Sources and Cost of Capital

Rinse John 11-Jun-12

Sources & Cost of Capital

1) Short Term Finance 2) Medium Term Finance 3) Long Term Finance

Purpose of Short-term Finance

After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business.

Short-term finance serves following purposes

1. It facilitates the smooth running of business operations by meeting day to day financial requirements. 2. It enables firms to hold stock of raw materials and finished product. 3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. 4. During this time gap, production continues and money will be needed to finance various operations of the business. 5. Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.

Sources of Short-term Finance

There are a number of sources of short-term finance which are listed Below: 1. Trade credit 2. Bank credit a. Loans and advances b. Cash credit c. Overdraft d. Discounting of bills 3. Customers advances 4. Installment credit

5. Loans from co-operatives

1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the Suppliers of raw material, finished goods, components, etc. Usually Business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.

2. Bank Credit
Commercial banks grant short-term finance to business firms which are known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. (i) Loans When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. (ii) Cash Credit It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. (iii) Overdraft When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account upto a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit upto Rs.20,000. In this system, the borrower has to show a positive balance in his account on the last Friday of every

month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit. (iv) Discounting of Bill When these documents are presented before the bank for discounting, banks credit the amount to customers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. Customers Advances Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its Short-term requirements with the help of customers advances. 4. Installment credit Installment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of installments. 5. Loans from Co-operative Banks Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state.

Sources of Medium-term Finance

Loans

The most popular financing for businesses are bank loans. Loans can be obtained for any amount and carry special terms for funding, length and repayment.

Leases

Leasing is an attractive financing option for companies needing equipment or facilities for a certain length of time. Lease generally range from one to three years, giving businesses options outside of traditional bank loans.

Bonds

Large companies may issue business bonds to gain financing for medium-length projects. Although this increases leverage, bonds do not dilute ownership levels or give outside individuals a vote in business operations.

Equity

Small companies may provide medium term financing through deposits of owner capital. Large companies may issue stock on a medium term plan for generating new capital for business financing.

Venture Capital

Venture capital financing is generated by offering outside investors an ownership stake in the business for their invested capital. This allows these outside individuals a vote in how the business is managed, which may be seen as a significant drawback to this type of financing.

Sources of Long-term Finance

Shares:

These are issued to the general public. These may be of two types: (i) Equity (ii) Preference. The holders of shares are the owners of the business.

Debentures:

These are also issued to the general public. The holders of debentures are the creditors of the company.

Public Deposits :

General public also like to deposit their savings with a popular and well established company which can pay interest periodically and pay-back the deposit when due.

Retained earnings:

The company may not distribute the whole of its profits among its shareholders. It may retain a part of the profits and utilize it as capital.

Term loans from banks:

Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years.

Loan from financial institutions:

There are many specialized financial institutions established by the Central and State governments which give long term loans at reasonable rate of interest. Some of these institutions are: Industrial Finance Corporation of India ( IFCI), Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations etc.

Primary Market
The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus. Primary markets create long term instruments through which corporate entities borrow from capital market. Features of primary markets are:

This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM). In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. The primary market performs the crucial function of facilitating capital formation in the economy. The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as "going public." The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

Public issuance, including initial public offering; Rights issue (for existing companies); Preferential issue.

Capital Market

The public issue is playing a major role in gearing up the Indian economy. Most of the companies are coming up with IPO's and post public issues to raise money from the public. This is the best way to raise capital form present perspective. Public Issue is a complicated process requires technical skills and diligence. To starting the process of an IPO- the first step required to be taken by an aspirant is evaluation of the company whether the company is legally and financially ready to meet the scrutiny by the public and government authorities and can meet the standards' of a listed company. Thus the pre IPO works becomes necessary for public issues. Pre-IPO work starts from the very beginning after the Board's decision to comes up with IPO. It includes assessing the company's legal status, compliance management, Internal control, listing requirements, defaults compounding growth prospects, etc. The IPO issue may involve a number of works which if not done carefully may spoil the whole purpose of issue and may attract heavy liability. We provide best legal and financial solution to the same. Global Jurix is a leading law firm having hands on experience to assist the companies to in IPO and Public issues. We are a single window service provider who can take care of legal as well as financial aspects of the issue. We have the best team consists of capital markets experts who can guide and assist the company in successful listing of the company like Company Secretaries, Chartered Accountants and Advocates. Our scope of services is as follows:

Legal Advisory:

Due Diligence Compliance with Listing Requirements Drafting of Prospectus and offer documents Drafting of other documents be submitted with Government Agencies Drafting of Applications Legal opinions

Money Market
As money became a commodity, the money market is nowadays a component of the financial markets for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in the money markets is done over the counter, is wholesale. Various instruments like Treasury bills, commercial paper, bankers' acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived mortgage- and asset-backed securities do exist.

It provides liquidity funding for the global financial system. Money markets and capital markets are parts of financial markets. The instruments bear differing maturities, currencies, credit risks, and structure. Therefore they may be used to distribute the exposure.

Computation of Cost of Capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Cost of debt = risk-free rate + company risk premium Cost of equity (risk-free rate + about 6% equity risk premium) o The equity risk premium is adjusted with the companys risk level o The risk level of a company depends on the business risk (business field) and on the financial risk (solvency) A companys cost of capital is calculated as a weighted average of the above costs of equity and debt. o The cost of capital is calculated with the target solvency ratio (The cost of capital can not be decreased simply by increasing leverage since increasing leverage increases the risk (and cost) of both equity and debt.) o Debt cost includes tax shield (1-tax rate) since interest on debt can be deducted from the taxable revenues EXAMPLE: o Cost of debt: 5,2% + 1% = 6,2% (in the long run) o Cost of equity: 5,2% + 1,2 * 6% = 12,5% o Weighted average cost of capital (WACC): 6,2% * 55% * (1-tax rate) + 12,5% * 45% = 9%

Cost of debt
o

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate. The yield to maturity can be used as an approximation of the cost of debt.

Cost of equity
Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market Where:
Es- The expected return for a security Rf - The expected risk-free return in that market (government bond yield) s - The sensitivity to market risk for the security RM - The historical return of the stock market/ equity market (RM-Rf) - The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. An alternative to the estimation of the required return by the CAPM as above, is the use of the FamaFrench three-factor model.

Cost of Retained Earnings

When a company earns profit, it does not distribute its all profit. Some of profit is retained in the form of reserve. This profit is used for development of company and other productive works. It means retained money is used for more earning of business. So, it will have cost like the cost of equity share capital.
If we have to define it, we can say, it is just minimum rate of return which company should earn on same reserve. Somebody can say that there is no need to calculate cost of retained earnings because this cost is not payable in the form of dividend. But in reality, if we think that company is using shareholder fund because all earned profit should be payable as dividend but company is not paying full amount, so shareholders are deserve for getting return on reserved amount. This is just opportunity cost of the amount which is not given as dividend to shareholders. We can calculate cost of retained earning with following formula.

Cost of retained earning = Expected dividend / Net proceed of retained earning + Growth rate Or Expected dividend/ N.P. X ( 1- tax rate ) ( 1- cost of new investment)

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.
The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.

In general, the WACC can be calculated with the following formula:

where

is the number of sources of capital (securities, types of liabilities); is the market value of all outstanding securities .

is the required rate of

return for security ;

Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of total market value of and cost of debt and cost of equity and one type of bonds with the is calculated as: , in a country with corporate tax rate

Marginal Cost of Capital

The cost associated with raising one additional dollar of capital. The marginal cost will vary according to the type of capital used.
Or

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost of another unit of capital raised. As more capital is raised, the marginal cost of capital rises.
With the weights and costs given in our previous example, we computed Newco's weighted average cost of capital as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12) WACC = 0.084, or 8.4% We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will remain unchanged as new debt, preferred stock and retained earnings are issued until the company's retained earnings are depleted. Example: Marginal Cost of Capital Once retained earnings are depleted, Newco decides to access the capital markets to raise new equity. As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2.00 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. Newco's cost of new equity (kc) is thus 12.3%, as calculated below: kc = 2+ 0.07 = 0.123, or 12.3%40(1-0.05)