CASE : 4

IIBMS – COMPUTATION OF COST OF CAPITAL OF PALCO LTD

IIBMS – COMPUTATION OF COST OF CAPITAL OF PALCO LTD

In October 2003, Neha Kapoor, a recent MBA graduate and newly appointed assistant to the Financial Controller of Palco Ltd, was given a list of six new investment projects proposed for the following year.  It was her job to analyse these projects and to present her findings before the Board of Directors at its annual meeting to be held in 10 days.  The new project would require an investment of Rs. 2.4 crore.

       Palco Ltd was founded in 1965 by Late Shri A. V. Sinha. It gained recognition as a leading producer of high quality aluminum, with the majority of its sales being made to Japan.  During the rapid economic expansion of Japan in the 1970s, demand for aluminum boomed, and palco’s sales grew rapidly.  As a result of this rapid growth and recognition of new opportunities in the energy market, Palco began to diversify its products line.  While retaining its emphasis on aluminum production, it expanded operations to include uranium mining and the production of electric generators, and finally, it went into all phases of energy production.  By 2003, Palco’s sales had reached Rs. 14 crore level, with net profit after taxes attaining a record of Rs. 67 lakh.

As Palco expanded its products line in the early 1990s, it also formalized its caital budgeting procedure.  Until 1992, capital investment projects were selected primarily on the basis of the average return on investment calculations, with individual departments submitting these calculations for projects falling within their division.  In 1996, this procedure was replaced by one using present value as the decision making criterion. This change was made to incorporate cash flows rather than accounting profits into the decision making analysis, in addition to adjusting these flows for the time value of money.  At the time, the cost of capital for Palco was determined to be 12 per cent, which has been used as the discount rate for the past 5 years.  This rate was determined by taking a weighted average cost Palco had incurred in raising funds from the capital market over the previous 10 years.

It had originally been Neha’s assignment to update this rate over the most recent 10-year period and determine the net present value of all the proposed investment opportunities using this newly calculated figure.  However, she objected to this procedure, stating that while this calculation gave a good estimate of “the past cost” of capital, changing interest rates and stock prices made this calculation of little value in the present.  Neha suggested that current cost of raising funds in the capital market be weighted by their percentage mark-up of the capital structure.  This proposal was received enthusiastically by the Financial Controller of the Palco, and Neha was given the assignment of recalculating Palco’s cost of capital and providing a written report for the Board of Directors explaining and justifying this calculation.

To determine a weighted average cost of capital for Palco, it was necessary for Neha to examine the cost associated with each source of funding used.  In the past, the largest sources of funding had been the issuance of new equity shares and internally generated funds.  Through conversations with Financial Controller and other members of the Board of Directors, Neha learnt that the firm, in fact, wished to maintain its current financial structure as shown in Exhibit 1.

 

Exhibit 1 Palco Ltd Balance Sheet for Year Ending March 31, 2003

Assets	Liabilities and Equity
Cash Accounts receivable Inventories Total current assets Net fixed assets Goodwill Total assets	Rs.      90,00,000 3,10,00,000 1,20,00,000 5,20,00,000 19,30,00,000     70,00,000 25,20,00,000	Accounts payable Short-term debt Accrued taxes Total current liabilities Long-term debt Preference shares Retained earnings Equity shares Total liabilities and equity shareholders fund	Rs.      8,50,000 1,00,000 11,50,000 1,20,00,000 7,20,00,000 4,80,00,000 1,00,00,000   11,00,000   25,20,00,000

 

She further determined that the strong growth patterns that Palco had exhibited over the last ten years were expected to continue indefinitely because of the dwindling supply of US and Japanese domestic oil and the growing importance of other alternative energy resources.  Through further investigations, Neha learnt that Palco could issue additional equity share, which had a par value of Rs. 25 per share and were selling at a current market price of Rs. 45.  The expected dividend for the next period would be Rs. 4.4 per share, with expected growth at a rate of 8 percent per year for the foreseeable future.  The flotation cost is expected to be on an average Rs. 2 per share.

       Preference shares at 11 per cent with 10 years maturity could also be issued with the help of an investment banker with an investment banker with a per value of Rs. 100 per share to be redeemed at par.  This issue would involve flotation cost of 5 per cent.

Finally, Neha learnt that it would be possible for Palco to raise an additional Rs. 20 lakh through a 7 – year loan from Punjab National Bank at 12 per cent.  Any amount raised over Rs. 20 lakh would cost 14 per cent.  Short-term debt has always been usesd by Palco to meet working capital requirements and as Palco grows, it is expected to maintain its proportion in the capital structure to support capital expansion.  Also, Rs. 60 lakh could be raised through a bond issue with 10 years maturity with a 11 percent coupon at the face value.  If it becomes necessary to raise more funds via long-term debt, Rs. 30 lakh more could be accumulated through the issuance of additional 10-year bonds sold at the face value, with the coupon rate raised to 12 per cent, while any additional funds raised via long-term debt would necessarily have a 10 – year maturity with a 14 per cent coupon yield.  The flotation cost of issue is expected to be 5 per cent.  The issue price of bond would be Rs. 100 to be redeemed at par.

In the past, Palco had calculated a weighted average of these sources of funds to determine its cost of capital.  In discussion with the current Financial Controller, the point was raised that while this served as an appropriate calculation for external funds, it did not take into account the cost of internally generated funds.  The Financial Controller agreed that there should be some cost associated with retained earnings and need to be incorporated in the calculations but didn’t have any clue as to what should be the cost.

1.        Palco Ltd is subjected to the corporate tax rate of 40 per cent.
2.        From the facts outlined above what report would Neha submit to the Board of Directors of palco Ltd? 

IIBMS – COMPUTATION OF COST OF CAPITAL OF PALCO LTD

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