FINANCIAL MANAGEMENT Section 2

SECTION 2 – CAPITAL STRUCTURE, COST OF CAPITAL & EQUITY VALUATION

I. Capital Structure

Every organization requires funds to operate a business, in the finance world, these funds are
known as Capital. Capital structure 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
 Preference Shares
 Bonds
 Bank Loan
 Debentures

Equity Shares: Its 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. Ownership in the company is determined by the number of shares a person owns
divided by the total number of shares issued. For example, if a company has issued 1000
shares and a person owns 50 of them, then he/she owns 5% 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 Public Company. A 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.

Preference Shares: It’s 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. Like equity share, preference shares represent partial ownership in a
company, although preference share shareholders do not enjoy any of the voting rights of
equity shareholders. Also unlike equity share, preference shares pay a fixed dividend that does
not fluctuate, although the company does not have to pay this dividend if it lacks the financial
ability to do so. The main benefit to owning preference shares are that the investor has a
greater claim on the company's assets than equity shareholders. Preference shareholders
always receive their dividends first and, in the event the company goes bankrupt, Preference
shareholders are paid off before equity shareholders. In general, there are four different types
of Preference shares: cumulative preferred, non-cumulative, participating, and convertible
preferred share.

Difference between Equity and Preference shares:

Claims – Preference shareholders have claim on the assets and income of the Company prior
to equity(ordinary) shareholders. Whereas, equity shareholders have only residual claim on
Company’s assets pr income
Dividend – In case of Preference shareholders, dividend rate is fixed, whereas in case of Equity
shareholders dividend rate is not fixed

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Redemption – Both Redeemable and Irredeemable preference shares can be issued.

Redeemable preference shares have a maturity. Irredeemable preference shares don’t have a
maturity. Equity shares have no maturity date
Conversion – A company can issue convertible Preference Shares wherein after a specified
date, such shares can be converted into equity. There is no concept of convertible equity
shares

Bonds: It is a debt instrument issued for a period of more than one year with the purpose of
raising capital by borrowing. The Federal government, states, cities, corporations, and many
other types of institutions sell bonds. Generally, 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. When an investor buys a bond, he/she becomes
a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the
issuer, unlike in the case of equities. On 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).
Bonds are often divided into different categories based on tax status, credit quality, issuer type,
maturity and secured/unsecured (and there are several other ways to classify bonds as well).
U.S. Treasury bonds are generally considered the safest unsecured bonds, since the possibility
of the Treasury defaulting on payments is almost zero. The 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). A 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. A riskier bond has to provide a higher payout to compensate for that
additional risk. Some bonds are tax-exempt, and these are typically issued by municipal, county
or state governments, whose interest payments are not subject to federal income tax, and
sometimes also state or local income tax.

Debentures: It’s an unsecured debt backed only by the integrity of the borrower, not by
collateral, and documented by an agreement called an indenture. One example is an unsecured
bond.

Bank Loan: An arrangement in which a Bank gives money to a borrower, and the borrower
agrees to repay the money, usually along with interest, at some future point(s) in time. Usually,
there is a predetermined time for repaying a loan. Generally a bank loan is backed by assets
belonging to the borrower in order to decrease the risk assumed by the Bank. The assets may
be forfeited to the Bank if the borrower fails to make the necessary payments.

II. Cost of Capital

The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This 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. In financial theory, cost of capital is the return that stockholders
require.

Cost of Equity

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A firm's cost of equity represents the compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership. There are two models to determine cost of
Equity namely:

 Dividend Growth Model

 Capital Asset Pricing Model (CAPM)

1. Dividend Growth Model

Under this model, cost of equity is the return(dividends) that shareholders expect on their
investment

Ke = [ {D0 (1+g)}/P0 ] + g

Where

Ke = Cost of Equity
D0 = Current Dividend
g = Growth rate of Dividends
P0 = Market Price of the share

Example – If a Company has issued equity shares which are currently quoted at Rs 125 each.
The company paid dividend of Rs 10 per share and expects a growth rate of 5% then cost of
equity will be calculated as follows:

Ke = {10 (1+.05)/125} + .05 = 0.134 or 13.4%

Calculating the growth rate

Following methods can be used of calculating the growth rate of Dividends (g)

a) Retention Ratio Method

g= bxr

Where, b = Profit retention ratio (or profits not distributed as dividends)

r = Return on Equity (or Return on Investment)

2. The capital asset pricing model (CAPM)

This model describes the relationship between risk and expected return and that is used in the
pricing of risky securities.

Ke = Rf + β(Rm-Rf)
Where:

Rf = Risk Free Return

β = Systematic Risk of the Security
Rm = Expected Market Return

The general idea behind CAPM is that investors need to be compensated in two ways: time

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value of money and risk. The time value of money is represented by the risk-free (rf) rate in
the formula and compensates the investors for placing money in any investment over a period
of time. The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This 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 (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-
free security plus a risk premium. If this expected return does not meet or beat the required
return, then the investment should not be undertaken. The security market line plots the
results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected return of
a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is
2 and the expected market return over the period is 10%, the stock is expected to return 17%
(3%+2(10%-3%)).

A calculation of a firm's cost of capital in which each category of capital is proportionately

weighted. All capital sources - common stock, preferred stock, bonds and any other long-term
debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the
beta and rate of return on equity increases, as an increase in WACC notes a decrease in
valuation and a higher risk.

Cost of Retained Earnings

Retained 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

Ke = Kr
Where
Ke = cost of equity
Kr = Cost of Retained Earnings

Cost of Debt

A Company may issue a debenture or bond at par, premium or discount to its face value. The
contractual rate of interest or the coupon rate forms the basis of calculating the cost of debt.

Irredeemable Debt

Kd = I (1-t)/SV
Where
Kd = Cost of debt
t = Tax rate
SV = Issue price/Market price minus flotation cost

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Example - A company issued 10% Debentures of Rs 100 each at 5% premium. Tax rate is 40%.
Calculate cost of debt.
Solution – I = 100 x 10% = 10 , t = 0.40 , SV = 100 x 5% + 100 = 105

Kd = 10 (1-0.4)/105 = 6/105 = 5.7%

Redeemable Debt

Kd = [I + {(RV-SV)}/n](1-t)/{(RV+SV)/2}
Where
Kd = Cost of debt
t = Tax rate
SV = Issue price/Market price minus flotation cost
RV = Redemption Value

Example - A company issued 15% Debentures of Rs 100 each at 5% discount redeemable at

10% premium after 10 years. Floation cost is 4%.. Tax rate is 40%. Calculate cost of debt.
Solution – I = 100 x 15% = 15 , t = 0.40 , SV =(100 - 100 x 5%) – 100 x 4% = 95 - 4 = 91, RV
= 100 + 100 x 10% = 110
Kd = [15 + {(110-91)}/10](1-0.4)/{(110+91)/2} = {15+(19/10)}x0.6/100.5 =
(16.9x0.6)/100.5 = 10.1%

Cost of Preference Shares

A Company may issue Preference Shares at par, premium or discount to its face value.

Irredeemable Preference Shares

Kp = D /P0
Where
Kp = Cost of Preference
D = Preference Dividend
P0 = Issue price/Market price minus flotation cost

Redeemable Preference Shares

Kd = [I + {(RV-SV)}/n](1-t)/{(RV+SV)/2}
Where
Kp = Cost of Preference
D = Preference Dividend
SV = Sales Value = Issue price/Market price minus flotation cost

RV = Redemption Value

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Weighted Average Cost of Capital (WACC)

WACC =( Ke x E + Kd x D + Kp x P +Kr x R)/ (E+D+P+R)

Where:
Ke = cost of equity
Kd = cost of debt
Kp= cost of Preference shares
Kr = Cost of Retained Earnings
E = Book value of the firm's equity
D = Book value of the firm's debt
P= Book value of the firm's Preference Shares
R = Book value of the firm's Retained Earnings

Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a
project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Weighted Average Cost Of Capital – WACC

Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its respective
use in the given situation. By taking a weighted average, we can see how much interest the
company has to pay for every dollar it finances.

A firm's WACC 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 expansionary
opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that
is similar to that of the overall firm.

III. Valuation of Equity Shares

Value of equity shares depend on the cash inflows expected by the investors. Valuation of Equity
Shares is relatively difficult because of two factors, first rate of dividend is not known second
payment of the dividend is discretionary.

Dividend Capitalization Model

Cash inflows expected from the equity shares consists of dividends that the shareholder expects
to receive and the price he expects to obtain when he sells his shares. Normally shareholder
doesn’t hold shares in perpetuity. He holds the share for some time, receives the dividend and
finally sells them to the buyer to obtain capital gains. When 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. The ultimate conclusion is that, for a shareholder, the expected 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 capital1. Hence value of an equity share is the
present value of its future stream of dividends.

Single Period Valuation

Let us assume that investors intends to buy a share and hold it for one year. Suppose he expects
a dividend of Rs 2 and market price at Rs 21 next year. If the investor’s opportunity cost of
capital is 15%, how much should he pay for the share. Present value(PV) of the share will be
equal to the PV of dividend at the end of one year plus the PV of expected market price of the
share after one year. Hence value of the share (P0) will be:

P0 = (D1+P1)/ (1+ke)

P0 = (2+21)/(1+0.15) = Rs 20

Multi- Period Valuation

In the above example let’s assume that the share holder intends to hold the share for 2 years
and the expected dividend at the end of 2nd year is Rs 2.10 and market price is 22.05. Based on
the logic that value of the share is equal to PV of expected dividends plus the liquidating price,
value of the share (P0) will be:

P0 = DIV1/ (1+ke) + (DIV2+P2)/ (1+ke)2

P0 = 2/(1+0.15) + (2.10+22.05)/(1+0.15)2 = Rs 20

Now if we have to derive the formula for “n” number of years it will be as follows:

PV = D1 + D2 + . . . . . . . . P n + Dn
(1+ke) (1+ke)2 (1+ke)n

n
PV = ∑ Dt + Pn
t=1 (1+ke)t (1+ke)n

Value of share under constant growth

In principle the time horizon of holding the shares could be very large. As the time horizon
lengthens, the proportion of PV contributed by dividends increases and PV of future price
declines. If the time horizon approaches infinity,, then the PV of the future price will approach to
zero. Thus the price of the share today is the present value of infinite stream of dividends.
Mathematically we can use the following formula:
1
Opportunity 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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P0 = D0 (1+g)/(ke-g)

Where; DIV1= DIV0(1+g)

g = dividend growth rate

Value of share under varied growth

In a situation where equity dividends exhibit 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 ∞
PV = ∑ D0(1+gs)t + ∑ D0(1+gn)t-n
t=1 (1+ke)t t=1 (1+ke)t

gs = supernormal growth rate

gn = normal growth rate
Example – A company has been growing at an abnormal rate of 14% which is expected to
continue for next 4 years. After that the company will grow normally at a rate of 5%. Required
rate of return on the investment is 12%. Dividend per share last year (D0) is Rs 3. Determine
market price of the share today.

Solution – D0 = 3 , ke = 0.12, gs = 0.14, gn = 0.05

We 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 1 - calculate future dividends till the time supernormal growth rate prevails. In the above
example it is 4 years

Year Dividends
2.2
1 2 x(1+.14) = 8
2.6
2 2 x(1+.14)2 = 0
2.9
3 2 x(1+.14)3 = 6
3.3
4 2 x(1+.14)4 = 8

Step 2 – Calculate present value of future dividends

Yea Dividen PV factor @

r ds 12% PV

1 2.28 0.893 2.04

2 2.60 0.797 2.07

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3 2.96 0.712 2.11

4 3.38 0.636 2.15

Total 8.36

Step 3 – Calculate the price of the share at the end of the year(“s”) when supernormal growth
ends, using the following formula

P0 = Ds (1+g)/(ke-g) x PV factor for the year when supernormal growth ends

P0 = 3.38(1+0.05)/(0.12-0.05) x PVF(12%,4)

P0 = (3.55/0.07) x 0.636

P0 = 50.67 x 0.636 = 32.2

Step 4 – Now add result of Step 2 and Step 3

P0 = 8.36 + 32.2 = Rs 32.20

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