sources & cost of capital
TRANSCRIPT
Sources & Cost of CapitalSreejith S FIMS
SS Fims March 2009
Sources of capital• Cost of Capital; Concept• Different Sources• Short Term & Long Term Sources• International Sources; ADR,GDR,ADS• Money Market instruments• Leasing, Factoring, Hire purchase, Installments• Securitisation• Commercial Paper• Venture Capital
SS Fims March 2009
Sources of Capital
• Long Term Sources• Short Term Sources
• Long Term Sources• Short Term Sources
SS Fims March 2009
Cost of Capital
• The Minimum Required rate of return• Financing Cost• It is the discount rate for project appraisal
• The Minimum Required rate of return• Financing Cost• It is the discount rate for project appraisal
SS Fims March 2009
Cost of Capital
• It is useful for - Evaluate investment decision - Designing a firms debt policy - Appraising the financial performance
SS Fims March 2009
Investment Evaluation
• Cut off rate/hurdle rate • Discount Rate
SS Fims March 2009
Designing the Debt Policy
• Tax Saving• Financial Risk• Maximising the share holder value
SS Fims March 2009
Performance Appraisal
• Compare the actual with Proposed• Exibits the future requirements• It is useful in dividend decision
SS Fims March 2009
Investment’s Risk & Return
Target Return% p.a.
Risk
5 10 15 20 25 30 35
EQUITY
Preference Shares
Other Debt instrument
s
Debentures
Risk Free
Security
SS Fims March 2009
Opportunity Cost
• Shareholder’s View• Next best option• Depend on the business risk• Considering Creditors Claims
SS Fims March 2009
Cost of Capital
• Weighted average cost of Capital• Specific Cost of Capital
SS Fims March 2009
WACC
• Combined Cost• Consider all Cost of capital• Weight age is given for each element
SS Fims March 2009
Specific Cost of Capital
• Cost of Capital for each element• Cost of each sources is calculated separately
SS Fims March 2009
Determinants of Cost of Capital
• Investors Required rate of return• Cost of Debt• Tax shield
SS Fims March 2009
Components ; Cost of Capital
• Cost of Debt• Cost of Preference capital• Cost of Equity
Cost of Debt
• Cost of Debentures• Cost of loans
Two Factors- Net cash Inflow
- Net Cash Outflow
Cost of Perceptual Debt
• It is the rate of return• Lender’s Expected rate of return• Debt Carries interest/Coupon rate • Before Tax Cost• Tax Adjusted Cost
Cost Before Tax
A. Debentures/Bonds Issued @ ParB. Debentures/Bonds Issued @ DiscountC. Debentures/Bonds Issued @ Premium
Ki = i . SV
Ki = Before Tax Cost of DebtSV= Sales Proceedsi = Annual Interest Payment
Cost Before Tax
Find out The cost of Capital (Before Tax)
• A Company Has 10% Debentures of Rs 100,000
a) Issued at Parb) Issued at Discount 10%c) Issued at Premium 10%
Tax Adjusted Cost
A. Debentures/Bonds Issued @ ParB. Debentures/Bonds Issued @ DiscountC. Debentures/Bonds Issued @ Premium
Tax Adjusted Cost
Kd = Ki(1-T)
Kd = Tax Adjusted CostKi = Before Tax CostT= Tax Rate
Find out The cost of Capital (Tax Adjusted)
• A Company Has 10% Debentures of Rs 100,000
• Tax Rate 35%a) Issued at Parb) Issued at Discount 10%c) Issued at Premium 10%
Trial & Error Method
SV = I(PVFA n, Kd) + RV(PVF n,Kd)
I =Annual Interest paymentRV = Redemption Value
SS Fims March 2009
Find out Cost of Debt
• Rs 15 Interest per year• No of Years 7• Face Value Rs 100
Three Casesa)Maturity @ parb)Maturity @ a discount of Rs 6c) Maturity @ a premium of Rs 10
SS Fims March 2009
Cost of Preference Shares
• Irredeemable Preference Shares• Redeemable Preference Shares
Irredeemable Preference Shares
Kd = PDIV SV
PDIV :- DividendSV = Sales Value
Find out The cost of Capital
• A Company Has 10% Irredeemable Preference Shares of Rs 100,000
a) Issued at Parb) Issued at Discount 10%c) Issued at Premium 10%
Trial & Error Method
SV = PDIV(PVFA n, Kd) + RV(PVF n,Kd)
RV = Redemption Value
SS Fims March 2009
Redeemable Preference Shares
Find out Cost of Preference Shares
• 15 % Dividend• No of Years 7• Face Value Rs 100;
Three Casesa)Issued @ parb)Issued @ a discount of Rs 6c) Issued @ a premium of Rs 10
SS Fims March 2009
Find out Cost of Preference Shares
• 15 % Dividend• No of Years 7• Face Value Rs 100;
Three Casesa)Redeemed @ parb) “ “ @ a discount of Rs 6c) “ “ @ a premium of Rs 10
SS Fims March 2009
Cost of Equity
• Zero Growth• Constant Growth• Supernormal Growth
SS Fims March 2009
Zero Growth
Ke = Div MV
DIV = DividendMV = Market Value
SS Fims March 2009
Constant Growth
SS Fims March 2009
Ke = Div + G MV
G = Growth
Find out Cost of Equity
• Market Price of Share is Rs 90• Expected Dividend is Rs 4.5• Dividend is expected to grow @ 8% rate
Supernormal Growth
Trial & Error Method MV = ∑DIV(1+g)^t (PV t, ke) + DIV x 1 (ke-gn) (1+ke)^n
SS Fims March 2009
n
t
Find out cost of Equity
• Market Value of Share : Rs 134• Current Dividend : Rs 3.5• Expected growth : 15% (next 6 years), Then 8%
SS Fims March 2009
Assuming that a firm pay tax at a Rs 50%, Calculate cost of Capital
Cases1.A 8.5 % preference shares sold at par2.Issue of 7% bond at par3.Equity share price @ market Rs 120; Dividend
Rs 9; Expected Growth 8%
SS Fims March 2009
Weighted Average Cost of Capital
• Calculate The specific Cost of Capital• Multiply it with the proportion in the capital
Structure• Add the weighted cost
Calculate WACC
Share Capital
450,000
Reserve 150,000
Preference Share
100,000
Debt 300,000
Share Capital
18%
Reserve 18%
Preference Share
11%
Debt 8%
Capital Structure Tax Adjusted Cost
Floatation Cost
• The present day business entities incur costs of flotation in a variety of forms.
A few of them may be mentioned as below:
• Charges of the underwriters• Legal Fees• Commission to be paid to brokers• Costs of Administration
Calculate cost of Equity
A company plans to issue some new equity shares to
raise additional funds. The net proceeds per share will be
the market price share (Which is Rs 120) less floatation
cost (which is 5% of the share price). If the company plans
to pay a dividend of Rs 6 per share and the growth in dividend
is expected to be 8%.
Sources of Capital
Internal Sources of Finance and Growth
• ‘Organic growth’ – growth generated through the development and expansion of the business itself. Can be achieved through:
• Generating increasing sales – increasing revenue to impact on overall profit levels
• Use of retained profit – used to reinvest in the business
• Sale of assets – can be a double edged sword – reduces capacity?
External Sources of Finance
• Long Term – may be paid back after many years or not at all!
• Short Term – used to cover fluctuations in cash flow
• ‘Inorganic Growth’ – growth generated by acquisition
'Inorganic Growth'
• Acquisitions• The necessity of financing
external inorganic growth– Merger/Joint Venture:
• firms agree to join together – both may retain some form of identity
– Takeover:• One firm secures control of
the other, the firm taken over may lose its identity
Sources of Capital
• Long Term Sources• Short Term Sources
• Long Term Sources• Short Term Sources
SS Fims March 2009
Long Term Sources
• Equity• Preference• Debt
Long Term
• Shares (Shareholders are part owners of a company)– Ordinary Shares (Equities):
• Ordinary shareholders have voting rights• Dividend can vary• Last to be paid back in event of collapse• Share price varies with trade on stock exchange
– Preference Shares:• Paid before ordinary shareholders• Fixed rate of return• Cumulative preference shareholders – have right to dividend carried over to next year in
event of non-payment
– New Share Issues – arranged by merchant or investment banks– Rights Issue – existing shareholders given right to buy new shares at discounted
rate– Bonus– change to the share structure – increases number of shares and reduces
value but market capitalisation stays the same
Equity
• IPO• Private Placements• Euro Issues
IPO
• Public issue of securities• New firms • First Time
Terms - IPO
• Authorized Capital• Issued Capital• Subscribed Capital• Paid-up Capital• Par Value• Share Premium
Features of Equity
• Claim on Income• Residual Ownership• Voting right• Right to Control etc
Private Placement
• Issue of Shares Privately• Less Compliance than Public Issue• Time Effective• Cost effective
Euro Issues
• Public issue of Shares• In Foreign Stock Exchanges• ADR• GDR
Debt Fund
• Bond• Debentures• Term Loans• Asset Based Financing
SS Fims March 2009
Bond/Debentures
• A long term promissory note• Tool for raising Loan Capital• Stipulated Interest and time• Public Sec Instruments- Bonds
SS Fims March 2009
Bond/Debenture Features
• Interest rate• Maturity• Redemption• Secured/Unsecured• Yield to Maturity
SS Fims March 2009
Types of Debentures
• Non-Convertible Debentures• Fully Convertible Debentures• Partly Convertible Debentures
SS Fims March 2009
Pros & Cons
• Less Costly• No ownership dilution• Fixed payment of interest• Reduced real obligation
• Obligatory Payment• Financial Risk• Redemption
SS Fims March 2009
Terms & Loans
• Long term debt• More Than one Year• From banks/Fis
SS Fims March 2009
Features
• Maturity• Direct Negotiation• Security• Convertibility
SS Fims March 2009
Leasing• Lease is a contractual arrangement/ transaction
• in which a party (lessor) owning an asset/equipment provides
• the asset for use to another party/ transfer the right to use the equipment to the user (lessee)
• over a certain/for an agreed period of time for consideration in form of / in return for periodic payments / rental with or without a further payment (premium).
• At the end of the contract period (lease period) the asset/equipment is returned to the lessor
Leasing
• Parties to Contract: -financer (or owner - Lessor) -user (lessee)
• there could be lease-broker who works as an intermediary in arranging lease finance deals
Leasing
• Ownership - Ownership vests with Lessor - Procession (Uses) is allowed to the lessee
On the Expiry date of the lease tenure; the asset revert to the lessor
Leasing
• Lease Rentals - The consideration lessee pays
• Term Lease - The period for of lease agreement
Classification of Leasing
• A lease contract can be classified onvarious characteristics in following categories:
. Finance Lease and Operating Lease . Sales & Lease back and Direct Lease. Single investor and Leveraged lease .Domestic and International lease
Finance Lease • A Finance lease is mainly an agreement for just financing the
equipment/asset, through a lease agreement.
• The owner /lessor transfers to lessee substantially all the risks and rewards incidental to the ownership of the assets (except for the title of the asset).
The lessor is only a financier and is usually not interested in the assets.
Economic life is normally utilized by one user – i.e. Ships,aircrafts etc.
Generally a finance lease agreement comes with an option to transfer of ownership to lessee at the end of the lease period.
Operating Lease• the lessor does not transfer all risks and rewards
• such assets which can be used by different users • without major modification
• The lessor provides all the services associated with the assets, and the rental includes charges for these services.
• The lessor is interested in ownership of asset/equipment as it can be lent to various users, during its economic life.
• Examples of such lease are Earth moving equipments, computers, automobiles etc.
Sale and Lease Back
• Sale and Lease Back: In this type of lease, the owner of an
equipment/asset sells it to a leasing company (lessor) which leases it back to the owner (lessee).
Sale and Lease Back
Direct Lease:
• Direct Lease: In direct lease, the lessee and the owner of the
equipment are two different entities. A direct lease can be of
two types: Bipartite and Tripartite lease.
Single Investor Lease
• This is a bipartite lease in which the lessor is solely responsible for financing part. The funds arranged by the lessor (financier) have no recourse to the lessee.
Leveraged Lease
• This is a kind of tripartite lease• the lessor arranges funds from another party. • the equipment is part financed by a third
party (normally through debt) • a part of lease rental is directly transferred to
such lender • towards the payment of interest and
installment of principal.
Leveraged Lease
Domestic Lease
• Domestic Lease:
A lease transaction is classified as domestic if all the parties to such agreement are domiciled in the same country
International Lease
• Import Lease• Cross Border Lease
Regulatory Framework of Leasing in India
• The Indian Contract Act,1872 are applicable to all lease contracts.
• Motor Vehicles Act are also applicable to specific lease agreements.
• Indian Stamp Act:• RBI NBFCs Directions:
A lease agreement includes• i. Nature of lease:• ii. Description of equipment• iii. Delivery and re-delivery of asset• iv. Lease Period & Lease Rentals• v. Uses of assets allowed• vi. Title: Identification and ownership of equipment• vii. Repairs and maintenance• viii. Alteration and improvements• ix. Possession:
Structure of Leasing Industry
• over 400 private and public limited leasing companies.
• Private Sector Leasing First Leasing Co of India Ltd. (FLGI), The Twentieth Century Finance Corporation Ltd. (TGFL),
The Grover Leasing Ltd
Adapted Companies
• Sundaram Finance Ltd (SFL), • Mercantile Commercial and Credit
Corporation ltd. (MCCL), • Motor and General Finance Ltd. (MGF).
Subsidiaries of Manufacturing Group Companies
• Swadeshi Leasing Ltd was floated by the Hindustan Motors Ltd.
• Classic Leasing by ITC Ltd• Ashok Leyland• Finance Ltd. of Ashok Leyland Ltd
• SBI Capital Markets Ltd.• Canbank Financial Services Ltd.• BOB Fiscal Services Ltd• BOI Financial Services Ltd• PNB Capital Services Ltd
Subsidiaries of Commercial Banks
Public Sector Organisations
• State Industrial Investment Corporation of Maharashtra (SICOM)
• Gujarat Industrial and Investment Corporation (GIIC)
• FIs
Performance of Lease till 1990
Hire Purchase
Hire Purchase
• The goods to be sold on a future date• The goods are let on hire• price is to be paid in installments
Hire Purchase Act,1972• a. Payments to be made in installments over a specified period.
• b. The possession is delivered to the hirer at the time of entering into the contract.
• c. The property in goods passes to the hirer on payment o the last installment.
• d. Each installment is treated as hire charges so that if default is made in payment of any installment, the seller becomes entitled to take away the goods, and
• e. The hirer/ purchase is free to return the goods without being required to pay any further installments falling due after the return.
National Small Industries Corporation (NSIC)
Features of Hire Purchase Agreement
• the buyer takes possession of goods immediately and agrees to pay price in installments
• Each installment is treated as hire charges.• The ownership of the goods passes from the seller to the
buyer on the payment of the last installment• In case the buyer makes any default in the payment of any
installment the seller has right to repossess the goods from the buyer and forfeit the amount already received treating it as hire charges
• The buyer can terminate the payment at any point of time
Installment
• the contract of sale is entered into the goods are delivered and the ownership is transferred to the buyer
• but the price is paid in specified installments over a period of time.
• It is not possible to terminate the contract by the buyer.
Hire purchase Vs Leasing Hire Purchase Leasing
Ownership is transferred on final installment
Ownership is never transferred
Hirer is entitled to claim depreciation Lessor is entitled to claim Depreciation
Maintenance is Hirer’s Responsibility Lessor is doing Maintanance
Hirer will get Tax benefit Lessor will get tax benefit
Magnitude is Low Magnitude is High
Less than 100% Finance extention 100% Finace Extention
Factoring
FACTORING
• it is the conversion of credit sales into cash
• a financial institution (factor) buys the accounts receivable of a company (Client)
• pays up to 80%(rarely up to 90%) of the amount immediately on agreement
Characteristics of factoring
• Usually the period for factoring is 90 to 150 days
• Factoring is considered to be a costly source of finance compared to other sources
• Bad debts will not be considered for factoring • The cost of factoring vary from 1.5% to 3% per month
• Indian firms offer factoring for invoices as low as 1000Rs
Classification of Factoring
• Disclosed and Undisclosed• Recourse and Non recourse
Disclosed Factoring
• In disclosed factoring client's customers are notified of the
factoring agreement
Undisclosed Factoring
• Client's customers are not notified of the factoring arrangement
• ledger administration and collection of debts are undertaken by the client
• Client has to pay the amount to the factor irrespective of
whether customer has paid or not
Recourse
• client undertakes to collect the debts from the customer
• If the customer don't pay the amount on maturity, factor will recover the amount from the client
• lower interest rate since the risk by the factor is low
Non recourse factoring
• factor undertakes to collect the debts from the customer
• Balance amount is paid to client at the end of the credit
period or when the customer pays the factor whichever comes first
• factoring will eliminate the need for credit and collection departments
Factoring In India
• Canbank Factors Limited
• SBI Factors and Commercial Services Pvt. Ltd
• The Hongkong and Shanghai Banking Corporation Ltd:
• Foremost Factors Limited:
• Global Trade Finance Limited:
• Export Credit Guarantee Corporation of India Ltd:
• Citibank NA, India:
• Small Industries Development Bank of India (SIDBI):
• Standard Chartered Bank:
Forfaiting
Forfaiting
• The forfaiting owes its origin to a French term ‘forfait’
• which means to forfeit (or surrender) one’s rights on something to some one else.
• Under this mode of export finance, exporter forfaits his rights to the future receivables and the forfaiter loses recourse to the exporter in the event of non-payment by the importer.
Methodology
• Forfeiting is generally extended for export of capital goods, commodities and services
where the importer insists on supplies on credit terms.
Mechanism
• There are five parties in a transaction of forfaiting. These are :
1. Exporter2. Exporter’s bank3. Importer 4. Importer’s bank and 5. Forfaiter
Mechanism
• The exporter and importer negotiate
• The exporter approaches the forfaiter
• The forfaiter collects all the relevant details of the proposed transaction,
viz., details about the importer, supply and credit terms, documentation, etc., in order to ascertain the country risk and credit risk involved in the transaction..
Mechanism• Depending upon extent of these risks the forfaiter
quotes the discount rate.
• Discount rate must be reasonable and would be acceptable to his buyer.
• He will then quote a contract price by loading the discount rate, commitment fee, etc.
• If the deals go through, the exporter and forfaiter sign a contract.
Mechanism
• Export takes place against documents guaranteed by the importer’s bank.
• The exporter discounts the bill with the forfaiter
• The forfaiter presents the same to the importer for payment on due date or even can sell it in secondary market.
Documentation and cost
• Forfaiting transaction is usually covered either by a promissory note bill of exchange.
it has to be guaranteed by a bank or, bill of exchange may be ‘avalled’ by the importer’ bank.
• The forfeiting cost ‘commitment fee’,
FACTORING & FORFAITING
1.Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange.
2. Usually provides financing for short-term credit period of upto 180 days.
1. Oriented towards single transactions backed by LC or bank guarantee.
2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorterm credit of 30–180 days is also available for large transactions.
3.Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor.
4. Factor assumes responsibility for collection, helps client to reduce his own overheads.
3. Seller need not route or commit other business to the forfaiter. Deals are concluded transaction-wise.
4. Forfaiter’s responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected.
FACTORING & FORFAITING
5. Separate charges are applied for — financing— collection— administration— credit protection and
— provision of information.
5. Single discount charges is applied which depend on— guaranteeing bank and country risk,— credit period involved and — currency of debt. Only additional charges is commitment fee, if firm commitment is required prior to draw down during delivery period.
FACTORING & FORFAITING
6. Service is available for domestic and export receivables.
7. Financing can be with or without recourse; the credit protection collection and administration services may also be provided without financing.
6. Usually available for export receivables only denominated in any freely convertible currency.
7. It is always ‘without recourse’ and essentially a financing product.
FACTORING & FORFAITING
DIFFERENCE BETWEEN FACTORING AND FORFAITING
8. Usually no restriction on minimum size of transactions that can be covered by factoring .
9. Factor can assist with completing import formalities in the buyer’s country and provide ongoing contract with buyers.
8. Transactions should be of a minimum value of USD 250,000.
9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries
Venture Capital
IMPERATIVES OF VENTURE CAPITAL (VC)
• Technological progress is the key driver of economic growth• Technological progress involves:
– Improvement in skills– Better capital equipment– New products, processes & business methods
• Technological progress in emerging economies will emerge from enterprises catch-up
• Technology capacity is necessary to adopt technologies to local conditions• VC encourages technological progress via research & development• VC converts research & development into new ventures
FINANCING STAGES DURING LIFE- CYCLE OF INITIATIVE
• VC funding is special which enterprises tap at different stages of life cycle of initiative
• Seed - to prove concept
• Start-up - product development & market testing
• First stage - commercial production
• Second stage - expansion to scale
• Later stage - expansion of profitable enterprise
• Bridge/ Mezzanine - preparation for going public
SNAPSHOT OF INDIAN VENTURE CAPITAL SCENARIO
Snapshot of Indian Venture Capital Scenario
20 80 250 5001200 1100 1050
10000
0
2000
4000
6000
8000
10000
12000
1996
-97
1997
-98
1998
-99
1999
-200
0
2000
-01
2001
-02
2002
-03
2007
-08
Year
To
tal
Inve
sted
($
mil
lio
ns)
SOURCE: www.nishithdesai.com/Research-Papers/VCF-Xroads.pdf
Sector investment (2008)
Regulations• Securities & Exchange Board of India (SEBI) to:
– preferential offering– Permit investment /surplus funds in bank deposits etc.– Substantial Acquisition & Takeover Regulations
• Reserve Bank of India (RBI) to:
– Grant general permission under FEMA – Allow banks to value VCF investments on cost basis– Allow investment in real estate
• Government of India:– Revisit tax issues for greater participation– Allow investments in pension funds– Streamline regulations under companies act including winding up &
valuation guidelines