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CORPORATE FINANCE

HEMANT MANUJ

January 4, 2023 1
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COST OF CAPITAL

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 LEARNING OBJECTIVES

➢ Cost of Debt
❖ Yield, Yield to Maturity
❖ Duration

➢ Cost of Equity
❖ Dividend Discount Model
❖ Other Valuation Measures

➢ Weighted Average Cost of Capital (WACC)

❖ Computation of WACC

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COST OF DEBT

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 COST OF DEBT

➢ The cost of debt for any business is the cost to

Liabilities Assets
the business of holding that debt
Equity 100 Fixed 200
➢ Cost of debt = Interest paid / Debt outstanding Debt 200 Current 100
Total 300 Total 300

➢ D1. Sohan Bearings has a debt of Rs. 420,000. P&L Account

It has a profit before interest and tax of Rs. PBIT 60
100,000. If it pays an annual interest of Rs. Interest 20
80,000 on a quarterly basis, compute the cost of
PBT 40
debt. Ignore the time value of money within a
Tax 10
year.
PAT 30

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 VALUATION OF BONDS

➢ A coupon bond is a promise to pay, against an initial investment, a stream of cash flows in
the form of interest and principal at various points in future
➢ Example: Marico Ltd issues a bond with a face value of Rs. 100 on January 01, 2017. It will pay
a semi annual interest at the rate of 7% p.a. till the date of maturity on January 01, 2022.

➢ Discount bond – No interest is paid, but is compounded and paid along with maturity. In
other words, bond is issued at a discount to the maturity price
➢ Example: Marico Ltd issues a bond with a face value of Rs. 100 on January 01, 2017. The bond
is issued at Rs. 67 and the date of maturity is January 01, 2022

➢ Bonds may be issued at par/ premium / discount

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 YIELD TO MATURITY (YTM) & DURATION OF A BOND
➢ Poonam holds a bond with a
➢ Yield to maturity (YTM)– the single discount rate that you would use to
maturity value of Rs. 100,
discount all of the bond’s cash flows to get today’s market price
paying a semi annual
➢ Price is inversely related to Yield of a bond coupon of 9% p.a. The last
coupon date was
31/03/2022 and the maturity
➢ YIELD (settlement, maturity, rate, price, redemption, frequency, [basis])
date of the bond is
31/03/2027. The market
➢ Duration – The % change in the price of a bond for a 1% change in yield. price of the bond, as of
today is Rs. 97.
❖ Computed as the PV of cash flows weighted maturity of the bond

❖ Measured in years; varies between zero and the maturity of the bond
➢ What is the YTM and
➢ DURATION(settlement, maturity, coupon, yield, frequency, [basis])
duration of the bond?

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 BOND RATINGS

➢ Credit rating
➢ Indicates the probability of default of a bond, as per a standardised scale used by a credit rating
agency
➢ Different scales for domestic rating and internal ratings (e.g. CRISIL and S&P)

➢ Yield on a bond = Inflation + Real Interest rate = Inflation + Risk free rate + Default risk
premium

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COST OF EQUITY

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 EQUITY SHARES
➢ Equity shares represent ownership in a company
➢ Primary market – Shares are issued by the company
❖ Fresh shares may issued, or existing shares may be sold to a set of new investors
❖ Initial Public offer (IPO) or Follow on Public Offer (FPO)

➢ Secondary market – Existing shares are sold by one investor to another investor
❖ Shares can be listed on stock exchanges
❖ Unlisted shares are transacted privately, not on stock exchanges

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 VALUATION OF STOCK
➢ Value of a stock is the present value of all future cash flows
❖ A share is never redeemed, hence future cash flows means future dividends

➢ PV(share) = PV(expected future dividends)

➢ For an investor, who buys a share to sell at a future date,
❖ Value of a share = Expected value of Future dividends for n periods+ Capital gains from sale of share

n
P0 = ∑ Di + Pn where
i=1
(1 + ki)i (1+ Kn)n
Di is the dividend in the ith period and Pn is the exit price of the stock

➢ When the stock is held till perpetuity, the present value of the exit price becomes zero. Then,
∞
P0 = ∑ Di
i=1
(1 + ki)

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 VALUATION OF SHARE

➢ Example V1: Suppose you wish to buy a share of Sharma Cements Ltd. The share will pay a
dividend of Rs. 5 per annum. You wish to hold the share for 5 years, and expect to sell the
share at Rs. 110. If the discount rate is 10% pa., what is the price that you should pay for the
share?

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 DIVIDEND DISCOUNT MODEL OF EQUITY VALUATION
➢ If the dividend is expected to grow at a constant rate, g, then
P0 = D0(1+g)/(1+ke) + D0(1+g)2/(1+ke)2 + D0(1+g)3/(1+ke)3 + …….
= D0 (1+g) / {(1+ke)-(1+g)}
= D0(1+ g) / (ke-g) , { Valid only when g < k, else stock value is infinite}

or, Value of a stock, P0 = D1/ (ke-g) { Gordon Growth Model}

Hence, the rate of return from a share, also called as the cost of an equity share is
ke = D1 / P0 + g

Cost of equity = Dividend yield + growth rate of dividend

= Dividend yield + Capital gains yield

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 DIVIDEND DISCOUNT MODEL OF EQUITY VALUATION
➢ Limitations of DDM
❖ Requires forecast of dividends
❖ Assumes a constant growth rate of dividends
❖ Most investors are focussed more on capital gains

➢ Example V2: Suppose you wish to buy a share of Sharma Cements Ltd. The share paid a
dividend of Rs. 5 per annum in the current year. You wish to hold the share for ever. If the
dividend is expected to grow at 8% per annum and the discount rate is 10% pa. what is the
price that you should pay for the share?

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 FREE CASH FLOW MODEL OF VALUATION
➢ Discounting the stream of free cash flows (FCFs) in the future

➢ R6: Compute the value of business with the following figures:

PAT - First year 100

Growth rate of earnings 10%

Depreciation - First year 30

Increase in depreciation per annum 10%
Capital Expenditure 30
Growth rate of capex 10%
Discount rate 15%

Terminal value of the company after 27 yrs 300

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 CAPM

➢ Capital Asset Pricing Model (CAPM)

➢ Used to estimate the return on a risky asset
➢ Can be used to compute the cost of equity

➢ Formula used for CAPM is:

➢ E(ri) = rf + βi {E(rM) - rf }
where βi = Cov i,M / σM2
{E(rM) - rf } = Market risk premium (MRP)
{E(ri) - rf } = Equity risk premium (ERP)

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 LEVERED BETA

➢ Levered beta
= Unlevered beta x {1+(1-tc)xD/E}
➢ Unlevered beta is used to take out the effect of debt from the cost of equity

R8 The levered beta for Ramu Farm Products is 1.20. The leverage (D/E) of the firm, as of
today, is 2. The effective tax rate for the firm is 25%. Compute:
a) The unlevered beta of the firm
B) The levered beta of the firm if the leverage is reduced to 1.

Answer: a) 0.48 b) 1.36

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 RELATIVE VALUATION MEASURES
➢ Price Earning Ratio (P/E)
❖ Most commonly used ratio – simple to compute and understand
❖ Earnings could be subject to accounting distortions/ manipulations

➢ Price Earnings to Growth Ratio (PEG)

❖ P/E in conjunction with growth rate of earnings ; helps in capturing the growth potential of the stocks

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 RELATIVE VALUATION MEASURES
➢ Price to Book Value
❖ Benefit of not affected by cyclicality of earnings
❖ However, book value is based on historical cost, hence does not reflect true value

➢ Price to cash flows

❖ Benefit of less distortion, but does not provide the full picture, as provided by earnings

➢ Price to Sales
❖ Used only in infancy businesses ; does not depict the clear benefit to the investor

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WEIGHTED AVERAGE COST OF CAPITAL

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 WEIGHTED AVERAGE COST OF CAPITAL

➢ Weighted average cost of capital (WACC) (Including preference shares)

❖ WACC = {D/ (D+P+E) * rd + P/(D+P+E)*rp + E/ (D+P+E) * re }
= (D * rd + P * rp + E * re ) / (D + P + E)
❖ re , rp and rd should all be the same, i.e. either post tax or pre-tax rates
❖ re and rp are usually available as post tax and rd is pre-tax

❖ WACC (post- tax) = {D* (1-T)/ (D+P+E) * rd + P/(D+P+E)*rp + E/ (D+P+E) * re }

= {(D *(1-T)* rd + P * rp + E * re )} / (D + P + E)
❖ WACC (pre- tax) = [{D/ (D+P+E) * rd + P/(D+P+E)*rp / (1-T) + {E/ (D+P+E)} * re / (1-T)} ]
= {(D* rd + P * rp (1-T) + E * re/(1-T)} / (D + P + E)

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 WACC

➢ Example R10
❖ The pre-tax cost of debt for Shyamali Farms is 8%. The cost of equity (post-tax) is 12%. If
the tax rate is 20%, the total debt is Rs. 5 crores, and equity is Rs. 2 crore, what is the post
tax weighted average cost of capital for the company?

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 WACC

➢ Example R5
❖ Calculate the WACC for the given data

Asset Value V 100

Debt Value D 30
Preference shares Value P 20
Equity Value E 50

Debt - Coupon rate rd 7.0%

Preference shares - coupoun rate rP 9.0%
Tax rate T 30%

Risk free rate of return rf 6.0%

Equity market rate of return rm 10.0%
Beta β 1.2

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