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

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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.