Trends in cost of capital in India
A recent survey done by the consulting firm Ernst & Young (EY) and National Stock Exchange (NSE) highlights some interesting data about the cost of capital of Indian businesses. “The Cost of Capital Survey” is an “attempt to understand the threshold cost of equity that India Inc. used for its capital allocation and investment decisions, and the process by which practicing finance professionals in the industry make capital costing decisions.”
The key findings of the Survey are as follows:
· India’s average cost of equity is ~14%. This has declined by ~100 basis points since our last cost of capital survey, over a period in which interest rates have declined by ~50 basis points.
· Real estate, healthcare (including pharmaceuticals and life sciences) and renewables command the highest cost of equity, whereas chemicals, media and entertainment and FMCG are at the lowest. ARCs and Startups recorded higher cost of equity on an average than all the other sectors. If ARCs and start-ups are excluded, then the average cost of equity drops further to ~13.5%.
· The results confirm that the Discounted Cash Flow (DCF) methodology is one of the key approaches for valuation analysis used by corporates, usually in combination with other methods such as peer company multiples or transaction multiples.
· It was observed that most companies that use the DCF approach typically consider a horizon of five years.
· The survey emphasizes our learning from the previous survey that “rule of thumb” or an organizational hurdle rate is preferred over objective models such as the Capital Asset Pricing Model (CAPM) to estimate cost of capital.
· The quantum of subjective company-specific adjustments made to arrive at the cost of capital has remained at similar levels as assessed in 2017. The top factors necessitating such adjustments as suggested by respondents are company/project specific risk factors and uncertainty around projections along with company size and gestation project also forming important considerations.
· Most respondents acknowledged that an additional risk premium is justifiable when considering strategic investments in start-ups and provided their views on the quantum. The quantum of premium varied across industries, with most sectors capping it at 10%.
· In using the DCF method for non-finite projects, another key area apart from cost of capital is the terminal value. Respondents were equally divided between using the Gordon Growth Model vs. an Exit • Multiple to arrive at terminal value; the popular long-term stable growth rate used was ~4%, down about 50bps since our last survey.
· Most of the respondents indicated that they did not make any temporary adjustments to discount rate and the inherent uncertainty arising out of the situation was met by businesses by adjusting their projections or evaluating multiple scenarios instead.
(Source: The Cost of Capital Survey, 2021, EY-NSE)
