CORPORATE FINANCE/

FINANCIAL MANAGEMENT

Cost of Capital

- Dr. Sandeep Goel

 COST OF CAPITAL
• Cost of raising the funds for investment purposes.

• It is often referred to as cut-off rate, target rate of return,

hurdle rate.
• Cost of Capital and (WACC) are used interchangeably

Importance
(i) Capital Budgeting decisions
- A yardstick to accept/reject a project.

(ii) Capital Structure Decision

 “Risk-Return Relationship”

Equity Share
Rate of Return/Cost of Capital

Preference
Share
Debentures

Government
Bonds
Risk-free
security

Risk
 CLASSIFICATION
Explicit Costs
- Cost that the firm pays to procure a source of finance
▪ Debt
▪ Preference Shares

Implicit Costs
- No ‘assured cost’ attached to a source of finance
▪ Equity Shares

▪ Retained Earnings
COMPUTATION OF COST OF CAPITAL
• Compute Specific Costs (Cost of each source of fund)
▪ Cost of Debt
▪ Cost of Preference Shares
▪ Cost of Equity
▪ Cost of Retained Earnings

• Assign Weights to specific costs (to each source of fund)

• Multiply (1) by (2) to get cost of capital (WACC)

▪ ko = kdwd + kpwp + kewe+ krwr
I COMPUTATION OF SPECIFIC COSTS
Cost of Debt
▪ Explicit Cost

▪ Tax Shield
o Interest paid is tax deductible
 Tax shield on Interest
25% tax rate
A (Zero debt) B (Rs. 2,000 debt@10%)
EBIT 1,000 1,000
Less: Interest - 200
EBT 1,000 800
Less: Tax 250 200
PAT 750 600

Effective interest rate 7.5%

Effective rate = I (1-T) = 10 (1-0.25) = 7.5%

➢ So, tax reduces the effective rate of debt for the company.
 Cost of Debt (kd) – Issued at Par “Unlisted
Bonds”
A company issues a 10% debenture of Rs. 1,00,000 at a
face value of Rs. 1000.The company is in 30% tax bracket.

Calculate the cost of debt (after tax):

(a) if it is 5-year debenture,
(b) if it is perpetual

Solution

kd (YTM) = I (1-T) = 100 (1-0.30) = 0.07 (7.0%)

MP/NP 1000
 Cost of Debt (kd) – Issued at Discount/Premium
MP/NP = ∑ I + P “Listed
(1+kd)^t (1+kd)^n Bonds”
n
I P
MP / NP =  +
t =1 (1 + kt )t (1 + kd )n
Short-cut method
kd = I + (P – MP/NP) / n (1-T)
(P + MP/NP) /2

Here, I = Annual Interest payment

P = Par value of debentures / Maturity value
MP/NP = Current Market Price / Net Sales Proceeds
T = Tax rate
n = Number of years to maturity
 Example “Listed Bonds”
A company issues a 5-year 10% debenture of Rs. 1,00,000 at a price
of Rs. 960. The face value is Rs.1000.The company is in 30% tax
bracket.
Calculate the cost of debt (after tax).

Solution
n
MP/NP = ∑ I + P MP / NP = 
I
+
P
(1+kd)^t (1+kd)^n t =1 (1 + k t )t
(1 + k d )n

960 = 100 + 100 + 100 + 100 + 100 + 1,000

(1+kd) 1 (1+kd)2 (1+kd) 3 (1+kd) 4 (1+kd)5 (1+kd) 5

kd (YTM) = 11% (7.7% after tax)

➢ The above method is applied to calculate “cost of listed debt” (YTM).
-contd.-

Short-cut method

kd = I + ( P-MP/NP) / n (1-T)
(P +MP/NP) /2

= 100 +(1000-960) / 5 (1- 0.30)

(1000+960) / 2

= 108 (0.70)
980

= 0.1102 x 0.70 = 0.07714 = 7.71%

 Cost of Preference Capital
▪ Explicit Cost – Fixed rate of dividend

▪ Dividend is not tax deductible

o No tax shield
 Cost of Preference Share (kp) – Issued at Par “Unlisted
Preference
A company issues a 10% preference share of Rs. 10,000
Shares”
at a face value of Rs.100.The company is in 30% tax bracket.

Calculate the cost of preference share:

(a) if it is 5-year preference share,
(b) if it is perpetual

Solution

kp = D = 10 = 0.1 (10%)
MP/NP 100
 Cost of Preference Share (kp) – Issued at
Discount/Premium
“Listed
MP/NP = ∑ D + P Preference
(1+kp)^t (1+kp)^n Shares”

Short-cut method
kp = D + (P – MP/NP) / n
(P + MP/NP) /2

Here, D = Annual dividend payment

P = Par value of preference shares / Maturity value
MP/NP = Current Market Price / Net Sales Proceeds

n = Number of years to maturity

 Example
A company issues a 5-year 10% redeemable preference share of Rs.
10,000 at a price of Rs. 95. The face value is Rs.100. The company
is in 30% tax bracket.
Calculate the cost of preference share.

Solution
MP/NP = ∑ D + P
(1+kp)^t (1+kp)^n

95 = 10 + 10 + 10 + 10 + 10+100
(1+kp) 1 (1+kp) 2 (1+kp) 3 (1+kp) 4 (1+kp) 5

kp = 11%
-contd.-

Short-cut method

kp = D + ( P-MP/NP) / n
(P +MP/NP) /2

= 10+(100-95) / 7
(100+95) / 2

= 10.71
97.5

= 0.1098 = 10.98%
 Cost of Equity Capital
▪ Implicit cost – no assured/coupon rate of return

▪ Rate of return that shareholders expect

➢ COEC is the rate of return that the firm must earn to meet
shareholders’ expectations and thereby increase
shareholders’ wealth.
 CAPITAL ASSET PRICING MODEL (CAPM)
o This approach to calculate cost of equity describes the ‘risk-
return’ trade-off for securities

o It is based on certain assumptions:

(a) the efficiency of the security markets
(b) investors’ preferences
-contd.-

CAPM Equation

ke = Rf + b (km - Rf )

Here, ke = Cost of equity capital

Rf = the risk free rate of return
km = Expected market return, i.e. return expected
on the market portfolio of shares

km - Rf = risk premium (difference between expected

market return and risk free rate of return)

b = beta of the firm’s share (systematic risk of

an equity share in relation to the market)
-contd.-

Calculation of Beta

βj = Covariance j m Co-movements of individual stock and market

Variance m Index volatility

Covar j, m
j =
σ 2m
σ j σ m Cor j, m σj
= =  Cor j, m
σm  σm σm
 Cost of Retained Earnings

▪ Implicit cost - No explicit obligation to pay a return

▪ Cost of retained earnings is the reearning foregone by the

shareholders.

➢ In other words, the cost of retained earnings is the

opportunity cost of retained earnings.

So, kr = ke
II ASSIGNING WEIGHTS TO SPECIFIC
COSTS
- This involves determination of the proportion of each source of
fund in the total capital structure of the company.
III MULTIPLY SPECIFIC COSTS WITH
WEIGHTS TO GET TOTAL COST

- Weighted Average Cost of Capital (WACC)

▪ ko = ∑ wiki

ko = kd (1-T)wd + ke we +kp wp + kr wr

Here, ko = WACC
wd,we,wp,wr = weights of each source in the capital structure
 CORPORATE FINANCE/
FINANCIAL MANAGEMENT

Designing Capital Structure

- Dr. Sandeep Goel

 PLANNING OF CAPITAL STRUCTURE
TWO ISSUES:

I. Is Capital Structure relevant for the valuation of a firm?

-Wealth maximization

II. Is there an Optimal Capital Structure?

-Financing mix that minimizes the overall cost of capital
and therefore maximizes the value of the firm is the
Optimal Capital Structure.

➢ At optimum level, the total cost of capital (ko) will be least.

 FACTORS AFFECTING CAPITAL
STRUCTURE
- Profitability Aspect
- Liquidity Aspect
- Cost of capital
- Control
- Flexibility
- Risk Attitude of the Management
- Period of Finance
 EBIT – EPS ANALYSIS
- It analyses the ‘Impact of various financing alternatives on EPS
at different levels of EBIT’

It helps the management in choosing the best financing plan.

➢ A technique used for ‘Shareholders Wealth Maximization’.

 EBIT-EPS Analysis

EPS
Debt

Debt advantage

Equity

EBIT
Equity
Indifference Point
advantage
 CORPORATE FINANCE/
FINANCIAL MANAGEMENT

Receivables Management

- Dr. Sandeep Goel

 RECEIVABLES
- Receivables arise from sale of goods or services in the ordinary
course of business on credit. [Commonly known as Debtors.]

Costs of Maintaining Receivables

• Opportunity cost

• Administrative cost

• Collection cost

• Default cost
RECEIVABLES MANAGEMENT
OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

Profitability

Costs &
Profitability Optimum Level

Liquidity

Stringent Liberal
THE AGEING SCHEDULE HIGHLIGHTS THE
DEBTORS ACCORDING TO THE AGE OR LENGTH
OF TIME OF THE OUTSTANDING DEBTORS.

AGEING SCHEDULE

Outstanding Period O/s Amount of Debtors % of Debtors

0 – 30 Days 40,00,000 40
31 – 60 Days 30,00,000 30
61 – 90 Days 10,00,000 10
Over 90 Days 20,00,000 20

Total 100,00,000 100

 HUL CASE
HUL is known for its liquidity management
The Company avails more days of credit facility from its suppliers
than it offers to its customers.

Current credit terms of suppliers 90 days

Credit terms to customers 11 days

Bill discounting facility with the bank

(rate of discounting is 8% p.a.) 60 days
 Types of Customers

Champion Demander
▪ Product/service is crucial ▪ Pays top-shelf price
▪ Good trading match ▪ Costly to serve

Cheapskate Losers
▪ Price-sensitive ▪ Low buying power
▪ Low service requirement ▪ Buying low-margin
 FACTORING

- The selling of receivables to a factor (financial institution / bank).

Factoring services
Fundamental
- Purchase of receivables of a firm

Other
- Maintenance of sales accounts and Credit management
- Credit collection and protection against default and bad- debt losses
- Financial Assistance, including loans and advance payments
- Information and counseling
 Bills Discounting – “Factoring”
Balance Sheet: Pre- Factoring Scenario
(Rs. in million)
Current liabilities Current assets
Bank borrowings 110 Inventory 100
Other current liabilities 40 Receivables 80
Other Current assets 20
Net working capital (NWC) 50 (including Cash & Bank)
Total current liabilities +NWC 200 Total current assets 200
Factoring of receivables 80 per cent @ 15 %
(Rs. 54 million for Rs. 64 million)
Balance Sheet: Post- Factoring Scenario
(Rs. in million)
Current liabilities Current assets
Bank borrowings 110 Inventory 100
Other current liabilities 40 Receivables 16
Other Current assets 74
Net working capital (NWC) 40 (including Cash & Bank)
Total current liabilities +NWC 190 Total current assets 190
 Factoring

Recourse Bad debt cover is not provided

(So, incase of default by the
customer, firm has to pay to the factor)

Non-recourse Bad debt cover is provided

 WHAT IS CASH?

• Cash and Bank Balance

- Ready cash / ready money

• Cash Equivalents
- Near money assets
Marketable securities /Short term, highly liquid investments
(Readily convertible into cash having a maturity of
less than 3 months)
 Cash Management Cycle
Business operations Cash collections

Sales and services Deficit Borrow

Surplus Invest

Cash payments
 CASH BUDGET
▪ A statement of firm’s expected cash inflows and outflows for
the time period.

▪ ‘Receipt & Payment Method’ is most commonly used

o Estimate Receipts
o Estimate Payments
o Surplus/ Deficit
 CORPORATE FINANCE/
FINANCIAL MANAGEMENT

Inventory Management

- Dr. Sandeep Goel

 INVENTORY MANAGEMENT
Inventory
- Goods held for sale by a firm

▪ Raw Material
▪ Work-in-Progress
▪ Finished Goods
▪ Stores and spares

Inventory Management
- To maintain an ‘optimum level’ of inventory at which the
total inventory costs are minimized.
 Basic Questions in Inventory Management

1. How much should be ordered? - Answered by EOQ/MOQ

2. How to control inventory movement? - ABC Analysis

3. How to optimize inventory usage? - JIT

 COST OF HOLDING INVENTORY
1. Ordering Cost - ‘Cost of acquiring raw materials (or supplies)’
(Cost per order x No. of orders)
- Cost of placing an order and securing supplies.

▪ Purchase requisition
▪ Purchase Order
▪ Transportation
▪ Receiving, inspecting and recording

➢ Generally it remains constant per order.

2. Carrying Cost - ‘Cost of holding’ (Carrying cost per unit x
- Cost of keeping items in stock. *Average Inventory)
*Order size /2
▪ Interest on Investment
▪ Store-keeping cost
▪ Deterioration and obsolescence losses
▪ Insurance premium
▪ Handling, etc.

➢ Larger the volume of inventory higher the carrying cost

and vice-versa

Total Cost = Ordering Cost + Carrying Cost

 Determination of Economic Order Quantity (EOQ)

- EOQ is the optimal size of the order at which total inventory

cost (ordering cost + carrying cost) is minimum.

Quantity of Order Total Inventory Cost

 ECONOMIC ORDER QUANTITY

Total costs

Carrying Costs

Costs

Ordering costs

(EOQ)

Quantity Per Order

EOQ = 2UO
C

▪ U = Annual Demand (units)

▪ O = Ordering Cost per order
▪ C = Carrying cost / Storage cost per unit

➢ Generally, Carrying cost is expressed as a percentage of

purchase price.
Example
A refrigerator manufacturer purchases 1,600 units of a certain
component from the supplier. His annual usage is 1,600 units. The
order placing cost is Rs. 100.The cost of purchasing one unit is Re1
and the cost of carrying one unit for a year is Rs. 8. Calculate the
EOQ.

Solution
2UO
EOQ = C

2 x 1,600 x 100
=
8
= 200 units
 EOQ vs. MOQ

EOQ Assumptions: ???

o Known & constant demand
o Instantaneous receipt of material
o Ordering cost & holding cost
 ABC Analysis
• Control by Exception

• Technique of ‘selective control’ of inventory

- More control is exercised over items which are more costly.

• Inventories are classified into three categories:

▪ Category A
Costliest Require more rigorous and intensive control
▪ Category B
Costlier Require relatively less control
▪ Category C
Costly Require Minimum control
 Just in Time (JIT) Approach
▪ Developed in Japan

▪ The objective is to have a perfect matching between

output of a firm needs of the market

▪ In case, something is not needed immediately it is not

manufactured.

▪ Maintain minimum level of inventory and rely on the suppliers

to provide parts and components’ “just in time”.
Requirements
o Strong & dependable relationship with suppliers
- Dependable quality
- Long term commitment

o Predictable production schedule

- Small lot size

o Geographical proximity
- Reliable transportation system

o Easy physical access to receiving and storage area

- Efficient receiving and material handling
 CORPORATE FINANCE/
FINANCIAL MANAGEMENT

Working Capital Management

- Dr. Sandeep Goel

 CASES!
❑ General Motors

❑ Jaypee

❑ Bata

❑ Indigo
 WORKING CAPITAL
• Capital needed for day to day operations.

Working Capital

Gross Working Capital Net Working Capital

Firm’s Investment in Current assets – Current liabilities

total current assets
 WORKING CAPITAL MANAGEMENT
Issues
▪ Level of Current Assets
Optimum
- Neither Too High / Nor Too Low

▪ Financing of Current Assets

- Aggressive vs. Conservative Policy
Trade off between ‘profitability and risk’
 OPERATING CYCLE
-The length of time required to complete the following cycle of events:

Operating Cycle =
Days in Inventory (115 days)
+
Days in Receivables (65 days)
=180 days

Operating Cycle =
Inventory Conversion Period +
Debtors (Receivable)
Conversion Period

Operating cycle = Time gap between sales and realization of cash

 Example
115 days are taken to deliver, process the raw material and sell the
finished goods to the customers.
Customers take further 65 days on average to pay.
Operating cycle = 115 inventory days + 65 debtor days = 180 days

➢ If the firm received a 30 days credit from its suppliers.

Cash conversion cycle = 180 days – 30 creditor days = 150 days

Cash Conversion Cycle / Cash Cycle/ Net operating cycle

= Operating Cycle – Accounts Payable Period

Cash conversion cycle = Time to receive the payments from sales –

Time to make payments for materials and labor
 Working Capital Cases
Working Capital
as at March, 2018
Industry: Automobiles (Rs. in Cr.)
Maruti Suzuki Mahindra &
India Ltd. Mahindra Ltd.
AHP (days) 14 20
ACP (days) 6 23
Operating Cycle (days) - (AHP+ACP) 20 43
APP (days) 50 62
Cash Cycle (days) - (Operating Cycle – APP) -30 -19
Current Assets (CA) 6,704.10 12,536.98
Current Liabilities (CL) 15,442.10 13,323.21
Working Capital (CA-CL) -8,738 -786.23
Total Assets 43,369.10 33,816.30
PAT 7,721.80 4,356.01
ROA (%) 17.80 12.88
-contd.-

Working Capital
as at March, 2018
Industry: FMCG (Rs. in Cr.)
Hindustan Unilever Ltd. Marico Ltd.
AHP (days) 24 84
ACP (days) 11 18
Operating Cycle (days) - (AHP+ACP) 35 102
APP (days) 90 46
Cash Cycle (days) - (Operating Cycle – APP) -55 56
Current Assets (CA) 8,268 1,884.95
Current Liabilities (CL) 8,636 951.18
Working Capital (CA-CL) -368 933.77
Total Assets 8,513 3,050.69
PAT 5,237 718.23
ROA (%) 61.52 23.54
-contd.-

Working Capital (Rs. in cr.)

as at March, 2018
(Rs. in cr.)
Industry: Automobiles Maruti Suzuki India Ltd. Mahindra & Mahindra Ltd.

Working Capital -8,738 -786.23

Industry: FMCG Hindustan Unilever Ltd. Marico Ltd.

Working Capital -368 933.77

Industry: Realty DLF Ltd. Sobha Ltd.

Working Capital 9,702.35 1,870.41

Industry: IT Infosys Ltd. TCS Ltd.

Working Capital 26,522 19,091

 FINANCING MIX POLICIES

Conservative Financing Policy

Total working capital (Permanent Working Capital

+ Temporary Working Capital)

Financed through Long-term sources

Positive working capital

➢ Less risky (regarding shortage of funds), more costly

Aggressive Financing Policy
Temporary Working Capital +Some Part of Permanent Working
Capital

Financed through Short-term Sources

Negative working capital

➢ More risky, less costly

Working Capital Investment (million pound)
Company British Cadbury Pizza
Petroleum Schweppes Express

Current assets 10,752 1,493 7

Current liabilities 10,617 1,902 14

Working capital 135 - 409 -7

Conservative Aggressive
 Working Capital – “Ratio Analysis, 2016!”

1. Operating cycle? = DIO+DSO

2. Cash Conversion Cycle (CCC) = DPO!
3. Different Industry/Business models – W.C. Management!
 1. W.C. – Industry Analysis

1. Industries in production of complex durable goods – Longer Operating Cycle

and CCC! Example : Construction Industry

2. Other end of Spectrum – Restaurants = Low OC + Zero/-ve CCC!

2. W.C. – Mfg. vs. Service Industry
 CORPORATE FINANCE/
FINANCIAL MANAGEMENT

Dividend Policy

- Dr. Sandeep Goel

 WHAT IS
DIVIDEND POLICY?
• It’s the decision to pay out earnings versus retaining and
reinvesting them.

• Includes these elements:

1. High or low payout?
2. Do we announce the policy?
 Legal restrictions
1. Indian Companies Act, 2013 & 1956
(a) Dividends can only be paid out of (i) the current profits of
the company, (ii) the past accumulated profits.
➢ Payment of dividend out of capital is illegal.

(b) A company is not entitled to pay dividends unless (i) it has

provided for present as well as arrears of depreciation, (ii) a
certain percentage of net profits of that year as prescribed by
the Central Government not exceeding 10% has been
transferred to the reserves of the company.
 TYPES OF DIVIDEND POLICY
• Constant dividend per share or Dividend rate
- As a per cent of the paid-up capital.

• Constant percentage (constant payout ratio)

- Constant percentage of the net profits is paid.

• Constant dividend per share plus extra dividend

➢ ‘Stability of dividends’ is emphasized in a dividend policy.

Stability - Regularity of dividends

 APOLLO TYRES
Constant dividend per share
35.00

30.00

25.00

20.00
EPS

DPS
15.00

10.00

5.00

0.00
2003 2004 2005 2006 2007

EPS 33.05 18.37 17.64 20.39 27.14

DPS 4.50 4.50 4.50 4.50 4.5

 BEL
Constant payout

120.00
100.00
80.00
60.00
40.00
20.00
0.00
March,05 March,06 March,07 March,08 March,09
EPS 55.80 72.88 89.86 103.34 93.23
DPS 11.20 14.60 18.00 20.70 18.70
D/P Ratio (%) 20.07 20.03 20.03 20.03 20.06
 HERO HONDA
Pay out ratio

80

70

60

50
%

40

30

20

10

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
CATERPILLAR – DIVIDEND HISTORY
GENERAL MOTORS – DIVIDEND
HISTORY
 BONUS SHARES
XYZ Ltd. declares a ‘1:1 bonus issue’, i.e. for every 1 share held,
the shareholders receive 1 additional share. PAT = Rs. 20 mn.
Promoters’ Holding: 4 million shares, 40%.
Pre and Post Bonus Issue Balance Sheet (in Rs. million)
Liabilities Assets Liabilities Assets
Share capital 100 - Share capital 200 -
(10 million (20 million
shares of shares of
Rs. 10 each) Rs. 10 each)

Reserves 200 - Reserves 100 -

300 300
EPS = Rs. 2 per share EPS = Rs. 1 per share
➢ A shareholder who earlier had 1 share will have 2 shares now.
 STOCK SPLIT
XYZ Ltd. declares a ‘5 for 1 stock split’, i.e. 1 old share will be
split into 5 new shares of Rs. 2. PAT = Rs. 20 mn.
Promoters’ Holding: 4 million shares, 40%.
Pre and Post Stock Split Balance Sheet (in Rs. million)
Liabilities Assets Liabilities Assets
Share capital 100 - Share capital 100 -
(10 million (50 million
shares of shares of
Rs. 10 each) Rs. 2 each)

Reserves 200 - Reserves 200 -

300 300
EPS = Rs. 2 per share EPS = Rs. 0.4 per share
➢ A shareholder who earlier had 1 share will have 5 shares now.
 REVERSE SPLIT/CONSOLIDATION OF
SHARES
XYZ Ltd. declares a ‘1:2 reverse split’, i.e. 2 old shares will be
consolidated into 1 new shares of Rs. 20. PAT = Rs. 20 mn.
Promoters’ Holding: 4 million shares, 40%.
Pre and Post Reverse Split Balance Sheet (in Rs. million)
Liabilities Assets Liabilities Assets
Share capital 100 - Share capital 100 -
(10 million (5 million
shares of shares of
Rs. 10 each) Rs. 20 each)

Reserves 200 - Reserves 200 -

300 300
EPS = Rs. 2 per share EPS = Rs. 4 per share
➢ A shareholder who earlier had 2 shares will have 1 share now.
 BUY BACK OF SHARES
XYZ Ltd. decides to buyback a ‘1 million shares’@ Rs. 14 per
Share. PAT = Rs. 20 mn.
Promoters’ Holding: 4 million shares, 40%.
Pre and Post Buyback Balance Sheet (in Rs. million)
Liabilities Assets Liabilities Assets
Share capital 100 - Share capital 90 (100-10) 14 (Cash)
(10 million (9 million
shares of shares of
Rs. 10 each) Rs. 10 each)

Reserves 200 - Reserves 196 (200-4) -

300 286
EPS = Rs. 2 per share EPS = Rs. 2.22 per share
 Top 5 companies that pay more than 25% dividend
(2009 to 2014)

• Average Indian wants: 'stable returns'.

• Stocks account: less than 5% of total household wealth.

➢ Top 10 dividend-paying stocks that have beaten the Sensex at

least seven times in the past 10 years.

Sanket Dhanorkar, ET Bureau|, Nov 24, 2014

https://economictimes.indiatimes.com/markets/stocks/news/top-10-companies-that-pay-more-than-25-
dividend/articleshow/45239432.cms?intenttarget=no
➢ ITC shares have shot up more than 10 times in the past 10 years.
➢ This manufacturer and distributor of innerwear brands has managed to
outperform the Sensex for each of the past seven years since it has been listed
in March, 2007.
➢ The stock has beaten the Sensex eight times in 10 years.