WEALTH MAXIMISATION (Value Creation)

Company MVA Capital ROIC WACC Spread

($ Bn) ($ Bn) % % %

Wealth Creators :
Microsoft 219.2 25.6 17.7 13.6 4.2
Gen Electric 183.4 99.4 14.5 8.1 6.4
Walmart 182.8 73.6 13.0 8.8 4.2
Johnson & J 116.4 47.5 15.0 9.0 6.0
Merck 103.7 37.5 19.1 8.7 10.4
Coca-Cola 92.0 24.1 17.5 6.9 10.6
Proctor & G 89.7 41.8 13.0 8.0 4.9
Dell 63.6 7.2 17.6 12.5 5.1

Wealth Destroyers :
Sears -8.2 51.7 6.1 6.7 -0.6
Motorola -14.3 45.9 0.0 12.8 -12.8
Gen Motors -15.5 119.8 1.8 7.0 -5.3
Time Warner -83.0 183.0 -8.0 9.4 -17.4

Source: Stern Stewart & Co.; data for year 2002.

WACC varies from 6.7% to 13.6% & has inverse relationship with PE Ratio.

MVA = Market Vaue Added (Market Value - Invested Capital)

ROIC = Return on Invested Capital
WACC = Weighted Average Cost of Capital

Four Factors Influence Shareholders' Wealth :

Profitability, Growth, Capital Turnover (requirements) & WACC

Recommended Book : Financial Management Theory & Practice by Brigham & Ehrhardt
 Remarks

High Growth & High Return

High Spread & Large Base
Large Base & Turnover

High Spread
High Spread

High Growth

Same business as Walmart!

ationship with PE Ratio.

ments) & WACC

ctice by Brigham & Ehrhardt

Price Earning (PE) Ratio

PE Ratio E/P %
ACC 11.8 8.47%
Bajaj Auto 18.8 5.32%
Colgate 25.8 3.88%
HDFC 28.7 3.48%
HDFC Bank 29.2 3.42%
Hindalco 4.9 20.41%
Hindustan ULever 27.1 3.69%
ICICI Bank 21.5 4.65%
Infosys 16.9 5.92%
L&T 25.4 3.94%
Nestle 29.3 3.41%
Reliance Comm 10.4 9.62%
Reliance Indusries 20.1 4.98%
Steel Authority 9.9 10.10%
SBI 9.8 10.20%
TCS 13.8 7.25%
Tata Motors 7.9 12.66%
Tata Steel 2.7 37.04%

(Eco Times dt. 23 Jun,09)

Cost of Debt

Company A issues 10% debentures and pays Income-tax @ 35%.

Cost of Debt = 10% (coupon rate) x (1-tax saving @ 35%)

6.50%

Why tax is deducted from interest payment ?

Case A Case B
PBIT 100 100
Less:
Interest 10 0

PBT 90 100

I. Tax @35% 31.5 35

PAT 58.5 65

Additional 6.5 (difference between 65 & 58.5)

Cost of Interest

For cost of capital calculation for the entire project, the operating liabilities like Accounts Payable(suppl
accruals and even short term funding are not considered as they are considerd as part of operating cos
included in the investment requirements of a project.
s like Accounts Payable(suppliers,etc),
iderd as part of operating cost. They are not
Debt with Floatation Cost

Company X issues 12% bonds of Rs 1000 each repayable after 10 years with yearly interest payment.
It collects Rs 980 per bond after meeting floatation cost like brokerage & other issue expenses.

980 = 120 + 120 + 120 + + 120 + 1,120

(present value) (1+r) (1+r)^2 (1+r)^3 ………. (1+r)^9 (1+r)^10

Present Inflow Outflow over 10 years

Pre Tax Calculation Growth
Year Flow Present Value Factor
0 980 980.00 1
1 (120) (106.80) (106.80) x 1.123592 = (120) 1.12
2 (120) (95.05) 1.26
3 (120) (84.60) 1.42
4 (120) (75.29) 1.59
5 (120) (67.01) 1.79
6 (120) (59.64) 2.01
7 (120) (53.08) 2.260790
8 (120) (47.24) 2.54
9 (120) (42.04) 2.85
10 (1,120) (349.25) (349.25) x 3.206904 = (1,120) 3.21
0.00
IRR (r) =12.3592%
pre tax calculation

Short Cut Approximate Method :

Cost of issue of debentures = interest payment pa + floation cost, discount on issue or premium on r
Life of debentures
Net realisation on issue of debentures

Rs120+Rs 20 = 120+2 = 122 or 12.449%

10 980 980
Rs 980

Year Cash Accretion Closing

Flow @ IRR Balance
0 980 980.00
1 (120) 1101.12 981.12 980 @ IRR becomes 1101.12
2 (120) 1,102.38 982.38 981.12 @ IRR becomes 1102.38
3 (120) 1,103.79 983.79
4 (120) 1,105.38 985.38
5 (120) 1,107.17 987.17
6 (120) 1,109.17 989.17
7 (120) 1,111.43 991.43
8 (120) 1,113.96 993.96
9 (120) 1,116.80 996.80
10 (1,120) 1,120.00 - 996.80 @ IRR becomes 1120
 Rate of Interest = 12%
Bond Value Rs 1,000

Pre tax

on issue or premium on redemption

fe of debentures

which is close to 12.359% calculated above.

after one year

after one year

after one year

Debt with Floatation Cost

Company X issues 12% bonds of Rs 1000 each repayable after 10 years with yearly interest payment.
It collects Rs 980 per bond after meeting floatation cost like brokerage & other issue expenses.

980 = 120 + 120 + 120 + + 120 + 1,120

(present value) (1+r) (1+r)^2 (1+r)^3 ………. (1+r)^9 (1+r)^10

980 = 120(1-t) + 120(1-t) + 120(1-t) + + 120(1-t) + 1000+120(1-t)

(present value) (1+r) (1+r)^2 (1+r)^3 ………. (1+r)^9 (1+r)^10

Present Inflow Outflow over 10 years

Pre Tax Calculation Post Tax Calculation @tax ra
Year Flow Present Value Year
0 980 980.00 0
1 (120) (106.80) (106.80) x 1.123592 = (120) 1
2 (120) (95.05) 2
3 (120) (84.60) 3
4 (120) (75.29) 4
5 (120) (67.01) 5
6 (120) (59.64) 6
7 (120) (53.08) 7
8 (120) (47.24) 8
9 (120) (42.04) 9
10 (1,120) (349.25) (349.25) x 3.206904 = (1,120) 10
0.00
IRR (r) =12.3592% IRR (r) =
pre tax calculation post tax calculation

Note : It is assumed that floation cost is fully tax deductible in Year 0.

Short Cut Approximate Method :

Cost of issue of debentures = interest payment pa net of tax + floation cost, discount on issue or premi
Life of debentures
Net realisation on issue of debentures

Rs78+Rs 20 *0.65 = 78+1.3 = 79.3 or 8.034%

10 987 987
Rs 980+7
 Rate of Interest = 12%
erest payment. Bond Value Rs 1,000
Tax rate 35%

Pre tax

1000+120(1-t) Post Tax

t=tax rate

Post Tax Calculation @tax rate 35% Growth

Flow Present Value Factor
987 987.00 1
(78) (72.23) 78=120*(1-.35) 1.07994
(78) (66.88) 1.16626
(78) (61.93) 1.25949
(78) (57.35) 1.36017
(78) (53.10) 1.46890
(78) (49.17) 1.58632
(78) (45.53) 1.71312
(78) (42.16) 1.85006
(78) (39.04) 1.99795
(1,078) (499.61) 2.15766
0.00
7.994%
post tax calculation

(1,078) / (499.61) = 2.15766

ost, discount on issue or premium on redemption net of tax

fe of debentures

which is close to 7.994% calculated above.

Since dividend on preference shares is not an admissible deduction while computing tax of a company,
the formula explained for pre-tax under the folder "debt&irrpreint" holds good.
ing tax of a company,
I. Under Capital Asset Pricing Model (CAPM):

Re = Rrf + Rpm x Beta

Cost of Equity Risk free Market Correlation
return risk premium between
market &
stock returns

e.g. Risk free return = 6%

Market risk premium = 5%
Beta = 1.1
Cost of Equity= 6% + 5%*1.1 = 11.50%

II. Dividend Yield plus Growth Rate Approach :

Cost of Equity= Dividend per Share + Expected Growth in Dividend

Price per Share

e.g. Rs 2 per share dividend + Expected growth 7%

Price per Share Rs 20

10% + 7% = 17%

III. Bond Yield plus Risk Premium Method :

Not very popular.

Cost of Equity= Bond Yield + Bond Risk Premium ( i.e. risk premium for equity over own Bond yield)

10% + 4% = 14%
Normally, cost of retained earnings is not separately calculated as the market value of equity
reflects equity capital and its reserves/ retained earnings.

Cost of Equity= Dividend per Share + Expected Growth in Dividend x (1-t) x (1-f)
Price per Share

t=tax rate of shareholders on dividend/ capital gains

f= floation cost (brokerage,publicity,etc) of equity issue

e.g. Rs 2 per share dividend + Expected growth 7% x ( 1- shareholders' tax rate 20%)
Price per Share Rs 20

= 10% + 7% x (1-0.2) (1-0.05)

= 17% x 0.8 x .95 or 12.92%

t value of equity

eholders' tax rate 20%) (1-floatation cost 5%)

 Weighted Average Cost of Capital

It is a weighted (or composite) average cost of each constituent of the company's capital.

Company A has 40 lac equity shares whose value is Rs 25 each. Dividend per share is Rs 2. Expected growth 10%.
10% Debentures aggregating to Rs 4 crore. Tax rate 35%.
8% preference shares totalling Rs. 3 crore.

Cost of equity = Dividend per Share Rs 2 + Expected growth 10% =8%+10% or 18%
Price per share Rs 25
Structure Post tax Cost Product
Total Equity Rs 100000000 18.00% 18000000

Total Debentures Rs 40000000 6.50% 2600000

Total Pref Shares Rs 30000000 8.00% 2400000

170000000 23000000

WACC= Product = 13.5294%

Total Capital

If the Company raises new 11% Bonds totalling Rs 3 crore. This will result in increasing expected dividend to
Rs 2.25 per share and share price falling to Rs 20 and expected growth increasing to 11%.

Cost of equity = Dividend per Share Rs 2.25 + Expected growth11%=11.25%+11% or 22.25%

Price per share Rs 20

Structure Post tax Cost Product

Total Equity Rs 80000000 22.25% 17800000

Total Debentures Rs 40000000 6.50% 2600000

Total Pref Shares Rs 30000000 8.00% 2400000

Total Bonds 30000000 7.15% 2145000

180000000 24945000

WACC= Product = 13.8583%

Total Capital
Expected growth 10%.

cted dividend to
Optimum Capital Structutre
Tax rate = 35% EBIT Rs = 30000000
(Rs in Lacs)
Debt Interest Post Tax EBIT Interest EBT Tax EAT Cost of
Interest Equity
- 0% 0.00% 300 - 300 105 195 10.50%
200 9% 5.85% 300 18 282 99 183 10.75%
400 9.5% 6.18% 300 38 262 92 170 11%
600 11% 7.15% 300 66 234 82 152 13%
800 13% 8.45% 300 104 196 69 127 15%
1000 15% 9.75% 300 150 150 53 98 18%

Optimum structure marked in bold when the Company's value is maximum.

Effects of Capital Structure on Value , Cost of Capital, Stock Price & EPS

% After tax Cost of WACC Market Share No. of PE Ratio

financed cost of Equity Value of Price, EPS Shares
with debt debt Company assumed
0% 0.00% 10.50% 10.50% 1,857.14 20 2.10 9,285,714 9.52
10% 5.85% 10.75% 10.24% 1,905.12 22 2.37 7,750,529 9.30
21% 6.18% 11.00% 10.01% 1,948.18 25 2.75 6,192,727 9.09
34% 7.15% 13.00% 11.02% 1,770.00 21.5 2.80 5,441,860 7.69
49% 8.45% 15.00% 11.82% 1,649.33 18.5 2.78 4,590,991 6.67
65% 9.75% 18.00% 12.65% 1,541.67 15 2.70 3,611,111 5.56
Market
Value of Market Value
Equity of Company
1,857.14 1,857.14
1,705.12 1,905.12
1,548.18 1,948.18
1,170.00 1,770.00
849.33 1,649.33
541.67 1,541.67

EPS lowest though PE Ratio highest

Though EPS highest, PE ratio deteriorates.

How should Finance Lease be treated for WACC calculation ?

What is 'Finance or Capital' Lease as against 'Operating Lease' ?

e.g. Jet Airways acquiring aircrafts on 'Finance Lease' rather than buying
Jaiprakash Associates acquiring specialised cement equipments installed in the factory on 'Financ
Taking office on rental is an instance of 'Operating Lease'; risk & reward of property remains with l

Treatment in financial statements

1. Capitalise as if it was a purchase :
Company A's Balance Sheet
Debt* 150 Curent Assets 50
Equity 50 Fixed assets* 150 (*Fixed assets & debt include 100 of leased asset
200 200

2. Disclose only by Notes to Accounts :

Company A's Balance Sheet
Debt 50 Curent Assets 50
Equity 50 Fixed assets* 50
100 100
Notes indicate lease obligations over years.

Discussion on Enron scandal on 'Finance Lease'.

n the factory on 'Finance Lease'
property remains with lessor (owner).

de 100 of leased assets)