As everything do cost, the capital has right to earn on its worth. Different type of capital source has different cost i.e. rate of return. However these costs are directly related to risk of capital employed.
The cost of capital has two aspects to it:
The cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company.
It is therefore the minimum return that a company should make on its own investments, to earn the cash flow out of which investors can be paid their return.
The cost of capital is an opportunity cost of finance, because it is the minimum return which an investor requires. For shareholders it is the dividend they expect to receive plus a capital gain on the value of their shares, while for loan holders it is the rate of interest which is quoted on the loan. Failure to pay such required return will result in the providers of finance transferring their holdings to other opportunities with a better rate of return
The purpose of this course work is to provide the practical and empirical problem in estimating the cost of capital from financial statement of quoted company.
Company's Brief:
Suzlon Energy Limited (Company) an Indian listed company. Company's business area is wind energy generation from different product and related technologies. Company has widened its net by providing wind energy services like operation and maintenance. Company has been doing constant research, development and innovation of its product. The company is operating in 21 countries with number of overseas subsidiaries and expects more acquisition and expansion in near future.
Company holds third largest total market share of 12.3% including REPower (GE) share of 3.3%. Its market capitalization is INR 1,081.93m (as on 23rd Feb 2010).Company is listed on Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) with code 532667 and symbol SUZLON respectively. Company is not a part of BSE Index Sensex, but it is part of NSE Index Nifty CNX S&P, Nifty S&P Defty, and Nifty S&P CNX 500 with weight of 0.35, 0.37 and 0.22 respectively. However company is listed in Group A section of BSE 100. The number of equity floated in the market 1,498,295,400 with the face value of Rs. 2 per share. However company issued share in the band price of Rs. 425-510 with expectation to raise Rs. 12,450-14,940m. The company's primary reportable segment is products and secondary segment is on the basis of location. Company has American Depository Receipts (ADR) and Global Depository Receipts (GDR) listed.
As on 31st March 2009 (Amt in INR millions)
Particulars
India
Europe
US
China
Others
Revenue
4,4526.5
8,4503.2
73,272.9
12,658.7
4,5855.7
Segment Asset
9,436.4
17,1578.7
30,194.9
19,969.9
2,1501.3
This analyse of cost of capital is on the bases of consolidated financial statement and has reference of standalone financial statement of company.
Capital Structure Tax Position:
The capital structure of company keeps on changing on the needs of fund and as per disclosure or reporting format of accounting standards. Source of capital includes following:
Common Equity (Ke):
Common Stock Issues (including in the form of option to employees)
Retained Earning
Preferred Equity (Kp)
Debt (Kd)
Bank Loan Long Term & Short term in the form of renewable credit
Bond Issues
Convertible Bonds
Delaying Payments on account of payable
For the purpose of calculation of cost of capital real cash flow is to be considered i.e. actual outflow and inflow of cash is considered. The balance sheet being historic and prepared on mercantile basis does not show the cash effect of during the year period.
There many factors influence capital structure namely business risk, tax position, financial flexibility and managerial style.
Apparently current capital structure of company is 1.742 of debt to equity and in the previous year it was 1.226, this is due to net increase in secured and unsecured loan excluding deferred tax liabilities.
Firms are interested to have more tax benefits to receive higher returns on their investment. To take the advantage of tax, firms are likely to source the tax deductible source of funds i.e. debt. Interest which is payable on debt is a tax deductible item and not the dividend or retained earnings. This way firms takes advantage of leverage and decrease the cost of capital by cheap fund.
Cost of equity
Capital After tax cost of capital
Cost of debt
Leveraged Ratio
Equity Risk Premium & Estimation:
Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and treasury bonds or bills over a long time period comprising the expected risk premium. I have noted the limitations of this approach, even in developed markets, which have long periods of historical data available, and its complete failure in emerging markets like India, where the historical data tends to be limited and noisy. Equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium.
Suzlon has following risk:
Decreases or eliminations of government subsidies relating to wind energy in key markets.
Competitors with longer industry experience who may be able to react faster to trends and changes in customer demand. Emergence of other sources of energy that are comparable to wind energy in form of reduced cost and generation efficiency may also pose risk to wind industry in general and Suzlon in particular.
Risks inherent in doing business in rural areas in developing countries due to lawlessness.
The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the risk free rate and an extra return to compensate for the risk. The disagreement, in both theoretical and practical terms, remains on how to measure this risk, and how to convert the risk measure into an expected return that compensates for risk. This required rate of return can be presented as r=R(f)+p, R(f) is risk free return and p is risk premium. Each type of finance has different level of risk and such risk is perceived by financer for such investment or credit.
There are several risk and return model in finance; they all share some common views about risk. Firstly all models define risk in terms of variance in actual returns around an expected return; thus, an investment is riskless when actual returns are always equal to the expected return. Second, they all argue that risk has to be measured from the perspective of the marginal investor in an asset, and that this marginal investor is well diversified. Therefore, it is only the risk that an investment adds on to a diversified portfolio that should be measured and compensated. In fact, it is this view of risk that leads models of risk to break the risk in any investment into two components. There is a firm-specific component that measures risk that relates only to that investment or to a few investments like it, and a market component that contains risk that affects a large subset or all investments. It is the latter risk that is not diversifiable and should be rewarded.
Beta Estimation:
The company's beta is 1.900 [1] , 1.489 [2] and on S&P CNX Nifty Index is 1.500 [3] . The company's equity are traded highly on both the stock exchange, for self calculation of beta, I have choose NSE CNX S&P index, as company is part of this index weight. However the self calculated beta is 1.542 [4] on daily data for 5 years. This is calculated as per capital and security market slope.
A share's beta factor is the measures of its volatility in terms of market risk. The beta of the market as a whole is 1 and beta of the risk free security is always zero. The security below beta of 1 is lesser risky in compare to market as whole.
The CAPM is also the most common method used, especially amongst larger listed companies. Most beta estimates used in practice are obtained from ordinary least squares (OLS) regression of the returns on the share against the monthly returns on a market/weekly index.
Regarding estimation, a common problem in the modelling of financial data is variation over time in the volatility of the OLS error term, especially in higher-frequency data. This problem of heteroscedasticity causes the OLS assumption that the error term is normally distributed with a constant variance to be violated. It means that the estimator of the model's parameters remains unbiased but is not efficient, in which case the beta coefficient can be either overestimated or underestimated.
The estimation of the beta coefficient has traditionally been achieved by running a Market Model regression. Running this regression can, however, lead to a variety of practical considerations which in turn could result in several different beta estimates. Some of these could be purely measurement related such as: How does one measure returns? What market proxy should be used? How long should the return intervals be? How many data points are needed? On the other hand, a further set of considerations involve the assumptions and the inferences: such as: Is thin trading a problem? Is the market segmented? Are betas likely to be stable?
In practice, however, I have compromise on both counts. I estimated the beta of an asset relative to the local stock market index, rather than a portfolio that is diversified across asset classes. This beta estimate is often noisy and a historical measure of risk. I have estimated the risk premium by looking at the historical premium earned by stocks over default-free securities over long time periods. These approaches might yield reasonable estimates in developed markets like the United States, with a large and diversified stock market and a long history of returns on both stocks and government securities. I will argue, however, that they yield meaningless estimates for both the beta and the risk premium in other countries, where the equity markets represent a small proportion of the overall economy, and the historical returns are available only for short periods.
Local versus Global Beta:
In a financially integrated world, equally risky investment projects in different countries should have the same cost of capital when expressed in a common currency. Consistent with the general view that United States and Europe's capital markets have become increasingly integrated internationally, most of the recent empirical research that focuses on the cross-section of security returns across countries finds evidence in favour of international integration e.g. Wheatley (1988), Campbell and Hamao (1992) and Heston, Rouwenhorst and Wessels (1995). The expected return on financial assets is nowadays determined primarily on world capital markets. Therefore, the maintained assumption is that international capital mobility is (almost) perfect, so that international capital markets are freely accessible with negligible costs. Then, an international Asset Pricing Model should be used to estimate a firm's beta and thus the cost of capital.
Estimating cost of capital using the domestic CAPM is substantially different from the International Cost of Capital (ICAPM) where it assumes perfect international capital market integration. The central question is to what extent three competing asset pricing should be used to price Suzlon's stock differently in an internationally integrated market: (i) multifactor factor ICAPM (Solnik-Secru) using both global market portfolio and exchange rate risk premiums (ii) Single factor model (Grauer, Litzenberg and Stehle, 1976) using only global market portfolio (assuming Purchase Power Parity Theory holds) (iii) the single factor domestic CAPM.
All the econometric sophistication will not completely solve the basic problem associated with the use of ex post data to test theories dealing with ex ante prediction (Sharpe, 1978). This problem is further compounded in tests of international asset pricing models where due to unavoidable data limitations the time period of examination is much shorter. This runs the risk during the period under consideration, realized returns may move in the opposite direction to expected returns, obscuring the relation between time-varying risk and expected returns. In addition, the noise in realized returns also makes asset pricing inferences difficult turning economically significant relationships statistically insignificant. From this we can infer that beta of multinational company will have same yield if it is been traded in same currency and primary or local market will contain all necessary information to price Suzlon's equity correctly, while other market may not. Campbell et al. (1997, p.251) state two dangers with multifactor models: models may over-fit through data-snooping and captures market inefficiency or investor irrationality. Campbell et al. further states that the usefulness of multifactor models will not be fully known until sufficient new data becomes available to provide an out-of-sample check.
India's risk is 0.393 on BSE Sensex index and for NSE CNX S&P index is 0.376, company's global beta 0.620 (NSE traded) compared to Morgan Stanley Capital Index (MSCI) [5] . As per Single factor Model of ICAPM, the implied (indirect) beta of Suzlon's equals to 1.54*0.376=0.579. The pricing error then is 0.0409 i.e. 0.620-0.579. As this method ignores the exchange rate for estimating beta cannot be considered right.
Cost of Debt:
A firm's cost of debt is determined by characteristics of the firm and those of the bond issue which affect default risk, agency costs, and information asymmetry problem (Bhojraj and Sengupta, 2003). Agency costs arise from the conflicts of interests between shareholders and bondholders, and shareholders and managers.
