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CHAPTER 5
COST OF CAPITAL IN COOPERATIVE SUGAR AND SPINNING MILLS
Introduction
The estimation of the cost of capital in cooperatives is an important
part of this study. The cost of capital is one of the most complex and
controversial topics in finance. This is true in the case of all forms of
enterprises including cooperatives. In the latter case the complexity is
compounded. Unfortunately little research has been done on this topic in
relation to the cooperative form of organization. In this 'chapter an attempt
is made to evolve a procedure for measuring the cost of capital in cooperatives
and to analyse the trend in the cost of capital in the selected cooperatives.
As a prelude, the concept and importance of cost of capital and its measure
ment in regular corporations are discussed.
Concept of Cost of Capital
The cost of capital represents the rate of return which the company
must pay to the suppliers of capital for the use of their funds. This would be
the minimum rate of return that a project must yield to keep the value
of the enterprise in tact. In brief, the cost of capital is simply the rate of
return the funds used should produce to justify their use within the firm in
the light of the wealth maximization objective.
Wilson, Ernest Walter, An Economic Analysis of Alternative Capital Financing Plan for Agricultural Cooperatives, Georgia : University of Georgia, 1974, p.52
1.
The cost of each component of capital like shares, debt, reserves
etc. is known as specific cost of capital. The over-all cost of capital is
the weighted average of specific costs of capital. This is thus "a summation
of all the cost associated with acquiring a firm's capital. The cost of capital
is simply the cost, expressed as a rate, of acquiring the total amount of
2 all funds employed in the capital structure."
Significance of the Cost of Capital
The cost of capital plays a crucial role in financial decision making.
Firstly, capital budgeting decision, which has a major impact on the firm,
requires an estimate of the cost of capital. Secondly, the cost of capital
is significant in designing the firm's capital structure. Capital structure
can affect both size and riskyness of the firm's earning stream, and hence
the value of the firm. A knowledge of the cost of capital and how it is
influenced by financial leverage is useful in making the capital structure
decision. Finally, the mesurement of the cost of capital is also important
in many other areas of decision making such as dividend decision, working
capital decision and so on.
Computation of the Cost of Capital
In order to compute the weighted average cost of capital, the firm
must determine the cost of each component in the capital structure. A
firm generally can finance its projects by utilizing various sources of funds.
Rasmussen A.E., Financial Management in Cooperative Enterprises, Saskatoon : Cooperative College of Canada, 1975, p.74-
179
2.
180
l\ usually raises funds through common stock, bonds, debentures, long and
short term borrowings and retained earnings. Each source of funds has its
cost. How the cost of each source of finance is calculated and hew the
weighted average cost of capital is arrived at are discussed below :
Cost of Common Stock : The cost of common stock is defined as
"the minimum rate of return that a company must earn on the equity-financed
portion of its investments in order to leave unchanged the market price 3
of the stock." According to this definition, the cost of equity is the discount
rate which equates its market value with the present value of the expected
benefits. This is given by the equation :
The cost of equity 'Ke' in the above definition is the rate which equates
the net amount of funds 'I' received by the firm at time V with the outflow
of funds C,, C2, C3 . . . Cn in period 't '. The anticipated future benefits
can be revealed either in dividends or in earnings. Accordingly there are
two approaches, namely, the dividend approach and earnings approach to
compute the cost of equity capital.
Van Home, 3ames C, Financial Management and Policy, New Delhi : Prentic Hall of India, 1983, p.213
3.
18 1
The cost of equity 'Ke' under dividend approach is given by
where
D - expected dividend
p = Market price of the share
g = Growth rate
This approach is based on the assumption that the market value of the share
is a function of expected dividends and that the dividends grow at constant
rate for ever.
According to earnings approach, the cost of equity can be measured
by earnings-price ratio. This is given by :
where E = Earnings per share
P = Market Price of the share
The assumption of this approach is that the future earnings will grow at
a constant rate and can be expressed as an average, and that the market
price of the share is decided by expected earning stream.
Cost of Retained Earnings
Retained earnings as a source of finance differ from other sources
like debt, preference share and ordinary share. A firm is not obliged, to
182
pay a return on retained earnings whereas it has to pay return on other
sources. Apparently retained earnings may appear to carry no cost since
they represent funds which have not been raised from outside. This is not
true. Although no interest is paid on these funds, they do have opportunity
cost. Had earnings not been retained, they would have been paid as dividends
to ordinary shareholders. When earnings are retained, shareholders are forced
to forego dividends. The dividend foregone by the shareholders therefore
implies an opportunity cost. There are two approaches for calculating the
cost of retained earnings. The first approach is based on what shareholders
are able to obtain on other investments. Under this, personal income tax
has to be considered since the investor can invest only that part of dividend
left with him after payment of personal income tax. Under the second
approach, called external yield criterion, the cost of retained earnings is
measured by what the firm is able to obtain on an external investment of
funds. The external-yield criterion is not affected by the personal income
tax. It is simply the return on the direct investment of the funds by the
firm. The external yield criterion represents an economically justifiable
opportunity cost that can be applied consistently. Moreover the problem
of determining the marginal tax rate of investors will not arise. A strong
case can therefore be made for the use of the cost of equity 'Ke' as the
cost of retained earnings. But then certain adjustments need to be made
in 'Ke' for arriving at a true cost of retained earnings. Firstly, retained
earnings do not involve any floatation costs and as such in operational terms,
the cost of retained earnings is likely to be less than the cost of equity.
183
Secondly, the personal income-tax has to be adjusted to arrive at the cost
of retained earnings. When earnings are paid out as dividends, shareholders
are liable to pay taxes depending upon the tax brackets in individual cases.
Thirdly, while investing the after-tax dividend, the investor has to incur
brokerage cost to acquire new shares. The brokerage fee he pays would
reduce the effective funds available for reinvestment. These adjustments
provide a framework for the measurement of the cost of retained earnings
which can be expressed in the form of an equation :
Di Kr = ( -p-^ + I ) (l-T) (1-B)
or simply
Kr = Ke (l-T) (1-B)
where
T = Shareholders' personal tax rate
B = Percentage Brokerage cost
Ke = Cost of equity
Cost of Preference Stock
The preference stock has the attributes of debt and common stock.
It carries fixed commitments like debt, and the preference shareholders
have prior claims over the common stock holders. The calculation of the
cost of preference stock is analogous to the computation of debt. The cost
of preference stock represents the rate of return that must be earned on
the preference stock - financed investments to keep the earnings available to
m
residual stockholders unchanged. This is obtained by dividing the dividend
stipulated per share by the current market price of the share. The equation is :
P
where D = Dividend per share
P M = Market price per share
Cost of Debt : The cost of debt capital is usually the easiest to
determine. Debt obligation normally has a stated interest rate, a repayment
plan and a stipulated due date. "The cost of debt is that discount rate which
equates the net proceeds of debt issues with present value of interest plus
principal payments." T n i s is explicit cost of debt. The effective cost
of debt is the tax-adjusted rate of interest. Therefore the before-tax cost
of debt should be adjusted for the tax effect. The formula is :
Kd = i (1-t)
Where
i = discount rate that equates the present value of the inflows
and outflows before taxes overtime
t = Corporate tax rate
Of the costs of various components of capital, the cost of debt is
the lowest because of the tax-deductibility of interest payments.
Van Home, dames C, Op.Cit., p.219
i
Weighted Average Cost of Capital : The term 'cost of capital1 as
stated earlier refers to the average cost of capital or overall cost of capital.
The calculation of overall cost of capital involves the following steps :
1. Assigning weights to specific costs
2. Multiplying the cost of each of the sources by the weight assigned
3. Dividing the total weighted costs by the total weights
The weight assigned to specific cost is the proportion of each source
of finance in the capital structure.
The overall cost of capital represented symbolically by 'ko' can be
expressed by the following equation :
ko = % D (kd) + % PS (kp) + % CS (Ke) + % RE (kr)
where
Kd --- Cost of debt
Kp = Cost of preference stock
Ke = Cost of common stock
Kr = Cost'of retained earnings
% D = Proportion of debt in the capital Structure
% PS = Proportion of preference stock in the capital structure
% CS = Proportion of common stock in the capital structure
% RE = Proportion of retained earnings in the capital structure
Khan M.Y. and 3ain P.K., Financial Management, New Delhi : Tata McGraw Hill Publishing Company, 1981, p.384
5.
185
186
So far our discussion has had its focus on methods and techniques
adopted in computing specific and overall cost of capital in the corporate
sector. Now we will see how the cost of capital can be calculated in co
operative organizations.
Cost of Capital in Cooperatives
The cost of capital in a cooperative is the cost over time of the overall
mix of debt and equity. A decision must be made on what particular
combination of capital funds the cooperatives will use with a view to
minimizing the long-term average cost of capital.
The cooperatives raise funds by issuing shares, borrowing loans and
retaining earnings. Generally they do not float debentures nor issue bonds.
They largely depend on borrowing from external financing agencies. The
proportion of share capital and retained earnings in many of the cooperatives
is the lowest. An attempt is made here to understand the difficulties involved
in computing the cost of capital and to evolve a procedure to calculate
the cost of capital in cooperatives.
Cost of Share Capital in Cooperatives : The procedure followed in
computing the cost of share capital in the corporte sector cannot be adopted
in calculating the cost of share capital of a cooperative organization for
obvious reasons. Firstly, shares in cooperatives are non-speculative. There
is no public market for cooperative shares, and they cannot be cashed in
above their par value. Regardless of the number of shares owned, the
18 7
owners of the shares get only one vote each at general body meetings.
Secondly,the rate of interest on share capital is limited to a maximum nominal
rate prescribed in the bye-laws. Hence the share cannot be considered as
a profitable form of investment. Thirdly, patronage refunds in a cooperative,
unlike the dividends in private enterprise, are not paid on the basis of the
shares held but on the basis of the amount of business that has been done
by the member-shareholders with the cooperatives. Fourthly, shares are
not transferable. Finally, payment of dividend is not compulsory. All these
factors make the value of share capital unchangeable and there is no market
value. Thus the question of equating the market value with the present
value of the expected benefits by a discount rate does not arise here.
Then, what is the specific cost of share capital in a cooperative ?
It is simply the average rate of dividend paid over a period of time. The
equation is :
where
d = Summation of dividend rate paid over a period
of time
n = Number of years in which dividend is paid
If a cooperative has not paid dividend in a particular year, the cost
of share capital in that year would be zero.
188
Cost of Retained Earnings in Cooperatives : The retained earnings
include mostly the statutory reserves as required by the Cooperative Societies
Act. The cost of retained earnings is calculated by adopting an opportunity
cost, that is, the average rate of dividend that has been paid to the share
holders. Here again, in the year where no dividend is paid, the cost of
retained earning will be zero.
Cost of Debt : As in the calculation of the cost of share capital,
a different method has to be adopted for calculation the cost of. debt in
cooperatives. The problem lies in finding out the exact discount factor
because cooperatives borrow from several sources, at different rates, at
different instalments and at different terms and conditions. The complication
that often arises is with regard of determining the actual rate of interest
on loans requiring monthly, quarterly or other instalments repayment times.
The actual annual rate of interest for such a loan depends upon the amount
of such instalment payments, the frequency of the instalment payments,
the number of instalment payments and other costs associated with the loan
such as closing or servicing costs. The actual annual rate of interest on
this type of loan is often camouflaged by the suppliers by charging interest
for the year on the principal balance outstanding at the beginning of the
year even though repayments on principal are made at regular intervals
during the year. , The closing or servicing costs are often ignored in arriving
at the cost of borrowed money and interest rates are quoted on time periods
related to the repayment schedule rather than on an annual basis.
189
Under such situations, a close estimate of the true annual and effective
rate of interest on such type of loan can be computed through the weighted
average cost of debt. The formula is :
where
Di = Sum of the products of amount borrowed and respective
interests
ED = Sum of the products of amount borrowed
The question of tax-deductibility of interest payments does not arise
here because the cooperatives under study did not pay income-tax during
the period under review. Hence, after-tax and before-tax cost of debt would
be the same.
Weighted Cost of Capital in Cooperatives : The formula used earlier
to calculate the weighted average cost can be followed to find out the average
cost of capital in cooperatives. But then, the crucial part of the exercise
is the decision regarding the appropriate weights. The key operational
questions are : What figures are included in the amount column ? Is it the
book value of each item appearing in the balance sheet on a particular date ?
Or, should it be the market value of the respective sources ? There is lack of
1L
190
unanimity on this choice among writers on financial management. Barges6
was found to have got biased results when he used market value based D/E
ratios. Robichek and others concluded that a book value measure of leverage
is superior to a market value basis in explaining empirically the effect of
8 9
leverage on the cost of equity capital. Dobrovolsky Archer and D\ Ambrosio,
Ben-Sahar preferred to use market value weights because these represent
the evaluation by the capital market of various kinds of funds employed
in the firm, and because these are consistent with using the market price
for computing the cost of each individual source of finance.
Both these methods have their own merits. It is argued that the
use of market value weights for calculation the cost of capital is more
appealing for two reasons : (i) market value of serurities closely approximate
the actual amount to be received from their sale ; and (ii) the cost of specific
sources of finance which constitute the capital structure of the firm are
calculated using prevailing market prices.
Barges A., The Effect of Capital Structure on Cost of Capital, Cnglewood Cliffs (New Jersy) : Prentice Hall Inc., 1963, p.101
Robichek A.A., Higgins R.L. and Kinsman M., "The Effect of Leverage on the Cost of Equity Capital of Electric Utility Firms", Journal of Finance, Vol. 28, No.2, May 1973, p.361
Dobrovolsky S.K., The Economics of Corporation Finance, New York : McGraw Hill, 1971, p.145
Archer S.H. and D'Ambrosio C.A., Business Finance, London : Collier Macmillan, 1972, pp.196-97
Ben-Sahar A., "The Capital Structure and the Cost of Capital", Journal, of Finance, Vol.23, No.*, September 1968, p.640-
Khan M.Y. and Jain P.K., Op.Cit., p.387
6.
7.
8.
9.
10.
11.
The merits of book values as noted by Barges are : (i) book value
measures of leverage are controllable by management in the interest of
the shareholders ; (ii) book value measures are the ones which are studied
12 by investors in actual practice. Further, book values are readily available
from the records of the firm and the analysis of capital structure in terms
of debt equity ratio is based on book value.
But this controversy and the debate over the values to be assigned
for calculating the cost of capital do not arise in cooperatives, for the simple
reason that the cooperative equities do not have market value. Cooperative
equities are not traded in share market. Hence book values of different
components are taken as the base for assigning weights in this study.
Trend in Cost of Capital in Selected Cooperatives
Based on the procedure described, the specific cost of each source
and the overall cost of capital have been computed.
The cost of specific source of finance reveals that debt is costlier
than the cost of share capital and retained earnings in both the sugar and
spinning mills. The cost of debt varies from 10 to 12 percent in 70 percent
of the sugar mills and in around 60 percent of cooperative spinning mills.
The average specific cost of debt for both the industries is more' or less
the same. The cost of share capital works out to zero in 60 percent of
the sugar and spinning mills. The industry average in the two categories
does not show much variation (See Tables 5.1 and 5.2) Thus the specific
cost of capital depicts a similarity in both the industries.
Barges A., Op.Cit., p.37 12.
191
192
Table 5.1
Specific Cost of Capital in Cooperative Sugar Mills
(In Percentage)
M;
193
Table 5.2
Specific cost of Capital in Cooperative Spinning Mills
(In Percentage)
m
The weighted cost of capital which was on the higher side in the
initial period declined over a period of time in cooperative sugar mills (See
Table 5.3) This was because of repayment of debt in instalments over a
period of time.
A similar behaviour was also observed in the case of cooperative
spinning mills. (See Table 5.k) But the movement of overall cost of capital
from higher brackets to lower brackets was a little faster in cooperative
sugar mills than in cooperative spinning mills. This may be due to the
inability of the cooperative spinning mills to bring down the proportion of
debt in their capital structure at a quicker pace. As debt is costlier in
the selected cooperatives, a higher proportion of debt in the capital structure
would result in higher weighted average cost of capital.
Further the cost of capital which was on the higher side at the time
of commencement of production on account of high gearing, declined over
a period of time in both the categories, thanks to reduction in debt arising
out of repayment in instalments. Likewise, at the time of expansion of
the capacity, gearing becomes high again and accordingly the cost of capital
• goes up. Subsequently, as and when debt was repaid in instalments, the
cost of capital tended to decline. (See Table 5.5 and 5.6)
Conclusion
The cost of debt is the highest and that of equity and reserves is
the lowest in cooperatives. The behaviour of the weighted average cost
195
Table 53
Cost of Capi ta l in Cooperative Sugar Mills
196
Table 5A
Cost of Capital in Cooperative Spinning Mills
M ^
197
Table 5.5
Cost of Capital in Cooperative Sugar Mills at the time of Commencement of Production, Expansion and Afterwards
198
Table 5.6
Cost of Capital in Cooperative Spinning Mills at the time oh Commencement of Production, Expansion and Afterwards
199
of capital is influenced by the proportion of debt in the capital structure.
There might be some linear relationship between the proportion of debt
in the capital structure and the overall cost of capital. This is tested in
the next chapter.
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