FINANCIAL MANAGEMENT 1

Prof. R Madhumathi
Department of Management Studies
 Module 4
Valuation of Debt / Equity
 Cost of Debt

Cost of Equity

Weighted Average Cost of Capital

Project / Division Cost of Capital

 Cost of Debt
Present Value of Bonds
A bond or debenture is a long-term debt instrument. Bonds issued by the
government or the public sector companies in India are generally secured. The
private sector companies issue secured or unsecured debentures. In the case
of a bond or debenture, the rate of interest is fixed and known to investors. A
bond is redeemable after a specified period. It is relatively easy to determine
the present value of a bond since its cash flows and the discount rate can be
determined without much difficulty. If there is no risk of default, then there is
no difficulty in estimating the cash flows associated with a bond. The expected
cash flows consist of annual interest payments plus repayment of principal. The
appropriate capitalization or discount rate to be applied will depend upon
riskiness of the bond. The risk in holding a government bond is less than the
risk associated with a debenture issued by a company. Consequently, a lower
discount rate would be applied to the cash flows of the government bond and a
higher rate to the cash flows of the company debenture.
Face value: Face value is called par value. A bond/debenture is generally issued at
a par value of INR 100 or INR 1000, and interest is paid on face value.

Interest rate: Interest rate is fixed and known to bondholders/debenture holders,

interest paid on a bond/debenture is tax deductible. The interest rate is also
called coupon rate. It is a rate mentioned on the certificate (coupon)

Maturity: A bond/debenture is issued for a specified period of time. It is repaid

on maturity.

Redemption value: The value which a bondholder/debenture holder will get on

maturity is called redemption value. A bond/debenture may be redeemed at par
or at premium (more than par value) or at discount (less than par value).

Market Value: A bond /debenture may be traded in a stock exchange. The price
at which it is currently sold or bought is called the market value of the
bond/debenture. Market value may be different from par value or redemption
value.
Bonds may be of two types:

a) Bonds with maturity

b) Perpetual bonds.
 Bond with a Maturity Period
• The following formula can be used to determine the value of bond:

Where:
P = Present value of bond/debenture
C = amount of Interest in period t
i = required rate of return on bond(%) also called cost of debt
M = terminal, or maturity, value in period n
N = number of years to maturity
A bond or debenture may be amortized every year. In that case, the principal
will decline with annual payments and interest will be calculated on the
outstanding amount.
Perpetual Bond

Bonds which will never mature, are known as perpetual

bond.
The value of the bond is determined as follows:

Bo = INT/kd
 Yield to Maturity:
• We may be required to calculate the required rate of return
when the bond's price and cash flow are known. This rate is
also known as yield to maturity (YTM) or bond's internal
rate of return.

Here i = Yield to maturity (YTM)

 Mini Case
• What is the value of a 10-year, INR 1,000 par value bond with a 10 percent annual
coupon, if its yield to maturity is 10%? .
• What would be the value of the bond described in #1 if, just after it was issued, the
expected inflation rate rose by 3 percentage points, causing investors to require a
13% interest return? Calculate the change in price.
• What would happen to the value of the bond described in #1 if inflation fell, and
the required rate of return declined to 7%? Calculate the change in price.
• What is the yield to maturity on a 6-year, 10% annual coupon, INR 100 par value
bond that sells for INR 96.75? What is the yield to maturity if the bond sells for
INR 91.62?
• Which bond has more interest rate risk, an annual payment 1-year bond or a 30-
year bond? Why?
• Which has more reinvestment risk, a 1-year bond or a 10-year bond? Why?
• What is the value of a perpetual bond with an annual coupon of INR 100 if its
required rate of return is 10%? 13%? 7%?
 Case Solution
• INR 1000
• INR 837.21
• INR 1210
• 10.76%; 12%
• 30-Year Bond
• 10-Year Bond
• INR 1000; INR 769.23; INR 1428.57
 COST OF EQUITY
The cost of equity denoted by Ke is the minimum expected rate of
return that the firm's stockholders require. The cost of equity can be
measured using the dividend discount model or the Capital Asset
Pricing Model.

The dividend discount model expects either a uniform payment of

dividend throughout the firm life or a growing dividend due to
internalization of profits.
 Dividend discount model
The dividend discount model for a constant dividend paying company
gives the following formula to compute the cost of equity.

Ke = Di / p

The dividend discount model for a growth company is:

Example:
The shares of a chemical company are selling at INR 20 per share.
The firm had paid dividend @ INR 2 per share last year. The
estimated growth of the company is approximately 5% per year.

(i) Determine the cost of equity capital of the company

(ii) Determine the estimated market price of the equity share if the
anticipated growth rate of the firm. (assume the cost of capital as
per earlier computation in (i))
(a) rises to 8% and (b) fall to 3%

Answer:
(I) Keg=(di/p)+g
= (2.10/20) + 0.05
= 0.105 + 0.05 = 0.155 i.e. 15.5%
ii)
(a)
g = 8% Then di=2.00 + 8% = 2.16
Ke = (di/p) + g
0.155 = (2.16 / p) + 0.08
0.155 - 0.08 = 2.16 / p
0.075 = 2.16 / p
p = 2.16 / 0.075 = INR 28.80

(b)
g = 3% Then di=2.00 + 3% = 2.06
Ke = (di/p) + g
0.155 = (2.06 / p) + 0.03
0.155 - 0.03 = 2.06 / p
0.125 = 2.06 / p
p = 2.06 / 0.125 = INR 16.48
 Mini Case
• The balance sheet indicates the capital structure for a company as:
Flotation costs are (a) 15 percent of market value for a new bond issue,
and (b) INR 2.01 per share for preferred stock.
• The dividends for common stock were INR 2.50 last year and are projected
to have an annual growth rate of 6 percent.
• The firm is in a 34 percent tax bracket.
• Market prices are INR 1,035 for bonds, INR 19 for preferred stock, and INR
35 for common stock.
• There will be sufficient internal common equity funding (i.e., retained
earnings) available such that the firm does not plan to issue new common
stock.

• What is cost of capital of equity and debt if the firm’s finances are in the
following proportions?

• Bonds: 8% INR 1000 par value with 16 year maturity (38% of book value)
• Preferred stock 5000 shares outstanding INR 50 par value with dividend
INR 1.50 (15% of book value)
• Common stock (47% of book value)
 Case Solution
• Cost of Debt: 10%. INR 1,035 (1 - .15) = INR
879.75 Value of debt at INR 879.75 = k d =
9.49%, After tax cost= 9.49%(1 - .34) = 6.26%
• Cost of Preferred Stock: k ps = 1.50/(19-
2.01)=8.83%
• Cost of Internal Common Funds: k cs = d/p + g
= 2.5(1.06)/35 + 0.06 = .07571+.06= .1357 =
13.57%
 WEIGHTED AVERAGE COST OF CAPITAL
Weighted average cost of capital is the average of the costs of the firm's
debt and equity weighted by their proportions in the firm's capital
structure.

The weights in the above formula is based on the market values. However, a
firm may also use the book value of debt and equity in its financial
composition to compute the weighted average cost of capital.
 WEIGHTED AVERAGE COST OF CAPITAL
Example:
Arise limited wishes to raise additional finance of INR 10 lakhs for
meeting its investment plans. It has INR 2,10,000 in the form of
retained earning available for investment purpose. The following
are the further details.
1) Debt / equity mix 30% / 70%

2) Cost of debt upto Rs 1,80,000 10% (before tax)

beyond Rs.1,80,000 16% (before tax)

3) Earnings per share Rs.4

4) Dividend pay out 50% of earnings
5) Expected growth rate in
10%
dividend

6) Current market price per share Rs.44

7) Tax rate 50%

You are required:
a) To determine the pattern for raising the additional finance.
b) To determine the post-tax average cost of additional debt.
c) To determine the cost of retained earnings and cost of equity,
and
d) Compute the overall weighted average after tax cost of
additional finance
 a)Pattern for raising the additional finance:-

Debt 30% of 10 lakhs INR 3,00,000

Equity 70% of 10 lakhs INR 7,00,000

Total INR10,00,000
Source Amount Cost
Debt 1,80,000 10%
Debt 1,20,000 16%
3,00,000

Retained Earnings 2,10,000

Equity 7,00,000-
4,90,000
2,10,000

Total 10,00,000
 B)Post - tax average cost of additional debt:-
Formula : kd(1-r)

kd= 1,80,000 X 10%= 18,000

Balance= 1,20,000 X16%= 19,200

Total= 3,00,000 37,200

37,200/3,00,000 X 100= 12.4%

Post-tax average cost of debt=12.4(1-0.5)= 6.2%

 C)Cost of Retained Earnings and cost of equity:

Cost of Retained Earnings:-

Kr= (di/po) +g
kr = (2.20 / 44) + 0.10 = 0.05 + 0.10 i.e. 15% (Note 1)

D) Cost of Equity:

ke = (2.20 / 44) + 0.10 = 0.05 + 0.10 i.e. 15%

Note 1:
Dividend pay-out =50% of earnings i.e.50% of 4=INR 2 per share
Growth rate g is 10%. Hence, at the end of year, dividend will be = INR 2 + 10%
=2.20
(d) Weighted Average after tax cost of additional
finance:-

Sources of After-tax Weighted Average

Amount Proportion
finance cost cost(%)

30% X 6.2% =
Debt 3,00,000 30% 6.2%
1.86%
Retained 21% X 15% =
2,10,000 21% 15%
Earnings 3.15%
49% X 15% =
Equity 4,90,000 49% 15%
7.35%

Total 10,00,000 100% 12.36%

 DIVISION / PROJECT COST OF CAPITAL
The Division/Project cost of capital is the risk-adjusted discount rate
at which the individual project's cash flow should be discounted.
When a firm evaluated individual projects, the project discount rate
may vary from one project to another because risk may vary. The risk
component varies due to the composition of project finance. A
project that is fully financed by equity is called an unlevered project
and one that is partially financed by equity and partially by debt is
called a levered project.
Example

M/s Efficient Corporation has a capital structure of 40% debt and 60% equity.
The company is presently considering several alternative investment
proposals costing less than INR 20 million. The corporation always raises the
required funds without disturbing its present debt equity ratio. The cost of
raising the debt and equity are as under:

cost of cost of
debt equity
Upto INR 2 million 10% 12%

Above INR 2 million & upto INR 5 million 11% 13%

Above INR 5 million & upto INR 10 million 12% 14%

Above INR 10 million & upto INR 20 million 13% 14.5%

Assuming the tax rate at 50% calculate:-

(i) Cost of capital of two projects X and Y whose fund requirements

are INR 6.5 million and INR 14 million respectively.

(ii) If a project is expected to give after tax return of 10% determine

under what conditions it would be acceptable?
Answer

Proportion of After tax cost (1- Weighted average

Project cost Financing
capital structure Tax 50%) cost(%)

Debt 0.4 10%(1-5)=5% 0.4 X 5 = 2.0

Upto INR 2 m 0.6 X 12=7.2
Equity 0.6 12%
9.2%
Debt 0.4 11%(1-5)=5.5% 0.4 X5. 5 = 2.2
Above INR 2 m &
upto INR 5 m 0.6 X 13=7.8
Equity 0.6 13%
10.0%
Debt 0.4 12%(1-5)=6% 0.4 X 6 = 2.0
Above INR 5 m &
upto INR 10 m 0.6 X 14=8.4
Equity 0.6 14%
10.8%
Debt 0.4 13%(1-5)=6.5% 0.4 X 6.5 = 2.6
Above INR 10 m &
upto INR 20 m 0.6 X 14.5=8.7
Equity 0.6 14.5%
11.3%
 cost of
Project Fund requirement
capital
X INR.6.5 million 10.8%

Y INR 14 million 11.3%

(ii) if a project is expected to give after tax return of 10%, it would be

acceptable provided cost does not exceed INR 5 million.

Acceptance criterion:
After tax return should be more than or at least equal to
the weighted average cost of capital.