Is Reliance beating its Cost of Capital? – Zaid Writings

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Reliance, as we all know is in multiple business segments like Refining, Petrochemicals, Oil and Gas, Retail, Digital services etc. It is the topmost company by market cap. To keep this in perspective, it is close to 8% of the total market cap of BSE.

There are two types of profit. First is accounting profit and the other is economic profit. Accounting profit is the profit calculated according to the generally accepted accounting principles. The economic profit is something which I learned from Michael J. Mauboussin (head of Consilient Research at Counterpoint Global – Morgan Stanley) that the company should earn more than its Cost of Capital.

I have tried to apply the same logic on Reliance Industries Ltd.

Calculation of the Cost of Capital –

I have calculated the cost of capital by using the combination of the cost of debt & equity which we call as WACC (Weighted Average Cost of Capital).

Source: Data is taken from the annual reports

Total equity is the summation of Share Capital and Reserves. Total Borrowings is the summation of Long-term debt, Short-term debt and current portion of long-term debt.

Finance cost is calculated by dividing the Interest Cost/expense (reported in the P&L) by the Total Borrowings.

The effective tax rate is calculated by dividing the Profit/Earnings before Tax by the total tax paid.

Weight of debt is calculated by dividing the debt portion by the total capital (Debt+Equity). Weight of equity is calculated by dividing the equity portion by the total capital (Debt+Equity).

Why the Cost of Equity is assumed at 13%?

Imagine you have enough money to start a business. What is the basic return that you’ll expect from your business? Or What is your opportunity cost?

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In my opinion, your opportunity cost is Nifty 50. It is the weighted average set of the topmost 50 companies in India. You are not investing your money into these top companies which have the experience to run the business, rather you want to start your own business. You can just sit at your home without doing any hard work for your own business by investing money in Nifty’s ETF. If you decide to not invest your hard-earned money in Nifty’s ETF, it becomes your opportunity cost.

What return Nifty has given until now?

Source: Data is taken from NSE

Every year the returns are different. To solve this, I have calculated the average of the rolling returns.     

If you are going to start your own business, it will take some years to settle. That’s the reason I have taken a 3/5/7/10/15-year average of Nifty. On average, the return is between 12-13%. It means that the opportunity cost is 12-13%.

Finance (Debt) cost is too low

If you look at the Finance cost, it is just about 3% on an average over the years. To put this in perspective, the Indian government is getting debt at a higher rate than Reliance.

Source: Gov. bond yield data is sourced from

It means that Reliance is safer than the Indian Government! This made me go deeper into the break-up of the Borrowings & the Finance cost.

Breakup of Borrowings

Source: Data is taken from the annual reports

Note – The breakup of the debt before FY12 is very different. That’s why to keep it simple I have taken the data after FY12.

Majority of the debt is financed through long-term loans & bonds. In the annual reports, Reliance has given the break-up of the rate of interest on the Bonds.

Let me show you the screenshot of the break-up.

Source: FY19 Annual report

Majority of the long-term bond’s rate is less than 6%. We can even refer to the same breakup in the previous annual reports, but it is unsecured long-term bonds where the breakup tends to remain the same (just the current year gets replaced from the breakup i.e. for example in FY17, we will get the rate of interest since FY17). I have checked it and the majority of the bonds is under 6% threshold for many years. There’s no doubt that the AAA rating is paying off.

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Reliance has also given the breakup of the maturity profiles of the NCD’s. But it will not add much value to our analysis because it doesn’t contain much weightage in the overall debt.

Breakup of Finance Cost

Source: Data is taken from the annual reports

Loss on foreign currency is more than 20%. Let’s just remove it & see whether there’s much change or not.

There’s not much even after adjusting the loss on foreign currency.

Is the finance cost truly this low? We need to adjust the finance cost for interest capitalized.

What is Interest capitalization?

Capitalized interest is the cost of the funds used to finance the construction of a long-term asset that an entity constructs for itself.

For example, a company wants to buy an asset for ₹100 crores. Now, it doesn’t have enough money, so it goes to a bank. Bank gives let’s say ₹100 crores loan at 13% payable in 5 years (Just an assumption of 100% Loan to Value, generally in reality it is not possible to get 100% of asset’s loan).

The company wants to defer the interest expense on an accrual basis so that the results of the business look better. This logic makes sense when the asset is under construction because that asset (normally know as CWIP) doesn’t contribute to revenue.

The company decides to “capitalize the interest cost” to the extent of 70%. It means that 70% of the interest portion of the loan amortization schedule will be added to the machine value every year in the balance sheet.

The interest is added to the cost of the long-term asset so that the interest is not recognized in the current period as interest expense. Instead, it is now a fixed asset and is included in the depreciation of the long-term asset. Thus, it initially appears in the balance sheet, and is charged to expense over the useful life of the asset; the expenditure, therefore, appears on the income statement as depreciation expense, rather than interest expense.

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Effects of Interest capitalization

Particulars Capitalizing Expensing Reason for the difference
Total Assets Higher Lower Asset value will rise by the interest amount in capitalizing.
Equity Higher Lower PAT will be higher due to the deferred exp. which will translate
into high equity in capitalizing.
PAT (First Year) Higher Lower In the first year, capitalizing co. has low interest hence PAT will be higher.
PAT(Subsequent years) Lower Higher Depreciation will be higher in the subsequent years for the capitalizing company (assuming interest exp. is lower than depreciation).
CFO Higher Lower We add the non-operating expenses (depreciation) in CFO which will increase the amount of CFO in capitalizing.
CFI Lower Higher As we add back the capitalized amount to the “purchase of fixed asset”
which is a negative line item in CFI. It will decrease the CFI in the capitalizing company.
Debt to equity Lower Higher Equity portion in capitalizing would be higher which translates into low D/E.
Asset turnover Lower Higher Assets are higher in capitalizing which leads to a lower asset turnover.

Reliance adjusted finance cost

Source: Data of Interest Capitalized is taken from the annual reports

Just because of this accounting tactic, the finance cost seems to be lower by 2-3% on average.

Is Reliance beating its Cost of Capital?

*ROCE = EBIT*(1-Tax rate)/(Debt + Equity) (In ROCE, we consider Debt as our capital, hence we are not excluding interest.
*Economic Profit/(Loss) = ROCE – WACC

Reliance is consistently making an economic loss. It has not generated an economic profit since FY11.

Maybe one of the reasons why the stock was range-bound from FY11 to FY16. After that, the entry of Jio and peaking capex cycle in petrochemicals and refineries business changed the fate of Reliance (in terms of share price).

It’s been around 3 years now after the launch of Jio through free service in the hands of the customer. As there are many more businesses which decide the number of Reliance.

Still, the number has not seen any signs of a turnaround. Hope so, it will!

Why even after economic loss, the share price rose after 2016?

News articles : – Reason for the rise in share price after 2016:

Note: I have calculated post tax finance cost in the calculation of WACC. Finance cost excepting WACC is pre-tax. The reason why I did this is that if we take the benefit of tax in calculation of finance cost & again while calculation of WACC, it will be double counting.

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Zaid Munshi

Zaid Munshi

Zaid started his journey in the Indian market in April 2018. He is always keen to understand the business and check whether the business is worth investing or not.
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