Sources of Finance and Cost of Capital | CMA Inter Syllabus
Table of Content
CMA Inter Blogs :
To start any buisness,
raising of funds or collection of funds is very much needed because without money one cannot do anything. So, we need to know about different sources of funds either long-term or short-term based on the requirement of the firm.
Financial sources may be external or internal, but they may also be short-term, medium-term and long-term in types. Generally, long-term sources of finance are used for a period of 5 to 10 years, medium-term sources of finance are needed for a period of 1 to 5 years. Here one thing to say that identification of medium-term financial needs is arbitrary. Sometimes, long-term requirements for which long-term funds cannot be arranged immediately may be financed from medium-term sources, thus generation of medium-term financial needs and short-term financial requirements means actually the ‘working capital requirements’. It is usually required for a period upto 1 year.
Sources of Finance – Classification
Based on financial requirements, there are a number of ways of raising finance i.e. collection of funds for a business. The source of finance chosen depends on the nature of the business. Some other internal and external factors are there. However, financial sources of a business may be classified as follows:
These three types of sources are mentioned below:
Sources of Finance
| Type of Funds | Owners Funds | Borrowed Funds |
| Long-Term | a. Equity Share Capital | a. Debentures/Bonds |
| b. Prefernce Share Capital | b. Term Loans from financial institutions | |
| i. Rupee Loan | ||
| ii. Foreign Currency Loan | ||
| c. Retained Earning (Plough back of profits) | c. Term-loan from Banks | |
| d. Capital Subsidy/Incentives | d. Venture Capital Financing | |
| e. Interest free Sales Tax Loan | ||
| f. Asset/Debt securitization | ||
| g. Euro Equity Issues | ||
| h. New Debt Instruments | ||
| Medium-term | Prefernce Share Capital | a. Debentures / Bonds |
| b. Public Deposits | ||
| c. Loans from Financial Institutions | ||
| d. Loan from Commercial Banks | ||
| e. Lease Financing | ||
| f. Hire Purchase / Installment Financing Scheme. | ||
| g. Euro Debt Issue | ||
| h. New Debt Instruments | ||
| Short-Term | Part of Working Capital | a. Credit from Trade and Expense |
| Creditors | ||
| i. Trade Credits | ||
| ii. Advances from customers | ||
| iii. Short-term provisions | ||
| b. Bank Advances | ||
| c. Factoring | ||
| d. Commercial Papers | ||
| e. Public Deposits | ||
| f. Inter-Corporate Deposits | ||
| g. Short-term Unsecured Debentures | ||
| h. Bridge Finance | ||
| i. Certificate of Deposits |
As stated above in table 4.1, the sources of capital are classified into three broad categories, where some sources may be internationally financed. However, these are —
The above sources are discussed below:
1.1 Long-Term and Short-term sources of finance
A. Long-Term Sources of Finance
Long-term financing means capital requirements for a period of more than 5 years to 10 or 15 or 20 years based on other factors. Long-term sources of finance are required for capital expenditures in fixed assets like plant and machinery, land and building, etc. Long-term financing sources can be in the form of any of them:
The above sources of long-term finance are discussed below:
i. Equity Share Capital
Equity share capital is a basic source of finance for any firm. It represents the ownership interest in the company. The characteristics of equity share capital are a direct consequence of its position in the company’s control, income and assets. Equity share capital does not have any maturity and there is no compulsion to pay dividend. The equity share capital provides funds, more or less, on a permanent basis. It also works as a base for creating the debt and loan capacity of the firm.
The advantages and disadvantages of equity share capital may be summarized as follows:
Advantages of Equity Share Financing
Disadvantages of Equity Share Financing
ii. Preference Share Capital
The preference share capital is also owner’s capital but it has a maturity period. In India, the preference shares must be redeemed within a maximum period of 20 years from the date of issue. The rate of dividend payable on preference shares is also fixed. As against the equity share capital, the preference shares have two references:
However, the preference share capital represents an ownership interest and not a liability of the company. The preference shareholders have the right to receive dividends in priority over the equity shareholders. Indeed, it is this preference which distinguishes preference shares from equity shares. A dividend need not necessarily be paid on either type of shares. However, if the directors want to pay equity dividend, then the full dividend due on the preference shares must be paid first. Failure to meet commitment of preference dividend is not a ground for liquidation. The advantages and disadvantages of the preference share capital are as follows:
Advantages of Preference Share Financing:
Limitations of Preference Share Financing:
iii. Term Loans
Term loans are also known as term or project finance. This is also an important source of long-term financing for expansion, diversification and modernization of business. There are different financial institutions like banks and other financial institutions to provide term loans. The maturity period of term loans is typically longer in the range of 6-10 years in comparison to 3-5 years of bank advances.
Sometimes, the funds are required in foreign currency to make payment for acquisition and import of plants and equipments. In 1992, the Government of India permitted Indian companies with good track record of 3 years or more to raise funds by issue of equity/debt capital in international market. There are different means of arranging long-term finance in foreign currency.
iv. Debenture/Bond
A bond or a debenture is the basic debt instrument which may be issued by a borrowing company for a price which may be less than, equal to or more than the face value. A debenture also carries a promise by the company to make interest payments to the debenture holders of specified amount, at specified time and also to repay the principal amount at the end of a specified period. Since the debt instruments are issued keeping in view the need and cash flow profile of the company as well as the investor, there have been a variety of debt instruments being issued by companies in practice. In all these instruments, the basic feature of being in the nature of a loan is not dispensed with and, therefore, these instruments have some or the other common features as follows:
In practice, different types of debentures have been issued. These are:
| On the basis of redemption | On the basis of security | On the basis of conversion | On the basis of regestration |
| i. Redeemable debentures | i. Secured debentures | i. Convertible debentures | i. Registered debentures |
| ii. Irredeemable debentures | ii. Un-secured debentures | ii. Non-convertible debentures | ii. Bearer debentures |
v. Lease Capital or Leasing
Leasing is an arrangement that provides a firm with the use and control over assets without buying and owning the same. It is a form of renting assets. Lease is a contract between the owner of asset (lessor) and the user of the asset (lessee), where by the lessor gives the right to use the asset to the lease over an agreed period of time for a consideration called the lease rental. The contract is regulated by the terms and conditions of the agreement. The lessee pays the lease rent periodically to the lessor as regular fixed payments over a period of time.
There are two basic kinds of leases:
I. Operating or Service Lease
An operating lease is usually characterized by the following features:
Operating or service leasing is common to the equipments which require expert technical staff for maintenance and are exposed to technological developments, e.g. computers, vehicles, data processing equipments, communications systems, etc. Operating lessors usually limit their activities to field and engage themselves in the purchase of large number of similar types of machines or equipment. They are able to offer attractive terms to their customers because savings in maintenance costs.
II. Financial Lease
A lease is classified as financial lease if it ensures the lessor for amortization of the entire cost of investment plus the expected return on capital outlay during the terms of the lease. Such a lease is usually for a longer period and non-cancellable. Financial Leases are commonly used for leasing land, building, machinery and fixed equipments, etc.
A financial lease is usually characterized by the following features:
vi. Retained Earnings
The portion of profits not distributed among the shareholders but retained and used in the business is called retained earnings. It is also known as ploughing back of profit or retained capital or accumulated earnings.
vii. Venture Capital
Venture capital is a form of equity financing especially designed for funding high risk and high reward projects. There is a common perception that venture capital is a means of financing high technology projects. However, venture capital is investment of long-term financial made in:
The term ‘venture capital’ represents financial investment in a highly risky project with the objective of earning a high rate of return.
Modes of Finance by Venture Capitalists
a. Equity
Most of the venture capital funds provide financial support to entrepreneurs in the form of equity by financing 49% of the total equity. This is to ensure that the ownership and overall control remains with the entrepreneur. Since there is a great uncertainty about the generation of cash inflows in the initial years, equity financing is the safest mode of financing. A debt instrument on the other hand requires periodical servicing of dept.
b. Conditional Loan
From a venture capitalist point of view, equity is an unsecured instrument hence a less preferable option than a secured debt instrument. A conditional loan usually involves either no interest at all or a coupon payment at nominal rate. In addition, a royalty at agreed rates payable to the lender on the sales turnover. As the units picks up in sales levels, the interest rate is increased and royalty amounts are decreased.
c. Convertible Loans
The convertible loan is subordinate to all other loans which may be converted into equity if interest payments are not made within agreed time limit.
From the financing point of view, short-term financing means financing for a period of less than 1 year. The need for short-term finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also named as working capital financing.
Any organisation requires working capital margin to take up day-to-day operations. The working capital amount is divided into two parts – (a) Permanent Working Capital, and (b) Temporary Working Capital. The permanent working capital should be financed from long-term sources and temporary working capital should be financed from short-term sources.
Short-term finances are available in the form of:
Important short-term sources are discussed below:
i. Trade Credit
When a firm buys goods from another, it may not be required to pay for these goods immediately. During this period, before the payment becomes due, the purchaser has a debt outstanding to the supplier. This debt is recorded in the buyer’s balance sheet as creditors; and the corresponding account for the supplier is that of debtors. The amount of such financing depends on the volume of purchases and the payment timing. Small and new firms are usually more dependent on the trade credit, as they find it difficult to obtain funds from other sources. Trade credit may take form of open account or bills payable.
ii. Accrued Expenses
Another source of short-term financing is the accrued expenses or the outstanding expenses liabilities. The accrued expenses refer to the services availed by the firm, but the payment for which has not yet been made. It is a built-in and an automatic source of finance as most of the services, are paid only at the end of a period. The accrued expenses represent an interest free source of finance. There is no explicit or implicit cost associated with the accrued expenses and the firm can save liquidity by accruing these expenses.
iii. Commercial Paper
Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period, generally, varying from a few days to a few months. For example, in India, the maturity period of CP varies between 15 days to 1 year. It is a money market instrument and generally purchased by Commercial Banks, money market mutual funds and other financial institutions desirous to invest their funds for a short period. As the CP is unsecured, the firms having good credit rating can only issue the CP. The details of commercial paper are discussed in working capital management chapter.
iv. Inter-Corporate Deposits (ICDs)
Sometimes, the companies borrow funds for a short-term period, say up to six months, from other companies which have surplus liquidity for the time being. The ICDs are generally unsecured and are arranged by a financier. The ICDs are very common and popular in practice as these are not marred by the legal hassles. The convenience is the basic virtue of this method of financing. There is no regulation at present in India to regulate these ICDs. Only the companies Act, 2013 provides that inter-corporate investments not to be made through more than two layers of investment companies. The transactions in the ICD are generally not disclosed as the borrowing under the ICDs imply a liquidity shortage of the borrower. The rate of interest on ICDs varies depending upon the amount involved and the time period. The entire working of ICDs market is based upon the personal connections of the lenders, borrowers and the financiers.
v. Short-term Unsecured Debentures
Companies have raised short-term funds by the issue of unsecured debentures for periods up to 17 months and 29 days. The rate of interest on these debentures may be higher than the rate on secured long-term debentures. It may be noted that no credit rating is required for the issue of these debentures because as per the SEBI guidelines, the credit ratings required for debentures having maturity period of 18 months or more. The use of unsecured debentures as a source of short-term financing, however, depends upon the state of capital market in the economy. During sluggish period, the companies may not be in a position to issue these debentures. Moreover, only established firms can issue these debentures as new company will not find favour from the investors. Another drawback of this source is that the company procures funds from retail investors instead of getting a lump-sum from one source only. Further, that the issue of securities in capital market is a time-consuming process and the issue must be planned in a proper way.
vi. Bank Credit
Credit facility provided by commercial banks to meet the short-term and working capital requirements has been important short-term sources of finance in India. The bank credit, in general, is a short-term financing, say, for a year or so. This short-term financing to business firm is regarded as self-liquidating in the sense that the uses to which the borrowing firm is expected to put the funds are ordinarily expected to generate cash flows adequate to repay the loan within a year. Further, these loans are called self-liquidating because the bank’s motive to provide finance is to meet the seasonal demand, e.g., to cover the seasonal increase in inventories or receivables. In principle, the bank credit is intended to carry the firm through seasonal peaks in financing need. The amount of credit extended by a bank may be referred to as a credit limit which denotes the maximum limit of loan which the firm can avail from the bank. Sometimes, the bank may approve separate limits for peak season and non-peak season.
Types of Bank Credit
In India, banks may give financial assistance in different shapes and forms. The usual form of bank credit is as follows:
The above sources will be discussed in Module 6 (Working Capital Financing) in details.
vii. Other sources as Financial Services
1. Hire Purchase System
Hire purchase means a transaction where goods are purchased and sold on the terms that payment will be made in instalments, the possession of the goods is given to the buyer immediately and the property (ownership) in the goods remains with the vendor till the last instalment is paid.
The main characteristics of a hire purchase agreement are as below:
2. Forfeiting
The term “a forfeit” means, “relinquish a right”. It refers to the exporter relinquishing his right to a receivable due at a future date in exchange for immediate cash payment, at an agreed discount, passing all risks and responsibilities for collecting the debt to the forfeiter.
It is discounting of international trade receivable on a 100% “without recourse” basis. “without recourse” means the client gets full credit protection and all the components of service, i.e. short-term finance, administration of sales ledger are available to the client.
Forfeiting transforms the supplier’s credit granted to the importer into cash transaction for the exporter protecting him completely from all the risks associated with selling overseas on credit. It effectively transforms a credit sale into a cash sale.
Procedure of Forfeiting
3. Bill Discounting
Generally, a trade bill arises out of a genuine credit trade transaction. The supplier of goods draws a bill on the purchaser for the invoice price of the goods sold on credit. It is drawn for a short period of 3 to 6 months and in some cases for 9 months. The buyer of goods accepts the same and binds himself liable to pay the amount on the due date. In such a case, the supplier of goods has to wait for the expiry of the bill to get back the cost of the goods sold. It involves locking up of his working capital which is very much needed for the smooth running of the business or for carrying on the normal production process. It is where the commercial banks enter into as a financier.
The commercial banks provide immediate cash by discounting genuine trade bills. They deduct a certain charge as discount charges from the amount of the bill and the balance is credited to the customer’s account and thus, the customer is able to enjoy credit facilities against the discounting of bills. Of course, this discount charges include interest for the unexpired period of the bill plus some service charges. Bill financing is the most liquid one from the banker’s point of view since, in time of emergencies, they can take those bills to the Reserve Bank of India (RBI) for rediscounting purposes. Infact, it was viewed primarily as a scheme of accommodation for banks. Now, the situation is completely changed. Today it is viewed as a kind of loan backed by the security of bills.
4. Factoring
Factoring may be defined as the relationship between the seller of goods and a financial firm, called the factor, whereby the latter purchases the receivables of the former and also administer the receivable of the former. Factoring involves sale of receivable of a firm to another firm under an already existing agreement between the firm and the factor.
Modus Operandi
A factor provides finance to his client up to a certain %age of the unpaid invoices which represent the sale of goods or services to approved customers. The modus operandi of the factoring scheme is as follows.
Basic Types of Factoring
Under this type, a factor provides all kinds of services discussed above. Thus, a factor provides finance, administers the sales ledger, collects the debts at his risk and renders consultancy service. This type of factoring is a standard one. If the debtors fail to repay the debts, the entire responsibility falls on the shoulders of the factor since he assumes the credit risk also. He cannot pass on this responsibility to his client and, hence, this type of Factoring is also called ‘Without Recourse’ Factoring.
As the very name suggests, under this type, the factor does not assume the credit risk. In other words, if the debtors do not repay their dues in time and if their debts are outstanding beyond a fixed period, say 60 to 90 days from the due date, such debts are automatically assigned back to the client. The client has to take up the work of collection of overdue account by himself. If the client wants the factor to go on with the collection work of overdue accounts, the client has to pay extra charges called ‘Refactoring Charges’.
Benefits of Factoring
The benefits of factoring can be summarized as follows:
a. Better Cash Flows
The seller can offer credit to the customers, within the terms approved by the factor, and can receive prompt payments as soon as, or shortly after invoicing. This may be cheaper than financing by means of bank credit. The factoring is an alternative source of financing and can be availed if the firm expects a liquidity problem on a regular basis. In fact, the factoring ensures a definite pattern of cash inflows from the credit sales.
b. Better Assets Management
The security for such financial assistance is the receivable itself and, therefore, the assets will remain available as security for other borrowings.
c. Better Working Capital Management
Since the finance available from factoring moves directly with the level of the receivables, the problem of additional working capital required to match the sales growth does not come at all. However, a close interaction among working capital components implies that efficient management of one component can have positive benefits on other components.
d. Better Credit Administration
The debt management services which factors provide relieve the seller of the burden of credit administration and the seller can concentrate on the cost of staff and office space. In other words, it enables the seller to concentrate on developing his business.
e. Better Evaluation
The debt management service may include formal or informal advice on credit standing. Factors hold large amounts of information about the trading histories of firms. This can be valuable to those who are using factoring services and can thereby avoid doing business with customers having bad payment record.
f. Better Risk Management
In case of non-recourse factoring, the seller will have the advantages of repositioning the risk of customers not properly paying due bills. This will cost more than with recourse factoring and thereby allows the seller to escape the potentially dire consequences of customer’s default.
Difference between Factoring and Bill Discounting
Factoring differs from discounting in many respects. Some of them are:
Differences between Factoring and Forfeiting
Both factoring and forfeiting are used as tools of financing. But there are some differences:
5. Securitization
Securitization of debt or asset refers to the process of liquidating the illiquid and long-term assets like loans and receivables of financial institutions like banks by issuing marketable securities against them. In other words, debt securitization is a method of recycling of funds. It is a process whereby loans and other receivables are underwritten and sold in form of asset. It is thus a process of transforming the assets of a lending institution into negotiable instrument for generation of funds.
Process of Debt Securitization:
The process of debt securitization is as follows:
The main advantages of securitisation are as follows:
C. International Sources of Finance
1. Depository Receipts (DRs)
A DR means any instrument in the form of a depository receipt or certificate created by the Overseas Depository Bank outside India and issued to the non-resident investors against the issue of ordinary shares. A DR is a negotiable instrument evidencing a fixed number of equity shares of the issuing company generally denominated by US dollars. DRs are commonly used by those companies which sell their securities in international market and expand their shareholdings abroad. These securities are listed and traded in International Stock Exchanges. These can be either American Depository Receipt (ADR) or Global Depository Receipt (GDR). ADRs are issued in case the funds are raised through retail market in United States. In case of GDR issue, the invitation to participate in the issue cannot be extended to retail US investors. As the DRs are issued in overseas capital markets, the funds to the issuer are available in foreign currency, generally in US $.
i. Global Depository Receipt (GDR)
A GDR is a negotiable instrument, basically a bearer instrument which is traded freely in the international market either through the stock exchange or over the counter or among Qualified International Buyers (QIB). It is denominated in US Dollars and represents shares issued in the local currency.
Characteristics of GDR
Modus Operandi of GDR
The GDR operates in the following ways –
Advantages of GDR
ii. American Depository Receipt (ADR)
The depository receipt in the US market is called ADR. ADRs are those which are issued and listed in any of the stock exchanges of US. It is an investment in the stock of non- US corporation trading in the US stock exchange.
Characteristics of ADR
Advantages of ADR
2. Foreign Currency Convertible Bonds (FCCBs)
The FCCB means bonds issued in accordance with the relevant scheme and subscribed by a non-resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole or in part, on the basis of any equity related warrants attached to debt instruments. The FCCBs are unsecured, carry a fixed rate of interest and an option for conversion into a fixed number of equity shares of the issuer company. Interest and redemption price (if conversion option is not exercised) is payable in dollars. Interest rates are very low by Indian domestic standards. FCCBs are denominated in any freely convertible foreign currency.
FCCBs have been popular with issuers. Local debt markets can be restrictive in nature with comparatively short maturities and high interest rates. On the other hand, straight equity-issue may cause a dilution in earnings, and certainly a dilution in control, which many shareholders, especially major family shareholders, would find unacceptable. Thus, the low coupon security which defers shareholders dilution for several years can be alternative to an issuer. Foreign investors also prefer FCCBs because of the Dollar denominated servicing, the conversion option and the arbitrage opportunities presented by conversion of the FCCBs into equity at a discount on prevailing Indian market price.
3. External Commercial Borrowings (ECB)
Indian promoters can also borrow directly from foreign institutions, foreign development bank, World Bank, etc. It is also known as Foreign Currency Term loans. Foreign institutions provide foreign currency loans and financial assistance towards import of plants and equipments. The interest on these loans is payable in foreign currency. On the payment date, interest amount is converted into domestic currency at the prevailing foreign exchange rate. The borrowings, repayment and interest payments can be tailor-made in view of the cash flow position of the project.
4. Other Sources
In addition to the sources discussed above, there are some sources which may be availed by a promoter on casual basis. Some of these are:
1.2 Financing a Start-up – Alternative Investment Funds and Crowd Funding
Meaning and Concept of Startup Financing
India aspires to become 5 trillion-dollar economy by 2024. To reach the mark, it needs to expand entrepreneurial activities in the form of startup activities. To start the startup business, funding or financing is very important. Funding refers to the money required to start and run a business. It is a financial investment in a company for product development, manufacturing, expansion, sales and marketing, office spaces, and inventory.
Financing of startups is something different from traditional financing. Many startups choose to not raise funding from third parties and are funded by their founders only (to prevent debts and equity dilution). However, most startups do raise funding, especially as they grow larger and scale their operations. No matter how great your business idea is, one essential element of startup success is your ability to obtain sufficient funding to start and grow the business. A startup might require funding for one, a few, or all of the following purposes. It is important that an entrepreneur is clear about why they are raising funds. Founders should have a detailed financial and business plan before they approach investors.
Stage-wise Sources of Finance for Startups
Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for startup financing. But first one need to consider how much money you need and when (at what stage) you will need it. However, the stage-wise requirement of sources of finance are discussed below -
Stage 1: Idea Generation
This stage where the entrepreneur has an idea and is working on bringing it to life. At this stage, the amount of funds needed is usually small. Additionally, at the initial stage in the startup lifecycle, there are very limited and mostly informal chanels available for raising funds.
Stage 2: Pre-Seed Stage
i. Bootstrapping / Self-financing
Bootstrapping a startup means growing the business with little or no venture capital or outside investment.
It means relying on your savings and revenue to operate and expand. This is the first recourse for most entrepreneurs as there is no pressure to pay back the funds or dilute control of your startup.
ii. Friends and Family
This is also a commonly utilized channel of funding by entrepreneurs still in the early stages. The major benefit of this source of investment is that there is an inherent level of trust between the entrepreneurs and the investors. This is the prize money/grants/financial benefits that are provided by institutes or organizations that conduct business plan competitions and challenges. Even though the quantum of money is not generally large, it is usually enough at the idea stage. What makes the difference at these events is having a good business plan.
Stage 3: Validation
At this stage, a startup has a prototype ready and needs to validate the potential demand of the startup’s product/ service. This is called conducting a ‘Proof of Concept (POC)’, after which comes the big market launch.
Stage 4: Seed Stage
A startup will need to conduct field trials, test the product on a few potential customers, onboard mentors, and build a formal team for which it can explore the following funding sources:
i. Incubators
Incubators are organizations set up with the specific goal of assisting entrepreneurs with building and launching their startups. Not only do incubators offer a lot of value-added services (office space, utilities, admin & legal assistance, etc.), they often also make grants/debt/equity investments. One can refer to the list of incubators here.
ii. Government Loan Schemes
The government has initiated a few loan schemes to provide collateral-free debt to aspiring entrepreneurs and help them gain access to low-cost capital such as the Startup India Seed Fund Scheme and SIDBI Fund of Funds.
iii. Angel Investors
Angel investors are individuals who invest their money into high-potential startups in return for equity. Reach out to angel networks such as Indian Angel Network, Mumbai Angels, Lead Angels, Chennai Angels, etc., or relevant industrialists for this. One can connect with investors by the Network Page.
iv. Crowdfunding
Crowdfunding refers to raising money from a large number of people where each contribute a relatively small amount. This is typically done via online crowdfunding platforms.
Stage 5: Early Traction Stage
At the Early Traction stage startup’s products or services have been launched in the market. Key performance indicators such as customer base, revenue, app downloads, etc. become important at this stage.
Funds are raised at this stage to further grow the user base, product offerings, expand to new geographies, etc. Common funding sources utilized by startups in this stage are:
i. Venture Capital Funds
Venture capital (VC) funds are professionally managed investment funds that invest exclusively in high-growth startups. Each VC fund has its investment thesis – preferred sectors, stage of the startup, and funding amount – which should align with the startup. VCs take startup equity in return for their investments and actively engage in the mentorship of their investee startups.
ii. Banks/Non-Banking Financial Companies (NBFCs)
Formal debt can be raised from banks and NBFCs at this stage as the startup can show market traction and revenue to validate its ability to finance interest payment obligations. This is especially applicable for working capital. Some entrepreneurs might prefer debt over equity as debt funding does not dilute equity stake.
iii. Venture Debt Funds
Venture Debt funds are private investment funds that invest money in startups primarily in the form of debt. Debt funds are typically invested along with an angel or VC round in different areas
Stage 6: Scaling Stage
At this stage, the startup is experiencing a fast rate of market growth and increasing revenues. Common funding sources utilized by startups in this stage are:
i. Venture Capital Funds
VC funds with larger ticket sizes in their investment provide funding for late-stage startups. It is recommended to approach these funds only after the startup has generated significant market traction. A pool of VCs may come together and fund a startup as well.
ii. Private Equity/Investment Firms
Private equity/Investment firms generally do not fund startups however, lately some private equity and investment firms have been providing funds for fast-growing late-stage startups who have maintained a consistent growth record.
Steps to Startup Fund Raising
The entrepreneur must be willing to put in the effort and have the patience that a successful fund- raising round requires. The fund- raising process can be broken down into the following steps:
The startup needs to assess why the funding is required, and the right amount to be raised. The startup should develop a milestone-based plan with clear timelines regarding what the startup wishes to do in the next 2, 4, and 10 years. A financial forecast is a carefully constructed projection of company development over a given time period, taking into consideration projected sales data, as well as market and economic indicators. The cost of Production, Prototype Development, Research, Manufacturing, etc. should be planned well. Basis this, the startup can decide what the next round of investment will be for.
Methods of Financing to Startups
Different popular methods or alternatives of financing to startups are discussed below:
A. Self-funding
Self-funding, also known as bootstrapping, is an effective way of startup financing, especially when you are just starting your business. Self-funding or bootstrapping should be considered as a first funding option. First-time entrepreneurs often have trouble getting funding without first showing some traction and a plan for potential success. You can invest from your own savings or can get your family and friends to contribute. This will be easy to raise due to less formalities/compliances, plus less costs of raising. In most situations, family and friends are flexible with the interest rate. Different methods of self-financing are Trade credit, Factoring, Leasing etc.
B. Alternative Investment Funds
As per the SEBI (Alternative Investment Funds) Regulations, 2012, ‘Alternative Investment Fund or AIF means any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.’
AIF does not include funds covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.
Categories of Alternative Investment Funds (AIF)
As per Regulation 3(4), AIF is classified into three categories:
Category I AIF:
AIFs which invest in startup or early-stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the Government or regulators consider as socially or economically desirable and shall include venture capital funds, SME funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified. [ Regulation 3(4)(a)]
Category II AIF
As per the AIF Regulation 3(4)(b), AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in the SEBI (Alternative Investment Funds) Regulations, 2012.
Various types of funds such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc. are registered as Category II AIFs.
Category III AIF
AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. [Regulation 3(4)(c)]
Various types of funds such as hedge funds, PIPE Funds, etc. are registered as Category III AIFs.
i. Angel Financing
Angel investors are individuals with surplus cash and a keen interest to invest in upcoming startups. They also work in groups of networks to collectively screen the proposals before investing. They can also offer mentoring or advice alongside capital. Angel investors have helped to start up many prominent companies, including Google, Yahoo and Alibaba. This alternative form of investing generally occurs in a company’s early stages of growth, with investors expecting a upto 30% equity. They prefer to take more risks in investment for higher returns. Some of popular Angel Investors in India are Indian Angel Network, Mumbai Angels, Hyderabad Angels etc. Angel Investment as a funding option has its shortcomings too. Angel investors invest lesser amounts than venture capitalists.
ii. Venture Capital
Venture Capitals (VCs) are professionally managed funds who invest in companies that have huge potential. They usually invest in a business against equity and exit when there is an IPO or an acquisition. VCs provide expertise, mentorship and acts as a litmus test of where the organisation is going, evaluating the business from the sustainability and scalability point of view. A venture capital investment may be appropriate for small businesses that are beyond the startup phase and already generating revenues.
iii. Funding From Business Incubators and Accelerators
Early-stage businesses can consider Incubator and Accelerator programs as a funding option. Found in almost every major city, these programs assist hundreds of startup businesses every year. Though used interchangeably, there are few fundamental differences between the two terms. Incubators are like a parent to a child, who nurtures the business providing shelter tools and training and network to a business. Accelerators so more or less the same thing, but an incubator helps/assists/nurtures a business to walk, while accelerator helps to run/take a giant leap.
These programs normally run for 4-8 months and require time commitment from the business owners. You will also be able to make good connections with mentors, investors and other fellow startups using this platform. In India, popular names of incubators and accelerators are Amity Innovation Incubator, AngelPrime, CIIE, IAN Business Incubator, Villgro, Startup Village and TLabs.
iv. Funds by Winning Contests
An increase in the number of contests has tremendously helped to maximize the opportunities for fund raising. It encourages entrepreneurs with business ideas to set up their own businesses. In such competitions, you either have to build a product or prepare a business plan.
v. Credit Cards
Business credit cards are among the most readily available ways to finance a startup and can be a quick way to get instant money. If you are a new business and do not have a sufficient money, you can use a credit card. However, keep in mind that the interest rates and costs on the cards can build very quickly, and carrying that debt can be detrimental to a business owner’s credit.
Government Initiatives SIDBI Fund of Funds Scheme
The Government of India formed a fund of ₹ 10,000 crore to increase capital availability as well as to catalyze private investments and thereby accelerate the growth of the Indian start-up ecosystem. The Fund was set up as a Fund of Funds for Start-ups (FFS), approved by the Cabinet and established by the Department for Promotion of Industry and Internal Trade (DPIIT) in June 2016. FFS does not invest in start-ups directly but provides capital to SEBI-registered Alternate Investment Funds (AIFs), known as daughter funds, who in turn invest money in high-potential Indian start-ups. SIDBI has been given the mandate of managing the FFS through the selection of daughter funds and overseeing the disbursal of committed capital. The fund of funds makes downstream investments in venture capital and alternative investment funds that in turn invest in start-ups. The fund has been formed in a way that creates a catalyzing effect. Funding is provided to startups across different life cycles. As of 31st May, 2021, SIDBI has committed ₹ 5,409.45 crore to 71 AIFs further ₹ 1,541.79 crore has been distributed to 51 AIFs. A total of ₹ 5,811.29 crore has been injected to boost 443 start-ups.
Startup India Seed Fund Scheme
The Department for Promotion of Industry and Internal Trade (DPIIT) has created Startup India Seed Fund Scheme (SISFS) with an outlay of ₹ 945.00 crore, which aims to provide financial assistance to startups for proof of concept, prototype development, product trials, market-entry, and commercialization. This would enable these startups to graduate to a level where they will be able to raise investments from angel investors or venture capitalists or seek loans from commercial banks or financial institutions. The scheme will support an estimated 3,600 entrepreneurs through 300 incubators in the next 4 years. The Seed Fund will be disbursed to eligible startups through eligible incubators across India.
C. Crowdfunding
Crowdfunding is a collaborative funding model that one can collect small contributions from many individuals (the crowd). There are two main types of crowdfunding. The donation model is what most people think of when crowdfunding is mentioned. Funders donate money to a cause in exchange for products, special pricing on items, or rewards. Beyond the perks, donation funders do not have the opportunity to get anything in return for their money. Kickstarter and Indiegogo are examples of donation crowdfunding. A more recent model is investment crowdfunding. Businesses sell ownership stakes in the form or equity or debt so funders (more accurately, investors) become shareholders in a sense, and they have the potential for financial return.
Some of the popular crowdfunding sites in India are Indiegogo, Wishberry, Ketto, Fundlined and Catapooolt. In US, Kickstarter, RocketHub, Dreamfunded, Onevest, DonorBox and GoFundMe are popular crowdfunding platforms.
Advantages of Crowdfunding
Crowdfunding is a great alternative way to fund a venture, and it can be done without giving up equity or accumulating debt. However, here are some advantages that crowdfunding offers an entrepreneur. These are –
a. Marketing Technique
In spite of being an investment tool, crowdfunding also works as a marketing tool. As mass people are involved in crowdfunding, you can reach them with your startup’s whereabouts. Raising of funds and reaching the probable customers as well as advertisement both are possible in case crowdfunding.
b. Indication of proof of Business Concept
Showing investors and convincing yourself that your venture has received sufficient market validation at an early stage is hard. However, crowdfunding makes this possible. A successful crowdfunding campaign may be the indication of proof of business concept. This shows trust and integrity towards a venture and will allow verification throughout the journey that one is on the right track.
c. Less Risky
In addition to finding enough funding, there will always be unpredictable fees, market validation challenges, and others looking to get your business off the ground. Launching a crowdfunding campaign prevents these risks. Crowdfunding today enables entrepreneurs to gain market acceptance and avoid giving up equity before committing to bringing a product concept to market.
d. Brainstorming
One of the biggest challenges for small businesses and entrepreneurs is to collect feedback about business’s performance at an early stage. Through crowdfunding campaigns, entrepreneurs have the opportunity to interact with the crowd and get comments, feedback, and ideas.
e. Information about Prospective Loyal Customers
Crowdfunding campaigns not only allow entrepreneurs to showcase their companies and products, but also give them the opportunity to share the information and purpose behind them. People who see an entrepreneur’s campaign and decide to contribute believe in the long-term success of the company. Essentially, these people are early adopters. Early adopters are very important to any business because they help spread the word in the first place without asking for anything in return. These people care about the company’s brand and message and are likely to be loyal customers throughout its lifespan.
f. Easier than Traditional Applications
Applying for a loan or pursuing other capital investments are two of the most painful processes that every entrepreneur has to go through, especially during the early stages of the startup. But the application process for crowdfunding is easier compared to these traditional methods.
g. Opportunity of Pre-selling
Launching a crowdfunding campaign gives an entrepreneur the ability to pre-sell a product or concept that they haven’t yet taken to market. This is a good way to gauge user reaction and analyze the market in order to decide whether to pursue or pivot on a given concept.
h. No Penalty
On all or nothing crowdfunding platforms (meaning that you only get the funds raised if you reach 100% or more of your funding goal) there are so many benefits, and no fee to participate. If an entrepreneur sets a goal and doesn’t reach it, there is no penalty.
In essence, crowdfunding is an excellent way for entrepreneurs to receive the financing and exposure they need in order to verify, execute, and help their ventures grow.
Disadvantages of Crowdfunding
There are two sides to every coin, and so it is with crowdfunding. Accordingly, some disadvantages of the crowdfunding are –
a. Inflexible
One downside to crowdfunding is the inability to make alterations to a campaign once it’s launched. This means the description, terms and conditions, and allotted completion time cannot be changed. So, these are static in that sense. If entrepreneurs are forced to make changes to the campaign, they could find the project null and void and be required to give investors a refund.
b. False and Negative Results
Another common disadvantage of crowd funded campaigns is conclusions based on false-negative results. This is particularly true when looking at idea validation. For example, entrepreneurs could falsely conclude that the project failed because the product didn’t meet a market need. However, in truth, its failure was largely down to poor marketing and a lack of understanding of what the product did. It does meet a market need – but just needs to be ‘marketed’ a little better.
c. Time Consuming
Many entrepreneurs fail to appreciate the time, effort, and planning a successful crowdfunding campaign requires. Regular communication with investors, detailed financial reports, forecasts, POA (Plan of Action) for the invested funds, etc.
d. Administration and Accounting
This is more of a warning than a negative, but entrepreneurs need to consider the administrative and accounting challenges they will face.
e. Idea Theft
Arguably the biggest drawback of publicly crowd funded campaigns is idea theft. This is very common picture in the periphery of startup business. Entrepreneurs are incredibly vulnerable to copycats swooping in, stealing their ideas, and taking them to other investors or corporations.
f. Difficult for Non-Consumer Projects
Currently, crowdfunding campaigns are largely successful in the B2C (Business-to-Consumer) marketplace. It’s not common to see the same success for B2B (Business-to-Business) ventures. This is largely down to the investment community. When they see a product that has a clear, tangible impact on consumers they can immediately identify with it. Its purpose is clear and they’re more willing to invest. Services and other forms of non-consumer ventures are more difficult to interpret, and their value unclear.
g. Lack of Transparency
Not everybody is keen on opening up financial and other sensitive information to the public. However, if an entrepreneur is looking to raise funding through one of these platforms, investors are going to need access to this material to make informed decisions. This is not for everybody, so think carefully before committing to a campaign.
f. Access To Funds
One of the drawbacks to crowdfunding campaigns is that you have to wait until the allotted time is up before receiving the funds. Depending on the duration of the campaign this could be anywhere between 60-90 days, so definitely worth taking into consideration.
Types of Crowdfunding
As per IOSCO Staff Working Paper, crowdfunding can be divided into four categories: donation crowdfunding, reward crowdfunding, peer-to-peer crowdfunding and equity crowdfunding.
Types of Crowfunding
Source: IOSCO Staff Working Paper - Crowdfunding: An Infant Industry Growing Fast , 2014.
The cost of capital
is the most important and controversial area in financial management. Capital budgeting decisions have a major impact on the firm, and cost of capital is used as a criterion to evaluate the capital budgeting decisions i.e. whether to accept or reject a project. The cost of capital is also equally important for financing decision.
2.1 Meaning of Cost of Capital
Definition of Cost of Capital
The cost of capital is an integral part of investment decisions as it is used to measure the worth of investment proposal. It is used as a discount rate in determining the present value of future cash flow associated with capital projects. Conceptually, it is the minimum rate of return that a firm must earn on its investments so as to leave market price of its. It is also referred to as cut-off rate, target rate, hurdle rate, required rate of return and so on.
According to James C. Van Horne, ‘Cost of capital is ‘a cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.’
Soloman Ezra stated that ‘Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure.’
So, the cost of capital is the rate of return that a firm must eearn on its project investments to maintain its market value and attracts funds.
Assumptions of Cost of Capital
The theory of cost of capital is based on certain assumptions. These are –
Cost of capital (k) consists of the following three components:
Or, k = rj + b + f
Importance or Significance of Cost of Capital
The cost of capital is an important element, as basic input information for taking decision in the field of capital budgeting, capital structure, dividend policy and for appraisal of performance management, etc. The correct cost of capital helps in the following areas:
a. Capital Budgeting Decision or Investment Evaluation
Cost of capital is usually taken as the cut-off rate or minimum required rate of return for an investment project. In the Net Present Value (NPV) method, an investment is accepted if it has a positive NPV. The projects NPV are calculated by discounting its cash flows by the cost of capital. The cost of capital is the minimum required rate of return on the investment project that keeps the present wealth of shareholders unchanged. So, for a profitable investment project, the NPV should be greater than zero.
Again, when Internal Rate of Return (IRR) method is used, the computed IRR is compared with the cost of capital and the investment proposal is accepted if it has an IRR greater than cost of capital. So, it provides a benchmark to measure the worth of investment proposal and perform the role of accept reject criterion. That is why, cost of capital is also called as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard return, etc.
b. Capital Structure Decision
Cost of capital plays an important role in designing the capital structure and debt policy of a firm. The decision about debt equity mix in the capital structure is taken with reference to the impact of the same on the average cost of capital. Debt helps to save taxes, as interest on debt is a tax-deductible expense. The interest tax shield as a result of use of debt in capital reduces the overall cost of capital, but it also increases the financial risk of the firm. On deciding the proportion of the debt and equity in the capital structure, the firm aims at maximising the firm value by minimising the overall cost of capital.
c. Appraisal of Financial Performance
The financial performance of the top management can be appraised by using the cost of capital. The performance of a project or business i.e., the return from the business is compared against the cost of capital to evaluate the profitability of the project investment. If the management has been able to earn higher return over its cost of capital, the management will be treated as an efficient one and vice-versa.
d. Designing of Optimum Credit Policy
Credit sale is an integrated part of today’s business and the decision of credit period to be allowed to the customers is an important one. To achieve the optimum credit policy, the cost of allowing credit period is compared against the benefits or profit earned by providing credit to customers. While doing this, cost of capital is used to arrive at the present value of cost and benefits received.
e. Inventory Management
While taking the decision regarding the inventory management cost of capital can be used as a guide to evaluate financial cost of carrying inventory.
f. Dividend Decision
The dividend policy of the firm can also be formulated after considering the cost of capital. Here, internal rate of return (r) is compared with the cost of capital (k) for fixing up the %age of dividend to be distributed to the shareholders.
Determining Factors of Cost of Capital
Cost of capital, like all other costs, is a variable term, subject to changes in a number of factors. The various factors that play a part in determination of cost of capital are described below:
a. Risk Profile of the Project
Given a particular set of economic conditions, the cost of capital might vary between industries and between firms in the same industry. This happens because of variation in the risk profile of the firm. A project considered risky would attract capital at a higher cost than a project in the same industry having lesser risk.
b. Market Conditions
If the security is not readily marketable when the investor wants to sell, or even if a continuous demand for the security exists but the price varies significantly, an investor will require a relatively high rate of return. Conversely, if a security is readily marketable and its price is reasonably stable, the investor will require a lower rate of return and the company’s cost of capital will be lower.
c. General Economic Conditions
The structure of interest rates is linked to the general economic conditions prevalent in the economy. Cost of capital, in turn, is related to the interest rate structure. Fluctuation in interest rates occurs as a result of changes in the demand supply equilibrium of investible funds. When investment demand is more than the supply, the rate of interest tends to rise and hence the cost of capital is also more during these periods. On the other hand, during times of slack investment demand, the cost of capital declines due to available supply of funds being more than the demand. The fluctuation in the cost of capital may not be as frequent as the changes in interest rates because the deployment of funds in the debt component of capital is for a longer period of time.
d. Amount of Financing
As the financing requirements of the firm become larger, the weighted cost of capital increases for several reasons. For instance, as more securities are issued, additional flotation costs, or the cost incurred by the firm from issuing securities, will affect the percentage of cost of the funds to the firm. Also, as management approaches the market for large amounts of capital relative to the firm’s size, the investors’ required rate of return may rise. Suppliers of capital become hesitant to grant relatively large sums without evidence of management’s capability to absorb this capital into the business.
Classification of Costs
Costs can be classified as follows:
A. Historical Cost and Future Cost: Historical cost is the cost which has already been incurred for financing a particular It is based on the actual cost incurred in the previous project. Historical cost is useful for analyzing the existing capital structure of the firm.
Future cost is the estimated cost for the future. In financing decision, the future cost is more important than the historical cost as most of the financing decision are related with the future or proposed project that are taken in future period. But at the same time, the future cost is estimated on the basis of previous experience or historical data, so both are related.
B. Specific Cost and Composite Cost: The cost of each component or source of capital is known as the specific cost or component The cost of finance is the minimum return expected by the investors which again depend on the degree of risk involved in the investment.
When all the specific cost of individual source are combined together to get a single cost of capital of the firm, it is known as overall or composite or combined or weighted average cost of capital (WACC). Composite cost is commonly referred as the firm’s cost of capital. It represents the minimum return that a firm must earn on its existing investment or asset base to satisfy its creditors, owners and other providers of capital.
C. Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash Van Horne defined explicit cost as – ‘the discount rate that equates the present value of the funds received by the firm, net of underwriting and other cost, with the present value of expected outflows.’ These outflows are interest payment, repayment of principal or dividends, etc.
For example, a firm raises ₹1,00,000 by issue of 10% Debenture. In this case, there will be an initial inflow of cash of ₹1,00,000 and an annual cash out flow of ₹10,000. So, explicit cost is that rate of return which equates the present value of cash inflows ₹1,00,000 with the present value of cash outflows ₹10,000.
The process of calculation of explicit cost of capital is similar to the determination of IRR. In case of IRR, cash outflow are involved in beginning followed by cash inflow subsequently. But in explicit cost of capital, it is just opposite, that is cash inflows takes places only once at beginning and there are series of cash outflow subsequently. The explicit cost of capital can be determined by following formula:
I0 +{ C1 / (1+k)1 } + { C2 / (1+k)2 + …… + { Cn / ( 1+k)n }
Where,
I0 = Initial cash inflow i.e. net amount of funds received by the firm at time 0
C = Cash outflow in period concerned
k = Explict cost of capital / Discount factor appropriate for the cash investment
n = No. of years.
Finally, it can be said that explicit cost of capital is the internal rate of return that the firm pays to procure financing.
Implicit cost, also known as the opportunity cost is the cost of the opportunity foregone in order to take up a particular project. The implicit cost can be defined as “the rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the projects presently under consideration by the firm were accepted.” For example, the implicit cost of retained earnings is an opportunity cost or implicit cost of capital to the shareholders as they could have invested the fund in anywhere else if the retained earnings were distributed to them as dividend.
Now, it can be said that explicit cost arises where funds are raised, whereas the implicit cost arises when funds are used.
D. Average Cost and Marginal Cost: An average cost is the combined cost or weighted average cost of various source of capital. When the aggregate of the cost of capital of each such source is divided by the aggregate of the weight of sources, the average cost of capital is The weight represents the proportion of each source of in the capital structure.
Marginal cost refers to the average cost of new additional funds required by a firm. It is simply the cost of additional fund raised. Marginal cost of capital is an important tool for evaluating a new project. The return of the new project is compared with the marginal cost of capital to decide on the acceptance or rejection of the project.
2.2 Computation of Weighted Average Cost of Capital
The term cost of capital, as a decision criterion, is the overall cost. This is the combined cost of the specific costs associated with specific sources of financing. The cost of the different sources of financing represents the components of the combined cost. The computation of the cost of capital, therefore, involves two steps: (I) the computation of the different elements of the cost in terms of the cost of the different sources of finance (specific costs), and (II) the calculation of the overall cost by combining the specific costs into a composite cost.
I. Computation of Specific Sources of Capital
The first step in the measurement of the cost of capital of the firm is the calculation of the cost of individual sources of raising funds. Apart from its relevance to the measurement of the combined cost, the specific cost will also indicate the relative cost of pursuing one line of financing rather than another. From the viewpoint of capital budgeting decision, the long-term sources of funds are relevant as they constitute the major sources of financing of fixed assets. In calculating the cost of capital, therefore, the focus is on long-term funds. In other words, the specific costs have to be calculated for (A) long-term debt (including debentures); (B) preference shares; (C) equity capital; and (D) retained earnings.
A. Cost of Debt Capital (kd)
Cost of debt capital is the required rate of return on investment of the lenders of a company. Long-term debt means Long-term loans from financial institutions, capital from issuing debentures or bonds, etc. These Long-terms debts do not have ownership to the providers of finance. The providers of debt finance do not participate in the affairs of the firm but they enjoy the charge on profit before tax. This means they are paid before the payment to the preference shareholders or equity shareholders.
|
Net Cash Proceeds = Face value of the debt – Floatation cost – Discount allowed at the time of issue (if any) + Premium charged at the time of issue (if any) |
For calculation of cost of debt, first we have to compute ‘Net cash proceed’ out of the issue and ‘Net cash outflow’. Net cash proceeds are the funds actually received from the sale of securities. Debt like debenture may be issued at a premium or discount and sometime the issue involve floatation cost like underwriting, brokerage, etc. So, the amount of discount, premium or floatation cost should be adjusted for calculation of ‘net cash proceed’.
The ‘net cash outflow’ is the amount of periodic interest and repayment of principal in installment or in lump-sum at maturity.
The calculation of cost of loan from a financial institution is similar to that of redeemable debenture. So, the discussion is mainly on debenture and bonds. Financing through debenture or bonds have some specific feature and some benefits also.
A debenture or bond may be issued at par or at discount as at premium as compared to its face value. Again, the debenture as bond may be redeemable or irredeemable (perpetual) in nature.
Perpetual / Irredeemable Debt:
Debts may be issued for perpetuity. The debentures which are not redeemed by the issuer is known as irredeemable debentures. Practically, a firm follows the policy of maintaining a given proportion of debt in its capital structure. Individual debts may be repaid but they are replaced by new ones. So, debts are never really paid. So, the permanent part of the debt capital continues for perpetuity.
Formula
kd = ( 1 / NP ) (1 - t)
Where,
kd) = Cost of debt after tax
I = Annual interest payment
NP = Net process of debentures or current market price
t = Tax rate
The cost of debt will be different if the bonds or debentures are issued (i) at par or (ii) at discount or (iii) at
premium. The following example will make it clear.
When Debentures are issued (i) at par or (ii) at discount or (iii) at premium –
Illustration 2
Five years ago, KPM Ltd issued 12% irredeemable debentures at ` 105, a ` 5 premium to their par value of ` 100. The current market price of these debentures is ` 95. If the company pays corporate tax at a rate of 35 % what is its current cost of debenture capital?
Solution:
Illustration 3
XYZ Limited keeps a perpetual fixed amount of debt in its books. It pays coupon of 15%. Its debt sells at par in the market. What is the cost of debt if the firm pays 35% tax? What is the cost of debt if it sells (a) at 5% premium (b) at 5% discount to the face value?
Solution:
Illustration 4
ABC Ltd. issued 5,000, 12% debentures of ₹ 100 each at a premium of 10% on 1.4.2016 to be matured on 1.4.2021. The debentures will be redeemed on maturity. Compute the cost of debentures assuming 35% as tax rate.
Solution:
Illustration 5
PQR Ltd. issued 5,000, 12% debentures of ₹100 each on 1.4.2016 to be matured on 1.4.2021. The market price of the debenture is ₹ 80. Compute the cost of existing debentures assuming 35% tax rate.
Solution:
Illsutration 6
Rima & Co. has issued 12% debenture of face value ₹ 100 for ₹ 10 lakh. The debenture is expected to be sold at 5% discount. It will also involve flotation cost of ₹ 5 per debenture. The debentures are redeemable at a premium of 5% after 10 years. Calculate the cost of debenture if the tax rate is 50%.
Solution :
Amortisation of Bond
A bond may be amortised every year i.e. principal is repaid every year rather than at maturity. In this situation, the principal will go down with annual payments and interest will be computed on the outstanding amount. The cash flows of the bonds will be uneven.
The formula for determining the value of a bond or debenture that is amortised every year is as follows :
VB = C1 / ( 1 + kd)1 + C2 / ( 1 + kd)2 + ………… + Cn / ( 1 + kd)n
Illsutration 7
X Ltd. is proposing to sell a 5-year bond of ₹ 10,000 at 10 % rate of interest per annum. The bond amount will be amortised equally over its life. What is the bond’s present value for an investor if he expects a minimum rate of return of 6 %?
Solution:
Cost of Convertible Debenture
A convertible debenture is a type of loan issued by a company that can be converted into stock.
Holders of the convertible debentures has the option to either get the debentures redeemed into the cash or get specified numbers of companies shares in leiu of cash. The calculation of cost of convertible debentures is very much similar to the redeemable debentures. While determining the redeemable value of the debentures, it is assumed that all the debenture holders will chose the option which has the higher value and accordingly it is considered to calculate cost of debt.
Illsutration 8
RR Ltd. issued 10,000, 12% convertible debentures of ₹100 each with a maturity period of 5 years. At maturity, the debenture holders will have the option to convert the debentures into equity shares of the company in the ratio of 1:10 (10 shares for each debenture). The current market price of the equity shares is ₹ 14 each and historically the growth rate of the shares are 5% per annum. Compute the cost of debentures assuming 35% tax rate.
Sollution:
Cost of Redeemable Debt:
While calculating the cost of redeemable debt, it is necessary to consider the repayment of the principal in addition to interest payments. The cost of redeemable debt can be calculated by using the following formula :
After - tax cost of Debt i.e.,
kd = { I (1-t) + {(F-5) / n}} / {(F + 5) / 2}
Where,
I = Annual Interest charge
t = Tax rate
n = Number of years
F = Redeemable value of the debt at the time of maturity
S = Net sale proceeds from the issue of debt (face value-expenses)
B. Cost of Preference Capital (kp)
The preference shares are those shares which carry the right to receive dividend at a fixed %age before any dividend is paid on equity shares. The dividend payable to the preference shareholders are to be treated as the cost of preference share capital. The payment of dividend to the preference shareholders are not charged as expenses but treated as appropriation of after-tax profit. So, dividend paid to preference shareholders does not reduce the tax liability of the firm. Hence, for preference share before tax cost of preference share capital is considered not the after-tax cost. The costs of preference share capital are of two types (a) Cost of Redeemable Preference Share Capital (b) Cost of Irredeemable Preference Share Capital.
Redeemable Preference Share Capital
The preference shares capital which are redeemed after a certain period of times which was mentioned in the terms of issue, are known as redeemable preference shares. The cost of redeemable preference share capital-
Cost of Preference Share (kp)
kp = { D + ( RV - NP ) } / {( RV + NP ) /2}
kp = { D(1+Dt) + ( RV - NP ) } / {( RV + NP ) /2}
Where,
kp = Cost of Preference Share Capital
Dt = Dividend Tax
D = Annual Preference Dividend
RV = Redeemable Value
NP = Net proceeds of the share
n = no. of year
| Computation of Dividend Tax: | ||
| Tax on Dividend | 000 | |
| Add: Surcharge (to be calculated on the Tax on Dividend) | 000 | 000 |
| Add: Education cess( to be calculated on the sum total of Tax on Dividend and surcharge) | 000 | |
| Add: Secondary and Higher Education cess ( to be calculated on the sum total of tax on dividend and surcharge) | 000 | |
| Dividend Tax (Dt) | 000 | 000 |
When Issue of Preference Share involved Floatation Cost and Redeemable at Premium
Illustration 9
BP Ltd. issued 60,000 12% Redeemable Preference Share of ₹100 each at a premium of ₹ 5 each, redeemable after 10 years at a premium of ₹ 10 each. The floatation cost of each share is ₹ 3. You are required to calculate cost of preference share capital ignoring dividend tax.
Solution:
Illsutration 10
Y Co. Ltd. issues 10,000 12% preference shares of ₹100 each at a premium @ 10% but redeemable at a premium @ 20% after 5 years. The company pays under writing commission @ 5%. If tax on dividend is 12.5%, surcharge is 2.5% and education cess is 3%, calculate the cost of preference share capital.
Solution:
Cost of Irredeemable Prefernce Share Capital
The preference shares capital which are not redeemed before the winding up of the company, are known as irredeemable preference shares. The cost of irredeemable preference share capital –
Cost of prefernce shares kp = D / NP
kp = (1+Dt) / NP
Where,
kp = Cost of prefernce share capital
D = Annual prefernce dividend
Dt = Dividend Tax
NP = Net proceeds of the share
Illustration 11
Simond Ltd. issues 10% irredeemable preference share of ₹ 100 each for ₹ 10,00,000. What will be the cost of preference share capital (kp), if preference shares are issued: (i) at par, (ii) at 10% premium and (iii) at 10% discount. Assume that there is no dividend distribution tax.
Solution:
C. Cost of Equity Share Capital (ke )
The cost of equity capital is most difficult to compute. Some people argue that the equity capital is cost free as the company is not legally bound to pay the dividends to equity shareholders. But this is not true. Shareholders will invest their funds with the expectation of dividends. The market value of equity share depends in the dividends expected by shareholders. Thus, the required rate of return which equates the present value of the expected dividends with the market value of equity share is the cost of equity capital. The cost of equity capital may be expressed as the minimum rate of return that must be earned on new equity share capital financed investment in order to keep the earnings available to the existing equity shareholders of the firm unchanged.
It may be computed in the following methods:
1. Dividend Yield/Price Approach
According to this approach the cost of equity capital (ke) is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. This method is based on the assumption that the market price per share is the present value of its future dividends. According to this method, there is a direct relation between market value of equity shares and future dividends. Another assumption of this approach is that future dividend is constant means there is zero growth in dividend. This method can be used in constant and variable growth situations and also in no-growth companies for estimation of cost of equity. This approach is based on the following assumptions:–
Assumptions:
Limitations:
There are certain limitations in this approach. The limitations are:
Formula: ke = D / P0
Where,
ke = Cost of equity share capital
D = Expected divined per share
P0 = Current market price per share
When it is expected that dividend to be received at a uniform rate over the years –
Illustration 12
MNC Ltd. paid dividend per share of ₹ 4 and the current market price of equity share is ₹20. Calculate the cost of equity share capital ke.
Solution:
Illustration 13
AB Ltd. issued shares of ₹ 100 each at a premium of 10%. The issue involved underwriting commission of 5%. The rate of dividend expected by the shareholders is 12%. Determine the cost of equity capital ( ke ).
Solution:
Illustration 14
The earnings available to the shareholders amount to ₹ 40,000. Firm is represented by 10,000 equity shares and the current market price of equity share is ₹ 25. Calculate the cost of equity share capital.
Solution:
Illsutration 15
Mamon Ltd. is expected to earn ₹ 30 per share. Company follows fixed payout ratio of 40%. The market price of its share is ₹ 200. Find the cost of existing equity if dividend tax of 15 % is imposed on the distributed earnings when:
Solution:
3. Dividend Growth Approach or Gordon’s Model
Every equity shareholder expects dividend to increase year after year and not to remain constant. In this case the expected growth in dividend is taken into consideration for computation of cost of equity. The growth in expected dividend in future may be either at a uniform normal rate or it may vary. Therefore, the dividend growth approach takes into account expected dividend under different growth assumptions. This approach is based on certain assumptions.
Assumptions
Formula :
ke = (D1 / p) + g
ke = Cost of equity share capital
D1 = Next expected dividend
P0 = Current market price per share
g = Constant growth rate of dividend
If flotation cost is considered in case of newly issued equity shares then cost of equity under this approach will be calculated as below
ke = (D1 / P0 - F) + g
Where,
F = Floating cost
Where dividend are expected to grow at a uniform rate in each year-
Illustration 16
XYZ Company’s share is currently quoted in the market at ₹ 20. The company pays a dividend of ₹ 2 per share and the investors expect a growth rate of 5% per year. You are required to calculate (a) cost of equity capital of the company and (b) the market price per share if the anticipated growth rate dividend is 7%.
Solution:
Illustration 17
Using Dividend Growth model, calculate cost of equity ( ke ) in the follwoing case:
| Equity share capital (share of ₹10 each) | ₹ 2,00,000 |
| Earnings for 2021 | ₹ 60,000 |
| Current market price per share | ₹ 180 |
| Dividends per share | ₹ |
| 2018 | 7 |
| 2019 | 8 |
| 2020 | 10 |
| 2021 | 11 |
Solution:
Derivation of future growth ‘g’
Two methods are used to determine the growth rate.
i. Average Method: Growth rate can be calculated using this method as follows:
Current Dividend (D0) = Dn (1+ g)n
Where,
D0 = Current Dividend
Dn = Dividend in n years ago
Gordon’s Growth Model
According to this method, a growing stream of future dividends arises from a growing level of investment by the firm in profitable projects, and it will, therefore, be this rate of investment which will partially determine the growth rate. This model is based on the following assumptions:
It can be calculated as below:
Growth (g) = b × r
Where
g = Future dividend growth rate
b = Constant portion of retained earnings each year* r = Average rate of return fund invested
*Proportion of earnings available to equity shareholders which is not distributed as dividend.
b = Net Profit (after dividend paid) / Net profit
r = Net profit / Book value of capital
4. Realized Yield Approach
It is the easy method for calculating cost of equity capital. Under this method, cost of equity is calculated on the basis of return actually realized by the investor in a company on their equity capital.
ke = PVf × D
Where,
ke = Cost of equity capital
PVƒ = Present value of discount factor D = Dividend per share
5. Capital Assets Pricing Model (CAMP) Approach
The Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe and John Linter in the 1960s. This model is useful for measuring the cost of equity capital of the firm, it shows the relationship between the unavoidable risk and expected return from a security. The model is based on the following assumptions:
According to CAPM,
ke = Rf + β ( Rm – Rf )
Where,
ke = Expected rate of return to the investors, or cost of equity capital
Rf = Risk free rate of return
Rm = Market rate of return
β = Beta coefficient by which the market risk is determined
Illustration 18
From the following information, determine the cost of equity capital using the CAPM approach.
Solution:
Illustration 19
The beta coefficient of Target Ltd. is 1.4. The company has been maintaining 8 % rate of growth in dividends and earning. The last dividend paid was ₹ 4 per share. The return on government securities is 10 % while the return on market portfolio is 15 %. The current market price of one share of Target Ltd. is ₹ 36.
Solution:
Illustration 20
Calculate the cost of equity capital of Mamon Ltd., whose risk free rate of return equals 10%. The firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.
Solution:
Illustration 21
If the risk free rate of return and the market rate of return of an investment are 14% and 18% respectively, calculate the cost of equity share capital if (a) β=1, (b) β= 2/3 and (c) β=5/4.
Solution:
Illustration 22
From the following information in respect of a company, you are required to calculate the cost of equity using CAPM approach:
Solution:
D. Cost of Retained Earnings (kr)
Retained earnings, as a source of finance for investment proposals, differ from other sources like debt, preference shares and equities. The use of debt is associated with a contractual obligation to pay a fixed rate of interest to the suppliers of funds and, often, repayment of principal at some predetermined date. An almost similar kind of stipulation applies to the use of preference shares also. In the case of ordinary shares, although there is no provision for any predetermined payment to the shareholders, yet a certain expected rate of dividend provides a starting point for the computation of cost of equity capital. That retained earnings do not involve any formal arrangement to become a source of funds is obvious. In other words, there is no obligation, formal or implied, on a firm to pay a return on retained earnings. Apparently, retained earnings may appear to carry no cost since they represent funds which have not been raised from outside. The contention that retained earnings are free of cost, however, is not correct. On the contrary, they do involve cost like any other source.
The alternative use of retained earnings is based on ‘external-yield criterion’. In brief, the cost of retained earnings represents an opportunity cost in terms of the return on their investment in another enterprise by the firm whose cost of retained earnings is being considered. The opportunity cost given by the external-yield criterion which can be consistently applied can be said to measure the kr which is likely to be equal to the ke. Therefore, ke should be used as kr but the latter would lower than the former due to differences in flotation cost and due to dividend payment tax.
The part of the distributable profit which is set aside without distributing among the shareholders in order to strengthen the financial position of the business is called retained earnings. Though these funds do not cost anything there is an opportunity cost involved. The opportunity cost of retained earnings is simply the dividend foregone by the shareholders. The two methods for measuring this cost is as follows:
a. It assumes that the shareholders would have invested the dividend on receipt. So, the cost of equity is to be adjusted by the marginal tax rate and the applicable commission, brokerage, The formula for calculating kr would be
kr = ke (1-t) (1-C)
Where, ke = Cost of equity
t = Marginal tax rate
C = Commission, brokerage, etc
b. The second method assumes the retained earnings as the investment of existing shareholders in the firm So, the retained earnings may be treated at par with the equity share capital. This is known as the external yield criterion. The cost of retained earnings may be measured in the same way as that of equity share capital.
Illustration 23
A firm’s ke (return available to shareholders) is 10%, the average tax rate of shareholders is 30% and it is expected that 2% is brokerage cost that shareholder will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?
Solution:
Illustration 24
AKS Ltd. retains ₹10,00,000 out of its current earnings. The expected rate of return to the shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 2% and the shareholders come in 30% tax bracket. Calculate the cost of retained earnings.
Solution:
II. Weighted Average Cost of Capital (WACC)
The term cost of capital is used to denote composite or weighted average or overall cost of capital. Once the component costs have been calculated, they are multiplied by the proportions of the respective source of capital to obtain the weighted average cost of capital (WACC). Here, weighted average concept is used not the simple average. The simple average cost of capital is not appropriate to use because firms hardly use various sources of funds equally in the capital structure. It is also important to remember that the weighted average after tax costs of the individual component of capital is to be taken not the before tax weighted average cost.
The main reason behind the computation of overall cost of capital is to use this rate as the decision criterion in capital budgeting or investment decision. Generally, it may be stated that this cost of capital is taken to be the cut-off rate for determining the profitability of proposed projects.
Steps taken for calculation of WACC
Step-1: Compute the specific cost of each source of capital.
Step-2: Calculate the proportion (or %) of each source of capital to the total capital (weight)
Step-3: Multiply the cost of each source by its proportion in the capital structure.
Step-4: Add the weighted component cost to get the WACC.
This is noted that the weighted average cost of capital may change due to (i) change in the cost of each component or
(ii) change in the relative important of each companies i.e. the change in proportion or weight or (iii) change in both.
The crucial part of the exercise is the decision regarding appropriate weights and the related aspects. We first illustrate the relevant aspects of the choice of the weights. This is followed by the mechanics of computation of k0 which is relatively simple.
Assignment of Weights
The aspects relevant to the selection of appropriate weights are (i) Historical weights versus Marginal weights: (ii) Historical weights can be - (a) Book value weights or (b) Market value
Historical versus Marginal Weights: The first aspect of the decision regarding the selection of appropriate weights for computing the overall cost of capital is: which system of weighting marginal or historical is preferable? The critical assumption in any weighting system is that the firm will raise capital in the specified proportions.
Marginal Weights: The use of marginal weights involves weighting the specific costs by the proportion of each type of fund to the total funds to be raised. The marginal weights represent the %age share of different financing sources the firm intends to raise/employ. The basis of assigning relative weights is, therefore, new/additional/ incremental issue of funds and, hence, marginal weights.
However, WACC can be computed by using the following three types of weight.
Book value Weight
Under this method, weight are computed by taking relative proportions of various sources of capital to the capital structure of the firm. The main advantage of book value weight is that book values are readily available from the published annual accounts or other records. The other advantage is that it depicts the real situation of the firm.
The main advantage of this weight are stated below:
The main disadvantages of this weight are stated below:
Market Value Weight
Under this method, the proportion of market values of various sources of capital are assigned as weight in computing the WACC. Book value weight may be operationally convenient but market value is theoretically more consistent sound and better indicatory of firm’s capital structure. The desirable practice is to employ market weight to compute the firm’s cost of capital as it aims to maximize the value of the firm.
The main advantage of using market value weights are stated below:-
But there are some practical difficulties for using market value weights which are stated below:-
Although market value weights are operationally inconvenient compared to book value weights, but theoretically it is more consistent and sounder in reflecting a better picture of the firm’s true capital structure.
Marginal Value Weight
Marginal weight means giving weight to the specific costs by proportion of each type of funds to the total funds to be raised. In the method the value of new or incremental capital is considered rather than the past or current market values.
In using marginal weight, the firm is concerned with the actual amount of each type of financing used in raising additional funds to finance new project by the company. Marginal weight is more helpful/ applicable to the actual process of financing project.
Comparison between Book Value and Market Value Weight
It has been observed that, cost of capital ascertained by using market value weight is higher than the using book value weight. This is mainly due to the fact, equity and preference share capital usually have higher market values than their book values. Thus higher cost of capital resulted due to greater emphasis assigned to these sources of finance.
While book value weights are readily available from the records of the company, the market value weight are not always available, particularly in the case of retained earnings. In brief, while the book value weights are operationally convenient, market value weights theoretical consistent and sound enough and as such a better indicator of a firms true capital structure.
Book value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure. Market value weights measure the proportion of each type of capital at its market value. Market value weights are appealing because the market values of securities closely approximate the actual Rupees to be received from their sale. Moreover, because firms calculate the costs of the various types of capital by using prevailing market prices, it seems reasonable to use market value weights. In addition, the long-term investment cash flows to which the cost of capital is applied are estimated in terms of current as well as future market values. Market value weights are clearly preferred over book value weights.
Historical versus Target Weight
Historical weights can be either book or market value weights based on actual capital structure proportions. For example, past or current book value proportions would constitute a form of historical weighting, as would past or current market value proportions. Such a weighting scheme would therefore be based on real - rather than desired proportions.
However, Target weights, which can also be based on either book or market values, reflect the firm’s desired capital structure proportions. Firms using target weights establish such proportions on the basis of the “optimal” capital structure they wish to achieve. When one considers the somewhat approximate nature of the calculation of weighted average cost of capital, the choice of weights may not be critical. However, from a Long-term perspective, the preferred weighting scheme should be target market value proportions.
Illustration 25
AKS Ltd. has the following capital structure on October 31, 2021:
| Source of Capital | (₹) |
| Equity Share Capital (1,00,000 shares of ₹10 each | 10,00,000 |
| Reserve & Surplus | 10,00,000 |
| 12% Preference Shares | 5,00,000 |
| 9% Debentures | 15,00,000 |
| 40,00,000 |
The market price of equity share is ₹ 50. It is expected that the company will pay next year a dividend of ₹ 5 per share, which will grow at 7% forever. Assume 30% income tax rate. You are required to compute weighted average cost of capital using market value weights.
Solution:
Illustration 26
|
Asianol Ltd. has the following Capital Structure: |
₹ (in Lakhs) |
|
Equity Share Capital (10 lakhs shares) |
100 |
|
12% Preference Share Capital (10,000 shares) |
10 |
|
Retained Earnings |
120 |
|
14% Debentures (70,000 Debentures) |
70 |
|
14 % Term Loan |
100 |
|
|
400 |
The market price per equity share is ₹ 25. The next expected dividend per share is ₹ 2 and is expected to grow at 8%. The preference shares are redeemable after 7 years at per and are currently quoted at ₹ 75 per share. Debentures are redeemable after 6 years at per and their current market quotation is ₹ 90 per debenture. The tax rate applicable to the firm is 50%.
Solution:
Illustration 27
The capital structure and cost of capital of a company are given below:
| Source | Book Value (₹/lakh) | After tax cost of capital (%) |
| Equity | 200 | 16 |
| Retained Earnings | 200 | ? |
| Debentures | 400 | 7 |
| 800 |
Equity shares represent shares of ₹ 10 each. The current market value of each share is ₹ 80 and the corporate tax rate is 40%.
Solution:
Marginal Cost of Capital
Marginal cost of capital may be defined as the cost of raising additional rupee of capital. The weighted average cost of new or incremental capital is also known as marginal cost of capital. The marginal cost of capital is derived when are calculate the weighted average cost of capital by using marginal weight.
This concept is used in capital budgeting decision. It is used as cut-off rate for any investment. To calculate the marginal cost of capital, the intended financing proportion should be applied as weight to marginal component cost. When a firm raises funds in proportional manner and the components cost remains unchanged, there ask be no difference between average cost of capital of the total funds and the marginal cost of capital.
Illustration 28
The following is the capital structure of ABC Ltd. as on 31.12.2021
| Source of Finance | (₹ ) |
| Equity Shares: 5,000 shares (of ₹ 100 each | 5,00,000 |
| 10% Preference Shares (of ₹ 100 each) | 2,00,000 |
| 12% Debentures | 3,00,000 |
| 10,00,000 |
The market price of the company’s share is ₹ 110 and it is expected that a dividend of ₹ 10 per share would be declared for the year 2021. The dividend growth rate is 6%:
Solution:
Illustration 29
XYZ Ltd. has the following book value capital structure:
|
Equity Capital (in share of ₹ 10 each, fully paid up at par) |
₹ 30 crore |
|
10% Preference Capital (in shares of ₹ 100 each, fully paid up at par) |
₹ 2 crore |
|
Retained Earnings |
₹ 40 crore |
|
14% Debentures ( of ₹ 100 each) |
₹ 20 crore |
|
15% Term Loans |
₹ 25 crore |
The next expected dividend on equity shares per share is ₹ 3.60; the dividend per share is expected to grow at the rate of 5%. The market price per share is ₹ 30.
Preference stock, redeemable after six years, are selling at ₹ 80 per debenture. The income tax rate for the company is 30%.
Solution:
Solved case 1
A financial consultant of Hypothetical Ltd. recommends that the firm should estimate its cost of equity capital by applying the capital asset pricing model rather than the dividend yield plus growth model. He has assembled the following facts:
Solution:
Solved case 2
The following facts relate to Hypothetical Ltd:
Risk-free interest in the market is 10 %. The firm’s beta coefficient, b, is 1.5.
Determine the cost of equity capital using the capital asset pricing model, assuming an expected return on the market of 14 % for next year. What would be the ke, if the b (a) rises to 2, (b) falls to 1.
Solution:
Solved case 3
Avon Electricals Ltd wishes to determine the weighted average cost of capital for evaluating capital budgeting projects.You have been supplied with the following information to calculate the value of k0 for the company:
| Balance Sheet as on March 31, 2021 | |||
| Liabilities | (₹ ) | Assets | (₹ ) |
| Current liabilities | 9,00,000 | Sundry asstes | 39,00,000 |
| Debentures | 9,00,000 | ||
| Prefernce share | 4,50,000 | ||
| Equity share | 12,00,000 | ||
| Retained earnings | 4,50,000 | ||
| 39,00,000 | 39,00,000 | ||
Anticipated external financing information:
Solution:
Solved case 4
From the following information, determine the appropriate weighted average cost of capital (WACC), relevant for evaluating long-term investment projects of the company.
Cost of equity 0.18
After tax cost of long-term debt 0.08
After tax cost of short-term debt 0.09 (₹)
| Souce of capital | Book value (BV) | Market value (MV) |
| Equity | 5,00,000 | 7,50,000 |
| Long-term debt | 4,00,000 | 3,75,000 |
| Short-term debt | 1,00,000 | 1,00,000 |
| 10,00,000 | 12,25,000 |
Solution:
A. Theoretical Questions:
1. Cost of capital refers to:
Answer: c. Required Rate of Return
2. Which of the following sources of funds has an implicit cost of capital?
Answer: d. Retained earnings
3. Which of the following has the highest cost of capital?
Answer: a. Equity shares
4. Cost of capital for Government securities is also known as:
Answer: a. Risk-free Rate of Intrest
5. Cost of capital for bonds and debentures is calculated on:
Answer: b. After Tax basis
6. Weighted Average Cost of Capital (WACC) is generally denoted by:
Answer: c. k0
7. Which of the following cost of capital require tax adjustment?
Answer: c. Cost f Debentures
8. Which is the most expensive source of funds?
Answer: a. New Equity shares
9. Marginal cost of capital is the cost of:
Answer: b. Additional funds
10. In case the firm is all-equity financed, the WACC would be equal to:
Answer: b. Cost of Equity
11. In case of partially debt-financed firm, k0 is less
Answer: b. ke
12. In order to calculate Weighted Average Cost of capitals (WACC) weights may be based on:
Answer: d. All of the above
13. Firm’s cost of capital is the average cost of:
Answer: a. All sources
14. An implicit cost of increasing proportion of debt is:
Answer: c. Equity shareholders would demand higher return
15. Cost of redeemable preference share capital is:
Answer: c. Discount Rate that equates PV of inflows and out-flows relating to capital
16. Which of the following is true?
Answer: c. Retained Earning are cheaper than External Equity
17. Cost of capital may be defined as:
Answer: d. Minimum rate of return that the firm should earn
18. Minimum rate of return that a firm must earn in order to satisfy its investors, is also known as:
Answer: b. Weighted Average Cost of Capital
19. Cost of capital for equity share capital does not imply that:
Answer: d. All of the three above
20. In order to calculate the proportion of equity financing used by the company, the following should be used:
Answer: b. Equity Share Capital plus Resrves and Surplus
21. The term capital structure denotes:
Answer: b. Equity Funds, Prefernce Capital and Long-term Debt
22. Debt financing is a cheaper source of finance because of:
Answer: c. Tax-deductibility of Interest
23. In order to find out cost of equity capital under CAPM, which of the following is not required:
Answer: c. Market Price of Equity Share
24. Tax-rate is relevant and important for calculation of specific cost of capital of:
Answer: c. Debentures
25. Advantage of debt financing is:
Answer: d. All of the above
26. Cost of issuing new shares to the public is known as:
Answer: c. Floating Cost
27. Cost of equity share capital is more than cost of debt because:
Answer: b. Equity shares have higher risk than debt
28. Which of the following is not a generally accepted approach for calculation of cost of equity?
Answer: c. Rate of Prefernce Dividend Plus Risk Model
29. is the basic debt instrument which may be issued by a borrowing company for a price which may be less than, equal to or more than the face value.
Answer: c. A bond or a debenture
30. Every debt instrument has .
Answer: c. A face value as well as a maturnity value
1. Identify the long-term, medium-term and short-term sources of finance.
Answer:
2. Write the advantages of equity share financing.
Answer:
3. Discuss the important international sources of finance.
Answer:
4. Describe how to finance to startup business in modern days.
Answer:
5. Identify alternative investment funds for startups.
Answer:
6. Explain the concept of crowdfunding.
Answer:
7. Discuss the advantages and disadvantages of start-up financing.
Answer:
8. State the concept and relevance cost of capital with appropriate examples.
Answer:
9. Discuss the different types of cost of capital involved in financing.
Answer:
10. Determine the specific cost of long-term debt, preference share capital, equity share capital and retained earnings.
Answer:
11. Write a short note on Weighted Average Cost of Capital (WACC).
Answer:
12. Write a short note on Marginal Cost of Capital (MCC).
Answer:
1. Discuss the different sources of finance available to management, both internal and external.
Answer:
2. State the advantages and disadvantages of the different sources of funds.
Answer:
3. Discuss how the cost of capital enters into the process of evaluating capital budgeting proposals? Particularly, how is it related to the various discounted cash flow techniques for determining a project’s acceptability?
Answer:
4. What is financial risk? Is it necessary to assume that firm’s financial structure remains unchanged when evaluating the firm’s cost of capital? Why is this assumption impractical?
Answer:
5. Explain why:
Answer:
6. Explain the problems faced in determining the cost of How is the cost of capital relevant in capital budgeting decisions?
Answer:
7. Examine critically the different approaches to the calculation of cost of equity capital.
Answer:
8. Explain the CAPM approach for computing the cost of Discuss the merits and demerits of the approach.
Answer:
9. The determination of any explicit cost of capital requires two things: (i) the net proceeds the firm will receive from the particular capital source and (ii) the expected future payments the firm will make to the investors. In spite of the similarity of estimation problems, it is recognised that the cost of equity (both internal and external) is the most difficult cost to estimate. Briefly explain why this is so.
Answer:
10. State briefly the assumptions on which the Gordon (valuation) Model for the cost of equity is What does each component of the equation represent?
Answer:
11. Discuss the approach to determine the cost of retained Also explain the rationale behind treating retained earnings as a fully subscribed issue of equity shares.
Answer:
12. Other things being equal, explain how the following events would affect the company’s weighted average cost of capital:
Answer:
13. What is the weighted average cost of capital? Examine the rationale behind the use of weighted average cost of capital.
Answer:
14. The weighted average cost of capital (k0) may be determined using ‘book’ or ‘market’ Compare the pros and cons of using market value weights rather than book value weights in calculating the value of k0.
Answer:
15. Compare the advantages and disadvantages of using marginal as opposed to historical weights for calculating the weighted average cost of capital (k0). Which of the weights are more consistent with the company’s goal of wealth maximization?
Answer:
B. Numerical Questions:
1. ABC company sold ₹ 1,000, 6 % debentures carrying no maturity date to the public a decade Interest rates since have risen, so that debentures of the quality represented by this company are now selling at 9 % yield basis.
Answer:
2. The shares of a textile company are selling at ₹ 20 per The firm had paid ₹ 2 per share dividend last year. The estimated growth of the company is approximately 5 % per year.
Answer:
3. Assuming a corporate tax rate of 35 %, compute the after-tax cost of the capital in the following situations:
Answer:
4. From the following information supplied to you, determine the appropriate weighted average cost of capital, relevant for evaluating long-term investment projects of the company:
|
Cost of equity |
12 % |
|
After-tax cost of long-term debt |
7 % |
|
After-tax cost of short-term loans |
4 % |
| Source of capital | Book value (₹ ) | Market value (₹ ) |
| Equity | 5,00,000 | 7,50,000 |
| Long-term debt | 4,00,000 | 3,75,000 |
| Short-term debt | 1,00,000 | 1,00,000 |
| TOTAL | 10,00,000 | 12,25,000 |
Answer:
Unsolved Case(s)
1. Ltd. manufactures blankets of high quality. Company’s history has been satisfactory, but for the past sometime its cash flow position was not good. That is why the company has not been able to pay sufficient dividend to its equity shareholders. The finance manager tried to find out the causes of poor financial situation of the company and observed that the control of the company was in the hands of several persons who are unable to take any concrete decision.
To come out of this financial crisis, the finance manager has been deliberating on the source of finance that needs to be tapped to arrange funds. He wants to make use of such a source as does not prove to be a fixed burden on the company. He has also kept in mind that company has got its premises on rent and the rent in exorbitant. Similarly, it has to bear the burden of fixed salaries. He is also worried about the fact that in future control of the company should not be in the hands of too many persons.
Answer:
2. Shyam Steel Ltd. is a large and creditworthy company that manufacture steel for the Indian market. It now wants to cater the Asian market and decides to invest in new Hi-tech Since the investment is large, it requires Long-term finance. It decides to raise funds by issuing equity shares. The issue of equality shares involves huge floatation cost. To meet the expenses of floatation cost, the company decides to tap the money market.
Answer:
3. From the given data, calculate the cost of equity shares of X
Current market price of the share is ₹ 120.
Floatation cost per share is ₹ 5.
Dividend paid on outstanding shares for the past three years is as shown in following Table:
| Year | Dividend Paid (₹) |
| 2019 | 10.5 |
| 2020 | 12.5 |
| 2021 | 14.5 |
The expected dividend on the new shares at the end of the current year is ₹ 15 per share.
Answer:
4. B Ltd. has equity stock with a listed beta of 1.35. The estimated market return is 12% and the risk-free rate based on government bonds is 6.5%. Calculate the cost of its equity based upon the CAPM.
Answer:
5. Assume that Rf is 9% and Rm is 18%. If a security has a beta factor of: (a)1.4; (b)1.0 and (c) 3, determine the expected return of the security.
Answer:
6. From the following information, calculate weighted average cost of capital of the company considering (i) Book value as weights and (ii) Market value as weights.
|
Cost of equity |
0.18 |
|
After tax cost of long-term debt |
0.08 |
|
After tax cost of short-term debt |
0.09 |
|
Cost of Reserve |
0.15 |
| Element | BV (₹) | MV (₹) |
| Capital | 3,00,000 | 4,50,000 |
| Reserve | 2,00,000 | 3,00,000 |
| L/T debt | 4,00,000 | 3,75,000 |
Answer:
Ruchika Saboo
An All India Ranker (AIR 7 - CA Finals, AIR 43 - CA Inter), she is one of those teachers who just loved studying as a student. Aims to bring the same drive in her students.
Ruchika Ma'am has been a meritorious student throughout her student life. She is one of those who did not study from exam point of view or out of fear but because of the fact that she JUST LOVED STUDYING. When she says - love what you study, it has a deeper meaning.
She believes - "When you study, you get wise, you obtain knowledge. A knowledge that helps you in real life, in solving problems, finding opportunities. Implement what you study". She has a huge affinity for the Law Subject in particular and always encourages student to - "STUDY FROM THE BARE ACT, MAKE YOUR OWN INTERPRETATIONS". A rare practice that you will find in her video lectures as well.
She specializes in theory subjects - Law and Auditing.
Yashvardhan Saboo
A Story teller, passionate for simplifying complexities, techie. Perfectionist by heart, he is the founder of - Konceptca.
Yash Sir (As students call him fondly) is not a teacher per se. He is a story teller who specializes in simplifying things, connecting the dots and building a story behind everything he teaches. A firm believer of Real Teaching, according to him - "Real Teaching is not teaching standard methods but giving the power to students to develop his own methods".
He cleared his CA Finals in May 2011 and has been into teaching since. He started teaching CA, CS, 11th, 12th, B.Com, M.Com students in an offline mode until 2016 when Konceptca was launched. One of the pioneers in Online Education, he believes in providing a learning experience which is NEAT, SMOOTH and AFFORDABLE.
He specializes in practical subjects – Accounting, Costing, Taxation, Financial Management. With over 12 years of teaching experience (Online as well as Offline), he SURELY KNOWS IT ALL.
"Koncept perfectly justifies what it sounds, i.e, your concepts are meant to be cleared if you are a Konceptian. My experience with Koncept was amazing. The most striking experience that I went through was the the way Yash sir and Ruchika ma'am taught us in the lectures, making it very interesting and lucid. Another great feature of Koncept is that you get mentor calls which I think drives you to stay motivated and be disciplined. And of course it goes without saying that Yash sir has always been like a friend to me, giving me genuine guidance whenever I was in need. So once again I want to thank Koncept Education for all their efforts."
"Hello everyone, I am Kaushik Prajapati. I recently passed my CA Foundation Dec 23 exam in first attempt, That's possible only of proper guidance given by Yash sir and Ruchika ma'am. Koncept App provide me a video lectures, Notes and best thing about it is question bank. It contains PYP, RTP, MTP with soloution that help me easily score better marks in my exam. I really appericiate to Koncept team and I thankful to Koncept team."
"Hi. My name is Arka Das. I have cleared my CMA Foundation Exam. I cleared my 12th Board Exam from Bengali Medium and I had a very big language problem. Koncept Education has helped me a lot to overcome my language barrier. Their live sessions are really helpful. They have cleared my basic concepts. I think its a phenomenal app."
"I cleared my foundation examination in very first attempt with good marks in practical subject as well as theoretical subject this can be possible only because of koncept Education and the guidance that Yash sir has provide me, Thank you."
