Unit 2: Sources of Finance and Cost of Capital

Part 1: Sources of Finance

Business finance involves the acquisition and utilization of funds by a business enterprise. Based on the time period for which funds are required, sources of finance are classified into Short Term, Medium Term, and Long Term.

1. Short Term Sources of Finance

These funds are required for a period not exceeding one year. They are primarily used to finance working capital needs (current assets).

• Trade Credit:

  • Definition: Credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment.
  • Nature: It is a spontaneous source of finance appearing automatically on the balance sheet.
  • Cost: While often "free" (no explicit interest), there is an implicit cost if cash discounts for early payment are foregone.

• Bank Overdrafts:

  • Definition: An arrangement with a bank allowing the account holder to withdraw more money than is available in the account, up to a specified limit.
  • Nature: Interest is charged only on the amount actually overdrawn and for the time period utilized.

• Commercial Paper (CP):

  • Definition: Unsecured, short-term promissory notes issued by large, creditworthy corporations.
  • Maturity: Usually ranges from 15 days to 1 year.
  • Cost: Issued at a discount to face value; the difference represents the interest cost.

• Factoring:

  • Definition: A financial service where a firm sells its accounts receivable (debtors) to a third party (the Factor) at a discount.
  • Types: Recourse (firm bears bad debt risk) and Non-recourse (Factor bears bad debt risk).
  • Benefit: Converts credit sales into immediate cash.

• Accrued Expenses:

  • Definition: Expenses that have been incurred but not yet paid (e.g., wages payable, taxes payable).
  • Nature: Represents an interest-free source of financing services or obligations.

2. Medium Term Sources of Finance

These funds are required for a period ranging roughly from 1 to 5 years. They are used for modernization, expansion, or replacement of assets.

• Lease Financing:

  • Definition: A contractual agreement where the owner of an asset (Lessor) grants the user (Lessee) the right to use the asset for a specific period in return for periodic payments (Lease Rentals).
  • Types: Operating Lease (short-term, cancellable) and Financial Lease (long-term, covers asset life, non-cancellable).

• Hire Purchase:

  • Definition: A system where the buyer pays the price of the asset in installments. Ownership transfers only after the payment of the final installment.
  • Distinction: Unlike leasing, the intent here is usually ownership.

• Public Deposits:

  • Definition: Deposits invited by companies directly from the public.
  • Regulation: Strictly regulated by central banks or corporate laws regarding the amount and interest rates.
  • Advantage: Usually carries a lower rate of interest than bank loans for the company but higher than bank deposit rates for the investor.

• Medium-Term Bank Loans:

  • Term loans provided by commercial banks for periods of 3–5 years, usually secured against assets.

3. Long Term Sources of Finance

These funds are required for a period exceeding 5 years (often permanent). They are used for purchasing fixed assets, structural changes, or permanent working capital.

• Equity Shares (Ordinary Shares):

  • Definition: Represents the ownership capital of the company.
  • Features: No fixed dividend; voting rights; residual claim on assets during liquidation.
  • Risk: Highest risk capital for investors; permanent capital for the company (not repaid during the life of the firm).

• Preference Shares:

  • Definition: Hybrid security with features of both equity and debt.
  • Features: Fixed rate of dividend; preferential right to dividend and repayment of capital over equity shareholders.
  • Types: Cumulative/Non-cumulative, Participating/Non-participating, Convertible/Non-convertible.

• Debentures / Bonds:

  • Definition: An instrument acknowledging a debt by a company.
  • Features: Fixed interest rate (coupon); usually secured against assets; no voting rights. Interest is tax-deductible for the company.

• Retained Earnings (Ploughing Back of Profits):

  • Definition: Portion of net profits not distributed as dividends but reinvested in the business.
  • Nature: Internal source of finance; cost-free in terms of cash outflow but carries an opportunity cost.

• Venture Capital:

  • Private equity provided to early-stage, high-potential, high-risk growth companies.

Part 2: Cost of Capital

1. Introduction to Cost of Capital

Cost of capital is the rate of return a firm must earn on its investment projects to maintain its market value and attract funds. It serves as the link between financing decisions and investment decisions.

• Also known as: Cut-off rate, Hurdle rate, Minimum required rate of return, or Target rate.
• Concept: Ideally, it represents the opportunity cost of the funds employed. If a firm invests in a project returning 10%, but the cost to acquire that capital was 12%, the firm loses value.

2. Significance of Cost of Capital

The cost of capital is a pivotal concept in financial management for several reasons:

1. Capital Budgeting Decisions: It is used as the discount rate to calculate Net Present Value (NPV). Projects are accepted only if their return exceeds the cost of capital.
2. Capital Structure Decisions: Helps in designing the optimal mix of debt and equity. The goal is to minimize the overall cost of capital (WACC) to maximize firm value.
3. Performance Evaluation: Used as a benchmark to evaluate the financial performance of top management or specific divisions (e.g., in EVA - Economic Value Added calculations).
4. Dividend Policy: Helps in deciding whether to retain profits or distribute them. If the firm cannot earn a return higher than the shareholders could earn elsewhere (Cost of Equity), profits should be distributed.

3. Components of Cost of Capital

To calculate the overall cost, a firm must first calculate the cost of each specific source of finance:

1. Cost of Debt ()
2. Cost of Preference Capital ()
3. Cost of Equity Capital ()
4. Cost of Retained Earnings ()

4. Cost of Debt ()

The cost of debt is the interest rate a company pays on its borrowings. A unique feature of debt is the Tax Shield: Interest payments are tax-deductible expenses, effectively reducing the actual cost to the company.

A. Cost of Irredeemable (Perpetual) Debt

Debt that has no maturity date.

Formula (After Tax):
Kd = (I / NP) * (1 - t)

Where:
I  = Annual Interest payment
NP = Net Proceeds (Issue price - Flotation costs)
t  = Tax rate

B. Cost of Redeemable Debt

Debt that is repaid after a specific period. The cost must factor in interest payments and the principal repayment (premium or discount).

Formula (Approximation Method):
Kd = [ I(1-t) + ( (RV - NP) / n ) ] / [ (RV + NP) / 2 ]

Where:
I  = Annual Interest
t  = Tax rate
RV = Redemption Value (Value paid at maturity)
NP = Net Proceeds (Money received today)
n  = Number of years to maturity

5. Cost of Preference Capital ()

Preference dividends are paid out of post-tax profits. Therefore, there is no tax deduction benefit.

A. Cost of Irredeemable Preference Shares

Formula:
Kp = PD / NP

Where:
PD = Annual Preference Dividend
NP = Net Proceeds

B. Cost of Redeemable Preference Shares

Similar to redeemable debt, but without the tax adjustment on the dividend.

Formula:
Kp = [ PD + ( (RV - NP) / n ) ] / [ (RV + NP) / 2 ]

Where:
PD = Preference Dividend
RV = Redemption Value
NP = Net Proceeds
n  = Number of years

6. Cost of Equity Capital ()

Cost of equity is the most difficult to calculate because there is no fixed commitment to pay dividends. It represents the minimum rate of return expected by equity shareholders to compensate for the risk of holding the shares.

There are several approaches to calculate :

A. Dividend Price (D/P) Approach

Assumes the investor expects a constant dividend stream.

Ke = D / P0

Where:
D  = Expected Dividend per share
P0 = Current Market Price per share

B. Dividend Growth Model (Gordon’s Model)

Assumes dividends will grow at a constant rate () forever. This is the most widely used algebraic model.

Ke = (D1 / P0) + g

Where:
D1 = Expected dividend at end of year 1 (D0 * (1+g))
P0 = Current Market Price
g  = Constant growth rate of dividends

C. Earnings Price (E/P) Approach

Used when the payout ratio is 100% or earnings are considered the primary driver of value.

Ke = E / P

Where:
E = Earnings Per Share (EPS)
P = Market Price Per Share

D. Capital Asset Pricing Model (CAPM)

Considered the most modern and scientifically accurate method. It relates risk to return.

Ke = Rf + β (Rm - Rf)

Where:
Rf = Risk-free rate (e.g., Govt treasury bonds)
β  = Beta coefficient (Measure of systematic risk)
Rm = Expected return on the market portfolio
(Rm - Rf) = Market Risk Premium

7. Cost of Retained Earnings ()

Retained earnings are not "free" because they belong to shareholders. The cost is the opportunity cost—the return shareholders could earn if the money were distributed to them and invested in alternative securities of similar risk.

• General Rule:
• Adjustment: If flotation costs (brokerage/underwriting) are significant for issuing new shares, will be slightly lower than the cost of new equity because retained earnings do not incur flotation costs.

8. Weighted Average Cost of Capital (WACC)

Also known as the Composite Cost of Capital or Overall Cost of Capital ().

Once specific costs () are calculated, WACC is computed by weighting the cost of each source by its proportion in the total capital structure.

Calculation Steps:

1. Calculate the specific cost of each source ().
2. Determine the weights () associated with each source. Weights can be:
   • Book Value Weights: Based on values in the Balance Sheet.
   • Market Value Weights: Based on current trading prices (Preferred method theoretically).
3. Multiply the cost of each source by its corresponding weight.
4. Sum the products to get WACC.

Formula:

Ko (WACC) = (Wd * Kd) + (Wp * Kp) + (We * Ke)

Where:
Wd, Wp, We = Weights of Debt, Preference, and Equity (Must sum to 1)
Kd, Kp, Ke = Cost of Debt, Preference, and Equity

Example Calculation Table: