Unit2 - Subjective Questions
FIN212 • Practice Questions with Detailed Answers
Define Cost of Capital and explain its fundamental concept from the perspective of a firm.
Definition
Cost of Capital may be defined as the minimum rate of return that a firm must earn on its investments to satisfy the expectations of the investors who provide the funds. It acts as a hurdle rate for new projects.
Fundamental Concept
From a firm's perspective, the cost of capital represents:
- Cost of Obtaining Funds: It is the price paid by the firm for using capital (debt, equity, preference shares).
- Opportunity Cost: It represents the opportunity cost of the funds employed in the business. If the firm cannot earn this rate, the value of the firm declines.
- Minimum Required Rate: It is the minimum return required to keep the market price of the shares unchanged.
Mathematically, it is the weighted average of the costs of various sources of finance used by the firm.
Distinguish between Short-term and Long-term sources of finance with suitable examples.
Distinction between Short-term and Long-term Sources
| Basis | Short-term Sources | Long-term Sources |
|---|---|---|
| Time Horizon | Funds are required for a period usually less than one year. | Funds are required for a period exceeding 5 years (or permanently). |
| Purpose | Used for working capital needs (e.g., inventory, payables). | Used for capital budgeting decisions (e.g., land, plant, machinery). |
| Risk | Generally lower risk due to shorter duration. | Higher risk due to uncertainty over a long period. |
| Cost | Often carries a lower interest rate (though not always). | Usually carries a higher expected rate of return due to higher risk. |
| Examples | Trade Credit, Commercial Paper, Bank Overdraft. | Equity Shares, Debentures, Long-term Loans. |
Explain Trade Credit as a source of short-term finance. What are its advantages?
Trade Credit refers to the credit extended by suppliers to manufacturers or traders for the purchase of goods and services. It is a spontaneous source of finance that arises during the normal course of business.
Advantages of Trade Credit
- Easy Availability: It is relatively easy to obtain compared to bank loans, provided the buyer has a good reputation.
- Flexibility: The credit limit and period can often be negotiated with suppliers.
- No Formalities: It does not involve complex legal documentation or flotation costs.
- Interest-Free: If payment is made within the credit period, it is effectively an interest-free loan (though foregoing cash discounts implies a cost).
- Asset Security: It typically does not require a specific charge on the assets of the company.
Discuss the significance of Cost of Capital in financial decision-making.
The Cost of Capital is a pivotal concept in financial management. Its significance includes:
- Capital Budgeting Decisions: It serves as the discount rate (cutoff rate) for evaluating investment proposals. Projects with a Net Present Value (NPV) calculated using the cost of capital as the discount rate are accepted only if positive.
- Capital Structure Decisions: It helps in designing an optimal capital structure. The firm aims to mix debt and equity to minimize the Weighted Average Cost of Capital (WACC).
- Evaluation of Financial Performance: It acts as a benchmark to evaluate the performance of top management and specific projects. Actual returns are compared against the cost of capital.
- Dividend Decisions: It helps in deciding whether to retain profits or distribute them. If the firm cannot earn a return higher than the cost of equity on retained earnings, the profits should be distributed to shareholders.
What are Equity Shares? Elaborate on their features as a long-term source of finance.
Equity Shares represent the ownership capital of a company. Equity shareholders are the residual claimants of the company's income and assets.
Features as a Long-term Source
- Permanent Capital: Equity capital is not redeemable during the lifetime of the company (except in buyback). It is a permanent source of funds.
- Variable Dividend: There is no fixed commitment to pay dividends. Dividends depend on profits and management discretion.
- Voting Rights: Equity shareholders have voting rights and control the management of the company through the appointment of directors.
- Risk Bearing: They bear the highest risk. In the event of liquidation, they are paid last, after creditors and preference shareholders.
- No Charge on Assets: issuing equity shares does not create any charge or encumbrance on the assets of the company.
Derive and explain the formula for the Cost of Irredeemable Debt (), considering the tax shield.
The cost of irredeemable (perpetual) debt is the rate of return required by lenders, adjusted for the tax benefit.
Concept
Interest paid on debt is a tax-deductible expense. This means the actual cost to the firm is less than the interest rate paid to the debenture holders because the firm saves tax on the interest amount.
Formula
Where:
- = Cost of Debt (after tax)
- = Annual Interest payment
- = Net Proceeds from the issue of debentures (Face Value Premium/Discount - Floatation Costs)
- = Corporate Tax Rate
Example: If a company issues 10% debentures and the tax rate is 30%, the effective cost is roughly .
Write a short note on Lease Financing as a medium-term source of finance.
Lease Financing is a contractual agreement where the owner of an asset (Lessor) grants the right to use the asset to another party (Lessee) in exchange for periodic payments (Lease Rentals).
Key Points:
- Medium to Long Term: Leases typically cover the economic life of the asset or a significant portion of it.
- No Upfront Cash Outflow: The lessee does not need to invest a large amount of capital initially to acquire the asset.
- Tax Benefits: Lease rentals are tax-deductible expenses for the lessee, reducing taxable income.
- Obsolescence Risk: In an operating lease, the risk of obsolescence is often borne by the lessor.
- Asset Types: Common for machinery, vehicles, equipment, and buildings.
Explain the calculation of the Cost of Redeemable Debt. Provide the approximation formula.
Redeemable debt refers to debt that must be repaid (principal amount) after a specific period. The cost calculation must account for interest payments and the amortization of the difference between the net proceeds and the redemption value.
Formula (Approximation Method)
The after-tax cost of redeemable debt is given by:
Where:
- = Annual Interest payment
- = Tax rate
- = Redemption Value of the debenture
- = Net Proceeds from the issue
- = Number of years to maturity
The numerator represents the average annual cost (interest + prorated capital loss/gain), and the denominator represents the average investment.
Compare Preference Shares and Debentures as sources of finance.
Preference Shares vs. Debentures
| Feature | Preference Shares | Debentures |
|---|---|---|
| Nature | Hybrid security (Ownership + Debt features). | Pure Debt/Loan capital. |
| Return | Fixed Dividend. | Fixed Interest. |
| Obligation | Dividend is paid only if profits exist; not mandatory if loss occurs (unless cumulative). | Interest payment is mandatory regardless of profit or loss. |
| Tax Treatment | Dividends are an appropriation of profit (Not tax-deductible). | Interest is a charge against profit (Tax-deductible). |
| Voting Rights | Generally no voting rights (except on matters affecting them). | No voting rights. |
| Security | Usually unsecured. | Usually secured by a charge on assets. |
Describe the Dividend Price Approach (Dividend Yield Method) for calculating the Cost of Equity (). What are its limitations?
The Dividend Price Approach assumes that the cost of equity capital is the discount rate that equates the present value of expected future dividends with the current market price of the share.
Formula
If dividends are constant:
Where:
- = Dividend per share
- = Current Market Price per share
Limitations
- Ignores Growth: It assumes dividends will remain constant forever, which is unrealistic for growing companies.
- Ignores Capital Appreciation: It does not account for the gain shareholders expect from the increase in share price.
- Retained Earnings: It does not consider the impact of retained earnings on future growth.
Explain the Dividend Growth Model (Gordon’s Model) for calculating the Cost of Equity.
The Dividend Growth Model improves upon the simple dividend yield method by assuming that dividends will grow at a constant rate indefinitely. It implies that the cost of equity is the dividend yield plus the growth rate.
Formula
Where:
- = Cost of Equity
- = Expected dividend at the end of the year ()
- = Current Market Price of the share
- = Constant annual growth rate of dividends
Assumptions
- Dividends grow at a constant rate .
- (Cost of equity is greater than the growth rate).
- The market price reflects the present value of future dividends.
What is the Capital Asset Pricing Model (CAPM) approach to calculating the Cost of Equity? Explain the equation.
CAPM calculates the cost of equity based on the risk associated with the investment. It separates risk into risk-free return and a risk premium based on the stock's sensitivity to market movements (Beta).
The Equation
Where:
- = Cost of Equity
- = Risk-free rate of return (e.g., Govt. bonds yield)
- = Beta coefficient (Measure of systematic risk)
- = Expected return of the market portfolio
- = Market Risk Premium
Explanation
Investors expect a risk-free return () for the time value of money, plus a premium for taking on additional market risk. The adjusts this premium based on how volatile the specific stock is compared to the overall market.
Why is the Cost of Retained Earnings () not zero? How is it calculated?
Although retained earnings are internal funds and do not involve explicit interest or dividend payments, they have an Opportunity Cost.
Why it's not zero
The funds belong to the shareholders. If the company distributes these earnings as dividends, shareholders could invest them elsewhere to earn a return. Therefore, the firm must earn at least that rate on retained earnings to justify keeping the money.
Calculation
Generally, is considered equal to the Cost of Equity () because the risk profile is the same.
However, if adjustments are made for personal taxes () and brokerage costs () that shareholders would incur if they received dividends and reinvested them:
Define Weighted Average Cost of Capital (WACC). What are the steps to calculate it?
WACC is the average rate of return a company expects to compensate all its different investors (equity, debt, preference). The weights are the proportion of each source in the total capital structure.
Calculation Steps:
- Calculate Specific Costs: Determine the cost of each specific source of capital ().
- Determine Weights: Assign weights () to each source based on their proportion in the total capital (using Book Value or Market Value).
- Calculate Weighted Cost: Multiply the specific cost by its corresponding weight ().
- Summation: Sum up the weighted costs to get WACC ().
In the calculation of WACC, discuss the choice between Book Value Weights and Market Value Weights.
When assigning weights to different sources of finance for WACC:
Book Value Weights
- Basis: Uses the values recorded in the balance sheet.
- Pros: Easy to calculate; data is readily available; stable over time.
- Cons: Represents historical costs, not current economic value. Can be misleading if market values differ significantly.
Market Value Weights
- Basis: Uses the current market price of the securities.
- Pros: Reflects the true economic value and current opportunity cost; theoretically superior for financial decision-making.
- Cons: Market prices fluctuate daily; market values for unlisted securities or specific debts may be hard to estimate.
Conclusion: Market Value Weights are generally preferred for capital budgeting decisions as they reflect the current capital structure reality.
What are Commercial Papers? Explain their features as a money market instrument.
Commercial Paper (CP) is an unsecured, short-term promissory note issued by large, creditworthy corporations to raise funds for meeting short-term liabilities.
Features
- Unsecured: It is not backed by collateral, so only firms with high credit ratings can issue them.
- Maturity: Short maturity period, typically ranging from 7 days to 1 year.
- Discount: Usually issued at a discount to face value and redeemed at face value. The difference represents the interest cost.
- Regulation: In India, they are regulated by the RBI.
- Liquidity: They are negotiable instruments and can be traded in the secondary market.
Calculate the Cost of Preference Capital () if a company issues 10% preference shares of $100$ each, redeemable after 10 years. Flotation cost is 5%.
Given Data:
- Dividend Rate = 10%
- Face Value (FV) = $100$
- Dividend () =
- Maturity () = 10 years
- Floatation Cost = 5%
- Net Proceeds () =
- Redemption Value () = $100$ (Assumed at par)
Formula:
Calculation:
Explain the concept of Floatation Costs and how they affect the Cost of Equity.
Floatation Costs are the expenses incurred by a company when issuing new securities to the public. These include underwriting fees, legal fees, registration fees, and printing costs.
Impact on Cost of Equity ()
When new equity is issued, the company does not receive the full market price per share (); it receives the Net Proceeds (), which is Market Price minus Floatation Costs.
In the Dividend Growth Model, the formula changes to:
Because , the denominator decreases, which increases the cost of new equity compared to retained earnings. This reflects the reality that external equity is more expensive than internal equity due to issuance expenses.
Distinguish between Explicit Cost and Implicit Cost of capital.
Explicit Cost vs. Implicit Cost
| Feature | Explicit Cost | Implicit Cost |
|---|---|---|
| Definition | The discount rate that equates the present value of cash inflows with the present value of cash outflows. It is the cost paid to procure funds. | The rate of return associated with the best investment opportunity foregone. It is the opportunity cost. |
| Payment | Involves actual cash outflow (e.g., Interest, Dividend). | No cash outflow occurs; it is an imputed cost. |
| Source | Arises when funds are raised from external sources (Debt, New Equity). | Arises when internal funds (Retained Earnings) are used. |
| Example | 10% Interest paid on Debentures. | The return shareholders could have earned if profits were distributed instead of retained. |
List and explain the factors affecting the Cost of Capital of a firm.
Several factors influence a firm's cost of capital, some controllable and others uncontrollable:
Uncontrollable Factors (External)
- Interest Rates: If the general level of interest rates in the economy rises, the cost of debt and subsequently the cost of equity increases.
- Tax Rates: Higher corporate tax rates lower the cost of debt (due to the tax shield), affecting the overall WACC.
- Market Conditions: Investor risk aversion and market liquidity impact the required rate of return.
Controllable Factors (Internal)
- Capital Structure Policy: Changing the mix of debt and equity affects the financial risk and WACC.
- Dividend Policy: The payout ratio affects the amount of retained earnings (cheaper source) vs. new equity (expensive source).
- Investment Policy: If a firm invests in high-risk projects, investors will demand a higher return, increasing the cost of capital.