ICFAI UNIVERSITY

DEHRADUN

Name: Gopal Krishan

IUD no. 0901202792

IBS no. 09BS0002792

Course Code: SLFI501

Course Title: Financial Management 1

Faculty Name: Sharon K Jose

Title of the project: Cost of capital computation and capital structure of Asian Paints Ltd

Date of Submission: 10th Sep 2009

Student’s Sign Faculty Sign

ContentsAsian Paints Capital Structure and Cost of Capital Computation...........................................................3

Aim of the project..............................................................................................................................3

Methods used:...................................................................................................................................3

Capital structure of Asian Paints:...........................................................................................................3

Capital Mix:........................................................................................................................................3

1. Debt-equity................................................................................................................................3

2. Debt:..........................................................................................................................................4

3. Reserves and Surplus.................................................................................................................4

Comparing the capital structure with the industry average..............................................................4

Calculating Cost of capital:....................................................................................................................4

Cost of equity....................................................................................................................................4

Cost of reserves and surplus:.............................................................................................................7

Cost of debt:......................................................................................................................................7

Weighted average cost of capital:.....................................................................................................7

References:............................................................................................................................................7

Asian Paints Capital Structure and Cost of Capital ComputationAim of the project: To study the capital structure of Asian Paints Ltd. with comparison with that of the industry and to calculate the cost of capital of the company.

Methods used:1. Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF) approach to find

out the cost of equity 2. Retention Growth Model to estimate the Growth for DCF3. Weighted Average Cost of Capital (WACC) for cost of capital 4. Ratio analysis to comment on the capital structure of the capital

Capital structure of Asian Paints: The choice of the long term financing mix is often called the capital structure decision. It is important for the company because of the two major reasons. First is that they usually involve long lived assets or liabilities. Second, they are not easily reversed and thus may commit the firm to a particular course of action for several years. Also the company has to maintain an ideal mix of the short term and long term finance to meet the long term as well as the short term requirements of money. If the money invested in the short term capital is lying idle that is a bad capital management decision by the company because the same time of those idle funds are invested in the long term finance they can earn more returns for the company.

When we look at the Balance Sheets of the company over the past 5 years, we see that there has been no capital issue by the company during the period and the amount of the unsecured loans has increased slightly in the year 2006. The amount of the secured loans has increased over the period and has also decreased.

Capital Mix:

1. Debt-equity: The debt-equity ratio is calculated to measure the extent to which debt

financing has been used in a business. It has an important implication from the view point of the creditors, owners and the firm itself. A high ratio shows large share of financing by the creditors of the firm, a low ratio implies a smaller claim. For a high ratio the creditor’s risk is high as owner’s funds are less in assets and they may behave irresponsibly. Moreover, a high ratio is also not good for the firm as the creditors will interfere in the activities of the business and more interest has to be paid. Currently the debt and equity ratio of the company is 0.0597 (Annexure 2) which is very small. Because the company is having very small amount of loan in its capital mix and almost all its capital has been raised through the equity issue.

One more thing to be noticed is that the company has issued 93989940 shares as

8.275.63

86.10

Capital Structure of Asian Paints Ltd

EquityDebtReserves and Surplus

bonus shares. So the company has actually used its high earnings to give bonus shares to the shareholders through its reserves and surplus.

2. Debt: The debt that has been raised by the company is all interest free as we can see in the schedules of the company’s financial statements (Annexure 3) that the loans are part of state government’s Sales Tax Deferment Schemes and the trade deposits are also interest free. Thus if we talk about the cost of debt it will be zero.

3. Reserves and Surplus: The general reserves of the company have been increasing

significantly over the past couple of years. This is because of the high profit earning ratios of the company. When we see the Annexure 4, which comprises all the financial ratios of the company, the operating profit ratio, the net operating profit ratio, the free reserves per share has been increasing very significantly. This talks about the strong financial position for the future prospects of the company. The reserves and surplus forms 86.10% of the total capital structure of the company.

Comparing the capital structure with the industry average

  Net Worth DebtDebt-Equity Ratio

Asian Paints 1094.47 65.29 0.059654

Kansai Nerolac 654.45 93.62 0.143051

ICI India 971.07 0 0

Berger Paints 425.13 78.06 0.183614

Shalimar Paints 39.09 60.4 1.545152

The average debt-equity ratio of the industry is 0.143 (taking the median of all the major players of the industry because the mean is deflected by the critical values, so to avoid that median is taken). The debt equity ratio of Asian Paints is very small as compared to that of the industry. Asian Paints can increase its loan and can start trading on equity which will help it to further increase the earning per share. As we can see that over the period of past 5 years the net profit margin and other profitability ratios are declining (Annexure 4)

Calculating Cost of capital:

Cost of equity: The cost of equity can be calculated by many methods. But in this case the Discounted Cash Flow method suits the most because there are a lot of shares issued as bonus shares. Actual issue made by the company in only 12.44 crores worth. Rest all are issued as bonus shares out of 95.92 crores of total share capital. (Annexure 6.1 & 6.2)

Assumptions made:

1. Dividend grows at a constant rate2. Dividend tax rate is 17% (founded by dividing the total dividend tax paid by the

company by the total amount of equity share capital) a. Tax amount taken from the profit and loss account of the company

3. Growth rate is found by using the retention ratio assuming that the growth of dividend will depend on the amount of income that they retain with them. Here the retention ratio is 47% (Annexure 4). Thus the growth rate will be 47% of the Return on Equity.Which will come to 47% of 33.1% (Annexure 4), that is 15.56%

4. We expect the payout rate, and thus the retention rate, to remain constant5. We expect the return on equity on new investment to remain constant6. The firm is not expected to issue new common stock, or, if it does, we expect this new

stock to be sold at a price equal to its book value7. Future projects are expected to have the same degree of risk as the firm’s existing

assets.8. There is no issue cost and even if there was any issue cost it has been written off

during the period as in the past 5 years balance sheets there is no accumulated issue cost.

In discounted Cash Flow Method we calculate the cost of equity as

r s=D 1

P0

+g

Where, r s is the cost of equity

Other inputs for the formula and their calculations:

D1 Is the expected dividend for the next year which is calculated by taking average of all the

dividends paid by the company over past 14 years and multiplying it with the expected growth factor that is 1.1556

P0 is the average market price of the equity at the beginning of the years over past 14 years.

g is the growth rate of the dividend

Formula Source: Corporate Finance, Chapter The cost of capital by Bringam

Here we have to add the dividend tax amount also to the cost of equity because in the profit and loss account of the company it is given that it has to pay dividend tax at the rate of 17%. Thus, the new formula will become

r s=D 1(1+ t)P0

+g

Where; t is the tax rate, here it is 17%

(Founded by dividing the total dividend tax paid by the company as per the profit and loss account of the company which is 28.53 crores by the total amount of the dividend declared which is 167.83 crores)

D1=¿ D0 (1+g)

Where D0 is the average dividend declared by the company over past 14 years. As per table 1.

Or, D1is 100.67 x 1.16 = 116.78%

P0=477.8 4

DateClose Price Year

Dividend %

3/31/1995 580 Mar 1995 65

3/29/1996 343 Mar 1996 65

3/31/1997 279.35 Mar 1997 75

3/31/1998 305.95 Mar 1998 75

3/31/1999 245 Mar 1999 80

3/31/2000 423.2 Mar 2000 100

3/30/2001 245.45 Mar 2001 70

3/28/2002 327.3 Mar 2002 90

3/31/2003 330 Mar 2003 110

3/31/2004 301.5 Mar 2004 85

3/31/2005 391.95 Mar 2005 95

3/31/2006 646.05 Mar 2006 125

3/30/2007 762.6 Mar 2007 130

3/31/2008 1199.9 Mar 2008 170

3/31/2009 786.35 Mar 2009 175

NSE Database Prowess DatabaseAverage 477.84 Average

100.6666667

Table 1

But we have to take into consideration the bonus shares also.

Thus (Annexure 6.1 & 6.2), we have to find out the ratio of the actual share issued and the bonus shares issued over the period by the company on the equity shares.

We observe that for the 99.28% of the total equity shares, the bonus shares to the actual shares issued is 6.68:1 and for the rest 0.72% of the total equity shares, which are being issued as consideration other than cash, the ratio is 1.4:1.

So we’ll calculate the cost of equity as:

((11.678 (1.17 )(7 .68)477.84 ) 99.28% + (11.678 (1.17 )(2 .4)

477.84 ) 0.72%) + 0.1556

=37.41% cost of equity

The cost of equity for the company is very high that is because of the high bonus shares issue rates of the company. They have actually raised only 12.44 crores through actual share selling, rest all has been issued as bonus shares.

Cost of reserves and surplus: The reserves and surplus belong to the shareholders. Therefore

the cost of equity is equal to the cost of reserves and surplus.

Cost of debt: The Company is having the debts raised through some sources and the ratio is very small. But as per the balance sheet and profit and loss account of the company the loans are all interest free and there is no interest cost to the debts as per the profit and loss account of the company also. Therefore, the cost of debt is 0.

Weighted average cost of capital:

The weighted average cost of capital can be computed by giving the weights to the different costs computed above. The weights given are according to the book values.

Thus:

8.27% of k e + 86.1% of K r + 5.63% of Kd

Where,

k e is the cost of equity

k r is the cost of reserves and surplus and

k d is the cost of debt (here it is zero because all the loans are interest free)

8.27% of 37.41% + 86.1% of 37.41%

Or 94.37% of 37.41

The cost of capital will be 35.30%

Assuming that there is no floatation cost for the equity shares.

References:1. www.moneycontrol.com 2. Prowess Database3. http://asianpaints.com 4. Financial Reports of Asian Paints ltd.5. Religare technova6. Corporate Finance, A Focused Approach by Bringham7. Financial Management by ICFAI University Press