ABC Ltd. has the following book value capital structure as on March, 31, 2024. Equity share capital (2,00,000 shares) 60,00,000 10% preference shares 10,00,000 12% Debentures 30,00,000 100,00,000 The equity share of the company sells at Rs. 30. It is expected that the company will pay next year a dividend of Rs. 3 per equity share which is expected to grow at 5% p.a. forever, Assume 40% corporate tax rates.

Posted By: November 23, 2024 Leave a Reply

 Q. ABC Ltd. has the following book value capital structure as on March, 31, 2024. Equity share capital (2,00,000 shares) 60,00,000 10% preference shares 10,00,000 12% Debentures 30,00,000 100,00,000 The equity share of the company sells at Rs. 30. It is expected that the company will pay next year a dividend of Rs. 3 per equity share which is expected to grow at 5% p.a. forever, Assume 40% corporate tax rates.

ABC Ltd.'s Capital Structure and Financial Analysis (For the Year Ending March 31, 2024)

ABC Ltd., a company that operates within the corporate sphere, has disclosed its capital structure as of March 31, 2024. The company’s capital structure is an essential element of financial analysis, as it indicates the proportion of debt, preference shares, and equity in its overall financing. Understanding the company’s capital structure can provide insights into its financial health, risk, and return expectations. The company’s capital structure is made up of the following components:

·         Equity Share Capital: ABC Ltd. has issued 2,00,000 equity shares, with a total book value of Rs. 60,00,000. The price at which these shares are currently trading is Rs. 30 per share, and this market value is crucial for calculating the company's overall equity market capitalization. Equity shares represent ownership in the company and provide a claim on its residual earnings after all other obligations (such as debt and preference dividends) are satisfied. Shareholders are entitled to receive dividends, which are typically paid from the company’s profits.

·         Preference Share Capital: The company has issued 10% preference shares with a total book value of Rs. 10,00,000. Preference shares provide a fixed dividend, and in the event of liquidation, they rank higher than equity shareholders but lower than debenture holders. The dividend on these preference shares is fixed at 10% of the nominal value. Preference shareholders do not usually have voting rights, but they have a priority claim over dividends before equity shareholders.

·         Debentures: The company also has Rs. 30,00,000 worth of debentures, bearing a fixed interest rate of 12%. Debentures represent a form of debt financing and are typically considered a safer investment compared to equity, as they offer fixed returns. However, the company must meet its obligations in the form of interest payments on debentures regardless of its financial performance, which can impose a financial strain if the company faces cash flow issues.

In total, ABC Ltd. has a capital structure amounting to Rs. 100,00,000. Understanding the relative proportions of these financing sources—equity, preference shares, and debt—is vital in assessing the company’s risk and return profile.



Market Capitalization and Valuation of Equity

The current market value of equity can be computed by multiplying the number of outstanding shares by the price at which they are trading in the market. Given that ABC Ltd. has 2,00,000 shares and each share is priced at Rs. 30, the market capitalization of the company’s equity is:

Market Capitalization of Equity=2,00,000×30=Rs. 60,00,000\text{Market Capitalization of Equity} = 2,00,000 \times 30 = \text{Rs. 60,00,000}Market Capitalization of Equity=2,00,000×30=Rs. 60,00,000

This market capitalization represents the total value that the market places on the company's equity, which is a crucial metric for investors looking to assess the company's overall worth.

Dividend Policy and Cost of Equity

ABC Ltd. is expected to pay a dividend of Rs. 3 per equity share next year, with a growth rate of 5% per annum. The dividend payout is a significant factor for equity investors as it provides an income stream. The fact that the dividend is expected to grow at 5% per annum indicates the company’s solid growth prospects, which is a positive signal for the market.

To evaluate the cost of equity capital, we can use the Dividend Discount Model (DDM), which is particularly useful for companies with predictable dividend growth. The formula for the cost of equity using the DDM is:

Cost of Equity (Re)=D1P0+g\text{Cost of Equity (Re)} = \frac{D1}{P_0} + gCost of Equity (Re)=P0​D1​+g

Where:

  • D1D1D1 is the expected dividend per share next year (Rs. 3),
  • P0P_0P0​ is the current market price per share (Rs. 30),
  • ggg is the growth rate of dividends (5% or 0.05).

    Substituting the values:

    \text{Re} = \frac{3}{30} + 0.05 = 0.10 + 0.05 = 0.15 \text{ or 15%}

    Thus, the cost of equity for ABC Ltd. is 15%. This is the return that equity investors expect for their investment in the company, considering the risk and potential for growth in dividends.

    Cost of Preference Shares

    The cost of preference shares is the dividend yield on the preference shares. Since ABC Ltd. has issued 10% preference shares, the cost of preference capital can be calculated as the dividend rate on the preference shares, which is 10%.

    Thus, the cost of preference capital (Rp) is:

    Rp=10%\text{Rp} = 10\%Rp=10%

    This fixed cost represents the return that preference shareholders expect in exchange for their capital.

    Cost of Debt

    The cost of debt is the interest rate the company must pay on its debentures. Since ABC Ltd. has issued 12% debentures, the pre-tax cost of debt is 12%. However, interest payments on debt are tax-deductible, so we need to adjust for the tax shield provided by the interest expense. The after-tax cost of debt can be calculated using the following formula:

    After-tax Cost of Debt=Interest Rate×(1−Tax Rate)\text{After-tax Cost of Debt} = \text{Interest Rate} \times (1 - \text{Tax Rate})After-tax Cost of Debt=Interest Rate×(1−Tax Rate)

    Given the interest rate of 12% and a corporate tax rate of 40%, the after-tax cost of debt is:

    \text{After-tax Cost of Debt} = 0.12 \times (1 - 0.40) = 0.12 \times 0.60 = 0.072 \text{ or 7.2%}

    Thus, the after-tax cost of debt for ABC Ltd. is 7.2%. This is the effective cost of borrowing after accounting for the tax deductibility of interest payments.

    Weighted Average Cost of Capital (WACC)

    The Weighted Average Cost of Capital (WACC) is a crucial measure that reflects the overall cost of the company’s capital, weighted by the proportion of each source of financing in the company’s capital structure. The WACC is the average rate of return required by all of the company’s investors, including equity holders, preference shareholders, and debt holders.

    The formula for calculating WACC is:

    WACC=(EV×Re)+(PV×Rp)+(DV×Rd×(1−T))\text{WACC} = \left( \frac{E}{V} \times \text{Re} \right) + \left( \frac{P}{V} \times \text{Rp} \right) + \left( \frac{D}{V} \times \text{Rd} \times (1 - T) \right)WACC=(VE​×Re)+(VP​×Rp)+(VD​×Rd×(1−T))

    Where:

    • EEE is the value of equity (Rs. 60,00,000),
    • PPP is the value of preference shares (Rs. 10,00,000),
    • DDD is the value of debt (Rs. 30,00,000),
    • VVV is the total value of the company (Rs. 100,00,000),
    • Re\text{Re}Re is the cost of equity (15%),
    • Rp\text{Rp}Rp is the cost of preference shares (10%),
    • Rd\text{Rd}Rd is the cost of debt (12%),
    • TTT is the corporate tax rate (40%).

      Substituting the values:

      WACC=(60,00,000100,00,000×0.15)+(10,00,000100,00,000×0.10)+(30,00,000100,00,000×0.072)\text{WACC} = \left( \frac{60,00,000}{100,00,000} \times 0.15 \right) + \left( \frac{10,00,000}{100,00,000} \times 0.10 \right) + \left( \frac{30,00,000}{100,00,000} \times 0.072 \right)WACC=(100,00,00060,00,000​×0.15)+(100,00,00010,00,000​×0.10)+(100,00,00030,00,000​×0.072) WACC=(0.60×0.15)+(0.10×0.10)+(0.30×0.072)\text{WACC} = (0.60 \times 0.15) + (0.10 \times 0.10) + (0.30 \times 0.072) \text{WACC} = 0.09 + 0.01 + 0.0216 = 0.1216 \text{ or 12.16%}

      Therefore, the weighted average cost of capital (WACC) for ABC Ltd. is 12.16%. This represents the company’s overall cost of capital, taking into account the proportions of debt, preference shares, and equity in the capital structure.

      Analysis of Capital Structure

      ABC Ltd.’s capital structure, with a WACC of 12.16%, indicates a balanced approach to financing. The company uses a mix of debt, preference shares, and equity, with equity being the largest component of the capital structure. This suggests that the company is relatively equity-heavy, which can provide a cushion against the risks associated with high debt levels.

      The company’s cost of equity (15%) is higher than the cost of debt (7.2%), which is typical for most companies. Equity is generally more expensive than debt because equity holders take on more risk. The preference shares, with a fixed dividend of 10%, fall in between, offering a moderate cost of capital.

0 comments:

Note: Only a member of this blog may post a comment.