A.

Cost of Equity

Cost of equity refers to a shareholder's required rate of return on an equity investment. It is

the rate of return that could have been earned by putting the same money into a different
investment with equal risk1

One way that companies and investors can estimate the cost of equity is through the Capital
asset pricing model (CAPM).

It is a model that describes the relationship between Risk and expected return and is used is
pricing of risky securities.

Ra = Rf + β (Rm-Rf)

where,

Ra = Cost of Equity

Rf = Risk Free rate of Return

β = The stock’s market risk

Rm = The Average return on market

For Sobha Developers, Considering data from financial results 2017-18; the required rate of
return for stockholders using CAPM model is as follows:

Beta (β) 0.92 Calculated market risk

Rf 7.58% 10 yrs government bonds
Rm 19.47% Average Market Return
Ra 18.6%

Ra = 7.58% + 0.92(19.47% - 7.58%)

= 18.6%

Therefore, the cost of Equity is 18.6%

B. Cost of Debt

The cost of debt is the return that a company provides to its debtholders and creditors.
These capital providers need to be compensated for any risk exposure that comes with
lending to a company. Not only does cost of debt, as a rate, reflect the default risk of a
company, it also reflects the level of interest rates in the market2

1 https://investinganswers.com/financial-dictionary/stock-valuation/cost-equity-2476
2 https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-debt/
The following formula is used for calculating the Cost of Debt:

finance cost
kd = x 100
average loan(long term liabilities)

Annual Report 2017-18 data

Finance costs

in ` million
For the year ended For the year ended
31-Mar-18 31-Mar-17
Interest
- On borrowings 2,257.80 2,479.50
- Others 253.66 92.34
Bank charges 198.1 169.23
2,709.56 2,741.07
Less: Interest cross -731.96 -1,244.37
charged/ inventorised/
capitalised on qualifying
assets
1,977.60 1,496.70

Finance cost = total finance cost – others – Bank Charges

= 1977.60 – 253.66 – 198.1

= 1525.84

Borrowings
in ` million
As at As at
31-Mar-18 31 March 2017
Non-current borrowings

Secured debentures
25,500 (31 March 2017 - 2,516.91 3,183.62
32,500) redeemable non-
convertible
debentures of ` 0.10
million each
Secured loans
Term loans from banks 496.18 1,417.21
Term loans from financial - 246.65
institutions
Equipment loans 0.19 0.19
496.37 1,664.05
 Amount disclosed under -225 -424.34
the head “other current
financial liabilities”
(refer note 18)
Net amount 271.37 1,239.71
Total non-current 2,788.28 4,423.33
borrowings
Current Borrowings
Secured loans
Term loans from banks* 14,541.14 11,274.20
Term loans from financial 2,756.52 4,036.99
institutions*
Cash credit from banks 3,001.71 2,060.63
Total current borrowings 20,299.37 17,371.82

* Term loan from banks and financial institutions represents amount repayable within the
operating cycle. Amount payable within twelve months ` 10,698.28 million (31 March 2017 - `
4,816.34 million)

March 2018 Long term Liabilities = Total non-current borrowings + [(Term loan from Bank
+ Term Loan from Financial Institutions) – term loan from bank and financial institutions
amount payable within 12 months]

= 2788.28 + [(14541.14 + 2756.52) – 10698.28]

= 9387.66

March 2017 Long term Liabilities = Total non-current borrowings + [(Term loan from Bank
+ Term Loan from Financial Institutions) – term loan from bank and financial institutions
amount payable within 12 months]

= 4423.33 + [(11274.20 + 4036.99) – 4816.34]

= 14918.18

Therefore,

Average Long-Term Liabilities = 12152.92

Kd = (1525.84/12152.92) x 100

= 12.55%

WACC of the company is as follows:

WACC = Ke x W e + Kd x Wd

Where, W e and W d are weightages of equity and debt in the capital structure.

Given, We = 54% Wd = 46%

Ke = 18.6% Kd = 12.55%
WACC = 18.6 x 0.54 + 12.55(1-0.32) x 0.46

= 13.97 %

B. Levered Unlevered Beta, WACC for the proposed project

The act of "unlevering" beta involves extracting the impact of debt obligations of a company
before evaluating an investment's risk in comparison to the market. Unlevered beta shows
the volatility of returns without financial leverage. Unlevered beta is known as asset beta,
while the levered beta is known as equity beta3

Unlevered beta is calculated as:

𝐸
𝛽𝑈 = 𝛽𝐿 𝑥
𝐷(1 − 𝑇) + 𝐸

where,

βU = unlevered beta

βL = levered beta

E = Equity

D = Debt

T = Tax rate
𝑇𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡
𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 (𝑇) = 𝐸𝐵𝑇
𝑋 100

Profit before tax 3,171.40 2,577.75

Tax expenses
Current tax 764.46 961.16
Deferred tax charge/ (credit) 238.24 9.06
Income tax expense 1,002.70 970.22

Tax rate (T) = (1002.70/3171.40) x 100

= 31.62%

βU = 0.92 x 27699.31/62548.84(1-0.3162) + 27699.31

= 0.36

3https://www.investopedia.com/ask/answers/102714/why-do-i-need-unlever-beta-when-making-wacc-
calculations.asp
The Subsidiary of Sobha developers, Sobha ventures ltd’s capital structure is as follows

The company continues to keep the Debt : Equity ratio as 1:1.5 so as to maintain the
balance between Debt and Equity. The company neither wants to take excessive financial
burden from the financial institutions nor it wants to incur heavy cost of equity.

Equity = 600 lakh rupees

Debt = 400 lakh rupees

Debt/Equity Ratio = 2:3

Wd = 0.40 We= 0.60

The relevering of beta is done to find the volatility for the new project

Using this future Debt/Equity Ratio and adding it back into the Unlevered Beta, to come up
with the levered Beta for the new project.

𝐸
𝛽𝑈 = 𝛽𝐿 𝑥
𝐷(1 − 𝑇) + 𝐸

0.36 = βL x 600/400(1-0.35) + 600

βL = 0.516

So now we have, a Beta which includes both business risk and financial risk.

Since there is no change in the financial cost,the kd (cost of Debt) will remain the same and
there will be change in Ke (cost of Equity) due to adjustment in the risk

Using CAPM,

Ra = Rf + β (Rm-Rf)

Ra = 7.58% + 0.516(19.47% - 7.58%)

= 13.71%

The WACC for the proposed project is,

WACC = Ke x W e + Kd x Wd

WACC = 13.71 x 0.60 + 12.55(1-0.35) x 0.40

= 11.49 %