Month: May 2020

Generally, cost of debt capital refers to the total cost or the rate of interest paid by an organization in raising debt capital. However, in a real situation, total interest paid for raising debt capital is not considered as cost of debt because the total interest is treated as an expense and deducted from tax.

This reduces the tax liability of an organization. Therefore, to calculate the cost of debt, the organization needs to make some adjustments. Let us understand the calculation of cost of debt with the help of an example.

Suppose an organization raised debt capital of Rs. 10000 and paid 10% interest on it. The organization is paying corporation tax at the rate of 50%. In this ca.se, the total 10% of interest rate would not be deducted from tax and the deduction would be 50% of 10%.

Therefore, the cost of debt would be only 5%. While calculating cost of debt capital, discount allowed, underwriting commission, and cost of advertisement are also considered. These expenses are added to the amount of interest paid, which is considered as total cost of debt capital.

For example, when an organization increases its proportion of debt capital more than the optimum level, then it increases its risk factor. Therefore, the investors feel insecure and their expectations of EPS start increasing, which is the hidden cost related to debt capital.

Formulae to calculate cost of debt are as follows

1. When the debt is issued at par

K_D = [(1-T)*R]*100

Where,

K_D = Cost of debt

T = Tax rate

R = Rate of interest on debt capital

K_D = Cost of debt capital

2. Debt issued at premium or discount when debt is irredeemable

K_D = [1/NP*(1-T)* 100]

Where,

NP = Net proceeds of debt

3. Cost of redeemable debt:

K_D = [{I (1-T) -H (P-NP/N) * (1- T)}/ (P -H NP/2)] * 100

Where,

N = Numbers of years of maturity

P = Redeemable value of debt

For example, an organization issued 10% debentures of the face value of Rs. 100 redeemable at par after 20 years.

Assuming 50% tax rate and 5% floatation cost, calculate cost of debt in the following conditions:

1. When debentures are issued at par
2. When debentures are issued at 10% discount
3. When debentures are issued at 10% premium

Solution

The solution is given as follows:

Cost of redeemable debt = [{I (1-T) + (P- NP/N) (1- T)}/ (P + NP/2)] * 100

1. When debentures are issued at par

K_D = [{10(1 – 0.50) + (100 – 95/20) (1 – 0.50)}/ (100 + 95/2)] *100

= 5.25%

2. When debentures are issued at 10% discount

K_D = [{10(1 – 0.50) + (100 – 85/20) (1 – 0.50)}/ (100 + 85/2)] *100

= 5.81%

3. When debenture is issued at 10% premium

K_D = [{10(1 – 0.50) + (100 – 110/20) (1 – 0.50)}/ (100 + 110/2)] *100

= 4.52%

Cost of Preference Share Capital: An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital.

Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt.

Formula for Cost of Preference Share:

Where,

K_p = Cost of Preference Share

D_p = Dividend on preference share

NP = Net proceeds from issue of preference share

(Issue price – Flotation cost)

RV = Redemption Value

N = Period of preference share

Example: A preference share issues at 12% worth Rs 60,000 at 5% discount and after 6 years it redeem at 10% premium. The flotation cost is 5% and tax rate is 20%. Find out the cost of preference share capital.

Solution:

Dividend on preference share (D_p) = 60,000*12/100 = Rs.7200

Discount = 60,000*5/100 = Rs.3000

Flotation Cost = 60,000*5/100 = Rs.3000

Net Proceeds (NP) = Rs. (60,000-3000-3000) = Rs. 54,000

Premium amount = 60,000*10/100 =Rs. 6000

Redemption Value = Rs. (60,000+6000) = Rs. 66,000

K_p = D_p+ ((RV-NP)/n)/ (RV+NP)/2

= 7200+ ((66,000-54,000)/6) / (66,000+54,000)/2

= 9200/60,000

= 15.33%

Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital being more expensive.

The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model (for companies that pay out dividends).

CAPM (Capital Asset Pricing Model)

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Where:

E(R_i) = Expected return on asset i

R_f = Risk-free rate of return

β_i = Beta of asset i

E(R_m) = Expected market return

Risk-Free Rate of Return

The return expected from a risk-free investment (if computing the expected return for a US company, the 10-year Treasury note could be used).

Beta

The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be found online or calculated by using regression: dividing the covariance of the asset and market’s returns by the variance of the market.

β_i < 1: Asset i is less volatile (relative to the market)

β_i = 1: Asset i’s volatility is the same rate as the market

β_i > 1: Asset i is more volatile (relative to the market)

Expected Market Return

This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time (five to ten years is an appropriate range) 

Dividend Capitalization Model

The Dividend Capitalization Model only applies to companies that pay dividends, and it also assumes that the dividends will grow at a constant rate. The model does not account for investment risk to the extent that CAPM does (since CAPM requires beta).

Dividend Capitalization Formula:

R_e = (D₁ / P₀) + g

Where:

R_e = Cost of Equity

D₁ = Dividends/share next year

P₀ = Current share price

g = Dividend growth rate

Dividends/Share Next Year

Companies usually announce dividends far in advance of the distribution. The information can be found in company filings (annual and quarterly reports or through press releases). If the information cannot be located, an assumption can be made (using historical information to dictate whether the next year’s dividend will be similar).

Current Share Price

The share price of a company can be found by searching the ticker or company name on the exchange that the stock is being traded on, or by simply using a credible search engine.

Dividend Growth Rate

The Dividend Growth Rate can be obtained by calculating the growth (each year) of the company’s past dividends and then taking the average of the values.

The growth rate for each year can be found by using the following equation:

Dividend Growth = (D_t/D_t-1) – 1

Where:

D_t = Dividend payment of year t

D_t-1 = Dividend payment of year t-1 (one year before year t)

The cost of retained earnings is the cost to a corporation of funds that it has generated internally. If the funds were not retained internally, they would be paid out to investors in the form of dividends. Therefore, the cost of retained earnings approximates the return that investors expect to earn on their equity investment in the company, which can be derived using the capital asset pricing model (CAPM). The CAPM combines the risk-free rate and a stock’s beta to arrive at the cost of equity capital.

Retained Earnings (RE) are the portion of a business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment back into the business. Normally, these funds are used for working capital and fixed asset purchases (capital expenditures) or allotted for paying off debt obligations.

The Purpose of Retained Earnings

Retained earnings represent a useful link between the income statement and the balance sheet, as they are recorded under shareholders’ equity, which connects the two statements. The purpose of retaining these earnings can be varied and includes buying new equipment and machines, spending on research and development, or other activities that could potentially generate growth for the company. This reinvestment into the company aims to achieve even more earnings in the future.

If a company does not believe it can earn a sufficient return on investment from those retained earnings (i.e., earn more than their cost of capital), then they will often distribute those earnings to shareholders as dividends or share buybacks.

Retained Earnings Formula

The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends

Where RE = Retained Earnings

Beginning of Period Retained Earnings

At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year’s income), minus dividends paid to shareholders. In the next accounting cycle, the RE ending balance from the previous accounting period will now become the retained earnings beginning balance.

The RE balance may not always be a positive number, as it may reflect that the current period’s net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of dividends that exceed the retained earnings balance can cause it to go negative.

How Net Income Impacts Retained Earnings

Any changes or movement with net income will directly impact the RE balance. Factors such as an increase or decrease in net income and incurrence of net loss will pave the way to either business profitability or deficit. The Retained Earnings account can be negative due to large, cumulative net losses.  Naturally, the same items that affect net income affect RE.

How Dividends Impact Retained Earnings

Distribution of dividends to shareholders can be in the form of cash or stock. Both forms can reduce the value of RE for the business. Cash dividends represent a cash outflow and are recorded as reductions in the cash account. These reduce the size of a company’s balance sheet and asset value as the company no longer owns part of its liquid assets. Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts. This allocation does not impact the overall size of the company’s balance sheet, but it does decrease the value of stocks per share.

End of Period Retained Earnings

At the end of the period, you can calculate your final Retained Earnings balance for the balance sheet by taking the beginning period, adding any net income or net loss, and subtracting any dividends.

Example Calculation

In this example, the amount of dividends paid by XYZ is unknown to us, so using the information from the Balance Sheet and the Income Statement, we can derive it remembering the formula Beginning RE – Ending RE + Net income (-loss) = Dividends

Leverage, as a business term, refers to debt or to borrowing funds to finance the purchase of inventory, equipment and other company assets. Business owners can use either debt or equity to finance or buy the company’s assets. Using debt, or leverage, increases the company’s risk of bankruptcy but, it also can increase the company’s profits and returns; specifically its return on equity. This is true because if debt financing is used rather than equity financing then the owner’s equity is not diluted by issuing more shares of stock.

Borrowing in order to expand or invest is called leverage because the goal is to amplify the loan into a greater value for the firm or investors.

With debt financing, regardless if whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. In addition, by making timely payments a company will establish a positive payment history and business credit rating.

Investors in a business prefer the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company’s default risk.

Significance of Leverage

Leverage refers to the use of fixed costs in an attempt to increase the profitability. Leverage affects the level and variability of the firm’s after tax earnings and hence, the firm’s overall risk and return. The study of leverage is significant due to the following reasons.

(i) Measurement of Operating Risk

Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since operating leverage depends on fixed operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.

(ii) Measurement of Financial Risk

Financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial cost, high fixed financial costs indicates higher degree of operating leverage and thus, high financial risk. High financial leverage is good when operating profit is rising and bad when it is falling.

(iii) Managing Risk

Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.

(iv) Designing Appropriate Capital Structure Mix

To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earning per share. One widely used means of examining the effect of leverage to analyze the relationship between EBIT and earning per share.

(v) Increase Profitability

Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It insures maximum utilization of capital and fixed assets in order to increase the profitability of a firm, It helps to know the reasons not having more profit by a company.

Disability Insurance, often called DI or disability income insurance, or income protection, is a form of insurance that insures the beneficiary’s earned income against the risk that a disability creates a barrier for a worker to complete the core functions of their work. For example, the worker may suffer from an inability to maintain composure in the case of psychological disorders or an injury, illness or condition that causes physical impairment or incapacity to work. It encompasses paid sick leave, short-term disability benefits (STD), and long-term disability benefits (LTD). Statistics show that in the US a disabling accident occurs, on average, once every second. In fact, nearly 18.5% of Americans are currently living with a disability, and 1 out of every 4 persons in the US workforce will suffer a disabling injury before retirement.

Factors to consider while selecting a disability insurance coverage:

• Coverage amount: Be diligent in assessing your needs and select the plan, keeping in mind your income level and age. Choose the sum assured such that you and your family could continue to maintain your current lifestyle even if a contingency arises.
• Determine the disabilities covered: While buying health insurance for disabled, there are a wide variety of options available in the market. Compare the degree of disability (total or partial) and types of disabilities covered across various products and choose the one with the widest coverage.
• Refund feature: Some products provide the functionality of refund of a part of your premium amount if no claim is made within the specified period.
• Read the policy wording: For the different degree of disability, different percentages of the sum insured is paid. In the case of partial disability, the percentage may differ depending on the policy wording. So, read the policy document carefully.

There are various government-sponsored health insurance policies for the disabled:

1. Nirmalya Health Insurance: It is a government-sponsored health insurance scheme for people with mental disabilities. This scheme provides coverage of Rs. 1 Lakh at a low premium rate with benefits including pre and post hospitalisation expenses and OPD treatment.
2. Swavalamban Health Insurance: It is a custom-tailored insurance scheme to suit the needs of those with disabilities. This plan requires the insured to pay a single premium in one go and avail the coverage at any time of treatment. This policy can be availed only for those disabled individuals with a family income of Rs. 3 Lakh and below. No pre-medical test is required. There is no exclusion of pre-existing conditions. It aims in providing affordable insurance to people with blindness, vision problem, disability related to hearing and mental disabilities.

Health insurance is an insurance that covers the whole or a part of the risk of a person incurring medical expenses, spreading the risk over numerous persons. By estimating the overall risk of [health risk] and health system expenses over the risk pool, an insurer can develop a routine finance structure, such as a monthly premium or payroll tax, to provide the money to pay for the health care benefits specified in the insurance agreement. The benefit is administered by a central organization such as a government agency, private business, or not-for-profit entity.

According to the Health Insurance Association of America, health insurance is defined as “coverage that provides for the payments of benefits as a result of sickness or injury. It includes insurance for losses from accident, medical expense, disability, or accidental death and dismemberment”

In India, provision of health care services varies state-wise. Public health services are prominent in most of the states, but due to inadequate resources and management, major population opts for private health services.

To improve the awareness and better health care facilities, Insurance Regulatory and Development Authority of India and The General Corporation of India runs health care campaigns for the whole population. IN 2018, for under privileged citizens, Prime Minister Narendra Modi announced the launch of a new health insurance called Modicare and the government claims that the new system will try to reach more than 500 million people.

In India, Health insurance is offered mainly in two Types:

• Indemnity Plan basically covers the hospitalization expenses and has subtypes like Individual Insurance, Family Floater Insurance, Senior Citizen Insurance, Maternity Insurance, Group Medical Insurance.
• Fixed Benefit Plan pays a fixed amount for pre-decided diseases like critical illness, cancer, heart disease, etc. It has also its sub types like Preventive Insurance, Critical illness, Personal Accident.

Depending on the type of insurance and the company providing health insurance, coverage includes pre-and post-hospitalisation charges, ambulance charges, day care charges, Health Checkups, etc.

It is pivotal to know about the exclusions which are not covered under insurance schemes:

• Treatment related to dental disease or surgeries
• All kind of STD’s and AIDS
• Non-Allopathic Treatment

Few of the companies do provide insurance against such diseases or conditions, but that depends on the type and the insured amount.

Some important aspects to be considered before choosing the health insurance in India are Claim Settlement ratio, Insurance limits and Caps, Coverage and network hospitals.

Benefits of having a Health insurance Policy

1. Cashless Treatment: If you are insured, you can get cashless treatments as your insurance company would work in collaboration with various hospital networks.
2. Pre and post hospitalization cost coverage: Insurance policy also covers pre and post hospitalization charges up to the period of 60 days, depending on the insurance plans purchased.
3. Transportation Charges: Insurance policy also covers the amount paid to ambulance towards the transportation of insured.
4. No Claim Bonus (NCB): This is the bonus element which is paid to the insured if the insured does not file a claim for any treatment in the previous year.
5. Medical Checkup: Insurance policy also provide options for health checkups. Free health checkup is also provided by some insurers based on your previous NCBs.
6. Room Rent: Insurance policy also covers room expenses depending on the premium being paid by the insured.  
7. Tax Benefit: Premium paid on Health insurance is tax deductible under section 80D of the Income Tax Act.

Selection the Right Insurance Policy

It’s difficult to select the best insurance policies as all insurance company provides a similar type of insurance plan. Hence some of the important points that any Person should look before purchasing any plans are:

1. Sum Assured
2. Minimum Entry Age and renewability clause
3. Room Rent Capping
4. Inclusion and Exclusion
5. No Claim Bonus
6. Other Benefits