Consulting firm PricewaterhouseCoopers announced the key findings of a survey conducted by its financial advisory services arm on the factors driving the costs of equity and debt in India, the expected trends therein, the historical trends in capital structure and the possible ways in which cost of capital can be reduced.

The survey, designed and implemented by PwC in the last quarter of 1999, incorporates views and opinions of leading Indian corporates, lenders and equity analysts / investors.

The survey findings indicate that 'business risk', 'quality and shareholder value orientation of management', 'cash flows' and 'leverage' are the important factors that influence the cost of equity for a company. As drivers of cost of debt for Indian companies, the importance of 'Reserve Bank of India policies' and 'asset backing of the company' is declining since 1991 and this trend is expected to continue. On the other hand, the importance of 'cash flows', 'quality of management' and 'business risk' has been rising. Leveraging continues to significantly influence the cost of debt.

Commenting on the significance of this survey, Amal Ganguli, chairman, PricewaterhouseCoopers India, says, "Requirements, preferences and perceptions of fund providers vary and need to be understood by corporates to manage their cost of capital. Indian companies are increasingly appreciating the greater relevance of cost of capital in running their businesses. We have tried to study all the pertinent factors that have a direct or indirect bearing on such costs. We believe that this survey will be of tremendous relevance to Indian companies."

According to Ashwani Puri, head of financial advisory services, PricewaterhouseCoopers India, "A substantive reduction in financial leverage of Indian companies over the past decade places many of them in a position to explore higher debt as a way of increasing valuations through the lowering of cost of capital. Optimisation of leveraging is, however, a complex multi-faceted analysis." 

While the survey confirms that corporations are generally cautious about substituting debt for equity despite the low gearing levels in many of these companies, equity analysts appear to favour such a shift in appropriate circumstances. The survey also indicates that 'enhancing business focus' and 'improving investor perception' are other important steps that help reduce the cost of capital. While global listing is also cited as important, the presence of international investors on Indian stock exchanges reduces its importance relative to other factors.

Lenders and investors perceived 'free cash flows', 'industry sector' and 'quality of management' as the three most important factors influencing the debt-equity ratio of a company. In comparison, 'asset backing of the company' and 'effective tax rate' rank relatively lower in importance. Debt-equity ratios for Indian companies have declined significantly over the last 10 years. This is attributable in direct measure to the 'expansion of equity markets' and 'higher internal cash generation' in recent times.

Cost of capital for most Indian companies is generally regarded to be in the 15-20 per cent range. This when compared with cost of capital for most US companies (believed to be in the 8-12 per cent range), places Indian companies at a significant competitive disadvantage. The future could, however, see a general reduction in cost of capital for Indian companies.

According to the survey, a majority of the respondents expect equity market risk premium and risk-free rate to decline in India over the next three years. This decline, which would lead to a reduction in cost of equity for Indian companies, is expected on account of improvement in corporate transparency, greater maturity (thereby reduced volatility) of the equity market, reduction in fiscal deficit, market-determined returns on government securities, fewer curbs on capital flow and lower transaction costs.

In addition, the State Bank of India's prime lending rate is expected to moderately decline over the next three years. This decline is expected primarily due to a reduction in the fiscal deficit and its consequent impact on inflationary expectations. Another factor mentioned for this decline expectation was 'greater emphasis on market-led determination of PLR'.