Faculty: Alok Katre (CA, CFA)

+91 99805 63255; alok.katre.vf@scmhrd.edu;

alok.prof2@gmail.com

Alok Katre 18/01/2021 1

WHAT WILL WE LEARN & DISCUSS

Investment Decisions - Review

 Risk & Return Prof. Dipasha Sharma
 Cost of Capital & its implication Alok Katre
 Basics of valuation using DCF Prof. Dipasha Sharma
Financing Decisions
 Long-term Financing – Debt & Equity Alok Katre
 Capital structure decisions Alok Katre
 Short-term financing Alok Katre
 Financing & valuation Prof. Dipasha Sharma
 Working Capital Management Alok Katre
 Dividend Decisions Alok Katre
 Other topics: M&A,Intl. Finance, etc Prof. Dipasha Sharma

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Alok Katre 18/01/2021 3
COST OF CAPITAL A KEY DRIVER OF VALUE
 Corporates generate value by investing in positive NPV generating opportunities

 NPV = Present Value of cash inflows – Present Value of cash outflows from a project

 PV = [CF1 / (1+r)1 + CF2 / (1+r)2 + ……+ CFn / (1+r)n]

 Positive NPV determined not only by cash flow, but importantly by the ‘r’: the Cost of Capital is
thus a key driver of value of a business & value creation by management (more on this later)

Shareholder
Firm with Pay cash dividend invests in
excess cash financial asset
A firm with excess cash can either pay a
dividend or make a capital investment

Invest in project Shareholder’s

Value

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WHAT IS COST OF CAPITAL – THREE PERSPECTIVES
What is ‘Cost of Capital’
 Very simply, it is the rate at which capital is available to a business. Defined in three ways:

 Rate of return that the suppliers of capital demand in return for providing the funds
 E.g. if investors expect a 15% return for investing in shares of HDFC Bank, then the cost of equity
capital for the bank is 15%.
 E.g. when Larsen & Toubro approaches a bank for loan, the bank charges a 8-9% interest rate on
that loan – this 8-9% becomes cost of debt capital for L&T
 It is the opportunity cost of funds for the suppliers of capital or for the firm itself
 E.g. if I can earn 8% on a bank FD, then a firm seeking debt capital from me needs to offer at least
that much for me to lend money to them..
 If a firm can invest money and earn 10%, then it needs to earn at least that much from any business
project it undertakes (e.g. expanding a factory, new product, etc)
 Hurdle rate that the company uses to decide on project acceptance
 E.g. company only selects projects with a return of 18% or more (so 18% is “cost of capital”)
 Food for thought: can a hurdle rate be different from the earlier two metrics?
 Cost of Capital is also a measure of risk. So higher the risk = higher the cost of capital

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 COMPONENTS OF COST OF CAPITAL
 Lets take the following example of the liability side of MSSL’s balance sheet
What cost Example of
of funds? rate

Cost of Equity and/or 15%

Div rate on
Pref. shares
[Cost of Equity, Ke]

Debatable, but 15%

usually as equity

YTM of bonds, Bank

9%
Interest rate, etc
[Cost of Debt, Kd]
Treat as Debt 9%

Treat as Debt 9%

Average 12.7%

PE firms, Banks, etc have more complex structures, but principle remains the same
Source: Motherson Sumi Annual Report
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WEIGHTED AVERAGE COST OF CAPITAL (WACC)
 Continuing with the previous example…
Capital Type Rs cr. Cost of funds Cost (%) WACC represents the
Equity Shares 1,44,424 Cost of Equity 15.0% overall cost of all sources
Reserves 0 Cost of Equity 15.0% of funds to a firm – in
Preference shares 0 Dividend Yield 11.0% proportion of their values
within its capital…
Tier 1 Bonds 80,995 Bond Yield 9.0%
Bank Loans 11,109 Interest Rate 9.0%
Total Capital 2,36,528 Cost of Capital 11.8% = WACC
 WACC = Wd*Kd + Wp*Kp + We*Ke; W = proportion of each component in total capital; K =
average cost of each component
But what about taxes?

 Interest is tax usually deductible, hence the lower effective cost is to be considered
 So WACC = Wd*[Kd *(1-tax rate)] + Wp*Kp + We*Ke

 Weights are typically based on:

 target capital structure, if available or structure of peers (for new companies)
 Market values of the components capital (more commonly used)
 Book values where market values are not available (e.g. bank loans, unlisted shares/bonds)
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 MARGINAL AVERAGE COST OF CAPITAL (MACC)
 Purists argue for using the “marginal” cost of each component since
 this reflects the changing financial status of the firm and
 Cost of capital changes after each fund raising and change in debt / equity mix

 Marginal cost = cost of an additional one rupee/$ of funds raised via that source today

 So does that mean we go to the bank everyday and ask about the loan rates?

 Naah.. The practical work around is to use the cost seen in the most recent fund raising
 Yield on the most recent long-term bond issued, or interest rate on most recent term-loan, etc

 MACC = Wd*MKd + Wp*MKp + We*MKe; MK = marginal cost of each component

 Challenges: latest issuance not always available, maturity, size vs total capital, etc

‘DDIS’
function in
Bloomberg
can help
here!!

Source: Bloomberg
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COST OF PREFERRED EQUITY – SIMPLEST!!
 Preference shares are hybrid instruments of sorts with characteristics of both debt and equity.
They have a preference for payout ahead of common equity in case of liquidation and for
dividends (they take limited risk).
 Preference shares are paid a “dividend” (usually fixed rate) from the net profit, before dividends
to ordinary shareholders.
 Cost of perpetual preferred equity = Dividend Yield on the preferred shares
 Basic formula for perpetuity is Price = CF/R or here PriceP = DividendP / Rp
 So Rp = Dividendp / Pricep.

 But preferred shares also come with variations: redeemable, cumulative, call options, variable
rate dividend, etc. To that extent, the cost should be adjusted.
 Companies sometimes issue preference shares to get the benefit of lower cost (vs common
equity) and boost LT capital without a burden of guaranteed payments like debt (barring
redeemable cumulative pref. shares).
 Like debt, always adjust for foreign currency depreciation, especially if preferred shares are
redeemable.
Remember Dividend on Pref. shares doesn’t fetch a tax shield – so no adjustment

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 COST OF DEBT – MSSL EXAMPLE
 In its simplest form cost of debt is nothing but the rate of interest due on it.

 Interest is tax usually deductible, so use after tax cost of debt (use marginal tax rate)

YTM (Yield) on the

bonds
+

Interest rate on
Loans
+
FX hedging costs

= Blended cost of
Debt
Source: Motherson Sumi Annual Report
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COST OF DEBT – METHODS TO ESTIMATE
Yield to Maturity Approach (YTM = pre-tax cost of Debt)
 YTM = returns on a bond that is held until maturity. i.e. combination of annual “coupon/interest
received” + gain on loss (Maturity value – Purchase price). It is always “annualised”.
 An approximation of the YTM can be done via the following formula
; where C = coupon/annual interest, FV = maturity value, PV = current
price and t = time remaining to maturity (in years)

 Example: L&T Finance NCD with a coupon of 8.65% p.a. maturing on 23 Dec 2026. Face value
of Rs. 1000 & market price is Rs. 1,015 on 23 Dec 2020.
 Coupon = 8.65% * 1000 = 86.5 In Excel we can use “PV” +
 FV = Rs. 1,000; PV = Rs. 1,015 goal seek functions
 T = 6-years (24 Dec 2020- 23 Dec 2026) Bloomberg: DDIS or
 So YTM = ___________________________ YAS function
 YTM affected by: interest rate in market, tenure of the bond, quality of issuer, ec

Use YTM of the latest issued long term bond / loan as Kd

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 COST OF DEBT – METHODS TO ESTIMATE
Debt rating/Matrix Pricing approach
 Based on a company’s debt rating: before-tax cost of debt est. based on yield on
comparably rated bonds for maturities that closely matching the company’s debt.

Long-term Corporate Bond Yields (Avg. from NSE)  Factors such as debt seniority and security,
Maturity
also affect ratings and yields, so must be
As of 31 Oct (yrs) Yield Spread
10-yr GSEC 10.0 6.76%
considered when determining comparable
AAA 9.3 7.77% 1.02% securities and yield
10-yr SDL 9.8 8.39% 1.64%
 This is example of pricing on the basis of
AA 8.8 8.62% 1.87%
A 7.4 9.64% 2.89%
valuation-relevant characteristics: Matrix
DHFL 'D' rated 2028 62.41% 55.66% Pricing in bond market terms

Challenges in est. cost of Debt

 Floating rate debt: e.g. LIBOR+spread – very difficult to est. LIBOR and spread over time

 Debt with option (call, put) or convertibles, etc. Adjustments to Yields are complex

 Unrated papers: benchmarking very subjective and YTM estimates very inaccurate.

Source: NSE
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 BOND YIELDS & DETAILS FOR MSSL VIA BLOOMBERG
On
Bloomberg,
use ‘DDIS’
function to get
a list of debt
instruments
and then drill
down to get
details of
each debt
instrument

This is the
latest issued
medium-term
bond, so YTM
of 5.886% can
serve as a
proxy for
Marginal Kd

Source: Bloomberg
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 COST OF (COMMON) EQUITY
 Cost of Equity is one of the most debated and improvised upon aspects of cost of capital

 Basic tenet: Cost of Equity = rate of return expected by equity shareholders..

 Sounds easy – but that’s where the simplicity ends!!

 Estimating Ke (or Re) is difficult since equity holders take all residual risk of the business
(unlimited) and hence all residual returns too…Both these factors are tough to estimate to
perpetuity
 As such multiple approaches are used and this leads to varying estimates of Ke

Capital Asset Pricing Model (CAPM) – most commonly used

 Ke (or expected return) = Rf + βe * [E(Rm) – Rf] or Risk free Rate + Beta * Risk Premium

 [E(Rm) – Rf] is the risk premium – in this specific case the “Equity Risk Premium” (ERP)
since we use market return vs risk free return
 Alternative is to use multi-factor models to capture other risks (political, co. specific, etc)

 CAPM uses three major inputs: Risk free rate, Beta and Market returns..

 Beta, which is sensitivity of asset returns to the market returns, is the most controversial

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COST OF (COMMON) EQUITY (CONTD…)
Gordon growth or dividend discount model approach
 As per DDM, P0 = Div1 / (Ke – g) for a perpetual dividend stream

 Rearranging we get: Ke = D1/P0 + g

 Or simply put, Ke = dividend yield + expected growth in dividends/earnings

 Dividend yield is the easy part (and mostly known). Estimating ‘g’ the hard bit…

 Three ways of estimating growth…

 Use external benchmarks of LT growth rates as a starting point (e.g. nominal growth in GDP) and adjust for
company specific factors.
 Look at the company’s historical growth rates (across cycles) including vs the macro trends (e.g. nominal
GDP growth) and make adjustments for the same
 Use one’s own bottom-up forecasts for 3-5yrs and then ‘normalise’ g based on external benchmarks

 Use sustainable growth rate: g = (1-Div/EPS)*RoE or earnings retention ratio * RoE

As a company moves from growth to mature stage, payout ratio increases – so dividends
will grow faster than earnings!

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 DECONSTRUCTING THE CAPM APPROACH
 Three Key inputs to CAPM: Rf, Rm and β. Lets look at each of these

Risk Free rate (simplest of the three)

 There is no real ‘Risk free’ asset, but in practice, yield on 10-yr government debt is considered
closest to risk free rate.
 If asset in question is of >10yr duration (say a 30-yr concession), then look at comparable bonds

 For India: Current 10-year G-Sec yield is ~6%. That is a fair Rf assumption.

 But remember bond yields/interest rates also vary over time…

Source: Trading Economics

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 DECONSTRUCTING THE CAPM APPROACH
Beta – a key input to measure relative risk of the stock…
 Beta is the magnitude & direction of sensitivity of a stock’s return to the market’s return

 Beta is nothing but the regression coefficient between the stock’s returns vs the market returns

 Mathematically

 A linear best fit trend line through the scatter plot is given by y = mx + c. ‘m’ is the β (= slope of the best fit line
or the regression coefficient)

 In excel, this can also be calculated by using the SLOPE function or using the ‘Regression’ tool.

 Use 6-8 year returns vs local stock market index (Sensex/NIFTY for India). BLOOMBERG FUNCTION ‘BETA’

MSSL vs Sensex daily returns Tata Motors vs Sensex daily returns

25% y=MSSL y = 0.6076x + 0.0013 40% y=Tata Motors
y = 1.2409x + 0.0002
20% R² = 0.083 R² = 0.3853
15% 30%
10%
20%
5%
0% 10%
-5%
-10% 0%
-15%
-10%
-20%
-25% X = Sensex returns X = Sensex returns
-20%
-15% -10% -5% 0% 5% 10% 15% 20% -20% -10% 0% 10% 20%

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DECONSTRUCTING THE CAPM APPROACH
Factors determining Beta of a security
 Cyclicality of revenues: higher the cyclicality, higher the Beta. Eg. Tata Motors Beta 1.3-1.5
while for ITC it is 0.8, NTPC 0.72, PowerGrid 0.62
 Operating leverage: i.e. proportion of fixed costs. A high proportion of fixed cost of
operations (e.g. due to operations in high cost countries or high insourcing or inflexible
workforce) tends to magnify the volatility in revenues and thus leads to high fluctuations in
earnings and cash flow across business cycles.
 Higher earnings volatility = higher risk = higher Beta.
 E.g. Semiconductor firms (β typically >1.8-2.0) vs consumer non-durables or utilities

 Financial leverage: Equity holders of companies with high debt are impacted by higher
interest (fixed costs!) and commitment to pay back the debt.
 This can enhance RoE if RoCE > Cost of Debt, but also increases earnings fluctuations.
 So high gearing/financial leverage = higher Beta (e.g. Airtel 1.22 vs Vodafone Idea 1.55).

 Size of the company: Small cap stocks tend to have higher Beta than large-caps as smaller
size limits ability to tolerate large fluctuations
 Qualitative factors: corporate governance, pricing power, etc.

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 RISK PREMIUM (RM – RF) OR RP
 Risk premium = the extra return over Rf demanded by
investors to take the risk of investing in equities. It is
among the hardest to estimate of the three factors.
 It is closely tied to “investor sentiment” and
“perception” and there is no one mathematical
formula to determine quantum of risk premium
 Risk premium is usually calculated for the entire market

 Multiple ways to calculate risk premium:

 Historical Rp approach: Use the LT difference between market returns and the Rf. But one needs to take
a sufficiently long period to cover multiple cycles.. CFA Institute’s material uses example of going back a
hundred years to estimate Rp.
 Gordon growth approach: Calculate Ke using DDM (i.e. Div Yield + Growth) and subtract Rf from it to get
implied Rp
e.g. Sensex current dividend yield = 1.1%; expected LT growth (=Nominal GDP) is 12-13% and Rf = 6.5%.
Using DDM, Ke = 1.14 + 12.5 = 13.64%. And Rp = 13.6% - 6.5% = 7.1%.
 Survey/Thumb rule approach: Conduct annual survey and conversations with market participants for
Expected market return or the equity risk premium itself. Lot of subjectivity involved so least preferred and
uncommon method.
Source: CFA Institute
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 LET’S PRACTICE WACC
Question 1

 Jorge Ricard, a financial analyst, is estimating the costs of capital for the Zeale Corporation. In the process of
this estimation, Ricard has estimated the before-tax costs of capital for Zeale’s debt and equity as 10% and
16%, respectively.

 What are the after-tax costs of debt and equity if there is no limit to the tax deductibility of interest and Zeale’s
marginal tax rate is: a) 30% and b) 48%

 What would Zeale’s WACC be if:

 Tax rate is 30% and it has Rs. 30 of debt for every Rs. 100 equity (book value)
 Tax rate is 48% and it has Rs. 60 of debt for every Rs. 100 equity (book value)

 What are your key conclusions?

Question 2: Borosil Renewables

 Using the data in the next slide and excel sheet and calculate Borosil Renewable’s Ke, Kd & WACC.

Question 3: Comparing WACC across sectors – this is for home Assignment

 In the excel sheet you are given data for the following companies – PI Industries, Ashok Leyland, Tata
Steel & Infosys. Using the information, calculate the Weighted Average cost of Capital for each of them.
Compare the outcomes and state the conclusions can you draw?

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 IN-CLASS EXERCISE: BOROSIL RENEWABLES..
 Please download 2020 Annual report:

 http://borosilrenewables.com/pdf/2020/shareholder-info/annual-reports/Annual_Report_2019_2020.pdf

 The following extract is available from the balance sheet + notes. Other details in the excel file..
Borosil Renewables - Balance sheet Liability side Data for 31 March 2020
Sr Particulars Amount Rs. Lakhs As of
Mar-20 Mar-19
Equity Capital 1,141 924
Equity Shares suspense 0 266
Share to be Cancelled 0 -50
Other Equity 31,503 32,079
A Shareholders' Equity 32,644 33,220

B Non-current Borrowings (note 22) 7,683 2,368

- Term Loan from Banks in INR 6,229 2,278
- Term Loan in foreign currency 1,454
- Deposit from related party 90
C Current Borrowings (Note 25) 667 1,873
- Working capital Loan (Banks) 667 1,311
- Buyers Credit 562
Other financial Liabilities (Note 27) 5,496 2,548
D - Current Maturity of Term Loan 879
E - Interest Accrued but not due 43 20
F Total Debt (= B+C+D+E) 9,229 4,241
G Finance cost in P&L 667 43
- Interest on Loans 570 51
- FX adjustment 97 -8

Source: Borosil Renewables annual Report 2020

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 ECONOMIC VALUE ADDED…
 Economic Value Added (EVA) is a “residual income” based measure of “economic” profits

 EVA assumes that “real” profit should be calculated after the costs of “all sources of capital” are taken into
account, unlike accounting profit which only considers Kd..

 EVA = Returns at the enterprise level – full cost of capital

 Simply put, EVA = [Return on Capital Employed (RoCE) – WACC] x Capital Employed

 RoCE can be calculated in multiple ways

 RoCE = NOPAT / Capital Employed
 NOPAT = Net Operating Profit after tax = EBIT * (1-Tax rate)  Mostly widely accepted definition
 Alternatively, NOPAT = PAT + Interest Expense
 Capital Employed = Book Value of Equity + Book value of Debt + Book value of preferred equity (if any)
 Net Debt or Total Debt?

 EVA concept implies that WACC is effectively is a threshold rate of return for management
 Target for all managements therefore is to generate RoCE > WACC for the firm/division/business
 RoCE & WACC are therefore the “holy grail” of corporate finance and yardsticks applied in many cases (e.g. M&A)

 Beware of its shortfalls: biggest being it is calculated using accounting data

When RoCE > WACC, business generates “economic value” for all stakeholders in true sense

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Q&A

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