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COST OF CAPITAL

Submitted to

CHITKARA BUSINESS SCHOOL(Bba-Bcom department)

Internal evaluation for financial management

COST OF CAPITAL

ANALYSIS OF ITC

Submitted by: Submitted to:

Loveleen Ms. Pallavi Sood

Roll No. 1820993062

CHITKARA BUSINESS SCHOOL

CHITKARA UNIVERSITY,2019
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ACKNOWLEDGEMENT

It was a new experience working on a research paper. I would like to thank Ms.
Pallavi Sood for giving me this opportunity and guiding me throughout the work. I
would also like to thank my friends who helped me in the assignment and guided
me.

It was a new experience and I got to learn a lot about the way of writing a research
paper. I also gained knowledge on the subject financial management. The assignment
was based on research which gave depth knowledge about the topic. The assignment
was completed on time and submitted as per the guidelines provided.

It was great working under such an assignment. I would like to use all the knowledge
gained during the further studies and surely hope to achieve maximum benefits later
on.

LOVELEEN

1820993062
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CONTENT

S.NO PARTICULARS PAGE NO.


1. ACKNOWLEDGEMENT 2
2. INTRODUCTION 4
3. LITERATURE REVIEW 5
4. NEED OF THE STUDY 6
5. OBJECTIVES 6
6. RESEARCH METHODOLOGY 7
7. Details of study 8- 10
8. interpretation 11-13
9. conclusion 14
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ABSTRACT
ITC Limited was established in 1910 dealing in fast moving consumer goods such
as personal care, food, education and stationary. The study is based on secondary
data. It is the analysis of cost of capital of ITC. Cost of capital refers to the amount
a company will pay in order to obtain the capital. Cost of capital comprises of cost
of debt, preference shares, equity, and weighted average cost of capital.

INTRODUCTION
Financial management concerns with financial decisions which are the dividend
decision, investment decision and financing decision. Investment decision is an
important decision to be taken by company so as to be able to achieve its goals.
Investment decision usually is the decision where the companies will analyses the
various costs associated with the investment and the benefit achieved. Every company
expects to more benefit then cost. Company will choose only those projects where the
benefit of the project is either more or equalivent to the cost. No company wishes to
operate in the situation of loss and will reject the project where there is no benefit or
benefit is less than the cost to obtain the project.

Cost of capital is the technique of financial management which the company uses to
find out about the cost associated to obtain the fund. It refers to the amount a
company will pay to raise a particular capital. Companies expect a minimum amount
of return or rate of return from the investments it makes and that rate is referred to as
cost of capital. The higher return investor’s wants will be more risky and leading to
high cost of capital. The minimum return a company can get from raise of a capital
will be the cost of that capital. The firm to maximizes its wealth and achieve the
object consider the cost of capital.

Cost of capital can be from either of the two components, explicit cost and implicit
cost. Implicit cost source is usually the retained earnings. Explicit cost will be the
discount rates equating present value of expected cash outflows with present value of
funds received. Cost of capital helps an investors to know the cash flows from the
investment and on basis of which the decision whether to raise that capital or not can
be taken carefully and properly.

Cost of capital comprises of cost of equity, cost of debt, cost of preference shares and
weighted average cost of capital. All of these terms are discussed further with an
analysis of ITC Company.

ITC is a private sector company and foremost company of India. ITC deals with fast
moving customer goods such as personal care, food, education and stationary and also
deals in hotels, agribusiness, IT etc.
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REVIEW LITERATURE
Cost of capital study and research was performed by many before and here is the
information of some of the research papers used to collect information about.

B. Navaneetha, D. Nikhilaa and Mrudula. V. Raj (2018):- Research paper on Study of


Cost of capital of ITC company. The study showed the data of the company from the
year 2013-2017 which had been collected from the annual report of various years and
then put together in form of research paper analyzing the cost of equity capital, the
cost of debt and also the financial break -even point. All of these were calculated for 5
year period. This research paper was based on ITC COMPANY and can be helpful for
all the stakeholders of the company also and also for people interested in knowing
about the cost of capital.

Richard Lambert, Christian Leuz, and Robert Verrecchia(2006):- All three wrote a
research paer and discussed about the cost of capital. analysis demonstrate that the
quality of accounting information can influence the cost of capital, both directly and
indirectly. The direct effect occurs because higher quality disclosures affect the firm’s
assessed covariance with other firms’ cash flows, which is nondiversifiable. When a
firm’s real decisions are affected with higher quality disclosures an indirect effect
occurs. The study concludes that this effect can go in either direction, but also derive
conditions under which an increase in information quality leads to an unambiguous
decline in the cost of capital.

Correia C and Cramer P (2008):- They did a study of analysis of cost of capital a
listed south African company. The study suggested that companies employ CAPM
method to determine the cost of equity. Companies employ either strict or flexible
debt- equity ratio. It also tells that firms which have transparent earnings have low
cost of capital.

Mary E Barth , Wayne R Landsman(2013) :- performed study on cost of capital. It


suggested that firm with transparent earnings are those whose earnings reflect change
in economic values in better way and also tells that they lower cost of capital and
excess returns on the investment of low cost of capital projects. It tells relationship
between expected cost of capital and transparency measures.

NEED/ SIGNIFICANCE OF THE STUDY


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Cost of capital helps the firm to achieve its objectives as it focuses on wealth
maximization of a firm and helps in proper and correct decision making.

Few points of importance of cost of capital :-

1. Capital structure framing: - capital structure is the capital mix formed by


different sources of funds such as equity, debt etc. cost of capital helps to
analyze the return from an investment and cost of that which can be compared
and then the source can be decided.
2. Decisions regarding capital budgeting:- cost of capital is used to help know
the discount rates and calculate the cash flows associated with the investments.
It helps the firm to decide whether to accept a project or reject.
3. Evaluation:- cost of capital can help firm to know the financial performance
and evaluate it by comparing the profit from the project with the cost incurred.
If the profit is more than the project can be treated as beneficial.
4. Risk analysis:- cost of capital can help firm to analyze the risk associated with
the project and the income they may earn. Usually higher the risk, higher will
be the return and if firm can be well prepared for the risk they can gain the
benefits from the project.
5. Decision making:- the decisions regarding dividend and finance can be made
more accurately using the cost of capital. It can help company to decide about
distribution of dividend and also the sources of finance,

OBJECTIVE OF STUDY

1. To study in detail the concept of cost of capital.


2. To practically analyze the cost of capital of the company.
3. To help understand the requirement of the topic.
4. To know how to calculate the cost of equity, the cost of debt and cost of
preference shares.
5. To understand the weighted average cost of capital.
6. To apply all these concepts to a company.
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RESEARCH METHODOLOGY

The sources of data used to collect all the information is the secondary source of data.
The data has been collected from all the past sources data’s collected by different
people. Secondary data refers to the data which is easily available as it has been
collected by people through primary sources. This type of data is usually used as
references by other people doing the same research. It is a source of help. It is usually
cheaper in case of cost time and easily available as it doesn’t require a filling of
questionnaire etc. to collect the data. The data helps in time saving. Its difficult to
reliable on the data as the way of collecting the data is not known to us.

The sources referred for the collection of the data:-

1. Research papers:- the published research paper available on the same topic
including the study done by various people were referred and used to collect
the information and use it wisely to prepare a research paper. The study of
similar topic regarding a company such as ITC was of great help. It was a
secondary source data.
2. Books – the books relating to the subject of financial management helped in
the study of the topic and gain knowledge which helped in completion of
research paper and also analyzing of the data using a company become easy.

3. Websites:- different websites and links were referred to gain the knowledge
and information about both the company and the subject of study. Most useful
and reliable data was used to help gain knowledge of the subject and all the
information gathered has been put together in form of a research paper.

These are few of the sources of secondary data which have been used to collect all the
information and prepare the research paper. A detailed study of the topic was done
and then put together in the paper. All the sources were analyzed and checked to use
the most reliable data and accurate data. Some of information was also gathered in
way of discussion with the friends and all information is briefly discussed.
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DETAIL OF STUDY
Cost of capital is the technique of financial management which the company uses to
find out about the cost associated to obtain the fund. It refers to the amount a
company will pay to raise a particular capital. Companies expect a minimum amount
of return or rate of return from the investments it makes and that rate is referred to as
cost of capital. The higher return investor’s wants will be more risky and leading to
high cost of capital. The minimum return a company can get from raise of a capital
will be the cost of that capital. The firm to maximizes its wealth and achieve the
object consider the cost of capital.

Cost of capital comprises of cost of equity, cost of debt, cost of preference shares and
weighted average cost of capital.

Measurement of specific cost of capital

1. Cost of debt
 Irredeemable debt (before tax)
 Irredeemable debt (after tax)
 Redeemable debt (before tax)
 Redeemable debt (after tax)
2. Cost of preference shares
 Irredeemable preference shares
 Redeemable preference shares

3. Cost of equity
 Dividend yield : no growth
 Dividend yield : with growth
 Earnings yield

Cost of debt:- debt can be either irredeemable or redeemable debt and can be issued at
par, discount, premium. it refers to effective rate of interest a company has to pay on
debt. After tax cost of debt is the interest which is tax deductible.

Formulas:-

Cost of debt (kd)

Irredeemable before tax

= INTEREST / NET PROCEEDS.

IRREDEMABLE AFTER TAX


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= INTEREST / NET PROCEEDS (1- TAX RATE)

REEDEMABLE DEBT BEFORE TAX

= INTEREST + (RV – NP)/n / (RV + NP)/2 *100

RV = REDEMPTION VALUE

NP = NET PROCEEDS

n= NO. OF YEARS IN WHICH DEBT WIL BE REEDEEMED.

REEDEMABLE DEBT AFTER TAX

= INTEREST + (RV – NP)/n / (RV + NP)/2 *100 (1- TAX RATE)

Cost of preference shares:- prference shareholders are paid dividend at the fixed rate
of interest. Dividend are not tax deductible as they are paid out of the profit left after
paying of interest and tax. So no tax adjustment is required in this case. By cost of
preference shares we calculate the amount we have to pay to the shareholders. We
calculate the fixed rate of dividend we have to pay to shareholders out from the
earnings.

Formulas :-

Cost of preference shares (kp)

Irredeemable preference share

= D/NP*100

D= DIVIDEND

NP = NET PROCEEDS

Redeemable preference shares

= (D + (RV-NP)/N (RV+NP)/2 *100

D= DIVIDEND

RV = REDEMPTION VALUE

NP = NET PROCEEDS

n= maturity period

Cost of equity
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It is expected rate of return by the equity shareholders. It can be referred as minimum


rate of return a firm must earn on the equity part of total investment so that the market
value of the shares remains stable.

Formulas:-

Dividend yield

It assumes shareholders give more importance to the dividend of the company and
that the risk of firm remains unchanged.

Cost of equity(ke)

Dividend yield

= DPS/MPS*100

Dps = dividend per share

Mps= market price of share.

Earnings yield

= EPS/MPS

EPS= EARNINGS PER SHARE.

WEIGHTED AVERAGE COST OF CAPITAL(kw)

It is also known as overall or average cost of capital. It is the average cost of various
sources of finance such as debt, equity, preference shares etc.

It shows opportunity cost of taking risk. It refers to the minimum return the company
must earn to satisfy its creditors, owners, and capital providers.

Formula

= EXW/EW

X = COST OF SPECIFIC SOURCES OF FINANCE.

W = WEIGHTS/ PROPORTION OF SPECIFIC SPOURCES OF FINANCE.


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INTERPREATION AND ANALYSIS

Cost of Equity

It refers to the require rate of return on equity investments in the market. Investers
who invest in the company require return to be influenced to by the shares of
company. The return requires both capital as well as dividend gain. Moreover
investors want good returns on equity capital because they have taken a risk while
investing in equity investments. Cost of equity of share capital may be termed as the
least rate of return which the company earns on equity finance portion of investment
in projects so as to leave the market price of such shares unchanged. The cost of
equity compensates investors for the value of there time and awards them with a
premium on risk taken by them . From the perspective of the company they try to earn
more then the cost of equity capital in order to keep the price of its shares stable.

Cost of equity share capital = dividend per share / share price

DIVIDEND PER SHARE

As we can observe in Itc Ltd company the company’s dividend is increasing initially
from 2013-2015 but suddenly it falls from 1.5 rs which is not a good state for a
company. Fall in dividend is a serious situation for the company. The Shareholders
start withdrawing their shares from the company so the company faces a serious
situation here. The company has to do hard work for maintaining the shares. When the
shareholders start withdrawing their shares then the shares supply increases in the
market so eventually the share price decreases.

However, the low dividend is not always related to the low performance of the
market. It can also be due to the increase in the Retained Earning of the company. If
the Retained Earning of the company is more then the company can give more
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dividends in the future. However it is very difficult to show the true and fair
performance of the market.

SHARE PRICE OF THE COMPANY

We can observe a good amount of decrease in the share price of the company. The
company share price increases initially during our period of study but then it
decreases. The sudden fall in the share price of the company is the result of the low
dividend to the shareholders. If the shareholders are not satisfied then they start
selling their shares to the market.

When they sell their share in the open market then the supply is more than the demand
so, the law of supply works. More supply leads to less price of the shares in the
market. This is a very serious situation in the market.

COST OF EQUITY

The cost of the equity of the company first increases in the 4th year it is maximum
that is 2.59 but then the company takes decision to decrease the dividend that to
decrease the dividend of the company. So, the company can reduce the cost of equity.
The cost of the equity relates to the tax expenses that is incurred upon the given
dividend.

Cost of debt

Cost of debt is the rate of interest a company pays on its borrowings. The cost of debt
is the rate return that a company pays to its creditors. These capital givers needs to
be compensated for risk exposure that comes along when lending to a company. It is
the average rate off return an organization must pays on all its debts. This typically
consist of bonds and loans from banks . It is nothing but the interest that is to be
payed on the Debt. It usually measures the discount rate which equates present the
value of Post-tax interest payable and principle repayments. Cost of Debt may be
calculated by dividing the annual rate of interest payment to the closing value of
Debt. Cost of Debt can be calculated as follows:

Cost of Debt = interest / cost of debt * 100


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Conclusion
The research paper shows the analysis of ITC company and the data of 5 years which
show the fluctuations in both the cost of equity and debt. The detailed study of the
cost of capital and sources of data have been included in the report. The ITC company
has the option to issue preference shares also. The company may look for ways to
reduce the cost of capital has some years there is increase and in some decrease. So
company should focus more on decreasing. The company can maintain a balance
between equity and debt. ITC Ltd has taken a balanced decision, like it has not
decreased the company’s dividend too much but the share price went down too much
from 328 to 280 so it was a balanced decision as it as reduced its cost of equity. If the
cost are reduced that means that the company is retaining more earnings so in the later
years the company would be able to give more dividend and also increase its share
price.

REFERENCES

[1] https://www.mbaknol.com/financial-management/importance-of-cost-of-capital

[2] http://www.yourarticlelibrary.com/financial-management/cost-of-capital/cost-of-
capital-meaning-importance-and-measurement/65195

[3] https://bbamantra.com/cost-of-capital-introduction-measurement

[4] https://www.slideshare.net/akankshagupta963871/new-microsoft-office-pow

[5] B. Navaneetha, D. Nikhilaa and Mrudula. V. Raj (2018):- Research paper on


Study of Cost of capital of ITC company.

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