Cost of Capital and Valuation

Cost Of Capital And Valuation

^v   Every rupee invested in a firm has a cost

^v   It is the minimum return expected by the suppliers.

^v   Debt is the cheaper source of finance due to (I) fixed rate of interest on debt (ii) legal obligation to pay interest (iii) repayment of loan (iv) priority at the time of winding up of the company

^v   Equity shares , not legal obligation to pay dividend and shareholders undertake more risk, investment is repaid at the time of winding up after paying to others

^v   Preference capital is also cheaper, less risk involved, fixed rate of dividend payable and priority given at the time of winding up of the company

Cash flow ability to service debt

^v   Firm generating larger and stable cash inflow use more debt in capital structure

^v   Debt implies burden of fixed charge due to the fixed payment of interest and principal

^v   Whenever firm wants to raise additional funds ,it should estimate, project future cash inflow to cover the fixed charges

Nature and size of firm

^v   All public utility has different capital structure as compared to manufacturing concern

^v   Public utility employ more debt because of stable and regularity of earnings

^v   Concern cannot provide stable earnings will depend on equity shares

^v   Small companies depend on owned capital it is very difficult to raise long term loans

Control

^v   Whenever additional funds are required by firm the management should raise without any loss of control over the firm

^v   If firm issue equity shares then the control of existing share holder is diluted

^v   So it might be raised by debt or preference capital

^v   Preference share and debt do not have voting right.

Flexibility

^v   Capital structure should be flexible

^v   It should be capable of being adjusted according to the needs of the changing condition

^v   It should be possible to raise additional funds with mush risk and delay.

^v   Redeemable preference shares and convertible debenture is preferred for flexibility

Requirement of investors

^v   Requirement is the another factor that influence the capital structure of the firm

^v   It is necessary to meet requirement of institutional as well as investor when debt financing is used

^v   Investors 3 kinds

Bold investor- takes all type of risk; prefer capital gains and control – so equity capital is preferred

Over-cautious – prefer safety of investment and stability in returns – so debenture is preferred

Less cautious -  prefer stability in return – so preference share capital is used.

Capital market condition

^v   Capital market conditions do not remain same forever.

^v   Sometime depression or may be boom in the market

^v   Share market depressed, then company should not issue equity capital as investor prefer safety

^v   Boom period, firm must issue equity shares.

Asset structure

^v   The liquidity and composition of assets should kept in mind while selecting capital structure.

^v   Fixed asset contribute the major portion of the company then company should raise long-term debt.

Purpose of financing

^v   Funds are required for productive purpose – debt financing is suitable because the company can pay interest out of profit generated.

^v   Funds are needed for unproductive or general development – company prefer equity capital

Period of finance

 The period is an important factor to be kept in mind while selecting appropriate capital mix

 Finance required for limited period (7 years) – debenture should be preferred

 Redeemable preference shares is also used for limited period

 Funds needed for permanent basis equity share capital is more appropriate.