PROJECT ON VALUATION OF SHARES

The cost of capital of a firm is the minimum rate of return expected by its investors. The capital used by a firm may be in the form of debt, preference capital, retained earnings and equity shares. The concept of cost of capital is very important in the financial management. A decision to invest in a particular project depends upon the cost of capital of the firm or the cut off rate which is the minimum rate of return expected by the investors. In case a firm is not able to achieve even the cut off rate, the market value of its shares will fall. In fact, cost of capital is the minimum rate of return expected by its investors which will maintain the market value of shares at its present level.

The cost of the capital of the firm or the minimum rate of return expected by its investors has a direct relation with the risk involved in a firm. Generally, higher the risk involved in a firm, higher is the cost of capital. Hampton. John J. defines cost of capital as “the rate of return the firm requires from the investment in order to increase the value of the firm in the market place. Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure Thus, we can say that cost of capital is that minimum rate of return which a firm, must and is expected to earn on its investments so as to maintain the market value of its shares.

1. Where the companies amalgamate or are similarly reconstructed, it may be necessary to arrive at the value of the shares held by the members of the company being absorbed or taken over. This may also be necessary to protect the rights of dissenting shareholders under the Companies Act, Where shares are held by the partners jointly in a company and dissolution of the firm takes place, it becomes necessary to value the shares for proper distribution of the partnership property among the partners. 3. Where a portion of the shares is to be given by a member of proprietary company to another member as the member cannot sell it in the open market, it becomes necessary to certify the fair price of these shares by an auditor or accountant.

4. When a loan is advanced on the security of shares, it becomes necessary to know the vale of shares on the basis of which loan has been advanced. 5. When preference shares or debentures are converted into equity shares, it becomes necessary to value the equity shares for ascertaining the number of equity shares required to be issued for debentures or preference shares which are to be converted. 6. When equity shareholders are to be compensated on the acquisition of their shares by the Government under a scheme of nationalization, then it becomes necessary to value the equity shares for reasonable compensation to be given to their holders.

Valuation of shares depends upon the purpose of valuation, the nature of business of the company concerned, demand and supply for shares, the government policy, past performance of the company, growth prospectus of the company, the management of the company, the economic climate, accumulated reserves of the company, prospects of bonus or right issue, dividend declared by the directors and many other related factors. The basic factor in the valuation of shares is the dividend yield that the investor expects to get as compared to normal rate prevailing in the market in the same industry. For small investors, rate of dividend declared by the directors plays an important role in the valuation of shares whereas investors holding bulk of shares would be able to affect the dividend rate, therefore for them total profits

Or earning capacity play an important part in the valuation of shares. Thus, for a bulk holders of shares net assts including goodwill or capitalized value on the basis of the expected profits may be basis of valuation.

COST OF PREFERENCE SHARE CAPITAL A fixed rate of dividend is payable on preference shares. Though dividend is payable at the discretion of the Board of Directors and there is no legal binding to pay dividend, yet it does not mean that preference capital is cost free. The cost of preference share capital is a function of dividend expected by its investors, i.e. its stated dividend. In case dividends are not paid to preference shareholders, it will affect the fund raising capital of the firm. Hence, dividends are usually paid regularly on preference shares except when there are no profits to pay dividends. The cost of preference capital which is perpetual can be calculated as:

Kp = D/p Where Kp = Cost of Preference Capital D = Annual Preference Dividend P = Preference Share Capital (proceeds) Further, if preference shares are issued Premium or Discount or when costs of floating are incurred to issue preference shares, the nominal or par value of preference share capital has to be adjusted to find out the net proceeds from the issue of preference shares. In such a case, the cost of preference capital can be computed as:- Kp = D/NP

It may be noted that as dividends are not allowed to be deducted in computation of tax, no adjustment is required for taxes. sometimes, Redeemable Preference Shares are issued which can be redeemed or cancelled on maturity date. The cost of redeemable preference share capital can be calculated as:- Kpr = D + MV-NP n _____________ ½ (MV + NP) Where: Kpr = Cost of Redeemable Preference Shares D = Annual Preference Dividend MV =Maturity Value of Preference Shares NP = Net Proceeds of Preference Shares

Illustration:- A company issues 10,000 10% Preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference share capital if these shares are issued (a) at par (b) at premium of 10% (c) at a discount of 5% Solution:- Cost of Preference Capital, Kp = D/NP (a)Kp = 1,00,000 * ,00,000 – 20,000 = 1,00,000 * 100 9,80,000 = 10.21% (b) Kp = 1,00,000 * ,00, ,000 – 20,000 = 1,00,000 *100 10,80,000 = 9.26%

(c) Kp = 1,00,000 * ,00,000 – 50,000 – 20,000 = 10.75%

The cost of equity is the ‘maximum rate of return that the company must earn on equity financed portion of its investments in order to leave unchanged the market price of its stock. The cost of equity capital is a function of the expected return by its investors. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every year. Moreover payment of dividend is not a legal binding. It may or may not be paid. But it does not mean that equity share capital is a cost free capital. Shareholders invest money in equity shares on the expectation of getting dividend and the company must earn this minimum rate so that the market price of the shares remains unchanged.

Whenever a company wants to raise additional funds by the issue of new equity shares, the expectations of the shareholders are evaluated. The cost of equity share capital can be computed in the following ways:- (a)Dividend Yield Method (b) Dividend Yield plus growth in dividend Method (c) Earning Yield Method (d) Realized Yield Method

According to this method, the cost of equity capital is the ‘discount rate that equates the present value of expected future dividends per share with the net proceeds (or current market price) of a share’. Symbolically Ke = D/NP OR D/MP WHERE, Ke = Cost of Equity Capital D = Expected dividend per share NP = Net proceeds per share MP = Market Price per share

The basic assumptions underlying this method are that the investors give prime importance to dividends and risk in the firm remains unchanged. The dividend price ratio method does not seem to consider the growth in dividend (i) It does not consider future earnings or retained earnings (ii) It does not take into account the capital gains This method of computing cost of equity capital is suitable when the company has stable earnings and stable dividend policy over a period time. Let us understand with an illustration given below:-

Illustration :- A company issues 1000 equity shares of Rs. 100 each at a premium of 10%. The company has been paying 20% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs ?? Solution :- Ke = D/NP = 20 * = 18.18% If the market price of a equity share is Rs. 160 Ke = D/MP = 20 * = 12.5%

When the dividend of the firms are expected to grow at a constant rate and the dividend-pay-out ratio is constant this method may be used to compute the cost of equity capital. According to this method the cost of equity capital is based on the dividends and the growth rate:- Ke = D1 + GP = D0(1+g) + G NP NP WHERE Ke = Cost of equity capital D1 = expected dividend per share at the end of the year NP = Net proceeds per share G = rate of growth in dividend D0 = Previous year’s dividend

Further, in case of existing equity share capital is to be calculated, the NP should be changed with MP (market price per share ) in the above equation. Ke = D1 + G MP This can be explained with the given illustration below:-

Illustration :- A company plans to issue 1000 new shares of Rs. 100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares. (b) If the current market price of an equity share is Rs. 150, calculate the cost of existing equity share capital. Solution :- Ke = D/NP = % = 15.53% (b) Ke = D + G MP = % 150 = 11.67%

According to this method, the cost of equity capital is the discount rate that equates the present value of expected future earnings per share with net proceeds (or, current market price of share) of a share. Symbolically Ke = Earnings per share Net Proceeds = EPS NP Where the cost of existing capital is to be calculated: Ke = Earnings per share Market Price per Share = EPS MPS

This method of computing cost of equity capital may be employed in the following cases:- (i)When the earnings per share are expected to remain constant. (ii) when the dividend pay-out-ratio is 100 per cent or when the retention ratio is zero, i.e. all the available profits are distributed as dividends. (iii) when a firm is expected to earn an amount on new equity shares capital, which is equal to the current rate of earnings. (iv) the market price of the share is influenced only by earnings per share. This can be explained with the help of following illustration:-

Illustration:- A firm is considering an expenditure of Rs. 60 lakhs for expanding its operations. The relevant information is as follows: Rs. No. of existing equity shares 10 lakhs Market value of existing shares 60 Net earnings 90 lakhs Compute the cost of existing equity share capital and of new equity capital assuming that new-shares will be issued at a price of Rs 52 per share and the costs of new issue will be Rs. 2 per share. Solution :- Cost of existing equity share capital: Ke = EPS MP EPS = 90,00,000 = Rs. 9 10,00,000 Ke = 9 * 100 = 15% 60

Cost of New Equity Capital: EPS = 90,00,000 = Rs. 9 10,00,000 Ke = 9 * 100 = 15% 60 Ke = EPS NP = 9 * 100 = 18% 52-2

One of the serious limitations of using dividend yield method or earnings yield method is the problem of estimating the expectations of the investors regarding future dividends and earnings. It is not possible to estimate future dividends and earning correctly ; both of these depends upon so many uncertain factors. To remove this drawback, realised yield method, which takes into account the actual average rate of return realised in the past, may be applied to compute the cost of equity share capital. To calculate the average rate of return realised, dividend received in the past along with the gain realised at the time of sale of shares should be considered. The cost of equity capital is said to be the realised rate of return by the shareholders. This method of computing cost of equity share capital is based upon the following assumptions:-

(i)The firm will remain in the same risk class over the period; (ii) the shareholders’ expectations are based upon the realised yield; (iii) the investors get the same rate of return as the realised yield even if they invest elsewhere: (iv) the marked price of shares does not change significantly.