Question 3. You are computing the discount rate for a project in the furniture b

Question

Question 3. You are computing the discount rate for a project in the furniture business. Your firm is 100% equity financed and will remain that way. There are three publicly traded firms that are in the furniture business and are not involved in any other lines of business. However, only one of these three firms is 100% equity financed. You should only use the 100% equity-financed pure play for your calculations because the equity betas of the other two pure plays are higher than their respective asset betas due to the presence of debt. Is the statement in italics correct?

Explanation / Answer

A cpmpany requires money to run its business. It is available from two main sources. They are:

1. Proprietors fund

2. Borrowed fund

Owners fund is coming from actual owners of the company. It consists of equity share issued, retained earnings and profit and loss.

Borrowed fund is loan. It is taken from financial Institutes or public. Bond, debentures etc are included herre. It may be taken for more than a year or for a period les than one year. Normally company is required to pay interest at fixed periodic intervals on this loan amount. It is known as price paid for using the fund. Principal amount is returned at the end of the year.

One of the benefits of using borrowed fund is availability of this money at a lower cost. Here the concept of cost of capital is very vital. When a person invest money in the business, he has some expectations. He expects a minimum return from the investment. If this return is received, then he will continue investing this money in that source. Otherwise he will withdraw money and invest in some other sources where better return is possible.

It is very crucial for a company to know these expectations. On the basis of these information company has to decide the minimum rate of return company has to earn for its survival. It is known as cost of capital. It is the weighted average of expectations of different fund contributors. Company cannot accept a project for execution which will yield a return less than this cost of capital. In fact it has to earn something more to add some value to the concern.

Expectations of investor will depend upon the degree of associated risk. If risk is high then expectations of return should be high to cover up the risk. Debt capital is less risky than equity capital. It is due to understated reasons:

1. Debt fund holders are not owner of the company. So they does not get share of profit earned by the concern. They are getting interest. It is a money which is independent of the actual return made by the concern. It is payable even when company has suffered loss. Proprietors on the other hand are owner. They are getting share of profit known as dividend. It is payable only when adequate profit is earned and company has good liquidity position.

2. Interest rate is known at the time of issue of bond. So bond holders are certain of their return at the time of investing money. But dividend receivable on the share is totally uncertain. It is not payable if return is inadequate or company does not have adequate return.

3. Further a comany will enjoy the benefit of low tax burden on its profit if debt capital is used. Interest paid is deducted from profit to get taxable profit. But dividend is not so deducted. It is appropriation of profit. So the dividend amount is not an expenditure for making profit.

Company will calculate overall cost of capital on the basis of cost of capital of debt capital and equity capital. Here cost of debt capital is calculated after deducting tax benefit from interest paid. Hence effective amount paid to bond holder is reduced. Thus cost of debt capital is lowered further. Cost of equity is much higher due to higher degree of associated risk and non availability of tax benefit. Hence equity capital is more costly than debt capital.

A firm using debt capital for funding purpose can improve the earnings of equity capital. Suppose a company is earning 20% return on its total fund. It is using debt capital of 10% cost of capital and equity capital of 15% cost of capital. Interest rate on debt capital is 12%. So after paying 12% interest company will have 20-12=8% return on its hand. It will be added with the profit available to equity shareholder. Thus equity shareholders return will be 20% normal earnings plus 8% savings from the use of lower cost debt capital. It will increase the earning per share. This benefit will not be available to company not using debt capital. Hence the EPS of borrowed fund user will be much higher than the EPS of 100% equity based firm. Higher EPS will mean dividend will be high. It will create a positive impact on the market price of share. Hence market price of share of borrowed fund user will be more than the market price of 100% equity fund user. It is known as advantage of financial leverage.

Now consider the concept of equity beta. It is a constant which indicates degree of risk of the share. Mathematically risk is ascertained from the deviations of actual return from the expected return of stock. If actual return is very close to the expected return, this stock is less risky. This Risk has two comonents . They are (1) systematic and (2) unsysstematic in nature. Unsystematic risk is company specific. Causes of uncetainty in return lies within the concern. It can be removed if proper measures are taken. Systematic risk iis common to the economy. All firms of the economy have to suffer from these causes. Equity beta is an indicator of impact of systematic risk on the companys return. It is calculated by comparing return of equity share with the overall market portfolio return. Market portfolio consists of a bunch of well diversified equity share. Due to its comoposition unsystematic risk is almost nil on this portfdolio. Thus beta value indicates impat of systematic risk on the share.

This beta value is used to estimate expected return of equity. If beta value is high then company must pay higher premium return to cover the risk. Here premium return is the extra amount paid to equity owners above risk free return. Here risk free return is the dividend paiid on bond issued by the government. thus lower berta will mean low systematic risk. Hence lower cost of equity capital.

But remember use of debt capital does not guarantee that variability of return on equity will be less. Debt capital imposes a permanent burden on the company to pay the interest. It is payable even when profit is inadequate. In that case equity return will be seriously affected. Market price of equity share will drop considerably due to this uncertainty. A firm can reap the benefit of financial leverage only when it has consistent and adequate market demand of its product. In that case it can earn a good return which is much higher than the required cost of capital. It will help then the company to improve its beta value and lower the cost of equity.

Asset beta on the other hand is an indicator of the associated risk based on asset value of the concern. If two different financially structured firm has equal asset value then their asset beta will be almost same. However use of low cost fund can help the concern to add value to the firm. Here value adition will improve the asset value and hence the asset betaa.

Thus it can be concluded that equity beta of of debt capital using two concerns will be better provided they have consistency in generating a higher surplus on its total fund used. Otherwise impact will be opposite. Thus statement in italics is not always true.

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