3 minute read 26 May 2021
Cost of capital

How does India Inc. view its cost of capital?

By EY India

Multidisciplinary professional services organization

3 minute read 26 May 2021
Related topics Strategy and Transactions

The India Cost of Capital Survey 2021 aims to understand the cost of capital that companies use for capital allocation and strategic decision-making. 

The survey inter alia concludes that in line with the falling interest rates, the cost of equity in India has declined since EY’s last cost of capital survey in 2017. While largely a measure of risk, the cost of equity is also a proxy for return expectation, and its decline with falling interest rates can be interpreted as signs of conservatism in return expectations from prospective investments.

The cost of capital is a threshold rate used to evaluate whether the shareholder funds have been utilized by the management in an efficient manner. One of the prime focus areas of management is to unlock and create value for its stakeholders which can only be achieved if returns generated on its investment are higher than the cost of capital. All projects considered by a company—whether they pertain to new investments or strategic transactions—are usually put through a robust assessment involving the measurement of expected returns from such a project against the appropriate hurdle rate or cost of capital. The cost of capital or the discounting rate used for evaluating projects or M&A targets therefore plays an important role in measuring shareholders’ value.

EY conducted the survey with close to 200 respondents from India Inc. spread across different sectors and company sizes 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. It also attempts to find out how views have changed over the last three years and what companies are doing differently to sharpen their estimation of cost of capital and investment evaluation processes vis-à-vis our findings in the previous editions of the survey.

Survey highlights include:

  1. India’s average cost of equity is ~14%; declined by ~100 basis points since EY’s last cost of capital survey in 2017.
  2. 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
  3. Start-ups or internet-age companies recorded higher cost of equity on an average.
  4. The Discounted Cash Flow (DCF) methodology is one of the key approaches for valuation analysis used and most companies typically consider a horizon of five years under this approach.
  5. In the light of the pandemic, 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.
  6. 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%.

Summary

While largely a measure of risk, the cost of equity is also a proxy for return expectation, and its decline with falling interest rates can be interpreted as signs of conservatism in return expectations from prospective investments and a great emphasis on getting forecasts right.

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By EY India

Multidisciplinary professional services organization

Related topics Strategy and Transactions