Finance Numericals

As we discuss in previous post about Dividend Discount Method to calculate Cost of Equity. Now we discuss another method that is CAPM (Capital Asset Pricing Model).   Capital Asset Pricing Model (CAPM):  It measure rate of return based on risk on investment. There are two type of risk - diversified risk which can be minimise  due to diversify the investment and another is non- diversified risk which can affect all firms like change in government policy, inflation, purchasing power etc. This model is based on some assumptions related to investors preferences ( investors are risk averse) and market efficiency (no tax, no investor can affect market price, no transaction cost, no restriction on investment, all investors have same market knowledge etc.). Beta is the measure of systematic risk and it is always between in 0.5 to 1.75. It can be positive or negative.If it is below 1 it means the asset is less volatile than market or you can say the price of the asset does not change

Cost of Equity:  It is a rate of return which a share holder earns for holding that companies share. It includes dividend and capital gain. Dividend Discount Model:  It is also called Dividend Growth Model or Gordon’s Growth Model. It is used to calculate the stock value by adding the present value of all future dividends with assumption of constant growth rate in dividend. Advantages of dividend discount model: ·           It helps to analyse the value of equity. ·           It helps to determine the current price of equity with growth. ·           It helps to build the image of a company. ·             Disadvantages of dividend discount model: ·           It is not applicable on that companies which do not pay dividend. ·           It depends on assumption like growth rate. Formula: P 0 = D 0  (1+g)/ (k e -g) OR  P 0  = D 1  / r-g K e = (D 1  / P 0 ) +g Where, P 0  = Current price of equity D 0  = Dividend on equity G = growth rate

Cost of Preference Share Capital:  An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital. Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt. Formula for Cost of Preference Share: Irredeemable Preference Share Redeemable Preference Share K p  = Dp/NP K p  = D p +((RV-NP)/n )/ (RV+NP)/2 Where, K p  = Cost of Preference Share D p  = Dividend on preference share NP = Net proceeds from issue of preference share (Issue price – Flotation cost) RV = Redemption Value N = Period of preference share Example:  A company issues 20,000 irredeemable preference share at 8% whose face value is Rs.50 each at 4% discount. Find out the Cost of Preference Share Capital.

Cost of capital : It is a minimum rate of return that a company earns on its investment. Importance of Cost of Capital: ·          With the help of cost of capital management can determine the return on capital . ·          It helps to determine which source of finance is good for the company. ·          It helps to formulate optimal capital structure of a company.  Cost of Debt: It is an interest rate that a company pays to its lenders or debenture holders whom it takes money to invest in company assets. Importance of Financing through debt: ·          The lender does not participate in management and in profit they receive interest on a borrowed amount. ·          The interest received by lenders are tax deductible and treated as expense for a company. ·          Company has to keep more profit to meet the burden of paying interest regularly. Net Proceeds : It is an amount which earn after subtracting related expenses from selling an asset. Floa