Financial Management I

S S S Kumar
Indian Institute of Management Kozhikode
Calicut 673 570

2
Are betas stable?
ACC beta using 2000 Nov Nov 2004 data is 1.08
ACC beta using 2006 Jan Dec 2006 data is 0.79
ACC beta using the last 12 months data is 0.96


3
Accuracy of historical betas
Betas for the period 7/1954 6/1961 and 7/1961
6/1968
4
Association of betas over time
No. of securities in PF Correlation coefficient
1 0.60
2 0.73
4 0.84
7 0.88
10 0.92
20 0.97
35 0.97
50 0.98
5
Betas on ranked portfolios
No. of securities in PF 7/54 6/61 7/61 6/68
1 0.393 0.620
2 0.612 0.707
3 0.810 0.861
4 0.987 0.914
5 1.138 0.995
6 1.337 1.169
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Adjustment 1
1 2
677 . 0 343 . 0
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7
Adjustment 2
raw
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8
A look at the industry betas
Bank beta
All bank 0.84
Andhra bank 0.93
Axis 1.29
PNB 0.98
BoI 1.31
Canara 1.31
Dena 1.45
Fed 1.31
HDFC 0.96
ICICI 1.24
SBI 1.47
9
Estimating the beta
Frequency?
Length of sample
Risk free rate


Cost of Capital
11
The Purpose of the Cost of Capital
The cost of capital is the average rate paid for the
use of capital funds
Primarily used in capital budgeting
Use as the hurdle rate, or benchmark for projects
Compare IRR to this rate
Discount cash flows at this rate to find NPV
Any investment which does not cover the firms cost
of funds will reduce shareholder wealth (just as if
you borrowed money at 10% to make an investment
which earned 7% would reduce your wealth)

12
A simple definition
The required return necessary to make a capital
budgeting project worthwhile. Predominantly cost
of capital would include the cost of debt and the
cost of equity.

13
CoC contd..
The Cost of Capital is the required return for a
capital budget.
It is the opportunity cost of funds tied up in the
project.
It is the rate of return at which investors are willing
to provide financing for the project today.
It reflects the risk of the project.
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Project risk Vs. Firms risk
Carbon copies
Different lines of business
14
15
Fixing our thoughts
The managers of Rocky Mountain Motors are considering the
purchase of a new tract of land which will be held for one year.
The purchase price of the land is $10,000. RMMs capital
structure is currently made up of 40% debt, 10% preferred
stock, and 50% common equity. This capital structure is
considered to be optimal, so any new funds will need to be raised
in the same proportions.
Before making the decision, RMMs managers must determine
the appropriate require rate of return. What minimum rate of
return will simultaneously satisfy all of the firms capital
providers?
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RMM Example (cont.)
Source of
Funds
Amount Dollar
Cost
After-tax
Cost
Debt $4,000 $280 7%
Preferred $1,000 $100 10%
Common $5,000 $600 12%
Total $10,000 $980 9.8%
At the current capital structure is optimal, the
firm will raise funds as follows:
17
RMM Example (Cont.)
Rate of Return 8% 9.8% 11%
Total Funds Available $10,800 $10,980 $11,100
Less: Debt Costs $4,280 $4,280 $4,280
Less: Preferred Costs $1,100 $1,100 $1,100
= Remainder to Common $5,420 $5,600 $5,720
The following table shows three possible scenarios:
Obviously, the firm must earn at least 9.8%. Any less,
and the common shareholders will not be satisfied.
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The Weighted Average Cost of Capital
We now need a general way to determine the minimum
required return
Recall that 40% of funds were from debt.
Therefore, 40% of the required return must go to
satisfy the debtholders. Similarly, 10% should go to
preferred shareholders, and 50% to common
shareholders
This is a weighted-average, which can be calculated
as:
WACC w k w k w k
d d p p cs cs
= + +
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Capital Components
Components of a firms capital are
Debt
Borrowed money, either loans or bonds
Common equity
Ownership interest
Preferred stock
Cross between debt and equity
Capital structure is the mix of the three capital
components
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Capital Structure
Book value weights vs Market value weights
Book values reflect the cost of capital already spent
Market value estimates the cost of capital to be
raised in the near future
Market values are appropriate because new projects are
generally funded with newly-raised equity
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Returns and the Costs of Capital
Investors provide capital to companies by purchasing
their securities
The returns to investors represent the costs to the firms in
which investments are made
Opposite sides of the same coin
Since equity is riskier than debt, generally the return
on an equity investment is higher than that of debt
(or preferred stock), thus the cost to the firm is
higher
Cost and return are not exactly equal, but are related
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Estimation of Cost of capital
Step 1: Determine the proportions of each source to be
raised as capital
Step 2: Determine the marginal cost of each source.
Step 3: Calculate the weighted average cost of capital

Note that the cost of capital for a firm is the cost of
raising an additional dollar of capital.
As a first step we have to estimate the optimum
proportions for our firm to issue new capital.
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Estimation of Cost of capital contd
If the firm is going to maintain the same capital structure our
task is simple.
We have to figure out the proportions of capital the firm has
at present.
You have two options
1. You may use book values
2. Or consider using market values
Once we determine the book value/market value of debt,
preferred stock, and common stock, we calculate the sum
of the market values of each, and then figure out what
proportion each source of capital
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Determination of component costs
The cost of debt:
We know how to determine the cost of debt it is nothing
but the reqd. return of lenders.
Since cost of capital is on after-tax basis the cost of
debt should be adjusted to reflect the taxation
effects.
Associated Bearings pays an interest of Rs. 1.5 lakhs on a
term loan of Rs. 10 lakhs what is the cost of term loan
for Associated Bearings?
Cost of T L = 1.5/10
= 15% ????
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The cost of debt contd..
Taxes does play a role in at least reducing the cost of
debt since INTEREST IS A TAX DEDUCTIBLE
expense.
Let us make some sense out of this
Suppose there are two companies Debty with a loan
having an interest outgo of Rs. 10 and Debtfree with
out any debt. Let us assume both the companies earn
an income of Rs. 200.
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The cost of debt contd..
Debty Debtfree
EBIT 200 200
Interest 10 0
EBT 190 200
Tax@50% 95 100
EAT 95 100

What is the inference???
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The cost of debt contd..
pre-tax debt cost has to be adjusted to arrive at the
post-tax cost of debt
k
d
*
= k
d
(1-t)
k
d
*
is the post-tax cost of debt
k
d
is the pre-tax cost of debt
t is the marginal tax rate

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The cost of preference shares
Since preference shares pay a fixed rate of dividend
their valuation/cost is akin to that of bonds.
Also the preference dividend is not tax deductible
expense therefore the cost of preference shares is
simply equal to their yield.
And cost of equity can be estimated using CAPM or
DDM discussed earlier.
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Putting it all together
The cost of capital is the of cost of each source,
weights equal to the proportion in the total capital it
represents. Hence, it is also referred to as the
weighted average cost of capital (WACC).
WACC = w
d
k
d
(1-t) + w
p
k
p
+ w
e
k
e

30
An example
The present capital structure of Ramanujam Electronics is as
follows
Equity capital Rs. 1200 lakhs
10% loan Rs. 600 lakhs
Total Rs. 1800 lakhs
The current market price of the ordinary share is Rs. 220 and
a dividend of Rs. 10 per share has just been paid. The
company is confident of maintaining its present 10% growth
rate.The loan has a market price of Rs. 88 per Rs. 100 face
value, they have a remaining life of 5 years.
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Example contd
If the company is in the 50% tax bracket compute the
weighted average cost of capital using (1) book value
weights and (2) market value weights. Also assume
the face value of the shares as Rs 100.
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An example
Cost of equity: using DDM Ke =
D1/P +g
= (10)*(1.1)/220 +10%
=15%
Cost of debt: The Excel working is
shown adjacently
So Kd = 13% but this is pre tax cost
Applying 50% tax rate
Post tax debt cost = 6.5%
Year Cashflow
0 -88
1 10
2 10
3 10
4 10
5 110
Kd 13%
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An example
Case 1: Book Value proportions
Equity 1200 1200/1800 0.67
Loan 600 600/1800 0.33
Total 1800 1800/1800 1.00
Case 2: Market value proportions
Equity 2640 2640/3168 0.83
Loan 528 528/3168 0.17
Total 3168 3168/3168 1.00
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Continued
Case 1: Book Value proportions
Component weight cost Weighted cost
Equity 0.67 15% 10.05
Loan 0.33 6.5% 2.14
Total 12.19 ~ 12.2
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Continued
Case 2: Market value proportions
Component weight cost Weighted cost
Equity 0.83 15% 12.45
Loan 0.17 6.5% 1.10
Total 13.55%

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Calculating Component Costs of Capital
Flotation costsadministrative fees and expenses
incurred in the process of issuing and selling
securities
Lower the amount received when a security is issued,
increasing the cost of the capital raised
Thus, when a firm issues securities it will only net a portion
of the total amount issued, as the remainder must be paid as
issuance costs
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The Cost of Retained Earnings
Retained earnings (RE) are not free to the company because
they represent reinvested earnings for the stockholders
Thus, retained earnings represent money stockholders could have
spent if it had been paid out as dividends
Stockholders deserve a return on retained earnings
The market return on new shares is an appropriate starting
point for estimating the cost of retained earnings
No adjustments are needed between the return earned by new
buyers and the cost of RE because RE are generated
internallyno need to adjust for flotation costs or taxes
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When project risk differs
Pure play technique
Asset betas vs equity betas
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Analyzing Leverage
Debt is a true "double-edged" sword as it allows for
the generation of profits with the use of other
people's (lenders) money, but creates claims on
earnings with a higher priority than those of the
firm's owners.
Financial Leverage is a term used to describe the
magnification of risk and return resulting from the
use of fixed-cost financing such as debt and
preferred stock
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Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.10,000
Equity Rs.20,000 Rs.10,000
Interest rate n/a 8%
Shares 400 200
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Shares Outstanding = 400
Recession Normal Prosperous
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0
Net income Rs.1,000 Rs.2,000 Rs.3,000
EPS Rs.2.50 Rs.5.00 Rs.7.50

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Shares Outstanding = 200
Recession Normal Prosperous
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 800 800 800
Net income Rs200 Rs.1,200 Rs.2,200
EPS Rs.1.00 Rs.6.00 Rs.11.00

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Estimating CoC when project risk differs
Find a group of proxy firms
Collect their capital structures and their levered
betas
Unlever the betas
Calculate the average unlevered beta
Relever the beta with the firms capital structure
Use this beta in estimating Ke and calculate the CoC


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Unlevering the betas
Deep Well Oil Company is planning to invest in corn
flake production. It is expected that the project will
be financed by 30 percent of debt and 70 percent of
equity. The management of Deep Well has identified
a pure play firm that has an equity beta of 0.9. The
market value of equity of the pure-play firm is $60
million, and the market value of its debt is $20
million. Government bonds provide a return of 7
percent, and the market risk premium is 6.2 percent.
The corporate tax rate applicable to both Deep Well
and the pure play firm is 40 percent.

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45
Unlevering contd..
What is the asset beta of the proxy firm?
When a firms beta is unlevered, what type of risk
is removed? What types of risk are captured by a
firms equity beta?
Estimate the corn flake projects equity beta.
Compute the projects cost of equity.
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Mistakes To Avoid When Estimating CoC
The project is going to be financed entirely with
debt, so its relevant cost of capital is the interest
rate on the debt.
Or, The project is going to be financed entirely
with equity, so its relevant cost of capital is the cost
of equity.
Wrong because
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47
Mistakes To Avoid When Estimating CoC
Although the project does not have the same risk as
the firm, its relevant cost of capital should be equal
to the firms WACC.
Wrong because
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Mistakes To Avoid When Estimating CoC
When a projects risk is different from the risk of
the firm, the projects cost of capital should be
lowered to account for the risk reduction that
diversification brings to the firm.
Wrong because