Cost OF equity

This query is : Resolved

Monil Shah (Querist)
Follow

13 April 2009 if suppose the co share capital is 90 lacs and carry forwards losses (P&L A/c Dr bal) is 99 lac. Than what should we consider as cost of equity.

Further if rate of interets at which co borrows is 15%p.a.

Than what will be cost of Equity,cost of debt and the total Weighted average capital cost of company.

What do we mean by quasi - Equity cost?Whether it taken in WACC calculation?

Please guide me

Sachidanand Singh

Sachidanand Singh (Expert)
Follow

13 April 2009 Your company has no equity. Obviously there is no cost of equity!

Jokes apart, cost of equity is the return an equity investor expects from capital markets if she were to make an investment of similar risk there. Risk depends primarily on nature of business and leverage – both financial leverage and operating leverage. In your case leverage is infinite (15/0). We take market values of debt and equity. Since liability of members in limited liability company is 0 market value of equity is never less than 0. Your firm is extremely risky as it is.

If you want to work out cost of equity first decide on the financial leverage the firm will have after it is capitalized - up to the planned level. CoE will change with leverage. You require higher return from a highly leveraged firm because by investing in such a firm you assume more risk.

And without working out cost of equity you cannot proceed towards WACC.

Now quasi equity, this I take is debt from promoters / friends etc. The rule for WACC is you consider all interest bearing liabilities as debt and your cost of debt would be the average cost of all interest bearing liabilities.

Monil Shah

Monil Shah (Querist)
Follow

14 April 2009 So can we consider in above example as
cost of equity =0 (as the Entire equity is less than the accumalated losses in reserves)
Cost of debt=15%
Cost of Quasi Equity=15%

You mean to say Wacc is to be as per the proportion of debt and quasi equity only.
We should ignore Equity cost as it negative in above example

Upgrade to CAclubindia Pro. Subscribe Now!

Sachidanand Singh

Sachidanand Singh (Expert)
Follow

16 April 2009 In your example, at present there is NO equity. If you have no equity obviously in WACC it will not appear. In fact WACC is not applicable in such a case.

And as I said earlier quasi equity is, in teh general sense of term, debt from persons close to promoters, and usually subordinated to debts in terms of claim on cash flows of the company or on assets of teh company at times of liquidation. Since it is an interest bearing liability, it will be part of debt only.

The firm as it is cannot survive. Clearly some investors will be putting in equity and they will be expecting some return. That return will be its cost of equity.

The return will not be only the dividend expectations. Return will come from increase in the value of their equity. If teh firm were listed, it becomes easy to estimate. For unlisted there are methods, a bit too involved / lengthy to be posted here.