Estimation of Cost of Capital 87retailers have started sourcing their requirement of towels from India, and the major share goes to Welspun.
Welspun India is a vertical manufacturing plant and has four types of technologies to produce towels:
- Plain dyed
- Dobby designed
- Jacquard designed
- Sheared beach towels
The input of the spinning division is cotton bales, which are processed, cleaned, combed and converted
into threads of required length and then winding the same on spindles, a part of which is transferred to the
terry towel division and the rest is marketed. The yarn is re-wound on beams, dyed and converted into terry
towels by weaving machines in the terry towels division.
In 2002, the managers of Welspun India were considering an investment. They had to decide whether the
investment was worthwhile. Whether an investment is worthwhile or not depends on what the investment
earns and how the return compares with that expected by the company. In other words, the managers need to
know if the investment meets the minimum return expected out of similar investments. How do companies
set minimum return requirements? Common sense in general, and the introduction to risk and return provided
in the last chapter in particular, tells us that return is a function of the riskiness of the investment.
The previous chapter provided a framework for pricing risky assets. The only relevant characteristics for
pricing a risky asset are its risk and return. Other characteristics like liquidity are expected not to have any
bearing on value. In a CAPM universe, only systematic risk as measured by beta matters. This chapter
describes the application of CAPM in estimating divisional required returns. The investor’s expected rate of
return on investment is the cost of equity for the firm. Thus, the expected return for the equity investor in
a CAPM universe,
E(R) = Rf + β[E(RM) – Rf], is also the cost of equity for the firm.It is important to understand that cost of equity is not the same as dividends. The cost of equity incorporates
both dividends and capital gains expected by investors. Estimation of cost of equity using CAPM involves
estimation of risk-free rate, beta and market risk premium.
Estimation of Risk-free Rate
An investor’s expected rate of return consists of two components—the time value of money and risk premium.
A risk-free asset rewards the investor for time value of money alone. Further, a risk-free asset is one whose
returns are certain (i.e., variance is zero) and unconnected with that of the market (i.e., covariance is zero).
Generally finance theorists agree that long T-bond rate can be used as proxy for risk-free rate. Sometimes the
365-day T-bill rate is also used. Obviously, what you choose as ‘Rf’ has a bearing on the cost of equity
estimate as it appears twice in the equation. As the T-bill rate tends to be volatile, the long-term T-bond rate
might be chosen. The T-bill rate is proposed when the investor has a short-term investment horizon. From a
finance manager’s perspective, the T-bond rate might be the appropriate rate. It must be understood that
there is no such thing as risk-free asset. The government securities do not have default risk^1 but reinvestment
risk remains. The current 10-year T-bond rate is 12.15 percent, and 365 day T-bill rate is 8 percent.
(^1) This is not true of those countries that default on sovereign borrowings. In such a situation we can probably take a rate,
which is slightly lower than the rate on AAA rated debt instruments as risk-free rate (say 50 basis points).