent of these risks
the forfaiter quotes the discount rate.

• Discount rate must be reasonable and

would be acceptable to his buyer.

• He will then quote a contract price by

loading the discount rate, commitment
fee, etc.

• If the deals go through, the exporter and

forfaiter sign a contract.
 Mechanism

• Export takes place against documents

guaranteed by the importer’s bank.

• The exporter discounts the bill with the forfaiter

• The forfaiter presents the same to the importer

for payment on due date or even can sell it in
secondary market.
 Documentation and cost
• Forfaiting transaction is usually covered
either by
a promissory note
bill of exchange.

it has to be guaranteed by a bank or, bill of

exchange may be ‘avalled’ by the
importer’ bank.

• The forfeiting cost

‘commitment fee’,
FACTORING & FORFAITING
1.Suitable for ongoing 1. Oriented towards
open account sales, single transactions
not backed by LC or backed by LC or bank
accepted bills or guarantee.
exchange. 2. Financing is usually for
2. Usually provides medium to long-term
financing for short- credit periods from
term credit period of 180 days upto 7 years
upto 180 days. though shorterm credit
of 30–180 days is also
available for large
transactions.
FACTORING & FORFAITING
3.Requires a continuous 3. Seller need not route
arrangements or commit other
between factor and business to the
client, whereby all forfaiter. Deals are
sales are routed concluded transaction-
through the factor. wise.
4. Factor assumes 4. Forfaiter’s
responsibility for responsibility extends
collection, helps client to collection of
to reduce his own forfeited debt only.
overheads. Existing financing
lines remains
unaffected.
 FACTORING &
FORFAITING
5. Separate charges are 5. Single discount charges
applied for is applied which depend
—  financing on
—  guaranteeing bank
—  collection and country risk,
—  administration —  credit period
—  credit protection involved and
and —  currency of debt.
—  provision of Only additional charges
information. is commitment fee, if
firm commitment is
required prior to draw
down during delivery
period.
 FACTORING &
FORFAITING
6. Service is available 6. Usually available
for domestic and for export
export receivables. receivables only
7.Financing can be with denominated in
or without recourse;
the credit protection
any freely
collection and convertible
administration currency.
services may also be 7.It is always
provided without ‘without recourse’
financing.
and essentially a
financing product.
 DIFFERENCE BETWEEN
FACTORING AND FORFAITING
8. Usually no restriction 8. Transactions should
on minimum size of be of a minimum
transactions that can value of USD 250,000.
be covered by 9. Forfaiting will accept
factoring . only clean
9. Factor can assist with documentation in
completing import conformity with all
formalities in the regulations in the
buyer’s country and exporting/importing
provide ongoing countries
contract with buyers.
Venture Capital
 IMPERATIVES OF VENTURE
CAPITAL (VC)
• Technological progress is the key driver of economic growth
• Technological progress involves:
– Improvement in skills
– Better capital equipment
– New products, processes & business methods
• Technological progress in emerging economies will emerge from
enterprises catch-up
• Technology capacity is necessary to adopt technologies to local
conditions
• VC encourages technological progress via research & development
• VC converts research & development into new ventures
 FINANCING STAGES DURING
LIFE- CYCLE OF INITIATIVE
• VC funding is special which enterprises tap at different stages
of life cycle of initiative
• Seed - to prove concept

• Start-up - product development & market testing

• First stage - commercial production

• Second stage - expansion to scale

• Later stage - expansion of profitable enterprise

• Bridge/ Mezzanine - preparation for going public

 SNAPSHOT OF INDIAN
VENTURE CAPITAL SCENARIO
Snapshot of Indian Venture Capital Scenario
12000
10000
10000
Total Invested ($

8000
millions)

6000

4000

2000 1200 1100 1050

80 250 500
20
0
7 8 9 00 1 2 3 8
6-9 7-9 8-9 0 0-0 1-0 2-0 7-0
9 9 9 2
19 19 19 99- 200 200 200 200
19 Year

SOURCE: www.nishithdesai.com/Research-Papers/VCF-Xroads.pdf
Sector investment (2008)
 Regulations
• Securities & Exchange Board of India (SEBI) to:

– preferential offering
– Permit investment /surplus funds in bank deposits etc.
– Substantial Acquisition & Takeover Regulations

• Reserve Bank of India (RBI) to:

– Grant general permission under FEMA

– Allow banks to value VCF investments on cost basis
– Allow investment in real estate

• Government of India:
– Revisit tax issues for greater participation
– Allow investments in pension funds
– Streamline regulations under companies act including winding
up & valuation guidelines