How to calculate cost of capital?, Financial Management

To calculate the Cost of Capital, we will use the Weighted Average Cost of Capital (WACC) formula

            WACC = (E/V) X RE + (D/V) X RD X (1 - TC)
where

            E = Market Value of the firm's equity

            D = Market Value of the firm's debt

            V = Combined Market value of debt and equity = (E + D)

            RE = Cost of Equity Capital

            RD = Cost of Debt Capital

            TC = Corporate Tax Rate

Example

            Calculating the cost of capital for BAL, we get:

 

Value

Formula

Amount (Rs.)

E

 

52,726,727,061

Secured Loans (S)

 

318,335,238

Unsecured Loans (U)

 

53,031,231

Interest on S and U (ISU)

 

33,817,261

Interest Rate on S and U (RSU)

 = ISU/(S + U) * 100%

9.11

Sales Tax Deferral Liability under Package Scheme of Incentives 1983, 1988, 1993 (L)

 

5,889,623,171

Interest on L (IL)

 

0

Interest Rate on L (RL)

 = IL/L * 100 %

0

D

 = S + U + L

6,260,989,640

V

 = E + D

53,045,062,299

E/V

 = E/V

0.98

D/V

 = D/V

0.12

RD

 = (S + U)/D*RSU + L/D*RL

0.54

Tc (%)

 

35.00

RD * (1 - Tc)

 = RD * (1 - Tc)

0.35

Beta

 

0.73

RF (%)

 

6.00

RM - RF (%)

 

9.00

RE

 = RF + Beta * (RM - RF)

12.57

WACC (%)

 = (E/V)* RE + (D/V) * RE * (1 - Tc)

12.54

         

The weighted average cost of capital works out to 12.54% a year. As can be seen for BAL, 98% of the capital is in the form of equity. Only about 2% of the capital is funded through debt. It can also be observed that the interest on loans works out to be approximately 9% (excluding the Sales Tax Deferral), whereas the cost of equity works out to be around 12.5%. Since the debt part of the capital is very low (D/E ratio = 0.22), we can see that the financial risk of the company is very low.

Hence it can be seen that in the current scenario of falling interest rates on loans, BAL has a higher cost of capital than is optimum. In addition, BAL has huge reserves of surplus cash that it is unable to invest at the rates matching the cost of capital. Bajaj Auto is estimated to hold about Rs.18, 000 million in the form of loans & advances, debt/equity investments and cash in hand.

BAL is aware of this problem, as is evident from the fact that BAL decided to buyback some of its outstanding equity shares in 2001. This reduction in the capital base has reduced the cost of equity for the company. It has also reduced the huge amount of surplus cash that the company has on its hand.

Posted Date: 7/25/2012 8:43:36 AM | Location : United States







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