Cost of capital for Indian companies has been declining, in line with the falling bond yields and policy rate. The average cost of capital is currently estimated to be around 14 per cent, down 100 basis points since 2017.
Cost of capital is the threshold rate used by companies to evaluate new projects and for other strategic decisions. It also helps in understanding the efficiency with which shareholders’ funds are being used.
Average cost of capital
The survey finds that India’s average cost of equity is around 14 per cent. Over one-third of the respondents expected their cost of equity to be in the 12-15 per cent range and about a quarter of the respondents considered it in the 15-20 range.
The decline in the 10-year bond yield, generally considered the risk free rate of return, from 6.7 per cent to 6.2 per cent between 2017 to March 2021, along with decline in policy rate of about 200 basis points has resulted in reducing the average cost of equity by about 100 basis points since 2017.
The lower reduction in the cost of equity could partly be due to the expansion in risk premium due to the growing uncertainty in the interim period.
If the sector-wise CoE is considered, highest cost is seen in start-ups, at 17.77 per cent. This is not surprising, given the greater risk taken by those investing in this category.
Real-estate sector comes next with 16.55 per cent. With the real-estate developers holding large inventory of unsold properties and most of them already laden with debt, banks have been averse to lend to this sector, resulting in their borrowing at higher rates from NBFCs or from the bond market.
At the other end of the spectrum, FMCG, media and chemical companies have the lowest cost of capital, below 12.6 per cent.
The survey has found that more than 50 per cent of the companies prefer using an organisation-specific hurdle rate as their cost of capital. A little over one-third of the respondents indicated that they use the CAPM approach. This is in contrast to the developed markets where the application of CAPM in discount rate estimation is much more widespread.
Almost 20 per cent of the respondents preferred to use the bank lending rate with some tweaks as a preferred benchmark for cost of capital. The use of bank lending rate as the starting point for discount rate estimation was observed predominantly in the FMCG, consulting, healthcare, chemicals and retail sectors.