FINANCIAL MANAGEMENT

Section 2

SECTION 2 CAPITAL STRUCTURE, COST OF CAPITAL & EQUITY VALUATION

I. Ca ita! St"#ct#"e Every organization requires funds to operate a business, in the finance world, these funds are known as Capital. Ca ita! $t"#ct#"e refers to the way a Company finances its assets through some combination of equity, debt, or hybrid securities. Capital structure of a Company may comprise following:

Equity Shares reference Shares !onds !ank "oan #ebentures

E%#it& S'a"e$( $ts an instrument that signifies an ownership position %called equity& in a Company, and represents a claim on its proportional share in the Company 's assets and profits. (wnership in the company is determined by the number of shares a person owns divided by the total number of shares issued. )or e*ample, if a company has issued +,,, shares and a person owns -, of them, then he.she owns -/ of the company. Equity share also provides voting rights, which give shareholders a proportional vote in certain corporate decisions. Equity shares can only be issued by a ublic Company. 0 company is not obliged to pay dividends to equity shareholders unless there are profits, even if there are profits, company may decide to reinvest the same. P"e)e"ence S'a"e$( $t1s a share which receives a specific dividend that is paid before any dividends are paid to equity share holders, and which takes precedence over equity share in the event of a liquidation. "ike equity share, preference shares represent partial ownership in a company, although preference share shareholders do not en2oy any of the voting rights of equity shareholders. 0lso unlike equity share, preference shares pay a fi*ed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. 3he main benefit to owning preference shares are that the investor has a greater claim on the company's assets than equity shareholders. reference shareholders always receive their dividends first and, in the event the company goes bankrupt, reference shareholders are paid off before equity shareholders. $n general, there are four different types of reference shares: cumulative preferred, non4cumulative, participating, and convertible preferred share. *i))e"ence +et,een E%#it& an- P"e)e"ence $'a"e$( C!ai.$ 5 reference shareholders have claim on the assets and income of the Company prior to equity%ordinary& shareholders. 6hereas, equity shareholders have only residual claim on Company1s assets pr income *i/i-en- 5 $n case of reference shareholders, dividend rate is fi*ed, whereas in case of Equity shareholders dividend rate is not fi*ed

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Re-e. tion 5 !oth 7edeemable and $rredeemable preference shares can be issued. 7edeemable preference shares have a maturity. $rredeemable preference shares don1t have a maturity. Equity shares have no maturity date Con/e"$ion 5 0 company can issue convertible reference Shares wherein after a specified date, such shares can be converted into equity. 3here is no concept of convertible equity shares 0on-$( $t is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. 3he )ederal government, states, cities, corporations, and many other types of institutions sell bonds. 8enerally, a bond is a promise to repay the principal along with interest %coupons& on a specified date %maturity&. Some bonds do not pay interest, but all bonds require a repayment of principal. 6hen an investor buys a bond, he.she becomes a creditor of the issuer. 9owever, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. (n the hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress %this is true for all creditors&. !onds are often divided into different categories based on ta* status, credit quality, issuer type, maturity and secured.unsecured %and there are several other ways to classify bonds as well&. :.S. 3reasury bonds are generally considered the safest unsecured bonds, since the possibility of the 3reasury defaulting on payments is almost zero. 3he yield from a bond is made up of three components: coupon interest, capital gains and interest on interest %if a bond pays no coupon interest, the only yield will be capital gains&. 0 bond might be sold at above or below par %the amount paid out at maturity&, but the market price will approach par value as the bond approaches maturity. 0 riskier bond has to provide a higher payout to compensate for that additional risk. Some bonds are ta*4e*empt, and these are typically issued by municipal, county or state governments, whose interest payments are not sub2ect to federal income ta*, and sometimes also state or local income ta*. *e+ent#"e$: $t1s an unsecured debt backed only by the integrity of the borrower, not by collateral, and documented by an agreement called an indenture. (ne e*ample is an unsecured bond. 0an1 Loan( 0n arrangement in which a !ank gives money to a borrower, and the borrower agrees to repay the money, usually along with interest, at some future point%s& in time. :sually, there is a predetermined time for repaying a loan. 8enerally a bank loan is backed by assets belonging to the borrower in order to decrease the risk assumed by the !ank. 3he assets may be forfeited to the !ank if the borrower fails to make the necessary payments.

II. Co$t o) Ca ita!

3he cost of capital determines how a company can raise money %through a stock issue, borrowing, or a mi* of the two&. 3his is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. Cost of capital includes the cost of debt, cost of preference shares and the cost of equity. $n financial theory, cost of capital is the return that stockholders require.

Co$t o) E%#it&

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0 firm's cost of equity represents the compensation that the market demands in e*change for owning the asset and bearing the risk of ownership. 3here are two models to determine cost of Equity namely:

#ividend 8rowth ;odel Capital 0sset ricing ;odel %C0 ;&

2. *i/i-en- G"o,t' Mo-e! :nder this model, cost of equity is the return%dividends& that shareholders e*pect on their investment 3e 4 5 6*7 829:;<=P7 > 9 : ?'e"e <e = Cost of Equity #, = Current #ividend g = 8rowth rate of #ividends rice of the share , = ;arket E*ample 5 $f a Company has issued equity shares which are currently quoted at 7s +>- each. 3he company paid dividend of 7s +, per share and e*pects a growth rate of -/ then cost of equity will be calculated as follows: 3e 4 627 829.7@;=22@< 9 .7@ 4 7.2AB o" 2A.BC

Ca!c#!atin: t'e :"o,t' "ate )ollowing methods can be used of calculating the growth rate of #ividends %g& a; Retention Ratio Met'og= b*r 6here, b = rofit retention ratio %or profits not distributed as dividends& r = 7eturn on Equity %or 7eturn on $nvestment& 2. T'e ca ita! a$$et "icin: .o-e! 8CAPM;

3his model describes the relationship between risk and e*pected return and that is used in the pricing of risky securities.

3e 4 R) 9 D8R.ER);
6here: 7f = 7isk )ree 7eturn ? = Systematic 7isk of the Security 7m = E*pected ;arket 7eturn 3he general idea behind C0 ; is that investors need to be compensated in two ways: time

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value of money and risk. 3he time value of money is represented by the risk4free %rf& rate in the formula and compensates the investors for placing money in any investment over a period of time. 3he other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. 3his is calculated by taking a risk measure %beta& that compares the returns of the asset to the market over a period of time and to the market premium %7m4rf&. 3he C0 ; says that the e*pected return of a security or a portfolio equals the rate on a risk4 free security plus a risk premium. $f this e*pected return does not meet or beat the required return, then the investment should not be undertaken. 3he security market line plots the results of the C0 ; for all different risks %betas&. :sing the C0 ; model and the following assumptions, we can compute the e*pected return of a stock in this C0 ; e*ample: if the risk4free rate is @/, the beta %risk measure& of the stock is > and the e*pected market return over the period is +,/, the stock is e*pected to return +A/ %@/B>%+,/4@/&&. 0 calculation of a firm's cost of capital in which each category of capital is proportionately weighted. 0ll capital sources 4 common stock, preferred stock, bonds and any other long4term debt 4 are included in a 60CC calculation. 0ll else equal, the 60CC of a firm increases as the beta and rate of return on equity increases, as an increase in 60CC notes a decrease in valuation and a higher risk.

Co$t o) Retaine- Ea"nin:$

7etained earnings are the profits not distributed to the equity shareholders as dividends. Since retained earnings belong to equity shareholders hence the cost of retained earnings is equal to cost of equity shares. i.e

3e 4 3"
6here <e = cost of equity <r = Cost of 7etained Earnings

Co$t o) *e+t
0 Company may issue a debenture or bond at par, premium or discount to its face value. 3he contractual rate of interest or the coupon rate forms the basis of calculating the cost of debt. I""e-ee.a+!e *e+t

3- 4 I 82Et;=SV
6here

<d = Cost of debt t = 3a* rate SC = $ssue price.;arket price minus flotation cost

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EFa. !e 4 0 company issued +,/ #ebentures of 7s +,, each at -/ premium. 3a* rate is D,/. Calculate cost of debt. So!#tion 5 $ = +,, * +,/ = +, , t = ,.D, , SC = +,, * -/ B +,, = +,-

3- 4 27 82E7.B;=27@ 4 G=27@ 4 @.HC

Re-ee.a+!e *e+t

3- 4 5I 9 68RVESV;<=n>82Et;=68RV9SV;=2<
6here

<d = Cost of debt t = 3a* rate SC = $ssue price.;arket price minus flotation cost 7C = 7edemption Calue EFa. !e 4 0 company issued +-/ #ebentures of 7s +,, each at -/ discount redeemable at +,/ premium after +, years. )loation cost is D/.. 3a* rate is D,/. Calculate cost of debt. So!#tion 5 $ = +,, * +-/ = +- , t = ,.D, , SC =%+,, 4 +,, * -/& 5 +,, * D/ = E- 4 D = E+, 7C = +,, B +,, * +,/ = ++,

3- 4 52@ 9 68227EI2;<=27>82E7.B;=682279I2;=2< 4 62@982I=27;<F7.G=277.@ 4 82G.IF7.G;=277.@ 4 27.2C

Co$t o) P"e)e"ence S'a"e$

0 Company may issue reference Shares at par, premium or discount to its face value. I""e-ee.a+!e P"e)e"ence S'a"e$

3 4 * =P7
6here

<p = Cost of reference # = reference #ividend , = $ssue price.;arket price minus flotation cost Re-ee.a+!e P"e)e"ence S'a"e$

3- 4 5I 9 68RVESV;<=n>82Et;=68RV9SV;=2<
6here

<p = Cost of reference # = reference #ividend SC = Sales Calue = $ssue price.;arket price minus flotation cost 7C = 7edemption Calue

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?ei:'te- A/e"a:e Co$t o) Ca ita! 8?ACC;

?ACC 48 3e F E 9 3- F * 9 3 F P 93" F R;= 8E9*9P9R;

6here: <e = cost of equity <d = cost of debt <p= cost of reference shares <r = Cost of 7etained Earnings E = !ook value of the firm's equity # = !ook value of the firm's debt = !ook value of the firm's reference Shares 7 = !ook value of the firm's 7etained Earnings !usinesses often discount cash flows at 60CC to determine the Fet resent Calue %F C& of a pro2ect, using the formula: F C = resent Calue % C& of the Cash )lows discounted at 60CC. 6eighted 0verage Cost (f Capital 5 60CC !roadly speaking, a company1s assets are financed by either debt or equity. 60CC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. !y taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. 0 firm's 60CC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of e*pansionary opportunities and mergers. $t is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

$$$.

Va!#ation o) E%#it& S'a"e$

Calue of equity shares depend on the cash inflows e*pected by the investors. Caluation of Equity Shares is relatively difficult because of two factors, first rate of dividend is not known second payment of the dividend is discretionary. *i/i-en- Ca ita!iJation Mo-e! Cash inflows e*pected from the equity shares consists of dividends that the shareholder e*pects to receive and the price he e*pects to obtain when he sells his shares. Formally shareholder doesn1t hold shares in perpetuity. 9e holds the share for some time, receives the dividend and finally sells them to the buyer to obtain capital gains. 6hen he sells the share. the new buyer is simply purchasing a stream of future dividends and a liquidating price when he also sells the share. 3he ultimate conclusion is that, for a shareholder, the e*pected cash inflows consists of

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only future dividends and therefore the value of an equity share is determined by capitalizing the future dividends stream at opportunity cost of capital+. 9ence value of an equity share is the present value of its future stream of dividends. Sin:!e Pe"io- Va!#ation "et us assume that investors intends to buy a share and hold it for one year. Suppose he e*pects a dividend of 7s > and market price at 7s >+ ne*t year. $f the investor1s opportunity cost of capital is +-/, how much should he pay for the share. resent value% C& of the share will be equal to the C of dividend at the end of one year plus the C of e*pected market price of the share after one year. 9ence value of the share % ,& will be:
,

= %#+B +&. %+Bke& = %>B>+&.%+B,.+-& = 7s >,

M#!tiE Pe"io- Va!#ation $n the above e*ample let1s assume that the share holder intends to hold the share for > years and the e*pected dividend at the end of >nd year is 7s >.+, and market price is >>.,-. !ased on the logic that value of the share is equal to C of e*pected dividends plus the liquidating price, value of the share % ,& will be:
,

= #$C+. %+Bke& B

%#$C>B >&. %+Bke&>

= >.%+B,.+-& B %>.+,B>>.,-&.%+B,.+-&> = 7s >,

Fow if we have to derive the formula for GnH number of years it will be as follows: C= #+ B #> B . . . . . . . . %+Bke& %+Bke&> n C= t=+ I #t %+Bke&t B %+Bke&n
n n

B #n %+Bke&n

Va!#e o) $'a"e #n-e" con$tant :"o,t' $n principle the time horizon of holding the shares could be very large. 0s the time horizon lengthens, the proportion of C contributed by dividends increases and C of future price declines. $f the time horizon approaches infinity,, then the C of the future price will approach to zero. 3hus the price of the share today is the present value of infinite stream of dividends. ;athematically we can use the following formula:
+

(pportunity cost of capital is the return that the shareholder could earn from an investment of equivalent value and risk in the market.

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,

Section 2

= #, %+Bg&.%ke4g&

6hereJ #$C+= #$C,%+Bg& g = dividend growth rate Va!#e o) $'a"e #n-e" /a"ie- :"o,t' $n a situation where equity dividends e*hibit supernormal growth for a number of years and then eventually taper off to the normal sustainable growth, then we need to modify the above stated formula as below: n C= t=+ I #,%+Bgs&t %+Bke&t B I t=+ #,%+Bgn&t4n %+Bke&t

gs = supernormal growth rate gn = normal growth rate E*ample 5 0 company has been growing at an abnormal rate of +D/ which is e*pected to continue for ne*t D years. 0fter that the company will grow normally at a rate of -/. 7equired rate of return on the investment is +>/. #ividend per share last year %#,& is 7s @. #etermine market price of the share today. Solution 5 #, = @ , ke = ,.+>, gs = ,.+D, gn = ,.,6e know that current market price of the share is the discounted value of future dividends plus the discounted value of the price prevailing in the future. Step + 4 calculate future dividends till the time supernormal growth rate prevails. $n the above e*ample it is D years Kear + > @ D #ividends > *%+B.+D& = > *%+B.+D&> = > *%+B.+D&@ = > *%+B.+D&D = >.> L >.M , >.E M @.@ L

Step > 5 Calculate present value of future dividends Kea r + > #ividen ds >.>L >.M, C factor N +>/ ,.LE@ ,.AEA C >.,D >.,A

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@ D

>.EM @.@L

,.A+> ,.M@M 3otal

>.++ >.+K.AG

Step @ 5 Calculate the price of the share at the end of the year%GsH& when supernormal growth ends, using the following formula
,

= #s %+Bg&.%ke4g& * C factor for the year when supernormal growth ends = @.@L%+B,.,-&.%,.+>4,.,-& * C)%+>/,D& = %@.--.,.,A& * ,.M@M = -,.MA * ,.M@M = @>.>

Step D 5 Fow add result of Step > and Step @

,

= L.@M B @>.> = 7s @>.>,

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