Study Note -

Basis for Valuation - Introduction

Principles and Techniques of Valuation
Role of Valuation

“Valuation is not an objective exercise, and any preconceptions and biases that an analyst brings to the process
will find their way into value”. Damodaran (2002, p.9)
Simply defined, a business valuation is an activity conducted towards rendering an estimate or opinion as to the
fair market value of a business interest at a given point in time. Generally, when valuing a business, a notional
transaction is assumed, that is, one which has not been subjected to the bargaining process. Like accounting,
valuation is an art rather than an exact science, and a properly conducted valuation is nothing more than an
expression of informed opinion, which is based on fact of past financial performance and judgmental estimation
for future. By their very nature, valuations are not precise. Consequently, valuation estimates and opinions are
generally stated as a range of values.
Business valuation is no precise science. There is no universal legal framework which dictates how the valuation
should be performed. Therefore, it is no right way to estimate the value of a company, its equity shares or an
identified cash generation unit.
Examples of when a business valuation may be required include any or more of the following instances:
• Mergers and acquisitions;
• Business restructuring;
• Initial public offering and listing of equity shares in stock exchanges;
• Shareholders’ disputes settlement;
• Purchase / sale of a business interest and step up acquisitions;
• Non-arm’s length transaction;
• Disgruntled minority shareholders’ actions;
• Damage claims;
• Estate planning;
• Deemed disposition at death
Value
In order to understand valuation, first we need to understand value. It is often the most complicated and
misunderstood phenomenon. Value is a subjective term as what is a specific measured value to one person
may not be the same for other. It is easy to understand the concept of value with the help of value of a property
because all of us are well versed with it. But it is not easy to value this well-known asset.

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A property might be more valuable to one person in comparison to another, because that person values certain
features of the property higher than the other person. Alternatively, the property might have a higher utility to
one person than to another. There may be many forces, which influences the value of a property, e. g., location,
environmental and physical characteristics of the property, social standards, economic trends like GDP, per capita
income, inflation etc. and government regulations.
The US Appraisal Foundation defines market value as, “The most probable price which a property should bring
in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting
prudently and knowledgeably, and non-happening assuming the price is not affected by undue stimulus.”
However, the concepts of open market, fair sale, action with prudence, knowledge and non-happening of undue
stimulus are all subjective and most often, unrealistic assumptions.
There may be substantial gap between subjective valuations and fluctuations of the free market. Thus, the
value of a property does not always correspond to its price. As a result, despite rigorous efforts by time series
econometricians the forces of supply and demand cannot be scientifically predicted.
In a nutshell, value is the “typical price a product fetches in an unregulated market”. There are different types
of values which are used in different ways of everyday business. These are original value, book or carrying value,
depreciated or written down value, sale value, purchase value, replacement value, market value, economic
value, residual value, scrap value etc. What investors buy is the future benefits and not the past. The point to be
carefully noted that there is nothing called the ‘correct value’ or the ’right value’. It all depends upon the type of
value which is being measured, the purpose of valuation, the methods adopted and the assumptions made. The
valuation which seems to be ‘base’ today may be criticised and rejected tomorrow based on variations in the
subjective conditions that we have discussed.
Distinction between Price and Value
The price may be understood as ‘the amount of money or other consideration asked for or given in exchange for
something else’. The price is therefore, an outcome of a transaction whereas the value may not necessarily require
the arrival of a transaction. The value exists even if some assets become unable to generate cash flows today but
can generate in future on the happening of some events.
“Experts are of the opinion that valuation must be differentiated from price. While the fair value of an asset is
based on the assessment of intrinsic value accruing from fundamentals on a stand-alone basis, varying return
expectation and underlying strategic aspects for different bidders could influence the price. A purchase and sale
would be possible only when two parties while forming different views as to the value of an asset, are eventually
able to reach agreement on the same price. It would be better appreciated by recognition of the fact that
Government can only realise what a buyer is willing to pay for the PSU, as the purchase price ultimately agreed
reflects its value to the buyer.
Another notable point is that valuation is a subjective figure arrived at by the bidder by leveraging his strengths with the
potential of the company. Depending on the level of business synergy with the target company, perception of
specific value realization and varying assessment regarding productivity, capex, etc., this figure may vary from
bidder to bidder.”
The oil reserve of an identified basin owned by a a hydrocarbon exploration company may not have any value
when the oil price is say ` 70 per barrel and the extraction cost of that oil is ` 110. However, when the price reaches
to ` 130 and is expected to prevail around this figure, it may have significant value.
Another example reaffirms that price and value is not same. A lawyer is having some question regarding a
professional assignment having remuneration of ` 2,50,000. He browses through some pages of a book at a
bookshop and buys it for ` 40,000. He has an idea in his mind that the book is essential for earning professional
services fees of ` 2,50,000 and expected contribution from the book would be around ` 80,000. At this stage the
value / worth of that book is ` 80,000. However, after reading the book he feels that the book is not useful for his
assignment. If the same book cannot be returned to the shop, its disposal value would be negligible.

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Valuation
Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making.
Valuation is an essential prerequisite in choosing investments for a portfolio, in deciding on the appropriate price
to pay or receive in a takeover, and in making investment, financing and dividend choices while running a
business. The basic premise of a valuation exercise is that the valuer can make reasonable estimates of value for
most assets. The same fundamental principles determine the values of all types of assets, real as well as financial.
Some assets are easier to value than others as the details of valuation vary from asset to asset and the uncertainty
associated with value estimates is different for different assets. However, the core principles remain the same.
The value of any asset must equal the present value of its future cash flows, discounted at a rate that reflects its
inherent risk. Since neither the future cash flows nor the appropriate discount rate can be known with certainty,
valuation is always estimation. Several valuation methods are used to value a business but not a single method
can be vouched to predict the exact price at which an entity can be sold.
Valuing a business is a pivotal function while acquiring a company as the buyer will be willing to pay the price
depending on the synergy value that will result when the companies are combined. The more the synergy value
a particular acquisition can generate, the higher the price an acquirer will be willing to pay.
In case of equity shares valuation is used for
1. stock selection,
2. concluding market expectation,
3. evaluating corporate events,
4. setting up an opinion,
5. evaluating business strategies,
as a communication among management, shareholders and analysts, appraisal etc.
Business Valuation
The art of valuation as an exercise is not just a discipline for finance professionals and investors. Used properly, it
can be a powerful, perhaps the most powerful, way that managers can run their companies in an increasingly
competitive world. By integrating accounting and performance measures with strategic thinking and day-to-
day operations, managers can learn to take decisions that enhance their businesses and add real value. As
knowledge capital becomes increasingly important, traditional financial measures such as earnings and book
value are accounting for less and less of a company’s actual market price. Investors are paying great attention to
non-financial factors in their efforts to assess the value of corporations.
In the USA, the importance of ‘‘shareholders’ value’’ is almost universally accepted in business. The concept is
here defined as being not only the ‘‘market value added’’ (MVA) – this is the difference between the stock market
capitalization of a company and the capital that has been invested in it – but also growth in employment and high
productivity. Although share prices fluctuate, over time they tend to reflect the underlying value of a company.
American CEOs and senior managers are expected to focus on creating shareholders’ value in their corporations.
This is not true in case of Europe and Asia. In these regions, corporations are seen as having other obligations
to their communities. Governments often define and regulate a company’s duties towards it’s ‘‘stakeholders’’.
Stakeholders include employees, customers, suppliers, the state, lenders, investors and the general public of the
society as a whole. Critics condemn the shareholders’ value approach as harmful to society as a whole. Rights
and obligations of stakeholders are given greater weight. Supporters of the stakeholder system have argued that
focusing on shareholders’ value may hurt the interests of other stakeholders, in particular the employees of the
company.
However, there remains possibilities of counter argument that most successful companies in any given market
would tend to enjoy better productivity, better Market Value Added (MVA) and employ more people than their
competitors. MVA is the difference between market value of its equity and debt and its economics book value

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of capital. In other words, successful companies are maximising shareholders’ value even if they do not explicitly
say so. In doing so they are also benefiting, not damaging, the other stakeholders’ interests. Shareholders’ value
implies a stock market where company shares are widely held by the public. Information about a Company is less
easily available in countries such as Germany and Japan, where shareholdings are concentrated in the hands of
promoters and financial institutions. Share prices may not reflect values as closely as they do in more efficient stock
markets. There is less incentive for managers to strive to create shareholder value.
Furthermore, the spectre of a hostile takeover does not loom as powerfully as it does in the USA. The USA has a
huge market for mergers and acquisitions (M&A) that is partly driven by perceived weaknesses in the current
management. Elsewhere, managers may not be as concerned that inefficiency may lead to a takeover.
[A hostile takeover is the acquisition of one company (called the target company) by another (called the acquirer)
that is accomplished by going directly to the company's shareholders or fighting to replace management to get
the acquisition approved.]
Purpose of Business Valuation

Purpose of Valuation Examples

Valuation for Purchase and sale of an entity or an independent Cash Generating Unit or Division,
transactions M&A, reverse merger, recapitalisation, capital restructuring, Equity participation by an
external investor like Private Equity and Venture Capital Funds, Leverage Buy Out (LBO),
Management by Objective (MBO), Management Buy In, Disinvestment by Joint Venture
Partner or a Promoter, IPO, ESOPs, buy back of shares, project planning and so on
Valuation for court Bankruptcy, contractual disputes, ownership disputes, dissenting and oppressive
cases shareholder cases, divorce cases, intellectual property disputes and others.
Valuation for Fair value accounting, tax issues
compliances
Valuation for Estate planning, personal financial planning, M&A planning, strategic planning
planning

The list is inclusive and not exhaustive.

Different approaches to Business Valuation
Analysts use a wide spectrum of models, ranging from the simple to the sophisticated. These models often make
very different assumptions about the fundamentals that determine value, but they do share some common
characteristics and can be classified in broader terms. There are several advantages to such a classification as
such classified items make it is easier to understand where individual models fit in to the big picture, why they
provide different results and when they have fundamental errors in logic.
In general terms, there are three approaches to valuation. The first, discounted cash flow valuation, relates the
value of an asset to the present value of expected future cash flows on that asset. The second, relative valuation,
estimates the value of an asset by looking at the pricing of ‘comparable’ assets relative to a common financial
variable like future earnings, cash flows, book value or sales. The third, contingent claim valuation uses option pricing
models to measure the value of assets that share option characteristics. While they can yield different estimates
of value, one of the objectives of discussing valuation models is to explain the reasons for such differences, and to
help in picking the right model to use for a specific task.
These three methods, however, does not consider another method and that is explored value through auction
bidding or public tendering. One may argue that this is not a process for valuation as such since the bidders will
conduct their own valuation exercise before putting up their respective bids.
Stakeholders of Valuation
For whom do we value? The fundamental role of valuation is to offer a base for negotiation between buyer and
seller. It has a great repercussion that can affect the whole financial and strategic dynamics of decision for which
the valuation is being conducted. However, an inclusive list of entities that are presumed to be affected by wrong

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or improper valuation will help understanding the role of valuation.
• Shareholders — who provide capital to the business;
• The company itself — they may become a takeover target or the prospective acquirer of the target company
or may merge with another company;
• Financial experts — who help in financial decision making;
• The buyers of property and business — who help in creating orderly market;
• Banks and others—who provide loan by taking the property or financial assets like equity shares as a collateral;
• Mutual funds and Hedge funds, Private Equity Players, Venture Capitalists, etc. — who heavily invest in listed
and unlisted companies and / or securities;
• Insurance companies — who provide risk mitigating products and invest in insecurities
• Governments — who buy products and services and deposit money with banks, mutual funds and others and
/ or participate in equity capital as a co-investor or qcquirer.
• Whole economy — a robust banking system is the necessary for the economy to move.
Global financial crisis (GFC) has reminded us the crucial significance of the issue of valuation. Fair value accounting
has been blamed as one of the main reasons behind GFC.
With the increase in cross border flow of capital in the form of foreign direct investments (FDI), acquisitions and
M&A transactions, the subject of valuation has become a global issue. Following entities may require valuation
to be carried out; (i) buyer or seller (ii) lender (iii) intermediary like agent, broker etc., (iv) regulatory authorities
such as tax authorities, (v) revenue authorities and (vi) general public. Value can also be estimated, assessed
or determined by professional valuers. Global /corporate investors have become highly demanding and are
extremely focused on maximising corporate value. The list of investors includes high net worth individuals, pension
and hedge funds and investment companies. They no longer remain passive investors but are keen followers of a
company’s strategies and actions aimed at maximising and protecting the value of their investments. Valuation
should be done of all assets and liabilities to know ‘what we own’ and “what we owe”. Assets must include both
tangibles as well as intangibles. Liabilities include both apparent and contingent.
Key Areas of Valuation
Globalisation has enhanced IT capabilities, all pervasive role of the media and financial analysts and growing
awareness of investors have rendered the situation more complex. Mergers, acquisitions, disinvestments and
corporate takeovers have become the order of the day across the globe and are a regular feature today.
Mentioned below are certain major areas of decision making where valuation plays a key role.
• Valuation of equity share in the primary, secondary as well as derivative market;
• Private placement of equity shares;
• Corporate restructuring and turnaround;
• Secured lending including project finance;
• Securitization and other debt instruments;
• Implementation of Basel-III recommendation;
• Portfolio management - Mutual fund, hedge fund and professional investors like PE, VC and Angels;
• Long term and medium term investment decisions, M&A, takeovers, divestiture, disinvestment, capital
budgeting, private equity investment, venture capital investment, strategic investors, financial investors and
others;
• Dividend decision and buy back of shares;
• Borrowing decisions, including by keeping equity shares as collaterals;

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• Financial risk management decisions;
• Court case related decisions;
• Tax related valuation including transfer pricing;
• Development projects valuation;
• Intangible assets;
• Financial reporting valuation;
• Equity research;
• Forensic accounting and financial fraud investigation;
• Dissolution of firm, partner buyout and admission;
• Insurance product valuation;
• Estate planning and financial planning;
• Corporate planning;
• Property valuation;
• Value based performance measurement;
• Credit rating;
• Fairness and solvency opinion; and
• Charitable donation.
Apart from the above, there could be reasons like ‘divorce’ etc. which could often be treated as occasions for
valuation. However, we will consider it beyond the scope of our study.
Valuer
There are different types of providers of valuation services. Like International Financial Reporting Standards (IFRS)
for accounting, and reporting, there is no single consistent valuation standard applicable across the world. In USA,
UK, Canada and other developed countries the valuation service provide there exist professional institutes that
provide necessary education training for valuation services and the profession is regulated to a large extent. In
India, valuation profession is yet to be regulated; there is no specified qualification for performing valuation. As of
today, the profession is fragmented and may be considered at its developing phase. This probably could be the
reason, why there is lack of clarity, consistency, transparency and quality in valuation reports.
Several Cost & Management Accountant firms are providing valuation services. With the introduction of fair value
accounting under Indian Accounting Standards (Ind AS), the professional service field of valuation practice is
bound to grow. It is relevant to mention here that India has adopted a new set of standards called Ind AS with the
objective to converge towards IFRS.
Merchant bankers, venture capitalists and private equity investors perform valuation usually as a part of a
transaction. Banks, financial institutions, and investment banking consulting and advisory services professionals
also participate in valuations of their companies or segments of their companies or for their investment activities.
Large brokerage houses have their own stock analysts’ team who perform valuation on a regular basis and use this
information for publishing research reports and advising clients. Services of valuation are really broad based and
should not be confused with that of actuaries who render much specialised services.
In today’s financial world, equity and business valuation services as a profession has become a commodity.
Any and every professional provides these services. It is therefore, absolutely essential that quality differentials
are maintained with absolutely dispassionate and independent involvement in valuation activities, so that the
provided valuation of any asset and expert opinion on the same can be relied upon for informed judgement and
business decisions.

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Valuation Bias
A valuation specialist starts valuing a firm with certain assumptions and certain preconceived conditions about
how the business ecosystem related to the company and sector to which it belongs, will shape up. All too often,
views on a company are formed before the specialist starts inserting the numbers, determined using those
assumptions, into the financial / econometric models that is used. Not surprisingly, conclusions tend to reflect
his / her preconceived conditions, biases both about the company and assumptions. A reviewer will begin by
considering the sources of bias in valuation and then move on to evaluate how biases manifest in the valuation
and to what extent it has been impacted. The reviewer then closes with a discussion of how best to minimise or at
least deal with bias in valuations.
Sources of Valuation Bias
The bias in valuation starts with the companies that is chosen to be valued. These choices are almost never
random, and how valuers are made can start laying the foundation for bias. It may be that the valuer has read
some news item or research based data points, good or bad, in the press or any other published literature about
the company and its related business sector or heard from an expert that it was under or overvalued. Thus, valuers
already begin with a perception about the company that they are about to value. Valuer add to the bias when we
collect the information they need to value the firm. The annual report and other financial statements include not
only operating results and financial state of affar is but also management discussions and analysis of performance,
guidance for near future outlook and various risk factors for the sector in general and the entity in particular. All
these often put the best possible revolve on the numbers, with many larger companies. It is easy to access what
other analysts following the stock think about these companies.
In many valuations, there are institutional factors that add to this already substantial bias. For instance, it is an
acknowledged fact that equity research analysts are more likely to issue buy rather than sell recommendations, i. e., that
they are more likely to find firms to be undervalued than overvalued. This can be traced partly to the difficulties
analysts face in obtaining access and collecting information on firms that they have issued sell recommendations
on, and partly to pressure that they face from portfolio managers, some of whom might have large positions in the
stock, and from their own firm’s investment banking arm which have other profitable relationships with the firms
under valuation exercise.
The reward and punishment structure associated with finding companies to be under and overvalued is also a
contributor to bias. An analyst whose compensation is dependent upon whether he / she finds a firm is under
or overvalued will be biased in his / her conclusions. This should explain why acquisition valuations are so often
biased upwards. The analysis of the deal, which is usually done by the acquiring firm’s investment banker, who also
happens to be responsible for carrying the deal to its successful conclusion, can come to one of two conclusions.
One is to find that the deal is seriously overpriced and recommends rejection, in which case the analyst receives
the eternal gratitude of the stockholders of the acquiring firm but little else. The other is to find that the deal makes
sense, no matter what the price is and to reap large financial windfall gain from getting the deal done.
Perceptions (bias) about Companies are manifested in Business Valuation
There are three ways in which an analyst’s views, perceptions on a company and most likely human biases that
creep in can manifest themselves in value. The first is in the inputs that are used in the valuation. When analysts
values companies, they constantly make assumptions to move on. These assumptions can be optimistic or
pessimistic. For a company with high operating margins now, one can either assume that competition will drive
the margins down to industry averages very quickly (pessimistic) or that the company will be able to maintain its
margins for an extended period (optimistic). The chosen path will reflect prior biases of the analyst. It should come
as no surprise that at the end of a day the value that is arrived at is reflective of the optimistic or pessimistic choices
made along the way.
There are two more important factors. The first one is the PESETL* analysis done prior to develop the financial
model, to help conducting predictive analysis of business environment for the sector under which the concerned
business falls, that will influence assumptions and estimation of financial variables. And the second one is due
diligence conducted to estimate how the internal factors and directional changes that have been planned will
affect operational and financial performance of the company in future. Many research scholars have pointed out
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that a large number of M&A transactions have either failed or not generated the predicted results, as considered
in valuation model, due to wrong assumptions, which again could have been free from bias and more accurately
considered if findings from due diligence would have been more bearing with facts.
*Note: PESTEL analysis means analyses of Political, Economic, Societal, Environmental and Legal aspects of business
ecosystem that prevailed at the time of conducting the valuation exercise and will shape up in future which will
influence market conditions, operations and financial factors related to the business entity which or whose equity
shares are being valued.
The second is in what is called post-valuation tinkering, where analysts revisit assumptions after a valuation in
an attempt to get a value closer to what they had expected to obtain starting off. Thus, an analyst who values
a company at `150 per share, when the market price is `250, may revise his growth rates upwards and his risk
downwards to come up with a higher value, if he /she believed that the company was undervalued to begin with.
The third is to leave the value as is but attribute the difference between the estimated value and the value he /
she thinks is the right one to a qualitative factor such as synergy related savings or strategic considerations. This is
a common device in acquisition valuation where analysts are often called upon to justify the unjustifiable. In fact,
the use of premiums and discounts, where the estimated value is augmented or reduced, provides a window
on the bias in the process. The use of premiums control and synergy are good examples of commonplace in
acquisition valuations, where the bias is towards pushing value upwards to justify high acquisition prices to use of
discounts illiquidity and minority discounts.

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Process to Minimize Valuation Bias
Bias cannot be regulated or legislated out of existence. Analysts are human beings and both knowingly and
unknowingly bring their biases to the table. However, there are ways and means by which we can mitigate the
effects of bias on valuation:
(i) Reduce institutional pressures: A significant portion of bias can be attributed to institutional factors. Equity
research analysts in the 1990s, for instance, in addition to dealing with all of the standard sources of bias
had to grapple with the demand from their employers that they bring in investment banking business.
Institutions that want honest sell-side equity research should protect their equity research analysts who issue
sell recommendations on companies, not only from irate companies but also from their own sales people and
portfolio managers.
(ii) De-link valuations from reward/punishment: Any valuation process where the reward or punishment
is conditional to the outcome of the valuation will result in biased valuations. In other words, if we want
acquisition valuations to be unbiased, we have to separate the deal analysis from the deal making to reduce
bias.
(iii) No pre-commitments: Decision makers should avoid taking strong public positions on the value of a firm before
the valuation is complete. An acquiring firm that comes up with a price prior to the valuation of a target firm
has put analysts in an untenable position, where they are called upon to justify this price. In far too many cases,
the decision on whether a firm is under or overvalued precedes the actual valuation, leading to seriously
biased analyses. Therefore, analysts should both the independent and dispassionate without any direct and
indirect link to the purpose and objective for which the valuation statement will be used.
(iv) Self-Awareness: The best antidote to bias is awareness. An analyst who is aware of the biases he or she brings
to the valuation process can either actively try to confront these biases when making input choices or open
the process up to more objective points of view about a company’s future. For this purpose, they have to
also validate the inferences drawn from findings of PESTEL analysis and due diligence exercise without any
preconceived notion or perception. Otherwise bias will creep into their assumptions and estimations of
numbers to be used as inputs for the valuation model.
(v) Honest reporting: In Bayesian statistics, analysts are required to reveal their priors (biases) before they present
their results from an analysis. Thus, an environmentalist will have to reveal that he or she strongly believes that
there is a hole in the ozone layer before presenting empirical evidence to that effect. The person reviewing
the study can then factor that bias while looking at the conclusions. Valuations would be much more useful if
analysts revealed their biases up front.
While we cannot eliminate bias in valuations, we can try to minimize its impact by designing valuation processes
that are more protected from overt outside influences and by report our biases with our estimated values.
Uncertainties in Business Valuation
Starting early in life, peoples are taught that if they do things right, they will get the right answers. In other words,
the precision of the answer is used as a measure of the quality of the process that yielded the answer. While this
may be appropriate in mathematics or physics, it is a poor measure of quality in valuation. Barring a very small
subset of assets, there will always be uncertainty associated with valuations, and even the best valuations come
with a substantial margin for error. In this section, we examine the sources of uncertainty and the consequences
for valuation.
The value of a business is not a static figure. It depends on change in purpose or circumstances. There are number
of uncertainties involved in the valuation process which if not handled appropriately, would lead to an absurd
value. Valuer may design complex financial models with several inputs to handle uncertainties but that does not
mean that the value derived is reasonable or the process is sound. What valuer need to understand is the impact
of each input on the value. Giving attention to following factors is crucial:
• The macro economic factors.
• The business.

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• Its growth potential in the industry in which it operates.
• How is the business positioned?
• Who are the competitors?
• What is the quality and stability of the company’s management?
The principles and methods of valuation are well settled and they are more or less the same across the classes
of transactions. What changes in the course of deriving value is the selection of approaches and methods. Seller
would like to get as much as possible and buyer would like to pay as little as possible. Somewhere between these
two the deal takes place. Could it be mentioned that value is the price at which the deal takes place? What if
there is no buyer or there is no intention to sell. Could it be concluded that the object or business is worth nothing?
The answer is ‘No’. There is a’ bigger fool theory’ which says’ any price can be justified if a buyer is ready to pay
the price. It might be you who is the last buyer ready to pay the any price. The theory makes us understand that
every price cannot be value and vice versa. We need to differentiate between value and price.
Misconceptions about Valuation
There are many areas in valuation where remains the scope for disagreement, including how to estimate true
value and how long it will take prices to adjust to true value. But asset prices cannot be justified merely by using
the argument that other investors are willing to pay higher price in future. Like all analytical disciplines, valuation
has developed its own Myths.
Myth 1: A valuation is an Objective search for true value.
There will hardly be any valuation exercise which can remain cent percent free from bias of the valuation team
members or valuer. However, the question is how much and in which direction. Understandably all ethically sound
professional valuers, worth the name, will make all possible efforts to objectively conduct the exercise to find out
the near actual value with certainty equivalent approach. However, the direction in magnitude of whatever little
or more impact of bias creeps into the assumptions and tool selection is directly proportional to who pays for the
asset being valued and how much professional fee is being paid to the valuer.
Myth 2: Since valuation models are quantitative, valuation is better.
However, one’s understanding of a valuation model is inversely proportional to the number of inputs required for
the model. Moreover, simpler valuation models work out much better than complex ones.
It seems obvious that making a model more complete and complex should yield better valuation. But it is not
necessarily so. As models become more complex the number of inputs needed to value a firm tends to increase.
Problems are compounded when models become too complex to become “black boxes.” When a valuation fails
the blame gets attached to the model rather than the analyst. Valuer often complains “It was not my fault. The
model did it.”
The following three points are common and important in all valuation works:
• Principle of parsimony, which essentially states that you do not use more inputs than what is actually needed.
• There should be trade-off between additional benefit arising from more inputs and cost arising from input errors
and using more number of inputs.
• The models or tools adopted do not value companies but the valuer does.
All information inputs and data points considered to frame the assumptions are a time of excessive information.
Identifying the minimum relevant information is almost as important as the valuation models and techniques that
a valuer uses to value a firm.
Myth 3: A well-researched and well done valuation tends to be timeless
The value obtained in any valuation model is affected by firm-specific as well as market related information. As a
consequence, the value will change as new information is revealed. Given the constant flow of information into
financial markets, a valuation done on a firm quickly becomes dated and has to be updated to reflect correct

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 information. In practice many stock brokerage firms publish bi-yearly follow up valuation updates
for large listed companies after publishing a detailed research based valuation.
Information about the state of the economy and the level of interest affects all valuation in an
economy. When analysts change their valuation, they will undoubtedly be asked to justify the change
and in some cases the fact that valuation change over time is viewed as a problem. The best response
may be the one that John Maynard Keynes gave when he was criticized for changing his position on
a major economic issue: “When the facts change I change my mind and what do you do, sir?
Myth 4: A good valuation provides a precise estimate of value.
The truth remains that there is no concept of precise valuation. The recompense of valuation is
greatest when valuation is least precise.
Myth 5: To make money on valuation, you have to assume that markets are inefficient.
If a market is efficient then market price is the best estimate of value. However, it has been
empirically tested that no single market is efficient for estimating price. It is recognised that market
makes mistakes but finding those mistakes requires a combination of skill and knowledge. This view
of markets generally leads to the following conclusions:
If something looks good to be true, a stock looks obviously undervalued or overvalued is properly not
true.
When the value from an analysis is significantly different from the market price, start-off with the
presumption that the market is correct; then valuer has to convince himself that this is not the case before
valuer to conclude that something is over or undervalued. The higher standard may lead you to be
more cautious in following through on valuation but given the difficulty of beating the market this is
not an undesirable outcome.
Myth 6: The product of valuation (i.e., value) matters and not the valuation
Valuation models focus exclusively on the outcome. That is the value of the company and whether it
is over or undervalued. In most of the cases valuable internal points are missed out that can be
obtained from the process of valuation and can answer some of the most fundamental questions,
e.g.,
What is the appropriate price to pay for high growth?
What is a brand name worth?
How important is to return and project?
What is the effect of profit margin on value?
Myth 7: How much a business is worth depends on what the valuation is used for?
The value of a business is its fair market value that is what a willing buyer will pay to a willing seller
when each is fully informed and under no pressure to transact.

THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

 Valuation of share methods
Valuation of shares is a fundamental concept in corporate finance, helping determine the true worth of
a company’s equity. Whether you’re preparing for mergers, taxation, investment decisions, or regulatory
compliance, understanding how to calculate the value of shares is critical, especially in 2025 when
precision and transparency are more important than ever.

Among the various methods available, the Net Asset Method is one of the most reliable approaches to
share valuation, particularly for asset-heavy businesses. This expert-backed guide explains how the Net
Asset Method works, when to use it, key formulas, and real-world examples to help you apply it correctly.

Why Accurate Share Valuation Matters?

Determining the true value of a company’s shares is crucial for investors, business owners, and
stakeholders alike. Accurate share valuation methods empower informed decision-making, whether it’s
for mergers, acquisitions, investments, or even strategic business planning. A miscalculated valuation
can lead to financial loss and missed growth opportunities.

What is the Net Asset Method of Valuation of Shares?

The Net Asset Method of valuation of shares is an asset-based valuation technique that calculates a
company’s worth by evaluating its total assets minus its total liabilities. Particularly suitable for asset-
intensive businesses, this method provides clarity by focusing on tangible and quantifiable elements. It’s
highly valuable when other methods, such as earnings-based approaches, might not reflect the true
financial health of a company.

Step-by-Step Guide to NAV Calculation

Understanding how to accurately calculate the Net Asset Value (NAV) is crucial for performing precise
asset-based valuation. The NAV calculation method involves systematically identifying, adjusting, and
calculating the net value of a company’s assets. Here’s a clear, step-by-step guide:

Step 1: Identify and List All Assets and Liabilities

Begin by compiling a comprehensive list of the company’s assets and liabilities from the balance sheet.
Include tangible assets like machinery, real estate, inventory, and cash, as well as intangible assets such
as intellectual property, if applicable. Clearly document liabilities, such as loans, debts, and obligations.

Step 2: Adjust the Value of Assets and Liabilities (Adjusted Net Asset Method)
Next, perform necessary adjustments to reflect the accurate current market value rather than historical or
book value. Common adjustments under the Adjusted Net Asset Method include:
 Updating the market valuation of real estate or equipment.
 Revaluing inventory based on realizable value.
 Adjusting accounts receivable to reflect collectible amounts.

Step 3: Calculate the Final NAV (Asset-Based Valuation)

After adjustments, the final step is calculating the NAV using the formula:
Net Asset Value (NAV) = Total Adjusted Assets – Total Adjusted Liabilities
This resulting figure represents the intrinsic value of the company’s equity based on its assets and
liabilities. Clearly presenting this NAV calculation provides transparency and confidence in your
valuation outcomes, particularly useful in transactions, mergers, or acquisitions involving asset-intensive
companies.
The Net Asset Method is not suitable for every company—but in specific scenarios, it’s the most logical
and accepted approach.

1. Valuing Investment Holding Companies

These companies typically generate little or no operational income, but own significant shareholdings or
physical assets. NAM accurately captures the intrinsic value of such holdings.

2. Startups and Private Companies with Asset-Heavy Structures

Early-stage or bootstrapped companies may not have revenue or profits, but hold valuable intellectual
property, real estate, or equipment. NAM helps determine a fair valuation of shares in such cases.

3. Transfer Pricing & Tax Compliance

In 2025, Indian tax laws (including Rule 11UA of the Income Tax Rules) continue to accept NAM for
share valuation during share transfers, capital restructuring, and under FEMA regulations.

4. Insolvency or Liquidation Scenarios

During IBC proceedings or liquidation, asset-based valuation becomes critical. NAM helps stakeholders
assess realizable value for distressed entities.

Common Mistakes to Avoid in NAV Valuations

 Ignoring asset market value: Using outdated book values instead of current market values.
 Overlooking intangible assets: Underestimating or completely missing intangible assets like
IP, patents, or trademarks.
 Improper liability adjustments: Not adjusting liabilities to reflect true market obligations.
 Excluding contingent liabilities: Omitting liabilities that may arise in the future, leading to
inaccurate valuation.
 Inconsistent accounting standards: Mixing accounting standards or methodologies, resulting
in valuation errors.
To ensure accuracy and reliability, it’s advisable to regularly update asset and liability valuations to
reflect market conditions, meticulously account for intangible and contingent assets or liabilities, and
consistently apply recognized accounting standards. Engaging experienced valuation services
significantly reduces risks of error. Expert valuation firms bring industry-specific insights, ensuring
valuations are precise, compliant with regulations, and capable of standing up to rigorous financial
scrutiny.

Net Asset Method vs. Other Popular Valuation Methods

Choosing the right valuation method significantly impacts strategic financial decisions. Here’s a brief
comparison of the Net Asset Method (NAV) with two other popular valuation techniques—Discounted
Cash Flow (DCF) and Earnings Multiple methods:
Valuation Basis of Valuation Ideal Scenario Limitations
Method

Net Asset Assets minus liabilities Asset-intensive companies, Less effective for businesses with
Method liquidation scenarios, tangible asset- high intangible assets
(NAV) heavy industries
Discounted Present value of future cash Stable, predictable cash flows; Highly sensitive to assumptions
Cash Flow flows growth-oriented businesses and forecasts
(DCF)

Earnings Company earnings Businesses with stable, consistent Depends heavily on accurate
Multiple multiplied by industry- earnings; mature companies industry multiples and market
Method specific factors conditions

The Net Asset Method is particularly suitable when assessing asset-intensive business valuation , such
as manufacturing, infrastructure, or real estate companies. It provides clarity in cases of liquidation,
mergers, acquisitions, or where the company’s value is predominantly in physical assets rather than
future earnings potential.
Professional valuation firms play a pivotal role in guiding businesses toward the most suitable valuation
method. Leveraging their expertise, valuation specialists thoroughly assess business structures, asset
types, and financial objectives, helping businesses select the valuation technique that provides the most
accurate and reliable outcomes.
Startups with early-stage assets like patents, software, or property may use NAV when they lack
revenues. However, investors also consider qualitative factors like IP strength and scalability alongside
NAM
Valuation of Shares (Net Assets Method)
Q.1. (Simple Question)
Total assets: ₹50,00,000; Total liabilities (excluding share capital and reserves): ₹15,00,000; Number of
equity shares: 10,000. Find value per equity share using Net Assets Method.

Q.2. (Preference share capital)

Fixed assets (book): ₹30,00,000; Current assets: ₹20,00,000; Liabilities: ₹25,00,000; Preference share
capital: ₹5,00,000; Equity shares: 5,000. Find value per equity share.

Q.3. (Moderate Difficulty)

Land & Building (MV): ₹40,00,000; Machinery: ₹20,00,000; Investments (MV): ₹10,00,000; Debtors &
Cash: ₹15,00,000; Creditors: ₹25,00,000; Bank Loan: ₹10,00,000; Equity shares: 10,000.

Q4 (Moderate Difficulty)
Book value of assets: ₹80,00,000; Revaluation increase in land: ₹10,00,000; Creditors: ₹20,00,000;
Outstanding expenses: ₹5,00,000; Preference share capital: ₹15,00,000; Equity shares: 13,000.

Q5 (Moderate Difficulty)
Machinery (Book): ₹30,00,000 (20% down); Land (Book): ₹25,00,000 (10% up);
Inventory & Receivables: ₹15,00,000; Creditors: ₹10,00,000; Debentures: ₹5,00,000; Equity shares:
8,000.

Q6 (High Difficulty)
₹1,20,00,000; Land revaluation: +₹30,00,000; Goodwill (remove): ₹10,00,000; Investment down:
₹5,00,000; Liabilities: ₹60,00,000; Pref. capital: ₹20,00,000; 2 yrs pref dividend due; Equity shares:
20,000.

Q7 (High Difficulty)
Assets: ₹ 2,50,00,000; Land (₹80L) appreciated 25%; Inventory overstated ₹ 5L; Liabilities: Creditors ₹
40L, Bank loan ₹ 60L, Pref. shares ₹ 30L; Equity shares: 50,000.
Q8 (High Difficulty)
Tangible assets: ₹90L; Land revaluation: ₹15L; Investments MV: ₹10L; Goodwill: ₹5L (exclude);
Liabilities: ₹55L total; Equity shares: 12,000. A shareholder claims 1,000 shares worth ₹600 each. Is he
right?

Background: Net Asset Method (NAM)

Under NAM, the value of equity shares is determined as:

Value per Share = (Net Assets - External Liabilities - Preference Share Capital) / Number of Equity
Shares

Adjustments are made for revaluation of assets, fictitious assets, contingent liabilities, non-trade
investments, etc.

Question 1:

Given:

 Fixed Assets (Book Value): ₹15,00,000 (Fair Value: ₹18,00,000)

 Current Assets: ₹7,00,000
 Investments (Non-trade): ₹1,00,000 (to be excluded)
 Liabilities: ₹4,00,000
 Preference Share Capital: ₹2,00,000
 Equity Shares: 20,000 shares

Calculate value per equity share using NAM.

Question 2: A company has:

 Total assets (book value): ₹40,00,000

 Fictitious assets: ₹1,00,000
 Liabilities: ₹15,00,000
 Preference Capital: ₹5,00,000
 1,00,000 Equity Shares

Calculate intrinsic value per share.

Question 3:

Explain how contingent liabilities are treated under the Net Asset Method of share valuation.

Solution:

Contingent liabilities (e.g., disputed claims, guarantees) are generally deducted from net assets if they
are likely to become actual liabilities, based on prudence.

Example: If a contingent liability of ₹2,00,000 is likely to arise, it should reduce the net assets used for
share valuation.

Question 4:

A company has:

 Land & Building (Book Value): ₹10,00,000; (Fair Value): ₹14,00,000

 Plant & Machinery: ₹6,00,000
 Current Assets: ₹3,00,000
 Creditors: ₹2,00,000
 Outstanding Expenses: ₹1,00,000
 Equity Share Capital: 10,000 shares

Calculate value per equity share.

Question 5:

State any three adjustments to be made under Net Asset Method.

Solution:

1. Revaluation of fixed assets to fair market value.

2. Deduction of fictitious assets like preliminary expenses.
3. Exclusion of non-trade investments or valuation at market price.

Question 6:Given:

 Net assets as per books: ₹50,00,000

 Market value of assets is ₹10,00,000 higher
 Liabilities: ₹20,00,000
 Preference Share Capital: ₹5,00,000
 Equity Shares: 50,000

Find intrinsic value per share.

Question 7:
A company has:
 Share Capital: ₹10,00,000 (₹100 per share)
 Free Reserves: ₹6,00,000
 Revaluation Reserve: ₹4,00,000
 Liabilities: ₹5,00,000
 Total Assets (fair value): ₹25,00,000
Calculate value per share using NAM.

Question 8:
If a company has intangible assets like goodwill worth ₹3,00,000, should they be included in NAM?
Solution:
No, intangible assets like goodwill, patents are generally excluded or valued at realizable value, which
is often zero unless there's a specific buyer value. Under conservative valuation, they are deducted from
total assets.

Balance Sheet As on 31-3-2015

Liabilities ₹ Assets ₹
1,000 8% Pref. Shares @₹100 1,00,000 Fixed Assets 4,00,000
30,000 Equity Shares @₹10 3,00,000 Current Assets 2,50,000
Debenture Redemp. Fund 50,000 Preliminary Expenses 20,000
6% Debentures 1,00,000 Discount on Debentures 5,000
Depreciation Fund 1,00,000 Profit & Loss A/c 45,000
Creditors 70,000 — —
Total 7,20,000 Total 7,20,000
Additional Info:
1. Interest on debentures due for 1 year.
2. ₹12,000 of book debts are doubtful (provision made).

Calculate intrinsic value per equity share using Net Asset Method.

Question 10
Balance Sheet As on 31-3-2015
Liabilities ₹ Assets ₹
2,000 6% Pref @₹10 20,000 Buildings 55,000
8,000 Equity @₹10 80,000 Machinery 65,000
Reserve Fund 50,000 Patents 10,000
P & L A/c 16,000 Stock 28,000
Workmen’s Savings A/c 15,000 Debtors 40,000
Sundry Creditors 49,000 Cash 26,000
Liabilities ₹ Assets ₹
Preliminary Expenses 6,000
Total 2,30,000 Total 2,30,000
Adjustments:
 Machinery under-depreciated by ₹5,000.
 Buildings market value: ₹1,30,000.
 Goodwill value: ₹20,000.
 Bad debts: ₹6,000.
 Preference shares have capital repayment priority.

Value both Preference and Equity shares under Net Asset Method.

Question 11
Balance Sheet & Profits
 Equity Capital: 50,000 shares @₹10
 5% Debentures: ₹1,00,000
 Current Liabilities: ₹1,30,000
 Fixed Assets: ₹5,50,000
 Current Assets: ₹2,00,000
 Goodwill: ₹50,000
Profits of last 3 years:
 ₹51,600, ₹52,000, ₹51,650
 20% of profit transferred to reserves
 Normal return: 10%
Compute values per share using:
Net Asset Method
 1

I. II. Introduction

III. Cost of Debt

IV. Cost of Preference Shares

V. Cost of Equity

VI. Cost of Retained Earnings

VII. Weighted Average Cost of Capital

VIII. Marginal Cost of Capital

Practice Questions

I. Introduction
The cost of capital is the return that must be provided for the use of an investor’s fund. If the funds are
borrowed, the cost is the interest that must be paid on the loan. If the funds are equity, the cost is the
return that investors expect, both from the stock’s price increase and dividends.

II. Cost of Debt

The main characteristics of debt or a debenture are as follows :-

a. Face Value :- Debt may be in the form of loans or debentures. The face value is the par value of the
debenture, also known as the nominal value. A debenture can be issued at par, premium or
discount. But in any case, the interest is always paid on the face value.

b. Interest Rate :- Interest rate is fixed and known to lenders / debenture holder. The interest rate is
also called coupon rate.

c. Tax Deductible :- Interest paid on debt or debentures is tax deductible.

d. Maturity :- A debenture is generally issued for a specific period of time. It is repaid on maturity.

e. Redemption Value :- The value that a debenture holder will get on maturity is called redemption
or maturity value. A debenture may be redeemed at par or at premium or at discount.

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A. Cost of Debentures Issued and Redeemable at Par (Redemption Value and Maturity not known)

Kd = I (1-t)
Where, Kd = Cost of Debenture after tax
I = Annual Interest Payment

t = Tax Rate

The amount of tax saved due to deduction of interest from taxable income (Interest X Tax Rate) is known
as Tax Shield.

Q.1.
Y Ltd. has ₹ 3,00,000, 10% Debentures of ₹ 100 each. The tax rate is 40%. Calculate the cost of debentures
and the tax shield.
Solution :-
I – 10% = 0.1 = 10% of 3,00,000 = ₹ 30,000
t – 40% = 0.4
Kd = I (1-t) = 0.1 (1 - 0.4) = 0.1 X 0.6 = 0.06 = 6%
= 30,000 (1 – 0.4) = 30,000 X 0.6 = ₹ 18,000
Tax Shield = Interest X Tax Rate = 0.1 X 0.4 = 0.04 = 4%
= 30,000 X 0.4 = ₹ 12,000

B. Cost of Debentures Issued at Premium / Discount (Redemption Value and Maturity not known)

Kd = I (1-t) X 100
NP
Where, Kd = Cost of Debenture after tax
I = Annual Interest Payment
t = Tax Rate
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

Q.2.
Sri Ram Industries Ltd. issued 10,000, 10% Debentures of ₹ 100 each. The tax rate is 50%. Calculate the after
tax cost of debt if the debentures are issued a) at par, b) at premium of 10%, c) at a discount of 10%.
Solution :-
I = 10% of ₹ 100 = ₹ 10
t = 50% = 0.5
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)
NP (Issued at Par) = ₹ 100
NP (Issued at 10% Premium) = 100 + 10% of 100 = ₹ 110
NP (Issued at 10% Discount) = 100 – 10% of 100 = ₹ 90

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Kd = I (1-t) X 100
NP

a) Issued at par
Kd = 10 (1-0.5) X 100 = 5%
100

b) Issued at 10% Premium

Kd = 10 (1-0.5) X 100 = 4.55%
110

c) Issued at 10% Discount

Kd = 10 (1-0.5) X 100 = 5.56%
90

Q.3.
T Ltd. issued ₹ 100 lakhs, 12% Debentures of ₹ 100 each. Corporate tax rate is 40%.Calculate the cost of
debt in each of the following cases :-
Case a) :- If debentures are issued at par with 5% floatation cost on issue price.
Case b) :- If debentures are issued at 10% premium with 5% floatation cost on issue price.
Case c) :- If debentures are issued at 10% discount with 5% floatation cost on issue price.
Solution :-
I = 12% of ₹ 100 = ₹ 12
t = 40% = 0.4
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)
NP (Issued at Par) = ₹ 100 – (5% of 100) = ₹ 95
NP (Issued at 10% Premium) = 100 + (10% of 100) – (5% of 110) = ₹ 104.50
NP (Issued at 10% Discount) = 100 – (10% of 100) – (5% of 90) = ₹ 85.50

Kd = I (1-t) X 100
NP

a) Issued at par
Kd = 12 (1-0.4) X 100 = 7.58%
95

b) Issued at 10% Premium

Kd = 12 (1-0.4) X 100 = 6.89%
104.50

c) Issued at 10% Discount

Kd = 12 (1-0.4) X 100 = 8.42%
85.50

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C. Cost of Debentures Issued and / or Redeemable at Premium or Discount (Redemption Value and
Maturity is known)

Kd = I (1-t) + (RV – NP)/N X 100

(RV + NP)/2

Where, Kd = Cost of Debenture after tax

I = Annual Interest Payment

t = Tax Rate

NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

RV = Redemption Value of Debenture (Face Value + Premium – Discount)

N = Life of Debentures (In Years)

Q.4.
A Company issues ₹ 10,00,000, 12% debentures of ₹ 100 each. The debentures are redeemable after the
expiry of fixed period of 7 years. The company is in 35% tax bracket. The discount / premium / floatation
cost is to be amortised.

a. Calculate the cost of debentures after tax, if debentures are issued at

i. Par
ii. 10% Discount
iii. 10% Premium
b. If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
Solution :-
I = 12% of 100 = ₹ 12

t = 35% = 0.35

NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

NP (Issued at Par) = ₹ 100
NP (Issued at 10% Premium) = 100 + 10% of 100 = ₹ 110
NP (Issued at 10% Discount) = 100 – 10% of 100 = ₹ 90

RV = Redemption Value of Debenture (Face Value + Premium – Discount) = ₹ 100 (assumed)

N = 7 Years

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Kd = I (1-t) + (RV – NP)/N X 100
(RV + NP)/2

(i) Issued at par

Kd = 12 (1-0.35) + (100 – 100)/7 X 100 = 7.8 + Nil X100 = 7.80%

(100 + 100)/2 100

(ii) Issued at 10% Premium

Kd = 12 (1-0.35) + (100 – 110)/7 X 100 = 7.8 – 1.43 X100 = 6.07%
(100 + 110)/2 105

(iii) Issued at 10% Discount

Kd = 12 (1-0.35) + (100 – 90)/7 X 100 = 7.8 + 1.43 X100 = 9.71%

(100 + 90)/2 95

b) NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

NP (Issued at Par) = ₹ 100 – (2% of ₹ 100) = 98

Kd = 12 (1-0.35) + (100 – 98)/7 X 100 = 7.8 + 0.29 X100 = 8.17%

(100 + 98)/2 99

Q.5.
Shakti Ltd. issued 10,000, 10% Debentures of ₹ 100 each at par. These debentures are redeemable after 10
years at a premium of 8%. The cost of issue is 2% of face value. Assuming a corporate tax rate of 50%,
calculate the after tax cost of debt capital.
Ans :- 5.83%

Q.6.
Mauli Ltd. issued 15,000, 12% Debentures of ₹ 100 each at a discount of 10%. The debentures are
redeemable after 10 years at a premium of 10%. Calculate cost of debt after tax, if the tax rate is 40%.
Ans :- 9.20%

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III. Cost of Preference Shares

The cost of preference share capital is the dividend payable to its shareholders. The payment of preference
dividend is not adjusted for taxes as they are paid after taxes.
Cost of Preference Shares also include the Dividend Distribution Tax (DDT), at present charged, on the
preference dividend paid.

The study of cost of preference shares can be divided as follows :-

A. Cost of Preference Shares (Redemption Value and Maturity is not known)

Kp = PD (1 + DDT) X 100
NP

Where,

Kp = Cost of Preference Shares

PD = Preference Dividend

DDT = Dividend Distribution Tax

NP = Net Proceeds of Preference Shares (Face Value + Premium – Discount – Floatation Cost)

B. Cost of Preference Shares (Redemption Value and Maturity is known)

Kp = PD (1 + DDT) + (RV – NP)/N X 100

(RV + NP)/2

Where,

Kp = Cost of Preference Shares

PD = Preference Dividend

DDT = Dividend Distribution Tax

NP = Net Proceeds of Preference Shares (Face Value + Premium – Discount – Floatation Cost)

RV = Redemption Value of Debenture (Face Value + Premium – Discount)

N = Life of Debentures (In Years)

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Q.7.
Dinesh Ltd. has issued 9%, 10,000 Preference Shares of ₹ 100 each. The issue expenses are ₹ 3 per share.
You are required to ascertain the cost of Preference Share Capital is the shares are issued
a) at par; b) at a premium of 10% and c) at a discount of 5%
Solution :-
PD = 9% of 100 = ₹ 9
DDT = NIL
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)
NP (Issued at Par) = 100 – 3 = ₹ 97
NP (Issued at 10% Premium) = 100 + 10% of 100 – 3 = ₹ 107
NP (Issued at 10% Discount) = 100 – 5% of 100 – 3 = ₹ 92

Kp = PD (1 + DDT) X 100
NP

(i) Issued at par

Kp = 9 X 100 = 9.28%
97

(ii) Issued at 10% Premium

Kp = 9 X 100 = 8.41%
107

(iii) Issued at 10% Discount

Kp = 9 X 100 = 9.78%
92

Q.8.
XYZ Ltd. issues 2,000, 10% Preference Shares of ₹ 100 each at a premium of 5%. The shares are redeemable
at par after 8 years. The issue expenses are 4% of the net proceeds. Calculate the cost of redeemable
preference capital.
Solution :-
PD = 10% of 100 = ₹ 10
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)
= 100 + (5% of ₹ 100) – (4% of 105) = ₹ 100.80
RV = ₹ 100
N = 8 Years

Kp = PD (1 + DDT) + (RV – NP)/N X 100

(RV + NP)/2

Kp = 10 + (100 – 100.80)/8 X 100 = 10 - 0.80/8 X100 = 10 - 0.10 X100 = 9.90 X100 = 9.86%
(100 + 100.80)/2 100.4 100.4 100.4

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Q.9.
XYZ Ltd. issues 2,000, 10% Preference Shares of ₹ 100 each at ₹ 95 each, redeemable after 10 years.
Calculate the cost of preference shares.
Solution :-

PD = 10% of ₹ 100 = ₹ 10
NP = ₹ 95

RV = ₹ 100
N = 10 Years

Kp = PD (1 + DDT) + [(RV – NP)/N] X 100

(RV + NP)/2

Kp = 10 + (100 - 95)/10 X 100 = 10 + 5/10 X 100 = 10 + 0.5 X 100 = 10.5 X 100 = 10.77%
(100 + 95)/2 (195 / 2) 97.5 97.5

Q.10.
A company issued 40,000, 12% Redeemable Preference Shares of ₹ 100 each at a premium of ₹ 5 each,
redeemable after 10 years at a premium of ₹ 10 each. The floatation cost of each share is ₹ 2. You are
required to calculate cost of preference share capital ignoring dividend tax.
Solution :-
PD = 12% of ₹ 100 = ₹ 12

NP = ₹ 100 + ₹ 5 – ₹ 2 = ₹ 103

RV = ₹ 100 + ₹ 10 = ₹ 110
N = 10 Years

Kp = PD (1 + DDT) + [(RV – NP)/N] X 100

(RV + NP)/2

Kp = 12 + (110 - 103)/10 X 100 = 12 + 7/10 X 100 = 12 + 0.7 X 100 = 12.7 X 100 = 11.93%
(110 + 103)/2 (213 / 2) 106.5 106.5

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Q.11.
M Ltd. issued ₹ 100 lakhs 12% Preference Shares of ₹ 100 each redeemable at par after 5 years. Calculate
the cost of Preference Share in each of the following cases :- (Assuming dividend distribution tax being
20%.)

Case a :- If shares are issued at par with no floatation cost

Case b :- If shares are issued at par with 5 % flotation cost on issue price
Case c :- If shares are issued at 10% premium with 5 % flotation cost on issue price
Case d :- If shares are issued at 10% discount with 5 % flotation cost on issue price

Solution :-
PD = 12% of ₹ 100 = ₹ 12

DDT = 20% = 0.20

PD (1+DDT) = 12(1+0.20) = 12 X 1.20 = 14.40

RV = ₹ 100

N = 5 Years
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

NP (Issued at Par with No Flotation Cost)

= ₹ 100

NP (Issued at Par with Flotation Cost 5% of issue price)

= ₹ 100 – 5% of 100 = 100-5 = ₹ 95

NP (Issued at 10% Premium with Flotation Cost 5% of issue price)

= 100 + 10% of 100 – 5% of 110 = 100+10-5.5 = ₹ 104.5

NP (Issued at 10% Discount with Flotation Cost 5% of issue price)

= 100 - 10% of 100 – 5% of 90 = 100-10-4.5 = ₹ 85.5

Kp = PD (1 + DDT) + [(RV – NP)/N] X 100

(RV + NP)/2

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Case a :- If shares are issued at par with no floatation cost
Kp = 14.4 + (100 - 100)/5 X 100
(100 + 100)/2

Kp = 14.4 + Nil X 100

100
Kp = 14.4%

Case b :- If shares are issued at par with 5 % flotation cost on issue price
Kp = 14.4 + (100 - 95)/5 X 100
(100 + 95)/2
Kp = 14.4 + 1 X 100
97.5

Kp = 15.4 X 100
97.5
= 15.79%
Kp

Case c :- If shares are issued at 10% premium with 5 % flotation cost on issue price

Kp = 14.4 + (100 – 104.5)/5 X 100

(100 + 104.5)/2
Kp = 14.4 – 0.9 X 100
102.25
Kp = 13.5 X 100
102.25
= 13.20%
Kp

Case d :- If shares are issued at 10% discount with 5 % flotation cost on issue price
Kp = 14.4 + (100 – 85.5)/5 X 100
(100 + 85.5)/2
Kp = 14.4 + 2.9 X 100
92.75
Kp = 17.3 X 100
92.75
Kp = 18.65%

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Q.12.
V Ltd. issued ₹ 100 lakhs 12% Preference Shares of ₹ 100 each redeemable at premium of 5% after 5 years.
Calculate the cost of Preference Share in each of the following cases :- (Assuming dividend distribution tax
being 20%.)

Case a :- If shares are issued at par with no floatation cost

Case b :- If shares are issued at par with 5 % flotation cost on issue price
Case c :- If shares are issued at 10% premium with 5 % flotation cost on issue price
Case d :- If shares are issued at 10% discount with 5 % flotation cost on issue price

Solution :-
PD = 12% of ₹ 100 = ₹ 12

DDT = 20% = 0.20

PD (1+DDT) = 12(1+0.20) = 12 X 1.20 = 14.40

RV = ₹ 100 + 5% of ₹ 100 = ₹ 105

N = 5 Years
NP = Net Proceeds of Debenture (Face Value + Premium – Discount – Floatation Cost)

NP (Issued at Par with No Flotation Cost)

= ₹ 100

NP (Issued at Par with Flotation Cost 5% of issue price)

= ₹ 100 – 5% of 100 = 100-5 = ₹ 95

NP (Issued at 10% Premium with Flotation Cost 5% of issue price)

= 100 + 10% of 100 – 5% of 110 = 100+10-5.5 = ₹ 104.5

NP (Issued at 10% Discount with Flotation Cost 5% of issue price)

= 100 - 10% of 100 – 5% of 90 = 100-10-4.5 = ₹ 85.5

Kp = PD (1 + DDT) + [(RV – NP)/N] X 100

(RV + NP)/2

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Case a :- If shares are issued at par with no floatation cost
Kp = 14.4 + (105 - 100)/5 X 100
(105 + 100)/2

Kp = 14.4 + 1 X 100
102.5
Kp = 15.02%

Case b :- If shares are issued at par with 5 % flotation cost on issue price
Kp = 14.4 + (105 - 95)/5 X 100
(105 + 95)/2
Kp = 14.4 + 2 X 100
100

Kp = 16.4 X 100
100
Kp = 16.40%

Case c :- If shares are issued at 10% premium with 5 % flotation cost on issue price

Kp = 14.4 + (105 – 104.5)/5 X 100

(105 + 104.5)/2
Kp = 14.4 + 0.1 X 100
104.75
Kp = 14.5 X 100
104.75
= 13.84%
Kp

Case d :- If shares are issued at 10% discount with 5 % flotation cost on issue price
Kp = 14.4 + (105 – 85.5)/5 X 100
(105 + 85.5)/2
Kp = 14.4 + 3.9 X 100
95.25
Kp = 18.3 X 100
95.25
Kp = 19.21%

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IV. Cost of Equity

The calculation of equity capital cost raises a lot of problems. The debenture interest rate and preference
dividend rate is fixed at the time of issue. However, equity dividend rates are not fixed at the time of issue.
Expected equity dividend rates must be estimated on the basis of current or expected dividends, current or
expected earnings available for distribution, expected future growth, risk premium and so on. Cost of equity
capital is the rate of return which equates the present value of expected dividends with the market or issue
price.
Cost of equity can be calculated through following approaches :-
A. Dividend Approach
B. Earnings Approach
C. Dividend Growth Approach
D. Capital Asset Pricing Model (CAPM)

A. Dividend Approach
This model assumes that dividends are paid at a constant rate to perpetuity. This dividend price ratio
expresses the cost of equity capital in relation to what yield the company should pay to attract investors.

Ke = D1 X 100
P0
Where,
Ke = Cost of Equity
D1 = Expected Future Dividend OR Current Dividend
P0 = Current Market Price Per Share OR Net Proceeds

Q.13.
A company offers equity shares of ₹ 10 each for public subscription at a premium of 5%. The company
pays 2% of the issue price as underwriting commission. The rate of dividend expected by equity
shareholders is 30%. You are required to compute the cost of equity capital. Will your cost of capital be
different if it is calculated on the basis of present market value of equity share which is only ₹ 13.

Solution :-
A) D1 = 30% of ₹ 10 = ₹ 3

P0 = ₹ 10 + 5% of ₹ 10 – 2% of ₹ 10.5 = ₹ 10 + ₹ 0.5 – ₹ 0.21 = ₹ 10.29

Ke = D1 X 100 = 3 X 100 = 29.15%
P0 10.29

B) D1 = 30% of ₹ 10 = ₹ 3
P0 = ₹ 13
Ke = D1 X 100 = 3 X 100 = 23.08%
P0 13

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Q.14.
A Co. pays a dividend of 20% on the equity shares of face value of ₹ 100 each. Find out the value (expected
market value) of the equity share given that the dividend rate is expected to remain same and the required
rate of return is 15%.
Solution :-
D1 = 20% of ₹ 100 = ₹ 20 P0 = ? Ke = 15% = 0.15

Ke = D1 X 100
P0
15 = 20 X 100
P0
P0 = 20 X 100 = ₹ 133.33
15

Q.15.
Dividend Payers Ltd. has a stable income and stable dividend policy. The average annual dividend payout
is ₹ 27 per share (Face Value is ₹ 100).
You are required to find out :-
1. Cost of equity capital if market price is ₹ 150.
2. Expected market price next year if cost of equity is expected to rise to 20%.
3. Dividend payout next year if the company were to have an expected current market price of ₹ 160
per share, at the existing cost of equity.
Solution :-
1) D1 = ₹ 27 P0 = ₹ 150
Ke = D1 X 100 = 27 X 100 = 18%
P0 150

2) D2 = ₹ 27 P1 = ? Ke = 20%
Ke = D2 X 100
P1
20 = 27 X 100
P1
P1 = ₹ 135

3) D1 = ? P0 = ₹160 Ke = 18%
Ke = D1 X 100
P0
18 = D1 X 100
160
D1 = ₹ 28.8

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B. Earnings Approach
This approach co-relates the earnings of the company with the issue price or market price of its share.
Accordingly, the cost of the ordinary share capital would be based upon the expected rate of earnings of a
company. The argument is that each investor expects a certain amount of earnings, whether distributed as

dividend
or not by the company. This approach ignores the effect of changes in the dividend policy.

Ke = E1 X 100
P0
Where,
Ke = Cost of Equity

E1 = Earnings Per Share (Expected or Current)

P0 = Current Market Price Per Share OR Net Proceeds

Q.16.
XYZ Ltd. is planning for an expenditure of ₹ 120 Lakhs for its expansion programme. Number of existing
equity shares are 20 Lakhs and the market price of equity share is ₹ 60 per share. It has net earnings of ₹
180 Lakhs. Compute the cost of existing equity shares and the new equity shares assuming that the new
equity shares will be issued at a price of ₹ 52 per share and the cost of new issue will be ₹ 2 per share.
Solution :-
A)

E1 = ₹ 180 Lakhs / 20 Lakhs Shares = ₹ 9

P0 = ₹ 60 (Market Price)

Ke = E1 X 100
P0
Ke = 9 X 100 = 15%
60
B)

E1 =₹180Lakhs/20LakhsShares = ₹ 9
P0 =₹ 52 – ₹ 2 (Net Proceeds)

Ke = E1 X 100
P0
Ke = 9 X 100 = 18%
50

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C. Dividend Growth Approach
Earnings and dividends do not remain constant and the price of equity shares is also directly influenced
by the growth rate in dividends. Where earnings, dividends and equity share price all grow at the same
rate, the cost of equity capital may be computed as follows :-

Ke = D1 X 100 + G
P0

Where,
Ke = Cost of Equity
D1 = Expected Future Dividend OR Current Dividend
P0 = Current Market Price Per Share OR Net Proceeds
G = Annual growth rate of earnings of dividend

Q.17.
ABC Ltd. plans to issue 1,00,000 new equity shares of ₹ 10 each at par. The flotation costs are expected to
be 5% of the share price. The company pays a dividend of ₹ 1 per share in the current year and the growth
rate in dividend is expected to be 5%. Compute the cost of new equity share. Also, if the current market
price is ₹ 15, compute the cost of existing equity.
Solution :-
i) P0 = Net Proceeds = 10 – 5% of 10 = 10 – 0.5 = 9.5
D0 = ₹ 1
D1 = ₹ 1 + 5% of ₹ 1 = ₹ 1.05
G = 5%
Ke = D1 X 100 + G
P0

Ke = 1.05 X 100 + 5%
9.5

Ke = 11.05% + 5%
Ke = 16.05%

ii) P0 = Market Price = ₹ 15

D0 = ₹ 1
D1 = ₹ 1 + 5% of ₹ 1 = ₹ 1.05
G = 5%
Ke = D1 X 100 + G
P0

Ke = 1.05 X 100 + 5%
15

Ke = 7% + 5%
Ke = 12%

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Q.18.
Triveni Industries Ltd. equity share is currently quoted at ₹ 68. Next year the company would pay
dividend of ₹ 8.16 per share of ₹ 10. The investor expects a growth rate of 6% p.a.
Compute :-
i. Company’s Cost of Equity Capital.
ii. If the anticipated growth rate is 8% p.a. What would be the indicated market price of the share if the
dividend of ₹ 9.80 per share to be declared in next year at the same cost of equity capital.
Solution :-
i) P0 = Market Price = ₹ 68
D1 = ₹ 8.16
G = 6%

Ke = D1 X 100 + G
P0

Ke = 8.16 X 100 + 6%
68

Ke = 12% + 6%
Ke = 18%

ii) P0 = ?
D1 = ₹ 9.8
G = 8%
Ke = 18%

Ke = D1 X 100 + G
P0

18% = 9.8 X 100 + 8%

P0
18% - 8% = 9.8 X 100
P0
10% = 9.8 X 100
P0

0.10 = 9.8
P0
P0 = ₹ 98

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D. Capital Asset Pricing Model (CAPM)
Another technique that can be used to estimate the cost of equity is the Capital Asset Pricing Model
(CAPM) approach. This model describes the linear relationship between risk and return for securities. The
basic factor behind determining the cost of ordinary share capital is to measure the expectation of
investors from the ordinary shares of that particular company.
Symbolically, the cost of equity capital can be computed using the following formula :-

Ke = Rf + β X Rp
Ke = Rf + β(Rm – Rf)
Where, Ke = Cost of Equity
Rf = Risk Free Rate of Return
Rm = Return on Market Portfolio
Rp = Rm – Rf = Risk Premium
β = Beta Co-efficient (Risk Factor) of Security

Q.19.
Calculate the cost of equity capital of Bharat Ltd., whose risk free rate of return equals 10%. The firm’s beta
equals 0.8 and the return on the market portfolio equals to 15%.
Solution :-
Rf = 10% = 0.1
Rm = 15% = 0.15
β = 0.8
Ke = Rf + β(Rm – Rf)
Ke = 0.1 + 0.8(0.15 – 0.1)
Ke = 0.1 + 0.8 X 0.05
Ke = 0.1 + 0.04
Ke = 0.14
Ke = 14%

Q.20.
From the following information calculate cost of equity according to CAPM :-
Rate of Return on Risk Free Investment = 8%
Rate of Return on Market Portfolio = 18%
Volatility of Securities return relative to the return of a broad based market portfolio = 1.275
Solution :-
Rf = 8% = 0.08
Rm = 18% = 0.18
β = 1.275
Ke = Rf + β(Rm – Rf)
Ke = 0.08 + 1.275(0.18 – 0.08)
Ke = 0.08 + 1.275 X 0.1
Ke = 0.08 + 0.1275
Ke = 0.2075
Ke = 20.75%

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Q.21.
Calculate cost of equity for the following firms with the help of the information available :-
Rate of Return on Government Securities = 6%
Return on Market Portfolio = 15%
Beta Factor :-
A Ltd. – 0.5; B Ltd. – 0.8; C Ltd. – 1; D Ltd. – 1.2; E Ltd. – 1.5; F Ltd. – 2.5; G Ltd. – 0 (Zero)
Solution :-
Rf = 6% = 0.06
Rm = 15% = 0.15
Rp = Rm – Rf = 0.15 – 0.06 = 0.09

Company Beta Factor Ke = Rf + β X Rp

A Ltd. 0.5 Ke = 0.06 + 0.5 X 0.09 = 0.06 + 0.045 = 0.105 = 10.5%
B Ltd. 0.8 Ke = 0.06 + 0.8 X 0.09 = 0.06 + 0.072 = 0.132 = 13.2%
C Ltd. 1 Ke = 0.06 + 1 X 0.09 = 0.06 + 0.09 = 0.15 = 15%
D Ltd. 1.2 Ke = 0.06 + 1.2 X 0.09 = 0.06 + 0.108 = 0.168 = 16.8%
E Ltd. 1.5 Ke = 0.06 + 1.5 X 0.09 = 0.06 + 0.135 = 0.195 = 19.5%
F Ltd. 2.5 Ke = 0.06 + 2.5 X 0.09 = 0.06 + 0.225 = 0.285 = 28.5%
G Ltd. 0 Ke = 0.06 + 0 X 0.09 = 0.06 = 6%

Q.22.
If the cost of equity capital is 17%, risk free rate being 7% and return on market portfolio is 12%, what will
be the beta factor of the firm?
Solution :-

Ke = 17% = 0.17
Rf = 7% = 0.07
Rm = 12% = 0.12
Ke = Rf + β(Rm – Rf)
0.17 = 0.07 + β (0.12 – 0.07)
0.17 - 0.07 = β X 0.05
0.1 = β X 0.05
β=2

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V. Cost of Retained Earnings

Like any other source of fund, retained earnings involve cost (implicit cost). It is the opportunity cost of
dividends foregone by shareholders. If it is assumed that the retained earnings are reinvested in the firm itself,
retained earnings may be treated at par with the equity share capital. In other words the cost of retained
earnings is equal to cost of equity.
Kr = Ke
However, while calculating cost of retained earnings, two adjustments should be made if the relevant
details are available :-

a) Income tax adjustment as the shareholders are to pay some income tax out of dividends, and
b) Adjustment for brokerage cost as the shareholders would incur some brokerage cost while
investing dividend income.

Therefore,
Kr = Ke (1 – t) (1 – b)

Where, Kr = Cost of Retained Earnings

Ke = Cost of Equity
t = Rate of Tax For Shareholders
b = Cost of Purchasing New Securities or Brokerage Cost

Q.23.
T Ltd. retains ₹ 7,50,000 out of its current earnings. The expected rate of return to the shareholders, if they
had invested the fund elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax
bracket. Calculate the cost of retained earnings.
Solution :-
Ke = 10% = 0.1
t = 30% = 0.3
b = 3% = 0.03

Kr = Ke (1 – t) (1 – b)
Kr = 0.1 (1 – 0.3) (1 – 0.03)
Kr = 0.1 X 0.7 X 0.97
Kr = 0.0679
Kr = 6.79%

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VI. Weighted Average Cost of Capital (WACC)

We have studied how to compute the cost of individual components of capital for a company. The composite or
overall cost of capital of a firm is the weighted average of the costs of various components or sources of funds.
The cost of specific source of fund is multiplied by its proportion in capital structure to find out its
weighted cost. The weighted cost of all sources is added up to find out the overall weighted average cost
of capital (WACC).

Book Value and Market Value Weights :- Book Value Weights use accounting values to measure the
proportion of each type of capital in the firm’s financial structure. Book Value Weights are based on values
as per balance sheet. Market Value Weights are based on the current market price. Market value weights
measure the proportion of each type of capital at its market value.

Q.24.
The following details are provided by GPS Ltd.
Equity Share Capital ₹ 65,00,000
12% Preference Share Capital ₹ 12,00,000
15% Redeemable Debentures ₹ 20,00,000
10% Convertible Debentures ₹ 8,00,000
The cost equity capital for the company is 16.30% and Income Tax rate for the company is 30%. You are
required to calculate the Weighted Average Cost of Capital of the company.
Solution :-
Ke = 16.30% = 0.163
Kp = 12% = 0.12
Kd (Redeemable Debentures) = I (1-t) = 0.15(1 – 0.3) = 0.15 X 0.7 = 0.105
Kd (Convertible Debentures) = I (1-t) = 0.10(1 – 0.3) = 0.10 X 0.7 = 0.07

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount Weight Cost of Capital WACC
(₹) (1) (2) (1 X 2)
Equity Share Capital 65,00,000 61.91 0.163 10.09
12% Preference Share Capital 12,00,000 11.43 0.12 1.37
15% Redeemable Debentures 20,00,000 19.04 0.105 2.00
10% Convertible Debentures 8,00,000 7.62 0.07 0.53
1,05,00,000 100 13.99
Weighted Average Cost of Capital = 13.99%

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Q.25.
SK Ltd. has obtained funds from the following sources, the specific costs are also given against them :-

Source of Funds Amount in ₹ Cost of Capital

Equity Shares 30,00,000 15%
Preference Shares 8,00,000 8%
Retained Earnings 12,00,000 11%
Debentures 10,00,000 9% (Before Tax)
You are required to calculate weighted average cost of capital, assume tax rate as 30%.
Solution :-
Ke = 15% = 0.15
Kp = 8% = 0.08
Kr = 11% = 0.11
Kd = I (1-t) = 0.09(1 – 0.3) = 0.09 X 0.7 = 0.063

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount Weight Cost of Capital WACC
(₹) (1) (2) (1 X 2)
Equity Share Capital 30,00,000 50 0.15 7.5
Preference Share Capital 8,00,000 13.33 0.08 1.07
Retained Earnings 12,00,000 20 0.11 2.2
Debentures 10,00,000 16.67 0.063 1.05
60,00,000 100 11.82
Weighted Average Cost of Capital = 11.82%

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Q.26.
The following information relates to the sources of long term finance used by Pioneer Industries Ltd.:-
Source Book Value (₹ in Lakhs) Market Value (₹ in Lakhs)
Paid U Equity Share Capital 300 800
Reserves and Surplus 400 -
Preference Shares 125 145
Debentures 250 245
Cost of Equity Share Capital – 20%
Cost of Preference Share Capital – 15%
Post Tax Cost of Debenture Capital – 8%
Calculate the difference between the weighted average cost of capital using book value weights and
market value weights.
Solution :-
Ke = 20% = 0.20
Kr = Ke = 20% = 0.20
Kp = 15% = 0.15
Kd = 8% = 0.08

Calculation of Weighted Average Cost of Capital (WACC) (Book Value Weights)

Source Amount Weight Cost of Capital WACC
(₹ in Lakhs) (1) (2) (1 X 2)
Equity Share Capital 300 27.90 0.20 5.58
Retained Earnings 400 37.21 0.20 7.44
Preference Share Capital 125 11.63 0.15 1.74
Debentures 250 23.26 0.08 1.86
1075 100 16.62
Weighted Average Cost of Capital (Book Value Weights) = 16.62%

Calculation of Weighted Average Cost of Capital (WACC) (Market Value Weights)

Source Amount Weight Cost of Capital WACC
(₹ in Lakhs) (1) (2) (1 X 2)
Equity Share Capital 800 67.23 0.20 13.45
Preference Share Capital 145 12.18 0.15 1.83
Debentures 245 20.59 0.08 1.65
1190 100 16.93
Weighted Average Cost of Capital (Market Value Weights) = 16.93%
Difference Between WACC (Book Value Weights) and WACC (Market Value Weights) = 16.62 – 16.93
= -0.31%

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Q.27.
The following is the capital structure of Simons Company Ltd. as on 31.03.2014 :-
Equity Shares : 10,000 shares of ₹ 100 each ₹ 10,00,000
10% Preference Shares of ₹ 100 each ₹ 4,00,000
12% Debentures ₹ 6,00,000
The market price of the company’s shares is ₹ 110 and it is expected that s dividend of ₹ 10 per share
would be declared for the next year. The dividend growth rate is 6%.
i) If the company is in the 50% tax brackets, compute the WACC.
ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of ₹
10 Lakhs bearing 14% rate of interest, what will be the company’s revised WACC. This financing
decision is expected to increase dividend from ₹ 10 to ₹ 12 per share. However, the market price
of equity share is expected to decline from ₹ 110 to ₹ 105 per share.

Solution :-

i) Ke = D1 X 100 + G = 10 X 100 + 6% = 9.09% + 6% = 15.09% = 0.1509

P0 110
Kp = 10% = 0.1
Kd = I (1-t) = 0.12 (1-0.50) = 0.12 X 0.50 = 0.06
Calculation of Weighted Average Cost of Capital (WACC)
Source Amount Weight Cost of Capital WACC
(₹) (1) (2) (1 X 2)
Equity Share Capital 10,00,000 50 0.1509 7.55
10% Preference Share Capital 4,00,000 20 0.1 2
12% Debentures 6,00,000 30 0.06 1.8
20,00,000 100 11.35
Weighted Average Cost of Capital = 11.35%

ii) Ke = D1 X 100 + G = 12 X 100 + 6% = 11.43% + 6% = 17.43% = 0.1743

P0 105

Kp = 10% = 0.1
Kd (Old) = I (1-t) = 0.12 (1-0.50) = 0.12 X 0.50 = 0.06
Kd (New) = I (1-t) = 0.14 (1-0.50) = 0.14 X 0.50 = 0.07
Calculation of Weighted Average Cost of Capital (WACC)

Source Amount Weight Cost of Capital WACC

(₹) (1) (2) (1 X 2)
Equity Share Capital 10,00,000 33.33 0.1743 5.81
10% Preference Share Capital 4,00,000 13.34 0.1 1.334
12% Debentures 6,00,000 20 0.06 1.2
14% Borrowed Funds (New) 10,00,000 33.33 0.07 2.33
30,00,000 100 10.67
Weighted Average Cost of Capital = 10.67%

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Q.28.
JKL Ltd. has the following book value capital structure as on March 31,2014.
Equity Share Capital (2,00,000 Shares) ₹ 40,00,000
11.5% Preference Shares ₹ 10,00,000
10% Debentures ₹ 30,00,000
₹ 80,00,000
The equity share of the company sells for ₹ 20. It is expected that the company will pay next year a
dividend of ₹ 2 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35% corporate tax
rate.
Required :-
i. Compute WACC of the company based on the existing capital structure.
ii. Compute the new WACC, if the company raises an additional ₹ 20 Lakhs debt by issuing 12%
Debentures. This would result in increasing the expected equity dividend to ₹ 2.40 and leave the
growth rate unchanged, but the equity share will fall to ₹ 16 per share.

Solution :-

i) Ke = D1 X 100 + G = 2 X 100 + 5% = 10% + 5% = 15% = 0.15

P0 20
Kp = 11.5% = 0.115
Kd = I (1-t) = 0.1 (1-0.35) = 0.1 X 0.65 = 0.065

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount Weight Cost of Capital WACC
(₹) (1) (2) (1 X 2)
Equity Share Capital 40,00,000 50 0.15 7.5
11.5% Preference Shares 10,00,000 12.5 0.115 1.4375
10% Debentures 30,00,000 37.5 0.065 2.4375
80,00,000 100 11.375
Weighted Average Cost of Capital = 11.375%

ii) Ke = D1 X 100 + G = 2.4 X 100 + 5% = 15% + 5% = 20% = 0.20

P0 16
Kp = 11.5% = 0.115
Kd (Old) = I (1-t) = 0.1 (1-0.35) = 0.1 X 0.65 = 0.065
Kd (New) = I (1-t) = 0.12 (1-0.35) = 0.12 X 0.65 = 0.078

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount Weight Cost of Capital WACC
(₹) (1) (2) (1 X 2)
Equity Share Capital 40,00,000 40 0.20 8
11.5% Preference Shares 10,00,000 10 0.115 1.15
10% Debentures 12% 30,00,000 30 0.065 1.95
Debentures 20,00,000 20 0.078 1.56
1,00,00,000 100 12.66
Weighted Average Cost of Capital = 12.66%

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Q.29.
AB Ltd. estimates the cost of equity and debt components of its capital for different levels of Debt-Equity
mix as follows :-

Debt as % of Total Capital Cost of Equity Cost of Debt (Before Tax)

0% 16% 12%
20% 16% 12%
40% 20% 16%
60% 22% 20%
Suggest the best Debt-Equity mix for the company. Tax rate applicable to the company is 50%.
Solution :-

Debt as % of Equity as % of Cost of Cost of Debt Cost of Debt (After Tax)

Total Capital Total Capital Equity (Before Tax) I (1-t) = I (1-0.50) = I X 0.5
0% 100% 16% 12% 12% X 0.5 = 6%
20% 80% 16% 12% 12% X 0.5 = 6%
40% 60% 20% 16% 16% X 0.5 = 8%
60% 40% 22% 20% 20% X 0.5 = 10%

Equity Debt Ke Kd Equity Weights Debt Weights X WACC

Weights Weights X Ke Kd
(3) (4) (5 = 1 X 3) (6 = 2 X 4) (7 = 5 + 6)
(1) (2)
0.16 0.06 16 0 16%
100 0
0.16 0.06 12.8 1.2 14%
80 20
0.20 0.08 12 3.2 15.2%
60 40
0.22 0.10 8.8 6 14.8%
40 60
WACC is least at Debt of 20% and Equity of 80%, hence the company should choose this capital structure.

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Q.30.
From the following data determine the amount of debt that the company should employ in its total capital
of ₹ 10,00,000 to maximise the value of the firm :-
Debts (₹) Interest Rate Cost of Equity Capital
Nil - 12%
1,00,000 10% 12%
2,00,000 11% 13%
3,00,000 12% 14%
4,00,000 12.5% 14.5%
5,00,000 13% 15%
6,00,000 14% 20%
The company is in tax brackets of 40%.
Solution :-

Debt as % of Equity as % of Cost of Cost of Debt Cost of Debt (After Tax)

Total Capital Total Capital Equity (Before Tax) I (1-t) = I (1-0.40) = I X 0.6
0% 100% 12% - -
10% 90% 12% 10% 10% X 0.6 = 6%
20% 80% 13% 11% 11% X 0.6 = 6.6%
30% 70% 14% 12% 12% X 0.6 = 7.2%
40% 60% 14.5% 12.5% 12.5% X 0.6 = 7.5%
50% 50% 15% 13% 13% X 0.6 = 7.8%
60% 40% 20% 14% 14% X 0.6 = 8.4%

Equity Debt Ke Kd Equity Weights Debt Weights X WACC

Weights Weights X Ke Kd
(3) (4) (5 = 1 X 3) (6 = 2 X 4) (7 = 5 + 6)
(1) (2)
0.12 - 12 - 12%
100 -
0.12 0.06 10.8 0.6 11.4%
90 10
0.13 0.066 10.4 1.32 11.72%
80 20
0.14 0.072 9.8 2.16 11.96%
70 30
0.145 0.075 8.7 3 11.7%
60 40
0.15 0.078 7.5 3.9 11.4%
50 50
0.20 0.084 8 5.04 13.04%
40 60
WACC is least at Debt of ₹ 1,00,000 and Equity of ₹ 9,00,000 and at Debt of ₹ 5,00,000 and Equity of ₹
5,00,000, hence the company should choose any of these to capital structures.

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VII. Marginal Cost of Capital

Marginal cost of capital is the cost of raising an additional rupee of capital. It is the cost of raising new
funds.
Marginal cost of capital is the weighted average cost of additional capital calculated using marginal
weights. The marginal weights represent the proportion of funds the firm intends to employ.
The revised WACC computed for the new capital structure is normally treated as the Marginal Cost.

VIII. Practice Questions

Q.31.
Vikram Ltd. issued ₹ 3,00,000, 8% Debentures of ₹ 100 each at a premium of 10%. The flotation costs (issue
expenses) are 2% on the net proceeds. The tax rate is 50%. You are required to ascertain cost of debt after
tax. [Ans. Kd = 3.71%]

Q.32.
KKL Ltd. issued 10% Debentures (₹ 100 each) of ₹ 5,00,000 and realized ₹ 4,85,000 after allowing 3%
commission to brokers. The debentures are due for maturity at the end of the 10th year. You are required to
calculate the effective cost of debt before tax. [Ans. Kd = 10.46%]

Q.33.
Y Ltd. issued 6,000, 8% Debentures of ₹ 100 each at premium of 10%. The maturity period is 6 years and
the tax rate is 50%. Compute the cost of debt of the company if the debentures are redeemable at par.
[Ans. Kd = 2.22%]

Q.34.
RK Ltd. issued ₹ 20,00,000, 11% redeemable debentures of ₹ 100 each at a discount of 10%. The issue
expenses are 4% of face value and the debentures are redeemable after 5 years. You are required to
ascertain cost of debt before tax assuming a ax rate of 40%. [Ans. Kd = 10.11%]

Q.35.
Srinivas Ltd. issued 10,000, 10% Debentures at ₹ 100 each. The debentures are redeemable after 10 years at
a premium of 5%. If the tax rate is 50%, calculate the cost of debt after tax. [Ans. Kd = 15.37%]

Q.36.
A company issues ₹ 10,00,000, 13% Debentures of ₹ 100 each at a discount of 5%. The debentures are
redeemable after 5 years at a premium of 5%. Calculate after tax cost of debt, if the tax rate is 50%.
[Ans. Kd = 8.50%]

Q.37.
Sumo Ltd. has issued 6,000, 8% Preference shares of ₹ 100 each. The flotation costs are ₹ 10,000. Compute
the cost of Preference share capital if the shares are issued a) at par, b) at a premium of 10% and c) at a
discount of 10%. [Ans. a) Kp = 8.14% b) Kp = 7.38% c) Kp = 9.06%]

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Q.38.
JJ Ltd. issued 7,500, 8% Preference Shares of ₹ 100 each at a premium of 10%. The shares are redeemable at
par after 7½ years. The flotation costs are 5% of the net proceeds. Compute the effective cost of redeemable
preference capital. [Ans. Kp = 7.24%]

Q.39.
Bhagat Ltd. has issued 4,400, 10% Preference Shares of ₹ 100 each at a discount of 10%. The shares are
redeemable after 8 years and the issue expenses are 4% of the face value of shares issued. Ascertain the
effective cost of Preference share Capital. [Ans. Kp = 12.63%]

Q.40.
Jaya Ltd. issued 9,000, 9% Preference shares of ₹ 100 at a discount of 5%. The shares are redeemable at par
after 9 years. The flotation cost is 2% of the face value of shares issued. Find out the effective cost of
Preference Capital. [Ans. Kp = 10.13%]

Q.41.
ARR Ltd. issued 5,00,000 Equity Shares of ₹ 10 each at a premium of 10%. The company has been paying a
dividend of 27% regularly for the past 5 years. It is expected to maintain the dividend in future also. You
are required to calculate :- a) the cost of equity capital, b) the cost of equity capital if the market price of the
share is ₹ 50. [Ans. a) Ke = 24.55% b) Ke = 5.4%]

Q.42.
A company issues Equity Shares of ₹ 10 each for public subscription at a premium of 20%. The company
pays @ 5% as underwriting commission on issue price. Expected rate of dividend by Equity Shareholders
is 25%. You are required to compute the cost of Equity capital. Will your answer be different if it is
calculated on the basis of present market value of Equity share of ₹ 16. [Ans. Ke = 21.93% Ke = 15.63%]

Q.43.
Your company’s share of ₹ 10 each is quoted in the market at ₹ 20 currently. The company pays a dividend
of ₹ 1 per share and the investor expects a growth rate of 5% per year. Compute :-
a) The company’s cost of Equity Capital.
b) If the anticipated growth rate is 6% p.a., calculate the indicated market price per share.
c) If the company’s cost of capital is 8% and the anticipated growth rate is 5% p.a., calculate the
indicated market price if the dividend of ₹ 1 per share is to be maintained.
[Ans. a) Ke = 10%, b) MP = ₹ 25, c) MP = ₹ 33.33]

Q.44.
The current market price of a share is ₹ 100. The firm needs ₹ 1,00,000 for expansion and the new shares
can be sold only at ₹ 95. The expected dividend at the end of current year is ₹ 4.75 with a growth rate of
6%. Calculate the cost of existing equity and new equity. [Ans. Ke = 10.75%, Ke = 11%]

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Q.45.
The following data relates to Harris Ltd.
Risk Free Interest rate in the Market = 10%
The firm’s Beta Co-efficient = 1.50
Determine the firm’s cost of equity capital using the capital asset pricing model assuming an expected
return on the market of 14% for next year.
What would be the Ke, if the firm’s Beta a) rises to 2 and b) falls to 1.
[Ans. Ke = 16%, a) Ke = 18%, b) Ke = 14%]

Q.46.
A company’s cost of equity capital is 12%. The brokerage cost for purchase of securities is 2%. The
personal tax rate of shareholders is 50%. Compute the cost of retained earnings. [Ans. Kr = 5.88%]

Q.47.
Rivers and Oceans Ltd. has the following capital structure :-
Equity Shares ₹ 145 Lakhs
8% Preference Shares ₹ 75 Lakhs
11% Debentures ₹ 80 Lakhs
The market price of the company’s equity shares is ₹ 44. It is expected that the company would next year
pay a dividend of ₹ 8.80 per share on the face value of ₹ 10. The company’s growth prospects are 7% per
annum. Assuming corporate taxation @ 30% you are required to compute weighted average cost of capital
based on the existing capital structure. [Ans. WACC = 17.10%]

Q.48.
Raja and Rani Ltd. has the following capital structure
Equity Shares ₹ 85 Lakhs
8% Preference Shares ₹ 50 Lakhs
11% Debentures ₹ 75 Lakhs
The market price of the company’s share is ₹ 84. It is expected that the company would next year pay a
dividend of ₹ 8.40 per share on the face value of ₹ 10. The company’s growth prospects are 6% per annum.
Assuming corporate taxation @ 35% you are required to compute weighted average cost of capital based
on the existing capital structure. [Ans. WACC = 10.70%]

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Q.49.
The following is the capital structure of Maruti Ltd.
Source of Capital Book Value (₹) Market Value (₹)
Equity Shares @ ₹ 100 each 80,00,000 1,60,00,000
9% Cumulative Preference Shares @ ₹ 100 each 20,00,000 24,00,000
11% Debentures 60,00,000 66,00,000
Retained Earnings 40,00,000 -
Total 2,00,00,000 2,50,00,000
The current market price of the company’s equity share is ₹ 200. For the last year the company had paid
equity dividend at 25% and its dividend is likely to grow 5% every year. The corporate tax rate is 30% and
shareholders personal income tax rate is 20%.
You are required to calculate :-
a) Cost of capital for each source of capital.
b) Weighted average cost of capital on the basis of book value weights.
c) Weighted average cost of capital on the basis of market value weights.
[Ans. a) Ke = 18.125%, Kp = 9%, Kd = 7.7%, Kr = 14.5%, b) WACC = 13.36%, c) WACC = 14.50%]

Q.50.
The capital structure of Falcon Company Ltd. as on 31.12.2007 is as follows :-
Equity Share Capital : 10,000 Shares of ₹ 100 each ₹ 10,00,000
10% Preference Shares of ₹ 100 each ₹ 4,00,000
12% Debentures ₹ 6,00,000
The market price of the company’s share is ₹ 110 and it is expected that a dividend of ₹ 10 per share would
be declared after one year. The dividend growth rate is 6%.
i) If the company is in the 40% tax bracket, calculate weighted average cost of capital using book value
weights.
ii) The company needs to borrow a fund of ₹ 10 Lakhs for its expansion plan, the rate of interest is
14%, what will be the company’s revised weighted average cost of capital? This financing decision
is expected to increase dividend from ₹ 10 to ₹ 12 per share. However, the market price of equity
share is expected to decline from ₹ 110 to ₹ 105 per share.
[Ans. i) WACC = 11.705%, ii) WACC = 11.38%]

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