Analysis of cost of equity and leverage of power

sector
Abstract— In this paper we have calculated the cost of equity
of companies working in power sector and checked under which III. METHODOLOGY
method the cost of equity is more relatable to the market growth
rate. Also we have calculated the various types of leverage to
assess the structure of assets and their nature of financing.
We have taken three companies such as: Torrent Power,
Index Terms—cost of equity, leverage, power companies TATA Power, and CESC Limited. We have taken these
companies because they are private companies.
First we will find out the cost of equity of these companies.
I. INTRODUCTION Then we will calculate the leverage of these companies.
Cost of capital is the required return necessary to make a
Cost of Equity
capital budgeting project. When analysts and investors discuss There are 6 methods for calculating the cost of equity,
the cost of capital, they typically mean the weighted average described as below:
of a firm's cost of debt and cost of equity blended together. 1) Historical rate of return method:
The cost of capital metric is used by companies internally to
judge whether a capital project is worth the expenditure of Average divide nd per share
Ke=( )+ Rate of increase∈share pr
resources, and by investors who use it to determine whether an Purchase price per share
investment is worth the risk compared to the return.
Many companies use a combination of debt and equity to
finance their businesses and, for such companies, the overall 2) Earnings price Ratio Model:
cost of capital is derived from the weighted average cost of all
E
capital sources, widely known as the weighted average cost of Ke=
capital (WACC). P
Where E = Earnings per share
Leverage means that a percentage change in one amount
causes a relatively large amount of change in other amounts. P = Current market price per share
The process of increasing the earning per share to the equity
shareholders by changing the fixed operating cost and fixed
financial cost with respect to the change in sales is called
3) Dividend Growth Model:
leverage. Leverages are of three types: 1) operating leverage
2) financial leverage 3) combined leverage. D
Ke= +g
P
Where D = Dividend per share
II.OBJECTIVES: P = Current market price per share
g = growth rate in dividend = b x r
Here, in this paper, we will find out the most effective way of
calculating the cost of equity. We have taken three companies b = (net profit – dividend) / net profit
from the power sector. We will calculate the cost of equity of r = Net profit / capital employed
these companies.
Also we will calculate the 3 types of leverage of these
companies and will try to find out the most effective one for 4) Earning Growth Model:
these companies
E
The objectives of the paper are as follows:
Ke= + g
P
• To calculate the cost of equity of the three companies and to
show that the CAPM method is the more reliable one. Where E = Earnings per share
• To find out the appropriate leverage indicator of these P = Current market price per share
companies.
g = growth rate in earning = b x r

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 b = (Net profit – Earning) / net profit If there is preference share capital in the capital structure,
r = Net profit / capital employed EBIT
DFL=
Pd
EBT −
(1−t)
5) Bond yield plus risk premium method: 3) Combined leverage:

Ke=pre tax interest rate∈longtermdebt +risk premium Contribution

Degree of Combined leverage ( DCL ¿=
Where risk premium is a judgmental factor. It is expected EBT
to be 2% to 4%. when there is no preference share capital in the capital
structure
If there is preference share capital in the capital structure,
Contribution
DFL=
6) Capital Asset Pricing Model: Pd
EBT −
(1−t)
Ke=R f + β ¿)
Where Rf= Risk free return
IV. ANALYSIS AND FINDINGS
Km = Market return or expected return
β = Risk factor Cost of Equity study

We have calculated cost of equity percentage for the three

private power companies. For this purpose we have used
Leverage: certain data as provided in the annual reports as well as some
published figures such as share price on certain dates.
Leverages are of three types: 1) operating leverage 2) financial
leverage 3) combined leverage. Particular Unit Tata Torrent CESC
s power power Ltd.
Dividend Cr. 384 127 190
1) Operating Leverage: paid in
2017-18
Operating leverage results when fluctuations in sales are Dividend Cr. 380 0 160
accompanied by disproportionate fluctuations in operating paid in
profit. This is due to presence of fixed cost in the cost
2016-17
structure of the firms. Since the power sector companies have
huge level of fixed cost, they have the advantage of operating Earnings in Cr. 1428.8 1375.53 864.66
leverage. 2017-18 -
EBT
Q( S−V ) Earnings in Cr. 1321.68 583.94 861
DOL= 2016-17 -
EBIT
Where Q = volume of sales EBT
share No. 27076055 48061678 13255
V = Variable cost per unit number in 70 4 7043
S = Selling price per unit 2017-18
Average 1.420 2.640 14.348
dividend
2) Financial Leverage: per share
Purchase Rs. 966.2
price per
It is the firm’s ability to use fixed financial charges to magnify
the effects of changes in EBIT on the firm’s EPS. share
Degree of financial leverage ( Rate of % 15%
E BIT increase in
DFL ¿= when there is no preference share price
EBIT −INTEREST
share capital in the capital structure EPS 12.05 19.18 65.23

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 Particular Unit Tata Torrent CESC growth model (DGM) in that it explicitly considers a
s power power Ltd. company’s level of systematic risk relative to the
Share price Rs. 90.35 230.35 841.2 stock market as a whole.
on 31-3-17  It is clearly superior to the WACC in providing
discount rates for use in investment appraisal.
Share price Rs. 81.9 234.1 966.2
on 31-3- We compared the cost of equity a calculated from the method
18) 6 with the growth of BSE Sensex.iii

We have seen that the market growth rate is around 11%,

After doing the analysis, we have got the results which are which is near the result we have calculated under CAPM
shown below in the table: model.

Methods Tata Torrent CESC Leverage Study

power power Ltd.
1. Historical -8% 3% 16% We have calculated the Degree of operating leverage (DOL),
rate of return Degree of financial leverage (DFL) and Degree of combined
method leverage (DCL) for these three companies from the published
annual reports. The Results are as follows:
2. Earning 15% 8% 7%
price Ratio
Model 2017-18 Units Tata Torrent CESC
3. Dividend -13% 5% 5% power power Ltd.
Growth EBIT Cr. 2860 2215 1377
Model Interest Cr. 1431 840 484
4. Earning -4% 6% 6%
Contribution or Cr.
growth fixed cost 3849 3519 2701
model Degree of operating 1.3 1.6 2.0
5. Bond 12% Not 12% leverage(DOL)
yield and Available (Contribution/EBIT
Risk )
premium Degree of financial 2.0 1.6 1.5
method leverage(DFL)
6. CAPM 13% 10% 13% EBIT/EBT
Model Degree of 2.7 2.6 3.0
combined
leverage(DCL)
contribution/EBT
Under CAPM model calculation, we have considered beta
value as published.i As we can see from the above table, the It can be seen from the above table For CESC, the DOL is
average cost of equity for the three power companies is around high and DFL is low which means high level of fixed cost
12% for the method 5 and method 6. structure and low level of debt financing. High operating
leverage indicates that company is making few sales but with
But for method 5, pretax interest rate in long term debt was high margins. Low financial leverage indicates that
not available for Torrent power. Also, the risk premium is a management has adopted a very good approach towards the
judgmental value. debt capital. This decreases the management decision making
on earning per share. This is the optimum situation.
Whereas, the advantages of CAPM are as followsii: For Tata Power, the DOL is low and DFL is high. Better
situation for maximizing return with minimum possible risk.
 It considers only systematic risk, reflecting a reality Full advantage of debt financing can be taken.
in which most investors have diversified portfolios For Torrent power the DOL is low and DFL is low: Low
from which unsystematic risk has been essentially degree of these leverages shows that the amount of fixed costs
eliminated. is very small and proportion of debts in capital is also low.
 It is a theoretically-derived relationship between
required return and systematic risk which has been
subject to frequent empirical research and testing. V. CONCLUSION
 It is generally seen as a much better method of
calculating the cost of equity than the dividend

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To conclude, we can say that the cost of equity calculated VI. REFERENCE
under CAPM method is more relatable with the market growth
rate. CAPM is the more effective method to calculate the cost
of equity.
In case of leverage, we have seen that for high DOL and low
DFL, management can partly dilute the adverse effect of high
operating leverage by having low financial leverage.
For low DOL and high DFL, operating cost is low so full
advantage of debt financing can be taken.
In case of low DOL and low DFL, management is taking a
very cautious approach towards debt financing. It is difficult
to maximize the return to the shareholders in this case.

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i
https://www.topstockresearch.com/INDIAN_STOCKS/POWER/PriceRangeOf_Torrent_Power_Ltd.html
ii
https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-
articles/CAPM-theory.html
iii
https://www.bseindia.com/markets/Equity/newsensexstream.aspx