Thursday, August 12, 2021

Cost of Capital Solved Problems Financial Management notes RBL Academy - cost of capital, WACC, Weighted Average Cost of Capital formula, cost of Debt, Cost of Equity, Cost of Preference Shares, irredeemable Preference Share, Irredeemable debt notes numerical problems with solutions

Links to Financial Management notes: -

Time Value of Money

https://rblacademy.blogspot.com/2021/06/time-value-of-money-formulae-financial.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-i-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-2-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-3-solved.html

https://rblacademy.blogspot.com/2021/05/time-value-of-money-i-financial.html

Leverage Analysis

https://rblacademy.blogspot.com/2021/08/financial-management-notes-leverage.html

Cost of Capital

https://rblacademy.blogspot.com/2021/08/cost-of-capital-solved-problems.html

EBIT – EPS Analysis

https://rblacademy.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html

Capital Structure Analysis

https://rblacademy.blogspot.com/2022/02/capital-structure-theories-solved.html

Planning & Designing of Capital Structure

https://rblacademy.blogspot.com/2022/03/planning-designing-of-capital-structure.html

Estimation of Cash Flow in Capital Budgeting

https://rblacademy.blogspot.com/2021/06/part-1-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-2-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-3-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2022/03/estimation-of-cash-flow-in-capital.html

Techniques of Capital Budgeting

https://rblacademy.blogspot.com/2021/05/techniques-of-capital-budgeting.html

https://rblacademy.blogspot.com/2021/05/capital-budgeting-i-httprblacademycom.html

https://rblacademy.blogspot.com/2021/05/financial-management-capital-budgeting.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_2.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_14.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html

Cost of Capital

Net Proceed (NP) = Face Value or Par Value – 

Floatation Cost + Premium on issue – Discount on 

issue

Net Proceed = Market Value – Floatation Cost + 

Premium on issue – Discount on issue


Net Proceed (NP) = Face Value or Par Value – Floatation Cost + Premium on issue – Discount on issue Net Proceed = Market Value – Floatation Cost + Premium on issue – Discount on issue Post tax Cost of Perpetual / Irredeemable Debt (Kd) = (I ×(1-t))/NP Post tax Cost of redeemable Debt (Kd) =   (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) Cost of Irredeemable Preference Share (KP) =(Preference Dividend )/NP Cost of Redeemable Preference Share (KP) =  (PD+(RV- NP)/n)/((RV+NP)/2) PD = Preference Dividend RV = Redeemable Value Cost of Equity Share (Ke) =
Net Proceed (NP) = Face Value or Par Value – Floatation Cost + Premium on issue – Discount on issue Net Proceed = Market Value – Floatation Cost + Premium on issue – Discount on issue Post tax Cost of Perpetual / Irredeemable Debt (Kd) = (I ×(1-t))/NP Post tax Cost of redeemable Debt (Kd) =   (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) Cost of Irredeemable Preference Share (KP) =(Preference Dividend )/NP Cost of Redeemable Preference Share (KP) =  (PD+(RV- NP)/n)/((RV+NP)/2) PD = Preference Dividend RV = Redeemable Value Cost of Equity Share (Ke) =

PD = Preference Dividend

RV = Redeemable Value

Cost of Equity Share (Ke) =

# 1. Zero Growth Dividend

Ke = D1 / P0

# 2. Constant Growth rate in Dividend perpetually

Ke = (D1 /P0) + g

P0 = D1 / (Ke – g)

D1 = D0 (1+ g)

D1 = Expected Dividend

D0 = Current Dividend

g = Growth rate

P0 = Current Market Price

CAPM Model

Ke = Rf + (Rm - Rf) × ß

Rf = Risk free rate

Rm = market return

ß = Beta

Cost of Loan (KL) = I (1- t )

Book Based WACC (K0) = (E/V) × Ke + (D/V) × Kd + (P.S./V) × KP + (L/V) × KL +(R&S/V) × Ke + (R.E./V) × Ke

Market Based WACC (K0) = (E/V) × Ke + (D/V) × Kd + (P.S./V) × KP + (L/V) × KL

Book Value of Firm = E + D + P.S + L + R.E. + R&S

Market Value of Firm = E + D + P.S + L

E= Value of Equity

D = Value of Debt

P.S. = Value of Preference Share

L = Value of Loan

R.E. = Value of Retained Earnings

R & S = Value of Reserve & Surplus

V= Value of Firm

While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus / Retained Earnings and then include Market value of Reserve & Surplus / Retained earnings while calculating WACC based on Market value.(Refer question 16)

Cost of Capital Solved Problems

1. ABC Ltd. issues 13 % debentures of face value of Rs. 100 each, redeemable at the end of 10 years. The debentures are issued at par and the flotation cost is estimated to be 5 %. Find out the cost of capital of debentures given that the firm has 40% tax rate.

Solution

After tax Cost of redeemable Debenture (Kd) = 
ABC Ltd. issues 13 % debentures of face value of Rs. 100 each, redeemable at the end of 10 years. The debentures are issued at par and the flotation cost is estimated to be 5 %. Find out the cost of capital of debentures given that the firm has 40% tax rate.

RV = Redeemable Value

NP = Net proceed = Face Value – Floatation Cost

= Rs 100 – Rs. 5 = Rs. 95

I = Interest amount = 13% of Rs.100 = Rs.13

n = Maturity Period of Debenture or Bond

2. ABC Ltd. issues 12% Preference shares of face value of Rs. 100 each at a flotation cost of 4%. Find out the cost of capital of preference share if (i) the preference shares are irredeemable, and (i) if the preference shares are redeemable after 10 years at a premium of 10%.

Solution


ABC Ltd. issues 12% Preference shares of face value of Rs. 100 each at a flotation cost of 4%. Find out the cost of capital of preference share if (i) the preference shares are irredeemable, and (i) if the preference shares are redeemable after 10 years at a premium of 10%. Cost of Irredeemable Preference Share (KP) =(Preference Dividend )/NP  = 12 / 96 = 0.125 = 12.5 % Cost of Redeemable Preference Share (KP) =  (PD+(RV- NP)/n)/((RV+NP)/2)  =   (12+(110- 96)/10)/((110+96)/2)    = 13.4 / 103 = 13.01% = .1301 PD = Preference Dividend = 12% of Rs. 100 = Rs.12 RV = Redeemable Value = FV + Premium on redemption = Rs.100 + Rs. 10 = Rs. 110 NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 0 – 4 = Rs. 96 n= Maturity Period =10 years

PD = Preference Dividend = 12% of Rs. 100 = Rs.12

RV = Redeemable Value = FV + Premium on redemption = Rs.100 + Rs. 10 = Rs. 110

NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 0 – 4 = Rs. 96

n= Maturity Period =10 years

3. ABC Ltd. has just declared and paid a dividend at the rate of 20 % on the equity share of Rs. 100 each. The expected future growth rate in dividends is 15%. Find out the cost of capital of equity shares given that the present market value of the share is Rs. 170.

Solution

Cost of Equity (Ke) = (D1 / Po) + g

ABC Ltd. has just declared and paid a dividend at the rate of 20 % on the equity share of Rs. 100 each. The expected future growth rate in dividends is 15%. Find out the cost of capital of equity shares given that the present market value of the share is Rs. 170. Solution Cost of Equity (Ke) = (D1 / Po) + g = (20 × (1 +0.15))/170 + 0.15 = 28.53 % = 0.2853 D1 = D0 × (1 + g) = Expected Dividend D0 = Current Dividend = 20 % of Rs.100 = Rs. 20 g = Growth rate = 15% = .15 P0 = Current Market Price = Rs.170

=  + 0.15 = 28.53 % = 0.2853

D1 = D0 × (1 + g) = Expected Dividend

D0 = Current Dividend = 20 % of Rs.100 = Rs. 20

g = Growth rate = 15% = .15

P0 = Current Market Price = Rs.170

4. The share of ABC Ltd. is presently traded at Rs. 60 and the company is expected to pay dividends of Rs. 4 per share with a growth rate expected at 10% per annum. It plans to raise fresh equity share capital. The merchant banker has suggested that an underpricing of Rs. 2 is necessary in pricing the new issue besides involving a cost of Re 1 per share on miscellaneous expenses. Find out the cost of existing equity shares as well as the new equity given that the dividend rate and growth rate are not expected to change.

Solution

Cost of existing Equity (Ke) = (D1 / Po) + g

Cost of new Equity (Ke) = (D1 / Po) + g

The share of ABC Ltd. is presently traded at Rs. 60 and the company is expected to pay dividends of Rs. 4 per share with a growth rate expected at 10% per annum. It plans to raise fresh equity share capital. The merchant banker has suggested that an underpricing of Rs. 2 is necessary in pricing the new issue besides involving a cost of Re 1 per share on miscellaneous expenses. Find out the cost of existing equity shares as well as the new equity given that the dividend rate and growth rate are not expected to change. Solution Cost of existing Equity (Ke) = (D1 / Po) + g = 4/60 + 0.1 = 16.67 % = 0.1667 Cost of new Equity (Ke) = (D1 / Po) + g = 4/57 + 0.1 = 17.02 % = 0.1702 Net Proceed (NP) = MP (P0) – Underpricing – Miscellaneous expenses = Rs. 60 – Rs. 2 – Re 1 = Rs.57
Net Proceed (NP) = MP (P0) – Underpricing – Miscellaneous expenses = Rs. 60 – Rs. 2 – Re 1 = Rs.57

 5.Assuming that the firm pays tax at a 30% rate, compute the after tax cost of capital in the following cases:

(a) A 13.5% preference shares sold at par.

(b) A perpetual bond sold at par, coupon rate being 12.5%.

(c) A ten year 9 % Rs. 1,000 per bond sold at 950.

(d) A common share selling at a market price of Rs. 120 and paying a current dividend of Rs. 10 per share which is expected to grow at a rate of 10 %.

(e) 15 %.Preference Shares of Rs. 100 each, issued at 10 % premium, redeemable at par after 6 years. Flotation cost is Rs. 12 and Dividend Distribution Tax is 20 %. Use both methods.

(f) 12% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%.

Solution

(a) A 13.5% preference shares sold at par.

After tax Cost of Preference Share (Kp) = 13.5 % = 0.135

(b) A perpetual bond sold at par, coupon rate being 12.5%.

After tax Cost of Perpetual Bond (Kd) = Interest rate × (1 – tax rate)

= 12.5 % × (1-0.3) = 0.0875 = 8.75 %

(c) A ten year 9 % Rs. 1,000 per bond sold at 950.

After tax Cost of redeemable Debenture = 

5.Assuming that the firm pays tax at a 30% rate, compute the after tax cost of capital in the following cases:  (a) A 13.5% preference shares sold at par.  (b) A perpetual bond sold at par, coupon rate being 12.5%.  (c) A ten year 9 % Rs. 1,000 per bond sold at 950.  (d) A common share selling at a market price of Rs. 120 and paying a current dividend of Rs. 10 per share which is expected to grow at a rate of 10 %.  (e) 15 %.Preference Shares of Rs. 100 each, issued at 10 % premium, redeemable at par after 6 years. Flotation cost is Rs. 12 and Dividend Distribution Tax is 20 %. Use both methods.  (f) 12% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%

  = (63 + 5) / 975 = 6.97 % = 0.0697

RV = Redeemable Value

NP = Net proceed

I = Interest amount

n = Maturity Period of Debenture / Bond

(d) A common share selling at a market price of Rs. 120 and paying a current dividend of Rs. 10 per share which is expected to grow at a rate of 10 %.

Cost of Equity (Ke) = (D1 / Po) + g

=

5.Assuming that the firm pays tax at a 30% rate, compute the after tax cost of capital in the following cases:  (a) A 13.5% preference shares sold at par.  (b) A perpetual bond sold at par, coupon rate being 12.5%.  (c) A ten year 9 % Rs. 1,000 per bond sold at 950.  (d) A common share selling at a market price of Rs. 120 and paying a current dividend of Rs. 10 per share which is expected to grow at a rate of 10 %.  (e) 15 %.Preference Shares of Rs. 100 each, issued at 10 % premium, redeemable at par after 6 years. Flotation cost is Rs. 12 and Dividend Distribution Tax is 20 %. Use both methods.  (f) 12% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%

D1 = D0 × (1 + g) = Expected Dividend

D0 = Current Dividend

g = Growth rate

P0 = Current Market Price

(e) 15 %.Preference Shares of Rs. 100 each, issued at 10 % premium, redeemable at par after 6 years. Flotation cost is Rs. 12 and Dividend Distribution Tax is 20 %. Use both methods.

After tax Cost of Preference Share Kp

After tax Cost of Preference Share Kp = (PD+DDT+(RV- NP)/n)/((RV+NP)/2) =   (15+3+(100- 98)/6)/((100+98)/2)    = 18.52% = .1852 PD = Preference Dividend = 15  DDT = Dividend Distribution Tax = 20 % of PD = Rs. 3 RV = Redeemable Value = Rs.100 NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 10 – 12 = Rs. 98 n= Maturity Period = 6 years Second Method: Using Interpolation Method: NP = PD including DDT × PVAF Kp, 6 + RV × PVFKp, 6  Considering KP at 18 % = 18 × 3.498 + 100 × 0.37 = Rs. 99.964  Considering KP at 19 % = 18 × 3.410 + 100 × 0.352 = Rs. 96.58  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 18 %+  (99.964-98)/(99.964-96.58)×(19 %-18 % ) = 18.58 % = .1858 (f) 13% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%. After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) =  (130 (1-.3)+ (1,000- 950)/5)/((1,000 +950)/2) = 10.36 % = 0.1036 Second Method: Using Interpolation Method: NP = Interest amount after tax × PVAF Kd, 5 + RV × PVF Kd, 5  Considering KP at 10 % = 130 × (1- 0.3) × 3.791 + 1,000 × 0.621 = Rs. 965.98 Considering KP at 11 % = 130 (1-0.3) × 3.696 + 1,000 × 0.593 = Rs. 929.34  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 10 %+  (965.98 -950)/(965.98 -929.34)×(11 %-10 % ) = 10.44 % = .1044

PD = Preference Dividend = 15

DDT = Dividend Distribution Tax = 20 % of PD = Rs. 3

RV = Redeemable Value = Rs.100

NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 10 – 12 = Rs. 98

n= Maturity Period = 6 years

Second Method: Using Interpolation Method:

NP = PD including DDT × PVAF Kp, 6 + RV × PVFKp, 6

Considering KP at 18 %

= 18 × 3.498 + 100 × 0.37 = Rs. 99.964

Considering KP at 19 %

= 18 × 3.410 + 100 × 0.352 = Rs. 96.58

Now using Interpolation Formula-

After tax Cost of Preference Share Kp = (PD+DDT+(RV- NP)/n)/((RV+NP)/2) =   (15+3+(100- 98)/6)/((100+98)/2)    = 18.52% = .1852 PD = Preference Dividend = 15  DDT = Dividend Distribution Tax = 20 % of PD = Rs. 3 RV = Redeemable Value = Rs.100 NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 10 – 12 = Rs. 98 n= Maturity Period = 6 years Second Method: Using Interpolation Method: NP = PD including DDT × PVAF Kp, 6 + RV × PVFKp, 6  Considering KP at 18 % = 18 × 3.498 + 100 × 0.37 = Rs. 99.964  Considering KP at 19 % = 18 × 3.410 + 100 × 0.352 = Rs. 96.58  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 18 %+  (99.964-98)/(99.964-96.58)×(19 %-18 % ) = 18.58 % = .1858 (f) 13% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%. After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) =  (130 (1-.3)+ (1,000- 950)/5)/((1,000 +950)/2) = 10.36 % = 0.1036 Second Method: Using Interpolation Method: NP = Interest amount after tax × PVAF Kd, 5 + RV × PVF Kd, 5  Considering KP at 10 % = 130 × (1- 0.3) × 3.791 + 1,000 × 0.621 = Rs. 965.98 Considering KP at 11 % = 130 (1-0.3) × 3.696 + 1,000 × 0.593 = Rs. 929.34  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 10 %+  (965.98 -950)/(965.98 -929.34)×(11 %-10 % ) = 10.44 % = .1044

(f) 13% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%.

After tax Cost of redeemable Debenture =  

After tax Cost of Preference Share Kp = (PD+DDT+(RV- NP)/n)/((RV+NP)/2) =   (15+3+(100- 98)/6)/((100+98)/2)    = 18.52% = .1852 PD = Preference Dividend = 15  DDT = Dividend Distribution Tax = 20 % of PD = Rs. 3 RV = Redeemable Value = Rs.100 NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 10 – 12 = Rs. 98 n= Maturity Period = 6 years Second Method: Using Interpolation Method: NP = PD including DDT × PVAF Kp, 6 + RV × PVFKp, 6  Considering KP at 18 % = 18 × 3.498 + 100 × 0.37 = Rs. 99.964  Considering KP at 19 % = 18 × 3.410 + 100 × 0.352 = Rs. 96.58  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 18 %+  (99.964-98)/(99.964-96.58)×(19 %-18 % ) = 18.58 % = .1858 (f) 13% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%. After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) =  (130 (1-.3)+ (1,000- 950)/5)/((1,000 +950)/2) = 10.36 % = 0.1036 Second Method: Using Interpolation Method: NP = Interest amount after tax × PVAF Kd, 5 + RV × PVF Kd, 5  Considering KP at 10 % = 130 × (1- 0.3) × 3.791 + 1,000 × 0.621 = Rs. 965.98 Considering KP at 11 % = 130 (1-0.3) × 3.696 + 1,000 × 0.593 = Rs. 929.34  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 10 %+  (965.98 -950)/(965.98 -929.34)×(11 %-10 % ) = 10.44 % = .1044

 = 10.36 % = 0.1036

Second Method: Using Interpolation Method:

NP = Interest amount after tax × PVAF Kd, 5 + RV × PVF Kd, 5

Considering KP at 10 %

= 130 × (1- 0.3) × 3.791 + 1,000 × 0.621 = Rs. 965.98

Considering KP at 11 %

= 130 (1-0.3) × 3.696 + 1,000 × 0.593 = Rs. 929.34

Now using Interpolation Formula-


After tax Cost of Preference Share Kp = (PD+DDT+(RV- NP)/n)/((RV+NP)/2) =   (15+3+(100- 98)/6)/((100+98)/2)    = 18.52% = .1852 PD = Preference Dividend = 15  DDT = Dividend Distribution Tax = 20 % of PD = Rs. 3 RV = Redeemable Value = Rs.100 NP = Face Value / Par Value + Premium on issue – Floatation Cost = 100 + 10 – 12 = Rs. 98 n= Maturity Period = 6 years Second Method: Using Interpolation Method: NP = PD including DDT × PVAF Kp, 6 + RV × PVFKp, 6  Considering KP at 18 % = 18 × 3.498 + 100 × 0.37 = Rs. 99.964  Considering KP at 19 % = 18 × 3.410 + 100 × 0.352 = Rs. 96.58  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 18 %+  (99.964-98)/(99.964-96.58)×(19 %-18 % ) = 18.58 % = .1858 (f) 13% Debentures of face value of Rs. 1000 each redeemable at par after 5 years, flotation cost being 5%. Use both methods given the tax rate @30%. After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2) =  (130 (1-.3)+ (1,000- 950)/5)/((1,000 +950)/2) = 10.36 % = 0.1036 Second Method: Using Interpolation Method: NP = Interest amount after tax × PVAF Kd, 5 + RV × PVF Kd, 5  Considering KP at 10 % = 130 × (1- 0.3) × 3.791 + 1,000 × 0.621 = Rs. 965.98 Considering KP at 11 % = 130 (1-0.3) × 3.696 + 1,000 × 0.593 = Rs. 929.34  Now using Interpolation Formula- Lower Rate+  (NP at Lower rate-Desired NP)/(NP at Lower Rate-NP at Higher Rate)×(Difference between rates) = 10 %+  (965.98 -950)/(965.98 -929.34)×(11 %-10 % ) = 10.44 % = .1044 = 10.44 % = .1044


6. RBL Company has the following capital structure on 1 July, 2021

 

Number/ Units

Amount (Rs.)

Equity Shares

40,000

8,00,000

11% Preference Shares

 

2,00,000

12 % Debentures

 

6,00,000

Total

 

16,00,000

The share of a company currently sells for Rs. 25. It is expected that the company will pay a dividend of Rs. 2 per share which will grow at 7 % forever. Assume a 40 per cent tax rate; you are required to compute weighted average cost of capital on existing capital structure.

Solution

D1 = Expected Dividend

P0 = Market Price of Equity Share

g = Growth rate

I = Interest rate on Debenture

E = Value of Equity Share

D = Value of Debenture

P = Value of Preference Share

V = Value of Firm = E + D + P

Cost of Equity (Ke) = (D1 / P0) + g = 2/25 + .07 = 0.15 = 15 %

Post Tax Cost of Debt (Kd) = I × (1 - t) = 0.12 × (1-0.4) = 0.072 = 7.2%

Cost of Preference Share (Kp) = 0.11 = 11 %

. RBL Company has the following capital structure on 1 July, 2021 	Number/ Units	Amount (Rs.) Equity Shares	40,000	8,00,000 11% Preference Shares		2,00,000 12 % Debentures		6,00,000 Total		16,00,000 The share of a company currently sells for Rs. 25. It is expected that the company will pay a dividend of Rs. 2 per share which will grow at 7 % forever. Assume a 40 per cent tax rate; you are required to compute weighted average cost of capital on existing capital structure. Solution D1 = Expected Dividend P0 = Market Price of Equity Share g = Growth rate I = Interest rate on Debenture E = Value of Equity Share D = Value of Debenture P = Value of Preference Share V = Value of Firm = E + D + P Cost of Equity (Ke) = (D1 / P0) + g = 2/25 + .07 = 0.15 = 15 % Post Tax Cost of Debt (Kd) = I × (1 - t) = 0.12 × (1-0.4) = 0.072 = 7.2% Cost of Preference Share (Kp) = 0.11 = 11 % Book value based WACC=(E/V)×Ke+(D/V)×Kd+(P/V)×Kp =((8,00,000)/(16,00,000))×.15+((6,00,000)/(16,00,000))×0.072+((2,00,000)/(16,00,000))×.11 = 0.075 + 0.027 + 0.01375 = 0.1158 = 11.58%

= 0.075 + 0.027 + 0.01375 = 0.1158 = 11.58%

7. RBL company's share is quoted in the market at Rs. 20 currently. The company has paid dividend of Rs. 2 per share and the investor's market expects a growth rate of 10 percent per year. You are required to compute-

(I) The Company’s Equity Cost of Capital.

(II) If the company's cost of capital is 15 per cent and the anticipated growth rate is 10 per cent per annum, calculate market price if the dividend of Rs. 2 is to be paid at the end of one year.

Solution

I. Cost of Equity (Ke) = (D1 / Po) + g

=

7. RBL company's share is quoted in the market at Rs. 20 currently. The company has paid dividend of Rs. 2 per share and the investor's market expects a growth rate of 10 percent per year. You are required to compute- (I) The Company’s Equity Cost of Capital. (II) If the company's cost of capital is 15 per cent and the anticipated growth rate is 10 per cent per annum, calculate market price if the dividend of Rs. 2 is to be paid at the end of one year. Solution I. Cost of Equity (Ke) = (D1 / Po) + g = (2× (1 +0.1))/20 + 0.1 = 21 % = 0.21 D1 = D0 × (1 + g) = Expected Dividend D0 = Current Dividend = Rs. 2 g = Growth rate P0 = Current Market Price  II. Market Price of Share Po =  D1/(Ke – g) = 2/(0.15-0.1) = Rs. 40 D1 = Rs. 2 = Expected Dividend

D1 = D0 × (1 + g) = Expected Dividend

D0 = Current Dividend = Rs. 2

g = Growth rate

P0 = Current Market Price

II. Market Price of Share 

RBL company's share is quoted in the market at Rs. 20 currently. The company has paid dividend of Rs. 2 per share and the investor's market expects a growth rate of 10 percent per year. You are required to compute- (I) The Company’s Equity Cost of Capital. (II) If the company's cost of capital is 15 per cent and the anticipated growth rate is 10 per cent per annum, calculate market price if the dividend of Rs. 2 is to be paid at the end of one year. Solution I. Cost of Equity (Ke) = (D1 / Po) + g = (2× (1 +0.1))/20 + 0.1 = 21 % = 0.21 D1 = D0 × (1 + g) = Expected Dividend D0 = Current Dividend = Rs. 2 g = Growth rate P0 = Current Market Price  II. Market Price of Share Po =  D1/(Ke – g) = 2/(0.15-0.1) = Rs. 40 D1 = Rs. 2 = Expected Dividend

D1 = Rs. 2 = Expected Dividend

8. Equity shares (Face value of Rs.10 each) of RBL Ltd. are being quoted at PE of 8 times. The retained earnings of the company are Rs. 6 at 40 %.

(I) find out the cost of equity, if the growth rate of the firm is 10%.

(II) Find out the indicated market price of the shares, given that

Ke remains as above and growth rate increases to 13%.

(III) If Ke of the firm is 16% and growth rate being 10%, then what is the indicated market price of the equity share?

Solution

I. Retention ratio = 0.4 = 40 % of EPS = Rs. 6

=> 0.4 EPS = Rs. 6

So, EPS = Rs. 6/0.4 = Rs. 15

Retained Earnings per Share = Rs. 6

EPS = Earnings per Share = E0

MPS = Market Price per Share = P0

PE ratio = MPS / EPS = P0 / E0

MPS = EPS × PE Ratio = Rs. 15 × 8 = Rs. 120

Dividend Payout Ratio = 1 – retention ratio = 1- 0.4 = 0.6 = 60 %

Dividend Per Share (D0) = 60 % of EPS = 0.6 × Rs. 15 = Rs. 9

Cost of Equity (Ke) = (D1 / Po) + g

Equity shares (Face value of Rs.10 each) of RBL Ltd. are being quoted at PE of 8 times. The retained earnings of the company are Rs. 6 at 40 %.  (I) find out the cost of equity, if the growth rate of the firm is 10%.  (II) Find out the indicated market price of the shares, given that  Ke remains as above and growth rate increases to 13%.  (III) If Ke of the firm is 16% and growth rate being 10%, then what is the indicated market price of the equity share?  Solution  I. Retention ratio = 0.4 = 40 % of EPS = Rs. 6  => 0.4 EPS = Rs. 6  So, EPS = Rs. 6/0.4 = Rs. 15  Retained Earnings per Share = Rs. 6  EPS = Earnings per Share = E0  MPS = Market Price per Share = P0  PE ratio = MPS / EPS = P0 / E0  MPS = EPS × PE Ratio = Rs. 15 × 8 = Rs. 120  Dividend Payout Ratio = 1 – retention ratio = 1- 0.4 = 0.6 = 60 %  Dividend Per Share (D0) = 60 % of EPS = 0.6 × Rs. 15 = Rs. 9  Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 18.25 % = 0.1825  D1 = D0 × (1 + g) = Expected Dividend  D0 = Current Dividend = Rs. 9  g = Growth rate  P0 = Current Market Price  II. Market Price of Share (Po)   =  = 10.17 / 0.0525 = Rs. 193.71  III. Market Price of Share (Po)    =  = 9.9/ 0.06 = Rs. 165

 = 18.25 % = 0.1825

D1 = D0 × (1 + g) = Expected Dividend

D0 = Current Dividend = Rs. 9

g = Growth rate

P0 = Current Market Price

II. Market Price of Share (Po)

Equity shares (Face value of Rs.10 each) of RBL Ltd. are being quoted at PE of 8 times. The retained earnings of the company are Rs. 6 at 40 %.  (I) find out the cost of equity, if the growth rate of the firm is 10%.  (II) Find out the indicated market price of the shares, given that  Ke remains as above and growth rate increases to 13%.  (III) If Ke of the firm is 16% and growth rate being 10%, then what is the indicated market price of the equity share?  Solution  I. Retention ratio = 0.4 = 40 % of EPS = Rs. 6  => 0.4 EPS = Rs. 6  So, EPS = Rs. 6/0.4 = Rs. 15  Retained Earnings per Share = Rs. 6  EPS = Earnings per Share = E0  MPS = Market Price per Share = P0  PE ratio = MPS / EPS = P0 / E0  MPS = EPS × PE Ratio = Rs. 15 × 8 = Rs. 120  Dividend Payout Ratio = 1 – retention ratio = 1- 0.4 = 0.6 = 60 %  Dividend Per Share (D0) = 60 % of EPS = 0.6 × Rs. 15 = Rs. 9  Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 18.25 % = 0.1825  D1 = D0 × (1 + g) = Expected Dividend  D0 = Current Dividend = Rs. 9  g = Growth rate  P0 = Current Market Price  II. Market Price of Share (Po)   =  = 10.17 / 0.0525 = Rs. 193.71  III. Market Price of Share (Po)    =  = 9.9/ 0.06 = Rs. 165


9. Shares of XYZ Ltd. are currently selling at Rs. 170 each. The company has been regularly paying dividends for last several years as follows:

Years

Amount

1

12.00

2

12.72

3

13.48

4

14.29

5

15.15

6

16.07

Find out the growth rate of the company, given that the company follows a policy of fixed DP Ratio. Also find out the cost of equity of the company.

Solution

Cumulative Growth rate for 5 years = 16.07 /12.00 = 1.339

In FVF table, the value nearest to 1.339 for 5 years is 1.338 at 6 % rate. So annual growth rate = 6 %

Second way to calculate growth rate in this case is calculating percentage increase in amount year on year since company follows a policy of fixed DP Ratio; hence growth rate will be same Year over Year

Years

Amount

%age Change

1

12.00

-------

2

12.72

(12.72 – 12) /12 = 0.06 or 6 %

3

13.48

(13.48 - 12.72 ) /12.72 = 0.06 or 6 %

4

14.29

(14.29 – 13.48) /13.48 = 0.06 or 6 %

5

15.15

(15.15 – 14.29) /14.29 = 0.06 or 6 %

6

16.07

(16.07 – 15.15) /15.15 = 0.06 or 6 %

Cost of Equity (Ke) = (D1 / Po) + g


Shares of XYZ Ltd. are currently selling at Rs. 170 each. The company has been regularly paying dividends for last several years as follows: Years	Amount 1	12.00 2	12.72 3	13.48 4	14.29 5	15.15 6	16.07 Find out the growth rate of the company, given that the company follows a policy of fixed DP Ratio. Also find out the cost of equity of the company. Solution Cumulative Growth rate for 5 years = 16.07 /12.00 = 1.339 In FVF table, the value nearest to 1.339 for 5 years is 1.338 at 6 % rate. So annual growth rate = 6 % Second way to calculate growth rate in this case is calculating percentage increase in amount year on year since company follows a policy of fixed DP Ratio; hence growth rate will be same Year over Year Years	Amount	%age Change 1	12.00	------- 2	12.72	(12.72 – 12) /12 = 0.06 or 6 % 3	13.48	(13.48 - 12.72 ) /12.72 = 0.06 or 6 % 4	14.29	(14.29 – 13.48) /13.48 = 0.06 or 6 % 5	15.15	(15.15 – 14.29) /14.29 = 0.06 or 6 % 6	16.07	(16.07 – 15.15) /15.15 = 0.06 or 6 % Cost of Equity (Ke) = (D1 / Po) + g = (16.07× (1 +0.06))/170 + 0.06 = 16.02 % = 0.1602 D0 = Dividend paid in 6th year (since 6th year is current year in which share is trading at Rs. 170)

D0 = Dividend paid in 6th year (since 6th year is current year in which share is trading at Rs. 170)

10. The following figures are taken from the current balance sheet of Diwakar & Co.

Particulars

Amount (Rs.)

Share Capital of Rs. 10 each

8,00,000

Share / Security Premium

2,00,000

Reserves

6,00,000

Shareholders’ Funds

16,00,000

14 % Perpetual Debentures of Rs. 100 each

4,00,000

An annual ordinary dividend of Rs. 3 per share has just been paid. In the past, ordinary dividends have grown at a rate of 10 per cent per annum and this rate of growth is expected to continue. Annual interest has recently been paid on the debentures. The ordinary shares are currently quoted at Rs. 30 and the debentures at 80 per cent Ignore taxation. You are required to estimate the weighted average cost of capital (based on market values) for Diwakar & Co.

Solution

D0 = Current Dividend paid = Rs. 3

Cost of Equity (Ke) = (D1 / Po) + g

The following figures are taken from the current balance sheet of Diwakar & Co. Particulars	Amount (Rs.) Share Capital of Rs. 10 each	8,00,000 Share / Security Premium	2,00,000 Reserves	6,00,000 Shareholders’ Funds	16,00,000 14 % Perpetual Debentures of Rs. 100 each	4,00,000 An annual ordinary dividend of Rs. 3 per share has just been paid. In the past, ordinary dividends have grown at a rate of 10 per cent per annum and this rate of growth is expected to continue. Annual interest has recently been paid on the debentures. The ordinary shares are currently quoted at Rs. 30 and the debentures at 80 per cent Ignore taxation. You are required to estimate the weighted average cost of capital (based on market values) for Diwakar & Co. Solution D0 = Current Dividend paid = Rs. 3 Cost of Equity (Ke) = (D1 / Po) + g = (3× (1 +0.1))/30 + 0.1 = 0.21 = 21 % Cost of Perpetual Debentures = Interest / NP or MP = 14/80 = 0.175 = 17.5% NP = Net Proceed MP = Market Price of Debenture Market Value of Equity Share (E) = Market Price per Share × no. of Equity Shares = Rs. 30 × Rs. 8,00,000 / 10 = Rs. 24,00,000. Market Value of Perpetual Debenture (D) = Market Price per Debenture × no. of Debentures = Rs. 80 × Rs. 4,00,000 / 100 = Rs. 3,20,000. Market Value of Firm (V) = Market Value of Equity Share + Market Value of Perpetual Debenture = Rs. 24,00,000 + Rs. 3,20,000 = Rs. 27,20,000 WACC (based on market values) = (E/V) × Ke + (D/V) × Kd  = (24,00,000 / 27,20,000) × 0.21 + (3,20,000 / 27,20,000) × 0.175 = 0.185 + 0.021 = 0.206 = 20.6 %

Cost of Perpetual Debentures = Interest / NP or MP

= 14/80 = 0.175 = 17.5%

NP = Net Proceed

MP = Market Price of Debenture

Market Value of Equity Share (E) = Market Price per Share × no. of Equity Shares = Rs. 30 × Rs. 8,00,000 / 10 = Rs. 24,00,000.

Market Value of Perpetual Debenture (D) = Market Price per Debenture × no. of Debentures = Rs. 80 × Rs. 4,00,000 / 100 = Rs. 3,20,000.

Market Value of Firm (V) = Market Value of Equity Share + Market Value of Perpetual Debenture = Rs. 24,00,000 + Rs. 3,20,000 = Rs. 27,20,000

WACC (based on market values) = (E/V) × Ke + (D/V) × Kd

= (24,00,000 / 27,20,000) × 0.21 + (3,20,000 / 27,20,000) × 0.175 = 0.185 + 0.021 = 0.206 = 20.6 %

11. The following information has been extracted from the balance sheet of RBL Ltd.

Particulars

Amount (Rs.)

Share Capital

5,00,00,000

12% Debentures

5,00,00,000

18% Term loan

12,00,00,000

Total

22,00,00,000

(a) Determine the weighted average cost of capital of the company. It had been paying dividends at a consistent rate of 20% per annum. Shares and Debentures are being traded at par. Tax rate is 40%.

(b) What difference will it make if the current price of share (Face Value Rs.100) is Rs. 170?

Solution

a. Cost of Debenture (Kd) = I (1- t)

= 12% × (1-0.4) = 7.2% = 0.072

Cost of Term Loan (KL) = I (1-t)

=18% × (1-0.4) = 10.8% = 0.108

Cost of equity (Ke) = Dividend / NP or P0 = 20 / 100 = 0.2

(Assuming Par value of Equity share to be Rs. 100; Dividend = 20 % of Face value = 20 % of Rs. 100)

Note: Since Market Price of Share and growth rate is not given and there is no premium or discount on issue of share and also no floatation cost is mentioned in the question, hence face value / Par value has been considered as Net proceed or Market Price of equity Share.

WACC = (E/V) × Ke + (D/V) × Kd + (TL / V) × KL

= (5,00,00,000 / 22,00,00,000) × 0.2 + (5,00,00,000 / 22,00,00,000) × 0.072 + (12,00,00,000 / 22,00,00,000) × 0.108

=0.045 + 0.0163 +0.0589 = 0.1202 = 12.02%

b. Cost of equity (Ke) = Dividend / P0 = 20 / 170 = 0.1176

Cost of Term Loan (KL) and Cost of Debenture (Kd) will remain same.

WACC (based on Book Value of company) = (E/V) × Ke + (D/V) × Kd + (TL / V) × KL

= (5,00,00,000 / 22,00,00,000) × 0.1176 + (5,00,00,000 / 22,00,00,000) × 0.072 + (12,00,00,000 / 22,00,00,000) × 0.108

=0.027 + 0.0163 +0.0589 = 0.102 = 10.2%

12. The following information is available from the Balance Sheet of a Company:

Particulars

Amount (Rs.)

Share Capital- 20,000 shares of Rs. 10 each

2,00,000

Reserve & Surplus

1,40,000

8 % Debentures

1,60,000

The rate of tax for the company is 50%. Current level of Equity Dividend is 15%. Calculate the weighted average cost of capital using the above figures.

Solution

 

Book Value

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Equity Share Capital

2,00,000

2,00,000/5,00,000 = 0.4

.15

0.06

Reserve & Surplus

1,40,000

1,40,000/5,00,000 = 0.28

.15

0.042

8 % Debentures

1,60,000

1,60,000/5,00,000 = 0.32

0.08 × (1-0.5) =0.04

0.0128

Total Value of Firm

4,00,000

WACC based on Book Value  =           ∑ Weighted Cost= 0.06 +  0.042 + 0.0128  = 0.1148

 

13. In considering the most desirable capital structure for a company, the following estimates of the cost of debt capital (after tax) have been made at various levels of debt-equity mix:

Debt as percentage of Total Capital Employed

Cost of Debt (Kd) %

Cost of Equity (Ke )%

0

7.0

20.0

10

7.0

20.0

20

7.0

20.5

30

7.5

21.0

40

8.0

22.0

50

8.5

25.0

60

9.5

27.0

You are required to find out the weighted average cost of capital of the firm for different proportions of debt and optimal capital structure.

Solution

Debt %

Kd

Equity %

Ke

WACC = (Debt % × Kd) +( Equity %× Ke)

 

 

 

 

 

0

7.0

100

20.0

20%

10

7.0

90

20.0

18.7%

20

7.0

80

20.5

17.8%

30

7.5

70

21.0

16.95%

40

8.0

60

22.0

16.4%

50

8.5

50

25.0

16.75%

60

9.5

40

27.0

16.5%

Since WACC is lowest with 40 % debt and 60 % equity. Hence, optimal capital Structure will be capital mix of 40:60 Debt- equity ratio.

Since value of debt and equity is given in percentage, there is no need to calculate weight of Debt and equity for WACC calculation as it will remain same. Since value of firm will be 100 % and if we divide debt % with firm value percentage or equity % with firm value percentage, result will remain same.

14. A company with net operating income of Rs. 3, 00,000 is attempting to evaluate a number of possible capital structures, given below. Which of the capital structure will you recommend and why?

Capital Structure

Debt in Capital Structure (Rs.)

Kd (Cost of Debt)

Ke (Cost of Equity)

1

1,00,000

10.0

12.0

2

2,00,000

10.0

12.0

3

3,00,000

10.0

12.0

4

4,00,000

10.0

12.5

5

5,00,000

11.0

13.5

6

6,00,000

12.0

15.0

7

7,00,000

14.0

18.0

Solution

Capital Structure

1

2

3

4

5

6

7

EBIT

3,00,000

3,00,000

3,00,000

3,00,000

3,00,000

3,00,000

3,00,000

Less: Interest

(10,000)

(20,000)

(30,000)

(40,000)

(55,000)

(72,000)

(98,000)

EBT / PAT

2,90,000

2,80,000

2,70,000

2,60,000

2,45,000

2,28,000

2,02,000

Ke

12.0

12.0

12.0

12.5

13.5

15.0

18.0

Value of Equity

24,16,667

23,33,333

22,50,000

20,80,000

18,14,815

15,20,000

11,22,222

Value of Debt

1,00,000

2,00,000

3,00,000

4,00,000

5,00,000

6,00,000

7,00,000

Value of Firm

25,16,667

25,33,333

25,50,000

24,80,000

23,14,815

21,20,000

18,22,220

 

Value of Equity = PAT / Ke

Value of Firm = Value of Debt + Value of Equity

Since, Value of Firm is highest for third Capital structure; hence third capital structure should be selected by company.

15. POR & Co. has the following capital structure as on Dec. 31.

Particulars

Amount (Rs.)

Share Capital- 5,000 shares of Rs. 100 each

5,00,000

9 % Preference Shares

2,00,000

10 % Debentures

3,00,000

The equity shares of the company are quoted at Rs. 110 and the company is expected to declare a dividend of Rs. 10 per share for the next year. The company has registered a dividend growth rate of 5% which is expected to be maintained.

 (I) Assuming the tax rate applicable to the company at 40%, calculate the weighted average cost of capital, and

(II) Assuming that the company can raise additional term loan at 12% for Rs. 10,00,000 to finance its expansion, calculate the revised WACC. The company's expectation is that the business risk associated with new financing may bring down the market price from Rs. 110 to Rs. 90 per share.

Solution

I. Cost of Equity (Ke) = (D1 / Po) + g

POR & Co. has the following capital structure as on Dec. 31. Particulars	Amount (Rs.) Share Capital- 5,000 shares of Rs. 100 each	5,00,000 9 % Preference Shares	2,00,000 10 % Debentures	3,00,000 The equity shares of the company are quoted at Rs. 110 and the company is expected to declare a dividend of Rs. 10 per share for the next year. The company has registered a dividend growth rate of 5% which is expected to be maintained.  (I) Assuming the tax rate applicable to the company at 40%, calculate the weighted average cost of capital, and (II) Assuming that the company can raise additional term loan at 12% for Rs. 10,00,000 to finance its expansion, calculate the revised WACC. The company's expectation is that the business risk associated with new financing may bring down the market price from Rs. 110 to Rs. 90 per share. Solution I. Cost of Equity (Ke) = (D1 / Po) + g = 10/110 + 0.05 = 0.141 = 14.1 % Cost of Debenture (Kd) = I × (1-t) = 0.1 × (1-0.4) =0.06 = 6 % Cost of Preference Share (Kp) = 0.09 = 9% 	Book Value	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Equity Share Capital	5,00,000	5,00,000/10,00,000 = 0.5	.141	0.0705 9 % Preference Shares	2,00,000	2,00,000/10,00,000 = 0.20	.09	0.018 10 % Debentures	3,00,000	3,00,000/10,00,000 = 0.30	.06	0.018 Total Value of Firm	20,00,000	WACC based on Book Value  =           ∑ Weighted Cost= 0.0705 +  0.018 + 0.018  = 0.1065 = 10.65% II. Cost of Term Loan (Kl) = I × (1- t) = .12 × .6 = 0.072 = 7.2% Cost of Equity (Ke) = (D1 / Po) + g = 10/90 + 0.05 = 0.1611 = 16.11 % 	Book Value	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Equity Share Capital	5,00,000	5,00,000/20,00,000 = 0.25	.1611	0.0403 9 % Preference Shares	2,00,000	2,00,000/20,00,000 = 0.10	.09	0.018 10 % Debentures	3,00,000	3,00,000/20,00,000 = 0.15	.06	0.018 12 % Term Loan	10,00,000	10,00,000/20,00,000 = 0.5	0.072	0.036 Total Value of Firm	10,00,000	WACC based on Book Value  =           ∑ Weighted Cost= 0.0403 +  0.018 + 0.018  + 0.036= 0.1123 = 11.23%

Post TaxCost of Debenture (Kd) = I × (1-t) = 0.1 × (1-0.4) =0.06 = 6 %

Cost of Preference Share (Kp) = 0.09 = 9%

 

Book Value

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Equity Share Capital

5,00,000

5,00,000/10,00,000 = 0.5

.141

0.0705

9 % Preference Shares

2,00,000

2,00,000/10,00,000 = 0.20

.09

0.018

10 % Debentures

3,00,000

3,00,000/10,00,000 = 0.30

.06

0.018

Total Value of Firm

20,00,000

WACC based on Book Value  =           ∑ Weighted Cost= 0.0705 +  0.018 + 0.018  = 0.1065 = 10.65%

II. Cost of Term Loan (Kl) = I × (1- t) = .12 × .6 = 0.072 = 7.2%

Cost of Equity (Ke) = (D1 / Po) + g

POR & Co. has the following capital structure as on Dec. 31. Particulars	Amount (Rs.) Share Capital- 5,000 shares of Rs. 100 each	5,00,000 9 % Preference Shares	2,00,000 10 % Debentures	3,00,000 The equity shares of the company are quoted at Rs. 110 and the company is expected to declare a dividend of Rs. 10 per share for the next year. The company has registered a dividend growth rate of 5% which is expected to be maintained.  (I) Assuming the tax rate applicable to the company at 40%, calculate the weighted average cost of capital, and (II) Assuming that the company can raise additional term loan at 12% for Rs. 10,00,000 to finance its expansion, calculate the revised WACC. The company's expectation is that the business risk associated with new financing may bring down the market price from Rs. 110 to Rs. 90 per share. Solution I. Cost of Equity (Ke) = (D1 / Po) + g = 10/110 + 0.05 = 0.141 = 14.1 % Cost of Debenture (Kd) = I × (1-t) = 0.1 × (1-0.4) =0.06 = 6 % Cost of Preference Share (Kp) = 0.09 = 9% 	Book Value	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Equity Share Capital	5,00,000	5,00,000/10,00,000 = 0.5	.141	0.0705 9 % Preference Shares	2,00,000	2,00,000/10,00,000 = 0.20	.09	0.018 10 % Debentures	3,00,000	3,00,000/10,00,000 = 0.30	.06	0.018 Total Value of Firm	20,00,000	WACC based on Book Value  =           ∑ Weighted Cost= 0.0705 +  0.018 + 0.018  = 0.1065 = 10.65% II. Cost of Term Loan (Kl) = I × (1- t) = .12 × .6 = 0.072 = 7.2% Cost of Equity (Ke) = (D1 / Po) + g = 10/90 + 0.05 = 0.1611 = 16.11 % 	Book Value	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Equity Share Capital	5,00,000	5,00,000/20,00,000 = 0.25	.1611	0.0403 9 % Preference Shares	2,00,000	2,00,000/20,00,000 = 0.10	.09	0.018 10 % Debentures	3,00,000	3,00,000/20,00,000 = 0.15	.06	0.018 12 % Term Loan	10,00,000	10,00,000/20,00,000 = 0.5	0.072	0.036 Total Value of Firm	10,00,000	WACC based on Book Value  =           ∑ Weighted Cost= 0.0403 +  0.018 + 0.018  + 0.036= 0.1123 = 11.23%


 

Book Value

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Equity Share Capital

5,00,000

5,00,000/20,00,000 = 0.25

.1611

0.0403

9 % Preference Shares

2,00,000

2,00,000/20,00,000 = 0.10

.09

0.018

10 % Debentures

3,00,000

3,00,000/20,00,000 = 0.15

.06

0.018

12 % Term Loan

10,00,000

10,00,000/20,00,000 = 0.5

0.072

0.036

Total Value of Firm

10,00,000

WACC based on Book Value  =           ∑ Weighted Cost= 0.0403 +  0.018 + 0.018  + 0.036= 0.1123 = 11.23%

 

16. International Foods Limited has the following capital structure:

Particulars

Book Value (Rs.)

Market Value (Rs)

 

 

 

Share Capital- 25,000 shares of Rs. 10 each

2,50,000

4,50,000

13% Preference Capital

(500 shares of Rs. 100 each)

50,000

45,000

Reserves and Surplus

1,50,000

----------

12 % Debentures

(1500 debentures of 100 each)

1,50,000

1,20,000

Total

6,00,000

6,15,000

The expected dividend per share is Rs.2 and the dividend per share is expected to grow at a rate of 10 percent forever. Preference shares are redeemable after 5 years at par whereas debentures are redeemable after 10 years at 10 % premium. The tax rate for the company is 30 per cent. You are required to compute the weighted average cost of capital for the existing capital structure using market value as weights.

Solution

Cost of Equity (Ke) = (D1 / Po) + g

International Foods Limited has the following capital structure: Particulars	Book Value (Rs.)	Market Value (Rs) 		 Share Capital- 25,000 shares of Rs. 10 each	2,50,000	4,50,000 13% Preference Capital (500 shares of Rs. 100 each)	50,000	45,000 Reserves and Surplus	1,50,000	---------- 12 % Debentures (1500 debentures of 100 each)	1,50,000	1,20,000 Total	6,00,000	6,15,000 The expected dividend per share is Rs.2 and the dividend per share is expected to grow at a rate of 10 percent forever. Preference shares are redeemable after 5 years at par whereas debentures are redeemable after 10 years at 10 % premium. The tax rate for the company is 30 per cent. You are required to compute the weighted average cost of capital for the existing capital structure using market value as weights. Solution Cost of Equity (Ke) = (D1 / Po) + g = 2/18 + 0.1 = 0.2111 = 21.11 % D1 = Expected Dividend g = Growth rate P0 = Current Market Price  P0 = Market Value (MV) of Equity / Total no. of Equity Shares = Rs. 4,50,000 / 25,000 = Rs. 18 After tax Cost of Preference Share Kp = (PD+(RV- MP)/n)/((RV+MP)/2) =   (13+(100- 90)/5)/((100+90)/2)    = 15.79% = .1579 PD = Preference Dividend = 13  RV = Redeemable Value = Rs.100 MP = Market Price n= Maturity Period = 5 years MP = Market Value of Pref. Share / Total no. of Pref. Shares = Rs. 45,000 / 500 = Rs. 90 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- MP)/n)/((RV+MP)/2)  = (12 × (1-0.3)+ (110- 80)/10)/( (110 +80)/2)  =  12 % = 0.12 RV = Redeemable Value = Par value + Premium on redemption = Rs. 100 + 10 % of Rs. 100 = Rs. 110 I = Interest amount n = Maturity Period of Debenture / Bond = 10 years MP = Market Price MP = Market Value of Debentures / Total no. of Debentures = Rs. 1,20,000 / 1,500 = Rs. 80 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	4,50,000	4,50,000/6,15,000 = 0.732	0.2111	0.1545 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	________	__________	___	____ 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.1545 + 0.0116+ 0.0234 = 0.1895 = 18.95%  Note: While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus and then include Market value of Reserve & Surplus while calculating WACC based on Market value. In this case,  Cost of Reserve & Surplus (KR&S) = Cost of Share Capital (Ke) In this case Market value of Equity that is Rs. 4,50,000 can be divided into Equity Share & Reserve & Surplus in the ration of book value of Equity Share & Reserve & Surplus That is in the ratio of 2,50,000 : 1,50,000.  MV of Equity = 2,50,000/4,00,000×4,50,000 = Rs.2,81,250 MV of Reserve & Surplus = 1,50,000/4,00,000×4,50,000 = Rs. 1,68,750 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	2,81,250	2,81,250/6,15,000 = 0.4573	0.2111	0.0965 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	1,68,750	1,68,750/6,15,000 = 0.2744	0.2111	0.058 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.0965 + 0.0116 + 0.058 + 0.0234 = 0.1895 = 18.95%

 0.2111 = 21.11 %

D1 = Expected Dividend

g = Growth rate

P0 = Current Market Price

P0 = Market Value (MV) of Equity / Total no. of Equity Shares = Rs. 4,50,000 / 25,000 = Rs. 18

After tax Cost of Preference Share Kp

International Foods Limited has the following capital structure: Particulars	Book Value (Rs.)	Market Value (Rs) 		 Share Capital- 25,000 shares of Rs. 10 each	2,50,000	4,50,000 13% Preference Capital (500 shares of Rs. 100 each)	50,000	45,000 Reserves and Surplus	1,50,000	---------- 12 % Debentures (1500 debentures of 100 each)	1,50,000	1,20,000 Total	6,00,000	6,15,000 The expected dividend per share is Rs.2 and the dividend per share is expected to grow at a rate of 10 percent forever. Preference shares are redeemable after 5 years at par whereas debentures are redeemable after 10 years at 10 % premium. The tax rate for the company is 30 per cent. You are required to compute the weighted average cost of capital for the existing capital structure using market value as weights. Solution Cost of Equity (Ke) = (D1 / Po) + g = 2/18 + 0.1 = 0.2111 = 21.11 % D1 = Expected Dividend g = Growth rate P0 = Current Market Price  P0 = Market Value (MV) of Equity / Total no. of Equity Shares = Rs. 4,50,000 / 25,000 = Rs. 18 After tax Cost of Preference Share Kp = (PD+(RV- MP)/n)/((RV+MP)/2) =   (13+(100- 90)/5)/((100+90)/2)    = 15.79% = .1579 PD = Preference Dividend = 13  RV = Redeemable Value = Rs.100 MP = Market Price n= Maturity Period = 5 years MP = Market Value of Pref. Share / Total no. of Pref. Shares = Rs. 45,000 / 500 = Rs. 90 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- MP)/n)/((RV+MP)/2)  = (12 × (1-0.3)+ (110- 80)/10)/( (110 +80)/2)  =  12 % = 0.12 RV = Redeemable Value = Par value + Premium on redemption = Rs. 100 + 10 % of Rs. 100 = Rs. 110 I = Interest amount n = Maturity Period of Debenture / Bond = 10 years MP = Market Price MP = Market Value of Debentures / Total no. of Debentures = Rs. 1,20,000 / 1,500 = Rs. 80 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	4,50,000	4,50,000/6,15,000 = 0.732	0.2111	0.1545 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	________	__________	___	____ 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.1545 + 0.0116+ 0.0234 = 0.1895 = 18.95%  Note: While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus and then include Market value of Reserve & Surplus while calculating WACC based on Market value. In this case,  Cost of Reserve & Surplus (KR&S) = Cost of Share Capital (Ke) In this case Market value of Equity that is Rs. 4,50,000 can be divided into Equity Share & Reserve & Surplus in the ration of book value of Equity Share & Reserve & Surplus That is in the ratio of 2,50,000 : 1,50,000.  MV of Equity = 2,50,000/4,00,000×4,50,000 = Rs.2,81,250 MV of Reserve & Surplus = 1,50,000/4,00,000×4,50,000 = Rs. 1,68,750 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	2,81,250	2,81,250/6,15,000 = 0.4573	0.2111	0.0965 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	1,68,750	1,68,750/6,15,000 = 0.2744	0.2111	0.058 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.0965 + 0.0116 + 0.058 + 0.0234 = 0.1895 = 18.95%

PD = Preference Dividend = 13

RV = Redeemable Value = Rs.100

MP = Market Price

n= Maturity Period = 5 years

MP = Market Value of Pref. Share / Total no. of Pref. Shares

= Rs. 45,000 / 500 = Rs. 90

After tax Cost of redeemable Debenture = 

International Foods Limited has the following capital structure: Particulars	Book Value (Rs.)	Market Value (Rs) 		 Share Capital- 25,000 shares of Rs. 10 each	2,50,000	4,50,000 13% Preference Capital (500 shares of Rs. 100 each)	50,000	45,000 Reserves and Surplus	1,50,000	---------- 12 % Debentures (1500 debentures of 100 each)	1,50,000	1,20,000 Total	6,00,000	6,15,000 The expected dividend per share is Rs.2 and the dividend per share is expected to grow at a rate of 10 percent forever. Preference shares are redeemable after 5 years at par whereas debentures are redeemable after 10 years at 10 % premium. The tax rate for the company is 30 per cent. You are required to compute the weighted average cost of capital for the existing capital structure using market value as weights. Solution Cost of Equity (Ke) = (D1 / Po) + g = 2/18 + 0.1 = 0.2111 = 21.11 % D1 = Expected Dividend g = Growth rate P0 = Current Market Price  P0 = Market Value (MV) of Equity / Total no. of Equity Shares = Rs. 4,50,000 / 25,000 = Rs. 18 After tax Cost of Preference Share Kp = (PD+(RV- MP)/n)/((RV+MP)/2) =   (13+(100- 90)/5)/((100+90)/2)    = 15.79% = .1579 PD = Preference Dividend = 13  RV = Redeemable Value = Rs.100 MP = Market Price n= Maturity Period = 5 years MP = Market Value of Pref. Share / Total no. of Pref. Shares = Rs. 45,000 / 500 = Rs. 90 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- MP)/n)/((RV+MP)/2)  = (12 × (1-0.3)+ (110- 80)/10)/( (110 +80)/2)  =  12 % = 0.12 RV = Redeemable Value = Par value + Premium on redemption = Rs. 100 + 10 % of Rs. 100 = Rs. 110 I = Interest amount n = Maturity Period of Debenture / Bond = 10 years MP = Market Price MP = Market Value of Debentures / Total no. of Debentures = Rs. 1,20,000 / 1,500 = Rs. 80 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	4,50,000	4,50,000/6,15,000 = 0.732	0.2111	0.1545 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	________	__________	___	____ 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.1545 + 0.0116+ 0.0234 = 0.1895 = 18.95%  Note: While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus and then include Market value of Reserve & Surplus while calculating WACC based on Market value. In this case,  Cost of Reserve & Surplus (KR&S) = Cost of Share Capital (Ke) In this case Market value of Equity that is Rs. 4,50,000 can be divided into Equity Share & Reserve & Surplus in the ration of book value of Equity Share & Reserve & Surplus That is in the ratio of 2,50,000 : 1,50,000.  MV of Equity = 2,50,000/4,00,000×4,50,000 = Rs.2,81,250 MV of Reserve & Surplus = 1,50,000/4,00,000×4,50,000 = Rs. 1,68,750 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	2,81,250	2,81,250/6,15,000 = 0.4573	0.2111	0.0965 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	1,68,750	1,68,750/6,15,000 = 0.2744	0.2111	0.058 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.0965 + 0.0116 + 0.058 + 0.0234 = 0.1895 = 18.95%

RV = Redeemable Value = Par value + Premium on redemption = Rs. 100 + 10 % of Rs. 100 = Rs. 110

I = Interest amount

n = Maturity Period of Debenture / Bond = 10 years

MP = Market Price

MP = Market Value of Debentures / Total no. of Debentures

= Rs. 1,20,000 / 1,500 = Rs. 80

 

Market Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

4,50,000

4,50,000/6,15,000 = 0.732

0.2111

0.1545

13% Preference Capital

45,000

45,000/6,15,000 = 0.0732

.1579

0.0116

Reserves and Surplus

________

__________

___

____

12 % Debentures

1,20,000

1,20,000/6,15,000 = 0.1951

0.12

0.0234

Total

6,15,000

WACC based on Market Value  =           ∑ Weighted Cost= 0.1545 + 0.0116+ 0.0234 = 0.1895 = 18.95%

 

Note: While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus and then include Market value of Reserve & Surplus while calculating WACC based on Market value. In this case,

Cost of Reserve & Surplus (KR&S) = Cost of Share Capital (Ke)

In this case Market value of Equity that is Rs. 4,50,000 can be divided into Equity Share & Reserve & Surplus in the ration of book value of Equity Share & Reserve & Surplus That is in the ratio of 2,50,000 : 1,50,000.

International Foods Limited has the following capital structure: Particulars	Book Value (Rs.)	Market Value (Rs) 		 Share Capital- 25,000 shares of Rs. 10 each	2,50,000	4,50,000 13% Preference Capital (500 shares of Rs. 100 each)	50,000	45,000 Reserves and Surplus	1,50,000	---------- 12 % Debentures (1500 debentures of 100 each)	1,50,000	1,20,000 Total	6,00,000	6,15,000 The expected dividend per share is Rs.2 and the dividend per share is expected to grow at a rate of 10 percent forever. Preference shares are redeemable after 5 years at par whereas debentures are redeemable after 10 years at 10 % premium. The tax rate for the company is 30 per cent. You are required to compute the weighted average cost of capital for the existing capital structure using market value as weights. Solution Cost of Equity (Ke) = (D1 / Po) + g = 2/18 + 0.1 = 0.2111 = 21.11 % D1 = Expected Dividend g = Growth rate P0 = Current Market Price  P0 = Market Value (MV) of Equity / Total no. of Equity Shares = Rs. 4,50,000 / 25,000 = Rs. 18 After tax Cost of Preference Share Kp = (PD+(RV- MP)/n)/((RV+MP)/2) =   (13+(100- 90)/5)/((100+90)/2)    = 15.79% = .1579 PD = Preference Dividend = 13  RV = Redeemable Value = Rs.100 MP = Market Price n= Maturity Period = 5 years MP = Market Value of Pref. Share / Total no. of Pref. Shares = Rs. 45,000 / 500 = Rs. 90 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- MP)/n)/((RV+MP)/2)  = (12 × (1-0.3)+ (110- 80)/10)/( (110 +80)/2)  =  12 % = 0.12 RV = Redeemable Value = Par value + Premium on redemption = Rs. 100 + 10 % of Rs. 100 = Rs. 110 I = Interest amount n = Maturity Period of Debenture / Bond = 10 years MP = Market Price MP = Market Value of Debentures / Total no. of Debentures = Rs. 1,20,000 / 1,500 = Rs. 80 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	4,50,000	4,50,000/6,15,000 = 0.732	0.2111	0.1545 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	________	__________	___	____ 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.1545 + 0.0116+ 0.0234 = 0.1895 = 18.95%  Note: While calculating WACC based on Market value, Reserve & Surplus and Retained earnings are not considered as it is absorbed in market value of equity share. Alternatively we can divide market value of Equity shares in the ratio of book value of Equity Share and Reserve & Surplus and then include Market value of Reserve & Surplus while calculating WACC based on Market value. In this case,  Cost of Reserve & Surplus (KR&S) = Cost of Share Capital (Ke) In this case Market value of Equity that is Rs. 4,50,000 can be divided into Equity Share & Reserve & Surplus in the ration of book value of Equity Share & Reserve & Surplus That is in the ratio of 2,50,000 : 1,50,000.  MV of Equity = 2,50,000/4,00,000×4,50,000 = Rs.2,81,250 MV of Reserve & Surplus = 1,50,000/4,00,000×4,50,000 = Rs. 1,68,750 	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	2,81,250	2,81,250/6,15,000 = 0.4573	0.2111	0.0965 13% Preference Capital	45,000	45,000/6,15,000 = 0.0732	.1579	0.0116 Reserves and Surplus	1,68,750	1,68,750/6,15,000 = 0.2744	0.2111	0.058 12 % Debentures	1,20,000	1,20,000/6,15,000 = 0.1951	0.12	0.0234 Total	6,15,000	WACC based on Market Value  =           ∑ Weighted Cost= 0.0965 + 0.0116 + 0.058 + 0.0234 = 0.1895 = 18.95%


 

Market Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

2,81,250

2,81,250/6,15,000 = 0.4573

0.2111

0.0965

13% Preference Capital

45,000

45,000/6,15,000 = 0.0732

.1579

0.0116

Reserves and Surplus

1,68,750

1,68,750/6,15,000 = 0.2744

0.2111

0.058

12 % Debentures

1,20,000

1,20,000/6,15,000 = 0.1951

0.12

0.0234

Total

6,15,000

WACC based on Market Value  =           ∑ Weighted Cost= 0.0965 + 0.0116 + 0.058 + 0.0234 = 0.1895 = 18.95%

 

17. A Limited has the following capital structure:

Particulars

Amount (Rs.)

Share Capital- 2,00,000 shares of Rs. 20 each

40,00,000

6 % Preference Shares

10,00,000

8 % Debentures

30,00,000

The market price of the company's equity share is Rs. 30. It is expected that company will pay a dividend of Rs. 2 per share at the end of current year, which will grow at 10 per cent forever. The tax rate is 30 per cent. You are required to compute the following:

(a) A weighted average cost of capital based on existing capital structure.

(b) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt by issuing 12 % debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of share will fall to Rs. 20 per share.

(c) The cost of capital if in (b) above, growth rate increases to 12 percent.

Solution

a. Cost of Equity (Ke) = (D1 / Po) + g

17. A Limited has the following capital structure:  Particulars  Amount (Rs.)  Share Capital- 2,00,000 shares of Rs. 20 each  40,00,000  6 % Preference Shares  10,00,000  8 % Debentures  30,00,000  The market price of the company's equity share is Rs. 30. It is expected that company will pay a dividend of Rs. 2 per share at the end of current year, which will grow at 10 per cent forever. The tax rate is 30 per cent. You are required to compute the following:  (a) A weighted average cost of capital based on existing capital structure.  (b) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt by issuing 12 % debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of share will fall to Rs. 20 per share.  (c) The cost of capital if in (b) above, growth rate increases to 12 percent.  Solution  a. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.1667 = 16.67 %  D1 = Expected Dividend  g = Growth rate  P0 = Current Market Price  Post Tax Cost of Debenture (Kd) = Interest rate × (1 - t)  = 0.08 × (1 - 0.3) = 0.056 = 5.6%  Cost of Preference Share (KP) = 6% = 0.06     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 80,00,000 =0.5  0.1667  0.0834  6% Preference Capital  10,00,000  10,00,000 / 80,00,000 = 0.125  .06  .0075  8 % Debentures  30,00,000  30,00,000 / 80,00,000 =0.375  0.056  .0210  Total  80,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.0834 + 0.0075 + 0.0210 = 0.1119 = 11.19 %     b. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.25 = 25 %  Post Tax Cost of 12 % Debentures (Kd) = Interest rate × (1 - t)  = 0.12 × (1 - 0.3) = 0.084 = 8.4 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.25  0.1  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.1 + 0.006 + 0.017 + 0.017 = 0.14 = 14 %     c. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.12 = 0.27 = 27 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.27  0.108  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.108 + 0.006 + 0.017 + 0.017 = 0.148 = 14.8 %

D1 = Expected Dividend

g = Growth rate

P0 = Current Market Price

Post Tax Cost of Debenture (Kd) = Interest rate × (1 - t)

= 0.08 × (1 - 0.3) = 0.056 = 5.6%

Cost of Preference Share (KP) = 6% = 0.06

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

40,00,000

40,00,000 / 80,00,000 =0.5

0.1667

0.0834

6% Preference Capital

10,00,000

10,00,000 / 80,00,000 = 0.125

.06

.0075

8 % Debentures

30,00,000

30,00,000 / 80,00,000 =0.375

0.056

.0210

Total

80,00,000

WACC based on Book Value  =         ∑ Weighted Cost = 0.0834 + 0.0075 + 0.0210 = 0.1119 = 11.19 %

 

b. Cost of Equity (Ke) = (D1 / Po) + g

17. A Limited has the following capital structure:  Particulars  Amount (Rs.)  Share Capital- 2,00,000 shares of Rs. 20 each  40,00,000  6 % Preference Shares  10,00,000  8 % Debentures  30,00,000  The market price of the company's equity share is Rs. 30. It is expected that company will pay a dividend of Rs. 2 per share at the end of current year, which will grow at 10 per cent forever. The tax rate is 30 per cent. You are required to compute the following:  (a) A weighted average cost of capital based on existing capital structure.  (b) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt by issuing 12 % debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of share will fall to Rs. 20 per share.  (c) The cost of capital if in (b) above, growth rate increases to 12 percent.  Solution  a. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.1667 = 16.67 %  D1 = Expected Dividend  g = Growth rate  P0 = Current Market Price  Post Tax Cost of Debenture (Kd) = Interest rate × (1 - t)  = 0.08 × (1 - 0.3) = 0.056 = 5.6%  Cost of Preference Share (KP) = 6% = 0.06     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 80,00,000 =0.5  0.1667  0.0834  6% Preference Capital  10,00,000  10,00,000 / 80,00,000 = 0.125  .06  .0075  8 % Debentures  30,00,000  30,00,000 / 80,00,000 =0.375  0.056  .0210  Total  80,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.0834 + 0.0075 + 0.0210 = 0.1119 = 11.19 %     b. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.25 = 25 %  Post Tax Cost of 12 % Debentures (Kd) = Interest rate × (1 - t)  = 0.12 × (1 - 0.3) = 0.084 = 8.4 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.25  0.1  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.1 + 0.006 + 0.017 + 0.017 = 0.14 = 14 %     c. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.12 = 0.27 = 27 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.27  0.108  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.108 + 0.006 + 0.017 + 0.017 = 0.148 = 14.8 %
Post Tax Cost of 12 % Debentures (Kd) = Interest rate × (1 - t)

= 0.12 × (1 - 0.3) = 0.084 = 8.4 %

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

40,00,000

40,00,000 / 1,00,00,000=0.4

0.25

0.1

6% Preference Capital

10,00,000

10,00,000 / 1,00,00,000= 0.1

.06

0.006

8 % Debentures

30,00,000

30,00,000 / 1,00,00,000=0.3

0.056

0.017

12 % Debentures

20,00,000

20,00,000 / 1,00,00,000 = 0.2

0.084

0.017

Total

1,00,00,000

WACC based on Book Value  =         ∑ Weighted Cost = 0.1 + 0.006 + 0.017 + 0.017 = 0.14 = 14 %

 

c. Cost of Equity (Ke) = (D1 / Po) + g

17. A Limited has the following capital structure:  Particulars  Amount (Rs.)  Share Capital- 2,00,000 shares of Rs. 20 each  40,00,000  6 % Preference Shares  10,00,000  8 % Debentures  30,00,000  The market price of the company's equity share is Rs. 30. It is expected that company will pay a dividend of Rs. 2 per share at the end of current year, which will grow at 10 per cent forever. The tax rate is 30 per cent. You are required to compute the following:  (a) A weighted average cost of capital based on existing capital structure.  (b) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt by issuing 12 % debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of share will fall to Rs. 20 per share.  (c) The cost of capital if in (b) above, growth rate increases to 12 percent.  Solution  a. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.1667 = 16.67 %  D1 = Expected Dividend  g = Growth rate  P0 = Current Market Price  Post Tax Cost of Debenture (Kd) = Interest rate × (1 - t)  = 0.08 × (1 - 0.3) = 0.056 = 5.6%  Cost of Preference Share (KP) = 6% = 0.06     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 80,00,000 =0.5  0.1667  0.0834  6% Preference Capital  10,00,000  10,00,000 / 80,00,000 = 0.125  .06  .0075  8 % Debentures  30,00,000  30,00,000 / 80,00,000 =0.375  0.056  .0210  Total  80,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.0834 + 0.0075 + 0.0210 = 0.1119 = 11.19 %     b. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.1 = 0.25 = 25 %  Post Tax Cost of 12 % Debentures (Kd) = Interest rate × (1 - t)  = 0.12 × (1 - 0.3) = 0.084 = 8.4 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.25  0.1  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.1 + 0.006 + 0.017 + 0.017 = 0.14 = 14 %     c. Cost of Equity (Ke) = (D1 / Po) + g  =  + 0.12 = 0.27 = 27 %     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40,00,000  40,00,000 / 1,00,00,000=0.4  0.27  0.108  6% Preference Capital  10,00,000  10,00,000 / 1,00,00,000= 0.1  .06  0.006  8 % Debentures  30,00,000  30,00,000 / 1,00,00,000=0.3  0.056  0.017  12 % Debentures  20,00,000  20,00,000 / 1,00,00,000 = 0.2  0.084  0.017  Total  1,00,00,000  WACC based on Book Value  =         ∑ Weighted Cost = 0.108 + 0.006 + 0.017 + 0.017 = 0.148 = 14.8 %

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

40,00,000

40,00,000 / 1,00,00,000=0.4

0.27

0.108

6% Preference Capital

10,00,000

10,00,000 / 1,00,00,000= 0.1

.06

0.006

8 % Debentures

30,00,000

30,00,000 / 1,00,00,000=0.3

0.056

0.017

12 % Debentures

20,00,000

20,00,000 / 1,00,00,000 = 0.2

0.084

0.017

Total

1,00,00,000

WACC based on Book Value  =         ∑ Weighted Cost = 0.108 + 0.006 + 0.017 + 0.017 = 0.148 = 14.8 %

 

18. An electric equipment manufacturing company wishes to determine the weighted average cost of capital for evaluating capital budgeting projects. You have been supplied with the following information:

Liabilities

Amount (Rs.)

Assets

Amount (Rs.)

Equity share capital

12,00,000

 

Fixed Assets

 

25,00,000

 

Pref. share capital

4,50,000

Current Assets

15,00,000

Retained Earnings

4,50,000

 

 

Debentures

9,00,000

 

 

Current Liabilities

10,00,000

 

 

 

40,00,000

 

40,00,000

Additional Information:

(a) 10 years 10% Debentures of 2,500 face value, redeemable at 5% premium can be sold at par. 2% Flotation costs.

(b) 12% Preference shares: Sale price Rs. 100 per share, 2% Flotation costs.

(c)  Equity shares: Sale price Rs. 120 per share, Flotation costs- Rs. 5 per share.

The corporate tax rate is 40% and the expected growth in equity dividend is 10 % per year. The expected dividend at the end of the current financial year is Rs.10 per share. Assume that the company is satisfied with its present capital structure and intends to maintain it.

Solution

Cost of Equity (Ke) = (D1 / NP) + g


An electric equipment manufacturing company wishes to determine the weighted average cost of capital for evaluating capital budgeting projects. You have been supplied with the following information: Liabilities	Amount (Rs.)	Assets	Amount (Rs.) Equity share capital	12,00,000  	Fixed Assets 	25,00,000  Pref. share capital	4,50,000	Current Assets	15,00,000 Retained Earnings	4,50,000		 Debentures	9,00,000		 Current Liabilities	10,00,000		 	40,00,000		40,00,000 Additional Information: (a) 10 years 10% Debentures of 2,500 face value, redeemable at 5% premium can be sold at par. 2% Flotation costs. (b) 12% Preference shares: Sale price Rs. 100 per share, 2% Flotation costs. (c)  Equity shares: Sale price Rs. 120 per share, Flotation costs- Rs. 5 per share.  The corporate tax rate is 40% and the expected growth in equity dividend is 10 % per year. The expected dividend at the end of the current financial year is Rs.10 per share. Assume that the company is satisfied with its present capital structure and intends to maintain it. Solution Cost of Equity (Ke) = (D1 / NP) + g = 10/115 + 0.1 = 0.187 = 18.7 % NP = Sales Price – Floatation Cost = Rs.120 – Rs.5 = Rs.115 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2)  = (250 × (1-0.3)+ (2,625- 2,450)/10)/( (2,625+ 2,450)/2)  = (175 + 17.5) / 2537.5  = 7.6 % = 0.076 RV = Face Value + 5 % Premium on redemption = Rs. 2,500 + Rs.125 = Rs.2,625 NP = Face Value – Floatation cost = Rs.2500 – 2 % of Rs.2500 = Rs.2,450 Cost of Irredeemable Preference Share (Kp) = PD / NP = 12/98 = 0.1224 = 12.24% NP = NP = Face Value – Floatation cost = Rs. 100 – 2 = Rs.98 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	12,00,000	12,00,000/30,00,000= 0.4	0.187	.0748 Retained Earnings	4,50,000	4,50,000/30,00,000 =.15	0.187	.0281 12% Preference Capital	4,50,000	4,50,000/30,00,000 =.15	0.1224	.0183 10 % Debentures	9,00,000	9,00,000/30,00,000 =0.3	0.076	.0228 Total	30,00,000	WACC based on Book Value  =         ∑ Weighted Cost =.0748+.0281+.0183+.0228= .1212 = 12.12%

NP = Sales Price – Floatation Cost = Rs.120 – Rs.5 = Rs.115

After tax Cost of redeemable Debenture = 

An electric equipment manufacturing company wishes to determine the weighted average cost of capital for evaluating capital budgeting projects. You have been supplied with the following information: Liabilities	Amount (Rs.)	Assets	Amount (Rs.) Equity share capital	12,00,000  	Fixed Assets 	25,00,000  Pref. share capital	4,50,000	Current Assets	15,00,000 Retained Earnings	4,50,000		 Debentures	9,00,000		 Current Liabilities	10,00,000		 	40,00,000		40,00,000 Additional Information: (a) 10 years 10% Debentures of 2,500 face value, redeemable at 5% premium can be sold at par. 2% Flotation costs. (b) 12% Preference shares: Sale price Rs. 100 per share, 2% Flotation costs. (c)  Equity shares: Sale price Rs. 120 per share, Flotation costs- Rs. 5 per share.  The corporate tax rate is 40% and the expected growth in equity dividend is 10 % per year. The expected dividend at the end of the current financial year is Rs.10 per share. Assume that the company is satisfied with its present capital structure and intends to maintain it. Solution Cost of Equity (Ke) = (D1 / NP) + g = 10/115 + 0.1 = 0.187 = 18.7 % NP = Sales Price – Floatation Cost = Rs.120 – Rs.5 = Rs.115 After tax Cost of redeemable Debenture =  (Interest (1-t)+ (RV- NP)/n)/((RV+NP)/2)  = (250 × (1-0.3)+ (2,625- 2,450)/10)/( (2,625+ 2,450)/2)  = (175 + 17.5) / 2537.5  = 7.6 % = 0.076 RV = Face Value + 5 % Premium on redemption = Rs. 2,500 + Rs.125 = Rs.2,625 NP = Face Value – Floatation cost = Rs.2500 – 2 % of Rs.2500 = Rs.2,450 Cost of Irredeemable Preference Share (Kp) = PD / NP = 12/98 = 0.1224 = 12.24% NP = NP = Face Value – Floatation cost = Rs. 100 – 2 = Rs.98 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	12,00,000	12,00,000/30,00,000= 0.4	0.187	.0748 Retained Earnings	4,50,000	4,50,000/30,00,000 =.15	0.187	.0281 12% Preference Capital	4,50,000	4,50,000/30,00,000 =.15	0.1224	.0183 10 % Debentures	9,00,000	9,00,000/30,00,000 =0.3	0.076	.0228 Total	30,00,000	WACC based on Book Value  =         ∑ Weighted Cost =.0748+.0281+.0183+.0228= .1212 = 12.12%

RV = Face Value + 5 % Premium on redemption

= Rs. 2,500 + Rs.125 = Rs.2,625

NP = Face Value – Floatation cost = Rs.2500 – 2 % of Rs.2500 = Rs.2,450

Cost of Irredeemable Preference Share (Kp) = PD / NP

= 12/98 = 0.1224 = 12.24%

NP = NP = Face Value – Floatation cost = Rs. 100 – 2 = Rs.98

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

12,00,000

12,00,000/30,00,000= 0.4

0.187

.0748

Retained Earnings

4,50,000

4,50,000/30,00,000 =.15

0.187

.0281

12% Preference Capital

4,50,000

4,50,000/30,00,000 =.15

0.1224

.0183

10 % Debentures

9,00,000

9,00,000/30,00,000 =0.3

0.076

.0228

Total

30,00,000

WACC based on Book Value  =         ∑ Weighted Cost =.0748+.0281+.0183+.0228= .1212 = 12.12%

 

19. The latest Balance Sheet of RBL Ltd. is given below:

Particulars

Amount (Rs.)

Share Capital- 50,000 shares of Rs. 10 each

5,00,000

Security Premium

1,00,000

Retained Profit

6,00,000

10 % Preference Shares – 16,000 shares

4,00,000

15 % Perpetual Debt – 6000 debentures

6,00,000

The ordinary shares are currently priced at Rs. 40 ex-dividend each and Rs.25 preference share is priced at Rs. 25 cum-dividend. The debentures are selling at 110 per cent ex-interest and tax is paid by RBL Ltd. at 40 per cent. RBL Ltd's cost of equity has been estimated at 20 per cent. Calculate the weighted average cost of capital (based on market value) WACC of D Ltd.

Solution

Ke = .20

Cost of Perpetual debt (Kd) =  

The latest Balance Sheet of RBL Ltd. is given below:  Particulars  Amount (Rs.)  Share Capital- 50,000 shares of Rs. 10 each  5,00,000  Security Premium  1,00,000  Retained Profit  6,00,000  10 % Preference Shares – 16,000 shares  4,00,000  15 % Perpetual Debt – 6000 debentures  6,00,000  The ordinary shares are currently priced at Rs. 40 ex-dividend each and Rs.25 preference share is priced at Rs. 25 cum-dividend. The debentures are selling at 110 per cent ex-interest and tax is paid by RBL Ltd. at 40 per cent. RBL Ltd's cost of equity has been estimated at 20 per cent. Calculate the weighted average cost of capital (based on market value) WACC of D Ltd.  Solution  Ke = .20  Cost of Perpetual debt (Kd) =    =  =0.082  Cost of Irredeemable Preference Share (Kp) = PD / NP  = 2.5 / (25 – 2.5) = 0.1111  Note: Since Price of Preference share is including dividend that is cum dividend as given in the question, hence dividend has been subtracted from Market Price.     Market Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  40×50,000 = 20,00,000  0.6623  0.2  .1325  10% Preference Capital  22.5 × 16,000 =3,60,000  .1192  0.1111  .0132  15 % Debentures  110×6,000=6,60,000  .2185  0.082  .018  Total  30,20,000  WACC based on Market Value  = ∑ Weighted Cost =.1325+.0132+ .018 = .1637 =16.37%

 =0.082

Cost of Irredeemable Preference Share (Kp) = PD / NP

= 2.5 / (25 – 2.5) = 0.1111

Note: Since Price of Preference share is including dividend that is cum dividend as given in the question, hence dividend has been subtracted from Market Price.

 

Market Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

40×50,000 = 20,00,000

0.6623

0.2

.1325

10% Preference Capital

22.5 × 16,000 =3,60,000

.1192

0.1111

.0132

15 % Debentures

110×6,000=6,60,000

.2185

0.082

.018

Total

30,20,000

WACC based on Market Value  = ∑ Weighted Cost =.1325+.0132+ .018 = .1637 =16.37%

 

20. Determine the weighted average cost of capital using (a) book value weights; and (b) market value weights based on the following information:

Book value structure

Amount (Rs.)

Share Capital- 1,00,000 shares of Rs. 10 each

10,00,000

Preference shares (2,000 Pref. Shares of Rs.100 each)

2,00,000

Debentures ( 8,000 units of Rs.100 each)

8,00,000

Total

20,00,000

Recent market prices of all these securities are: Debentures: Rs. 110 per Debenture; Preference shares: Rs. 120 per share and Equity shares: Rs. 22 per share. External financing opportunities are:

(i) Rs. 100 per Debenture redeemable at par, 10 year maturity, 13% coupon rate, 4% flotation cost and sale price Rs. 100;

(ii) Rs. 100 per Preference Share redeemable at par, 10 year maturity, 14% dividend rate, 5% flotation cost and sale price 100; and

(iii) Equity shares: Rs. 2 per share flotation costs and sale price Rs. 22.

Dividend expected on equity shares at the end of the year is Rs. 2 per share; anticipated growth rate in dividends is 7%. Company pays all its earnings in the form of dividends. Corporate tax rate is 30%.

Solution

a. Cost of Equity (Ke) = (D1 / NP) + g

Determine the weighted average cost of capital using (a) book value weights; and (b) market value weights based on the following information:  Book value structure  Amount (Rs.)  Share Capital- 1,00,000 shares of Rs. 10 each  10,00,000  Preference shares (2,000 Pref. Shares of Rs.100 each)  2,00,000  Debentures ( 8,000 units of Rs.100 each)  8,00,000  Total  20,00,000  Recent market prices of all these securities are: Debentures: Rs. 110 per Debenture; Preference shares: Rs. 120 per share and Equity shares: Rs. 22 per share. External financing opportunities are:  (i) Rs. 100 per Debenture redeemable at par, 10 year maturity, 13% coupon rate, 4% flotation cost and sale price Rs. 100;  (ii) Rs. 100 per Preference Share redeemable at par, 10 year maturity, 14% dividend rate, 5% flotation cost and sale price 100; and  (iii) Equity shares: Rs. 2 per share flotation costs and sale price Rs. 22.  Dividend expected on equity shares at the end of the year is Rs. 2 per share; anticipated growth rate in dividends is 7%. Company pays all its earnings in the form of dividends. Corporate tax rate is 30%.  Solution  a. Cost of Equity (Ke) = (D1 / NP) + g  =  + 0.07 = 0.17 = 17 %  NP = Sales Price – Floatation Cost = Rs.22 – Rs.2 = Rs.20  After tax Cost of redeemable Debenture =   =   = (9.1 + .4) / 98 = 0.097 = 9.7%  NP = Face Value – Floatation cost = Rs.100 – 4 % of Rs.100 = Rs. 96  After tax Cost of Preference Share Kp =   =       = 14.5 / 97.5 = .149 = 14.9%  NP = Sales Price – Floatation Cost = Rs.100 – Rs.5 = Rs.95     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  10,00,000  10,00,000/ 20,00,000 = 0.5  .17  0.085  14% Preference Capital  2,00,000  2,00,000/ 20,00,000 =.1  .149  0.0149  13 % Debentures  8,00,000  8,00,000/ 20,00,000 =.4  .097  0.0388  Total  20,00,000  WACC based on Book Value  = ∑ Weighted Cost =.085+.0149+.0388 =.1387 = 13.87%  b.     Market Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  22 × 1,00,000 =22,00,000  .6627  .17  .1127  10% Preference Capital  120 × 2,000 = 2,40,000  .0723  .149  .0108  15 % Debentures  110 × 8,000 = 8,80,000  .2650  .097  .0258  Total  33,20,000  WACC based on Market Value  = ∑ Weighted Cost =.1127+.0108+ .0258= .1493 =14.93%

0.17 = 17 %

NP = Sales Price – Floatation Cost = Rs.22 – Rs.2 = Rs.20

After tax Cost of redeemable Debenture =

Determine the weighted average cost of capital using (a) book value weights; and (b) market value weights based on the following information:  Book value structure  Amount (Rs.)  Share Capital- 1,00,000 shares of Rs. 10 each  10,00,000  Preference shares (2,000 Pref. Shares of Rs.100 each)  2,00,000  Debentures ( 8,000 units of Rs.100 each)  8,00,000  Total  20,00,000  Recent market prices of all these securities are: Debentures: Rs. 110 per Debenture; Preference shares: Rs. 120 per share and Equity shares: Rs. 22 per share. External financing opportunities are:  (i) Rs. 100 per Debenture redeemable at par, 10 year maturity, 13% coupon rate, 4% flotation cost and sale price Rs. 100;  (ii) Rs. 100 per Preference Share redeemable at par, 10 year maturity, 14% dividend rate, 5% flotation cost and sale price 100; and  (iii) Equity shares: Rs. 2 per share flotation costs and sale price Rs. 22.  Dividend expected on equity shares at the end of the year is Rs. 2 per share; anticipated growth rate in dividends is 7%. Company pays all its earnings in the form of dividends. Corporate tax rate is 30%.  Solution  a. Cost of Equity (Ke) = (D1 / NP) + g  =  + 0.07 = 0.17 = 17 %  NP = Sales Price – Floatation Cost = Rs.22 – Rs.2 = Rs.20  After tax Cost of redeemable Debenture =   =   = (9.1 + .4) / 98 = 0.097 = 9.7%  NP = Face Value – Floatation cost = Rs.100 – 4 % of Rs.100 = Rs. 96  After tax Cost of Preference Share Kp =   =       = 14.5 / 97.5 = .149 = 14.9%  NP = Sales Price – Floatation Cost = Rs.100 – Rs.5 = Rs.95     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  10,00,000  10,00,000/ 20,00,000 = 0.5  .17  0.085  14% Preference Capital  2,00,000  2,00,000/ 20,00,000 =.1  .149  0.0149  13 % Debentures  8,00,000  8,00,000/ 20,00,000 =.4  .097  0.0388  Total  20,00,000  WACC based on Book Value  = ∑ Weighted Cost =.085+.0149+.0388 =.1387 = 13.87%  b.     Market Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  22 × 1,00,000 =22,00,000  .6627  .17  .1127  10% Preference Capital  120 × 2,000 = 2,40,000  .0723  .149  .0108  15 % Debentures  110 × 8,000 = 8,80,000  .2650  .097  .0258  Total  33,20,000  WACC based on Market Value  = ∑ Weighted Cost =.1127+.0108+ .0258= .1493 =14.93% 

NP = Face Value – Floatation cost = Rs.100 – 4 % of Rs.100 = Rs. 96

After tax Cost of Preference Share Kp

=  Determine the weighted average cost of capital using (a) book value weights; and (b) market value weights based on the following information:  Book value structure  Amount (Rs.)  Share Capital- 1,00,000 shares of Rs. 10 each  10,00,000  Preference shares (2,000 Pref. Shares of Rs.100 each)  2,00,000  Debentures ( 8,000 units of Rs.100 each)  8,00,000  Total  20,00,000  Recent market prices of all these securities are: Debentures: Rs. 110 per Debenture; Preference shares: Rs. 120 per share and Equity shares: Rs. 22 per share. External financing opportunities are:  (i) Rs. 100 per Debenture redeemable at par, 10 year maturity, 13% coupon rate, 4% flotation cost and sale price Rs. 100;  (ii) Rs. 100 per Preference Share redeemable at par, 10 year maturity, 14% dividend rate, 5% flotation cost and sale price 100; and  (iii) Equity shares: Rs. 2 per share flotation costs and sale price Rs. 22.  Dividend expected on equity shares at the end of the year is Rs. 2 per share; anticipated growth rate in dividends is 7%. Company pays all its earnings in the form of dividends. Corporate tax rate is 30%.  Solution  a. Cost of Equity (Ke) = (D1 / NP) + g  =  + 0.07 = 0.17 = 17 %  NP = Sales Price – Floatation Cost = Rs.22 – Rs.2 = Rs.20  After tax Cost of redeemable Debenture =   =   = (9.1 + .4) / 98 = 0.097 = 9.7%  NP = Face Value – Floatation cost = Rs.100 – 4 % of Rs.100 = Rs. 96  After tax Cost of Preference Share Kp =   =       = 14.5 / 97.5 = .149 = 14.9%  NP = Sales Price – Floatation Cost = Rs.100 – Rs.5 = Rs.95     Book Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  10,00,000  10,00,000/ 20,00,000 = 0.5  .17  0.085  14% Preference Capital  2,00,000  2,00,000/ 20,00,000 =.1  .149  0.0149  13 % Debentures  8,00,000  8,00,000/ 20,00,000 =.4  .097  0.0388  Total  20,00,000  WACC based on Book Value  = ∑ Weighted Cost =.085+.0149+.0388 =.1387 = 13.87%  b.     Market Value (Rs)  Weight  After Tax Cost  Weighted Cost = Weight × After Tax Cost  Share Capital  22 × 1,00,000 =22,00,000  .6627  .17  .1127  10% Preference Capital  120 × 2,000 = 2,40,000  .0723  .149  .0108  15 % Debentures  110 × 8,000 = 8,80,000  .2650  .097  .0258  Total  33,20,000  WACC based on Market Value  = ∑ Weighted Cost =.1127+.0108+ .0258= .1493 =14.93%

NP = Sales Price – Floatation Cost = Rs.100 – Rs.5 = Rs.95

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

10,00,000

10,00,000/ 20,00,000 = 0.5

.17

0.085

14% Preference Capital

2,00,000

2,00,000/ 20,00,000 =.1

.149

0.0149

13 % Debentures

8,00,000

8,00,000/ 20,00,000 =.4

.097

0.0388

Total

20,00,000

WACC based on Book Value  = ∑ Weighted Cost =.085+.0149+.0388 =.1387 = 13.87%

b.

 

Market Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

22 × 1,00,000 =22,00,000

.6627

.17

.1127

10% Preference Capital

120 × 2,000 = 2,40,000

.0723

.149

.0108

15 % Debentures

110 × 8,000 = 8,80,000

.2650

.097

.0258

Total

33,20,000

WACC based on Market Value  = ∑ Weighted Cost =.1127+.0108+ .0258= .1493 =14.93%

 

21. The following information is provided in respect of the specific cost of capital of different sources along with the book value (BV) and market value (MV) weights.

Source

Cost of Capital (%)

Book Value

Market Value

Equity share capital

20

.5

.55

Preference shares

15

.2

.20

Debenture

10

.3

.25

(a) Calculate the Weighted Average Cost of Capital, WACC, using both the BV and the MV weights.

(b) Calculate the WMCC using marginal weights given that the company intends to raise additional funds using 50 % long term debts, 30% preference share and 20% by retaining profits.

Solution

Source

Cost of Capital (COC)

Book Value (BV)

Market Value (MV)

BV × COC

MV ×COC

Equity share capital

.20

.5

.55

.1

.11

Preference shares

.15

.2

.20

.03

.03

Debenture

.10

.3

.25

.03

.025

 

 

 

 

WACC based on BV =.16 = 16%

WACC based on MV=.175 = 16.5%

 

Source

Cost of Capital (COC)

Weight

Weighted Cost = Weight × COC

Retained Earnings

.20

.2

.04

Preference shares

.15

.3

.045

Debenture

.10

.5

.05

 

WMCC = ∑ Weighted Cost = .135=13.5%

 

22. X Ltd. has assets of Rs. 32,00,000 that have been financed by Rs. 18,00,000 of equity shares (of Rs. 100 each), General Reserve of Rs. 4,00,000 and Debt of Rs. 10,00,000. For the year ended 31-3-2021, the company's total profits before interest and taxes were Rs. 6, 50,000. X Ltd. pays 10 % interest on borrowed capital and is in a 30% tax bracket. The market value of equity as on 31-3-2021 was Rs.150 per share. What was the weighted average cost of capital? Use market values as weights.

Solution

Cost of debt (Kd) = Interest rate × (1 – t) = .1 ×.7 = .07 = 7 %

Cost of Equity (Ke) = PAT / MV of Equity

= 3,85,000 / 27,00,000 = 0.1426 = 14.26 %

PAT = (EBIT – Interest) × (1 – t) = (6,50,000 – 1,00,000) ×.7

= 3,85,000

MV of Equity Share = MP of Share × no. of Equity Shares

X Ltd. has assets of Rs. 32,00,000 that have been financed by Rs. 18,00,000 of equity shares (of Rs. 100 each), General Reserve of Rs. 4,00,000 and Debt of Rs. 10,00,000. For the year ended 31-3-2021, the company's total profits before interest and taxes were Rs. 6, 50,000. X Ltd. pays 10 % interest on borrowed capital and is in a 30% tax bracket. The market value of equity as on 31-3-2021 was Rs.150 per share. What was the weighted average cost of capital? Use market values as weights. Solution Cost of debt (Kd) = Interest rate × (1 – t) = .1 ×.7 = .07 = 7 % Cost of Equity (Ke) = PAT / MV of Equity  = 3,85,000 / 27,00,000 = 0.1426 = 14.26 % PAT = (EBIT – Interest) × (1 – t) = (6,50,000 – 1,00,000) ×.7 = 3,85,000 MV of Equity Share = MP of Share × no. of Equity Shares = 150 ×18,00,00/100 = Rs.27,00,000  	Market Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Equity Share Capital	27,00,000	27,00,000/37,00,000 = .73	.1426	.1041 Debt	10,00,000	10,00,000/37,00,000 = .27	.07	.0189 Total	37,00,000	WACC based on Market Value  = ∑ Weighted Cost = .123 = 12.3%

 = Rs.27,00,000


 

Market Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Equity Share Capital

27,00,000

27,00,000/37,00,000 = .73

.1426

.1041

Debt

10,00,000

10,00,000/37,00,000 = .27

.07

.0189

Total

37,00,000

WACC based on Market Value  = ∑ Weighted Cost = .123 = 12.3%

 

23. The following is the capital structure of Simons Company Ltd-

Particulars

Amount (Rs.)

Share Capital- 10,000 shares of Rs. 100 each

10,00,000

12 % Preference Shares of Rs. 100 each

4,00,000

10 % Debentures

6,00,000

The market price of the company's share is Rs. 120 and it is expected that a dividend of Rs. 10 per share would be declared after 1 year. The dividend growth rate is 10%:

(i) If the company is in the 40% Tax bracket, compute weighted average cost of capital.

(ii) Assuming that in order to finance an expansion plan, the Company intends to borrow a fund of Rs.10 lacs bearing 12% rate of interest, what will be the company’s revised weighted average cost of capital? This financing is expected to increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs. 120 to Rs. 110 per share.

Solution

i. Cost of Equity (Ke) = (D1 / MP) + g

The following is the capital structure of Simons Company Ltd- Particulars	Amount (Rs.) Share Capital- 10,000 shares of Rs. 100 each	10,00,000 12 % Preference Shares of Rs. 100 each	4,00,000 10 % Debentures	6,00,000 The market price of the company's share is Rs. 120 and it is expected that a dividend of Rs. 10 per share would be declared after 1 year. The dividend growth rate is 10%: (i) If the company is in the 40% Tax bracket, compute weighted average cost of capital. (ii) Assuming that in order to finance an expansion plan, the Company intends to borrow a fund of Rs.10 lacs bearing 12% rate of interest, what will be the company’s revised weighted average cost of capital? This financing is expected to increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs. 120 to Rs. 110 per share. Solution i. Cost of Equity (Ke) = (D1 / MP) + g = 10/120 + 0.1 = 0.1833 = 18.33 % Cost of Pref. Share (Kp) = 0.12 Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6% 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	10,00,000	10,00,000/ 20,00,000 = 0.5	.1833	0.092 12% Preference Capital	4,00,000	4,00,000/ 20,00,000 =.2	.12	0.024 10 % Debentures	6,00,000	6,00,000/ 20,00,000 =.3	.06	0.018 Total	20,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.092 + 0.024 + 0.018 = 0.116 = 11.6 %  ii. Cost of Equity (Ke) = (D1 / MP) + g = 12/110 + 0.1 = 0.2091 = 20.91 % Cost of Pref. Share (Kp) = 0.12 Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6% Cost of Loan / Borrowed Fund (KL) = I × (1 - t) = .12 × (1 – 0.4) = 0.072 = 7.2% 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	10,00,000	10,00,000/ 30,00,000 = 0.333	.2091	0.07 12% Preference Capital	4,00,000	4,00,000/ 30,00,000 =.1333	.12	0.016 10 % Debentures	6,00,000	6,00,000/ 30,00,000 =.2	.06	.012 12 % Borrowed Funds	10,00,000	10,00,000/ 30,00,000 = 0.333	.072	.024 Total	30,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.07+0.016+.012 + .024 = .122 = 12.2%

Cost of Pref. Share (Kp) = 0.12

Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6%

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

10,00,000

10,00,000/ 20,00,000 = 0.5

.1833

0.092

12% Preference Capital

4,00,000

4,00,000/ 20,00,000 =.2

.12

0.024

10 % Debentures

6,00,000

6,00,000/ 20,00,000 =.3

.06

0.018

Total

20,00,000

WACC based on Book Value  = ∑ Weighted Cost = 0.092 + 0.024 + 0.018 = 0.116 = 11.6 %

 

ii. Cost of Equity (Ke) = (D1 / MP) + g

The following is the capital structure of Simons Company Ltd- Particulars	Amount (Rs.) Share Capital- 10,000 shares of Rs. 100 each	10,00,000 12 % Preference Shares of Rs. 100 each	4,00,000 10 % Debentures	6,00,000 The market price of the company's share is Rs. 120 and it is expected that a dividend of Rs. 10 per share would be declared after 1 year. The dividend growth rate is 10%: (i) If the company is in the 40% Tax bracket, compute weighted average cost of capital. (ii) Assuming that in order to finance an expansion plan, the Company intends to borrow a fund of Rs.10 lacs bearing 12% rate of interest, what will be the company’s revised weighted average cost of capital? This financing is expected to increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs. 120 to Rs. 110 per share. Solution i. Cost of Equity (Ke) = (D1 / MP) + g = 10/120 + 0.1 = 0.1833 = 18.33 % Cost of Pref. Share (Kp) = 0.12 Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6% 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	10,00,000	10,00,000/ 20,00,000 = 0.5	.1833	0.092 12% Preference Capital	4,00,000	4,00,000/ 20,00,000 =.2	.12	0.024 10 % Debentures	6,00,000	6,00,000/ 20,00,000 =.3	.06	0.018 Total	20,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.092 + 0.024 + 0.018 = 0.116 = 11.6 %  ii. Cost of Equity (Ke) = (D1 / MP) + g = 12/110 + 0.1 = 0.2091 = 20.91 % Cost of Pref. Share (Kp) = 0.12 Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6% Cost of Loan / Borrowed Fund (KL) = I × (1 - t) = .12 × (1 – 0.4) = 0.072 = 7.2% 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital	10,00,000	10,00,000/ 30,00,000 = 0.333	.2091	0.07 12% Preference Capital	4,00,000	4,00,000/ 30,00,000 =.1333	.12	0.016 10 % Debentures	6,00,000	6,00,000/ 30,00,000 =.2	.06	.012 12 % Borrowed Funds	10,00,000	10,00,000/ 30,00,000 = 0.333	.072	.024 Total	30,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.07+0.016+.012 + .024 = .122 = 12.2%

Cost of Pref. Share (Kp) = 0.12

Cost of Debt (Kd) = I × (1 - t) = .1 × (1 – 0.4) = 0.06 = 6%

Cost of Loan / Borrowed Fund (KL) = I × (1 - t) = .12 × (1 – 0.4) = 0.072 = 7.2%

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

10,00,000

10,00,000/ 30,00,000 = 0.333

.2091

0.07

12% Preference Capital

4,00,000

4,00,000/ 30,00,000 =.1333

.12

0.016

10 % Debentures

6,00,000

6,00,000/ 30,00,000 =.2

.06

.012

12 % Borrowed Funds

10,00,000

10,00,000/ 30,00,000 = 0.333

.072

.024

Total

30,00,000

WACC based on Book Value  = ∑ Weighted Cost = 0.07+0.016+.012 + .024 = .122 = 12.2%

 

24. XYZ Ltd wishes to raise additional funds of Rs.10,00,000 to take up an investment proposal. Following information is provided:

 

 

Retained Earnings

2,50,000

Earnings Per share

5

Dividend Payout Ratio

60%

Expected Growth Rate

10%

Current Market Price of Share 

30

Debt- Equity Mix

30%:70%

Cost of Debts (before tax):

Funds up to Rs. 2,00,000

Funds More than 2,00,000

 

10%

12%

Tax Rate

40%

You are required to:

(i) Determine the pattern for raising additional funds.

(ii) Determine the Cost of Equity and Cost of Retained Earnings.

(iii) Determine the Required Rate of Return for the new Project.

Solution

i. Debt to be raised – 30 % = Rs. 3,00,000

Equity – 70% = Rs. 7,00,000

Retained Earnings (2,50,000)

Equity fund to be raised = Proportion of Equity amount – Retained Earnings

= Rs. 7,00,000 – Rs. 2,50,000 = Rs. 4,50,000

After tax Cost of Debt (Kd) = I × (1- t) = .12 × (1- 0.4) = .072 = 7.2%

ii. Cost of Equity (Ke) = Cost of Retained Earnings (KRE)

= (D1 / MP) + g

XYZ Ltd wishes to raise additional funds of Rs.10,00,000 to take up an investment proposal. Following information is provided: 	 Retained Earnings 	2,50,000 Earnings Per share	5 Dividend Payout Ratio	60% Expected Growth Rate	10% Current Market Price of Share  	30 Debt- Equity Mix	30%:70% Cost of Debts (before tax): Funds up to Rs. 2,00,000 Funds More than 2,00,000	 10% 12% Tax Rate	40% You are required to:  (i) Determine the pattern for raising additional funds. (ii) Determine the Cost of Equity and Cost of Retained Earnings. (iii) Determine the Required Rate of Return for the new Project. Solution i. Debt to be raised – 30 % = Rs. 3,00,000 Equity – 70% = Rs. 7,00,000 Retained Earnings (2,50,000) Equity fund to be raised = Proportion of Equity amount – Retained Earnings  = Rs. 7,00,000 – Rs. 2,50,000 = Rs. 4,50,000 After tax Cost of Debt (Kd) = I × (1- t) = .12 × (1- 0.4) = .072 = 7.2% ii. Cost of Equity (Ke) = Cost of Retained Earnings (KRE)  = (D1 / MP) + g = 3.3/30 + 0.1 = 0.21 = 21 % Current Dividend (D0) = Rs. 3 Expected Dividend (D1) = D0 (1 + g) = Rs. 3 × 1.1 = Rs.3.3 Dividend Payout Ratio = 60 % of EPS = 60 % of Rs.5 = Rs. 3 iii. 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital including Retained Earnings	7,00,000	7,00,000/ 10,00,000 = 0.7	0.21	0.147 12 % Debentures	3,00,000	3,00,000/ 10,00,000 =.3	.072	0.0216 Total	10,00,000	WACC = ∑ Weighted Cost = 0.147+ 0.0216 = 0.1686 = 16.86 %

Current Dividend (D0) = Rs. 3

Expected Dividend (D1) = D0 (1 + g) = Rs. 3 × 1.1 = Rs.3.3

Dividend Payout Ratio = 60 % of EPS = 60 % of Rs.5 = Rs. 3

iii.

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital including Retained Earnings

7,00,000

7,00,000/ 10,00,000 = 0.7

0.21

0.147

12 % Debentures

3,00,000

3,00,000/ 10,00,000 =.3

.072

0.0216

Total

10,00,000

WACC = ∑ Weighted Cost = 0.147+ 0.0216 = 0.1686 = 16.86 %

 25. ABC company has the following capital structure and is considered to be an optimum.

Particulars

Amount (Rs.)

Share Capital- 1,00,000 shares

16,00,000

15 % Preference Shares

1,00,000

20 % Debentures

3,00,000

 

20,00,000

The company has paid a dividend of Rs. 4 with a growth rate of 10%. The company's share has a current market price of Rs. 20 per share. The expected dividend per share next year is 50% of the dividend for the current year. 20 % new debentures can be issued by the company. The company's debentures are currently selling at Rs. 98 per debenture. 15 % preference share can be sold at a net price of Rs. 9.5 (face value Rs. 10 each). The company's tax rate is 30%.

(a) Calculate after tax cost of (i) Debt, (ii) Preference share capital and (iii) Equity shares

(b) Also calculate Weighted Average Cost of Capital, WACC.

Solution

After tax cost of new Debt (Kd) =

ABC company has the following capital structure and is considered to be an optimum. Particulars	Amount (Rs.) Share Capital- 1,00,000 shares 	16,00,000 15 % Preference Shares 	1,00,000 20 % Debentures	3,00,000 	20,00,000 The company has paid a dividend of Rs. 4 with a growth rate of 10%. The company's share has a current market price of Rs. 20 per share. The expected dividend per share next year is 50% of the dividend for the current year. 20 % new debentures can be issued by the company. The company's debentures are currently selling at Rs. 98 per debenture. 15 % preference share can be sold at a net price of Rs. 9.5 (face value Rs. 10 each). The company's tax rate is 30%. (a) Calculate after tax cost of (i) Debt, (ii) Preference share capital and (iii) Equity shares  (b) Also calculate Weighted Average Cost of Capital, WACC. Solution After tax cost of new Debt (Kd) = (Interest amount (1 – tax rate) )/MP = (20 × (1- 0.3) )/98 = 14 / 98 = 0.1429 = 14.29 % After tax cost of Pref. Share (KP) = (Preference Dividend  )/MP = 1.5 / 9.5 = 0.158 = 15.8% Cost of Equity (Ke) = (D1 / MP) + g = 2/20 + 0.1 = 0.20 = 20 % D1 = 50 % of D0 = 50 % of Rs.4 = Rs. 2 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital 	16,00,000	16,00,000/ 20,00,000 = 0.8	0.20	0.16 15 % Preference Shares 	1,00,000	1,00,000/ 20,00,000 =.05	.158	0.008 20 % Debentures	3,00,000	3,00,000/ 20,00,000 =.15	.1429	.0214 	20,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.16 + 0.008 + .0214 = .1894 = 18.94 %


After tax cost of Pref. Share (KP) = 

= 1.5 / 9.5 = 0.158 = 15.8%

Cost of Equity (Ke) = (D1 / MP) + g

ABC company has the following capital structure and is considered to be an optimum. Particulars	Amount (Rs.) Share Capital- 1,00,000 shares 	16,00,000 15 % Preference Shares 	1,00,000 20 % Debentures	3,00,000 	20,00,000 The company has paid a dividend of Rs. 4 with a growth rate of 10%. The company's share has a current market price of Rs. 20 per share. The expected dividend per share next year is 50% of the dividend for the current year. 20 % new debentures can be issued by the company. The company's debentures are currently selling at Rs. 98 per debenture. 15 % preference share can be sold at a net price of Rs. 9.5 (face value Rs. 10 each). The company's tax rate is 30%. (a) Calculate after tax cost of (i) Debt, (ii) Preference share capital and (iii) Equity shares  (b) Also calculate Weighted Average Cost of Capital, WACC. Solution After tax cost of new Debt (Kd) = (Interest amount (1 – tax rate) )/MP = (20 × (1- 0.3) )/98 = 14 / 98 = 0.1429 = 14.29 % After tax cost of Pref. Share (KP) = (Preference Dividend  )/MP = 1.5 / 9.5 = 0.158 = 15.8% Cost of Equity (Ke) = (D1 / MP) + g = 2/20 + 0.1 = 0.20 = 20 % D1 = 50 % of D0 = 50 % of Rs.4 = Rs. 2 	Book Value (Rs)	Weight 	After Tax Cost	Weighted Cost = Weight × After Tax Cost Share Capital 	16,00,000	16,00,000/ 20,00,000 = 0.8	0.20	0.16 15 % Preference Shares 	1,00,000	1,00,000/ 20,00,000 =.05	.158	0.008 20 % Debentures	3,00,000	3,00,000/ 20,00,000 =.15	.1429	.0214 	20,00,000	WACC based on Book Value  = ∑ Weighted Cost = 0.16 + 0.008 + .0214 = .1894 = 18.94 %

D1 = 50 % of D0 = 50 % of Rs.4 = Rs. 2

 

Book Value (Rs)

Weight

After Tax Cost

Weighted Cost = Weight × After Tax Cost

Share Capital

16,00,000

16,00,000/ 20,00,000 = 0.8

0.20

0.16

15 % Preference Shares

1,00,000

1,00,000/ 20,00,000 =.05

.158

0.008

20 % Debentures

3,00,000

3,00,000/ 20,00,000 =.15

.1429

.0214

 

20,00,000

WACC based on Book Value  = ∑ Weighted Cost = 0.16 + 0.008 + .0214 = .1894 = 18.94 %

 

26. RBL & Co. wishes to find out its weighted marginal cost of capital, WMCC, based on target capital structure proportions. Using the data given below, find out the WMCC.

Source

Proportion

Range

Cost

Equity share capital

 

50%

Up to Rs. 3,00,000

3,00,000-7,50,000

7,50,000 and above

13.00%

13.5%

15.5%

Preference shares

10%

Up to 1,00,000

1,00,000 and above

10 %

11%

Long term debt 

 

40%

Up to Rs. 4,00,000

4,00,000-8,00,000

8,00,000 and above

6 %

6.50%

7 %

Solution

Source

Prop.

Range

Cost

Breaking Points

E. Share

.5

Up to Rs. 3,00,000

3,00,000-7,50,000

7,50,000 and above

13.00%

13.5%

15.5%

3 L /.5=6 L

7.5 L /.5=15L--------------

P. Share

.1

Up to 1,00,000

1,00,000 and above

10 %

11%

1 L / .1 = 10 L

--------------

L.T. Debt 

 

.4

Up to Rs. 4,00,000

4,00,000-8,00,000

8,00,000 and above

6 %

6.50%

7 %

4 L / .4 = 10L

8 L / .4 = 20 L

---------------

 

Range

Source

Prop.

cost

Weighted Cost = Weight × After Tax Cost

Up to 6 L

E. Share

P. Share

L T Debt

 

.5

.1

.4

.13

.1

.06

.065

.01

.024

WMCC=.099

6 L – 10 L

E. Share

P. Share

L T Debt

.5

.1

.4

.135

.1

.06

.0675

.01

.024

WMCC=.1015

10 L – 15 L

E. Share

P. Share

L T Debt

.5

.1

.4

.135

.11

.065

.0675

.011

.026

WMCC=.1045

15 L – 20 L

E. Share

P. Share

L T Debt

.5

.1

.4

.155

.11

.065

.0775

.011

.026

WMCC=.1145

20 L & above

E. Share

P. Share

L T Debt

.5

.1

.4

.155

.11

.07

.0775

.011

.028

WMCC=.1165

Links to Financial Management notes: -

Time Value of Money

https://rblacademy.blogspot.com/2021/06/time-value-of-money-formulae-financial.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-i-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-2-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-3-solved.html

https://rblacademy.blogspot.com/2021/05/time-value-of-money-i-financial.html

Leverage Analysis

https://rblacademy.blogspot.com/2021/08/financial-management-notes-leverage.html

Cost of Capital

https://rblacademy.blogspot.com/2021/08/cost-of-capital-solved-problems.html

EBIT – EPS Analysis

https://rblacademy.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html

Capital Structure Analysis

https://rblacademy.blogspot.com/2022/02/capital-structure-theories-solved.html

Planning & Designing of Capital Structure

https://rblacademy.blogspot.com/2022/03/planning-designing-of-capital-structure.html

Estimation of Cash Flow in Capital Budgeting

https://rblacademy.blogspot.com/2021/06/part-1-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-2-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-3-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2022/03/estimation-of-cash-flow-in-capital.html

Techniques of Capital Budgeting

https://rblacademy.blogspot.com/2021/05/techniques-of-capital-budgeting.html

https://rblacademy.blogspot.com/2021/05/capital-budgeting-i-httprblacademycom.html

https://rblacademy.blogspot.com/2021/05/financial-management-capital-budgeting.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_2.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_14.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html

Cost of Capital is one of the most important topics in Financial Management / Corporate Finance. The minimum rate of return that a firm must earn in order to satisfy the expectations of its investor is the cost of capital of the firm. If the firm’s return is more than its cost of capital, then it becomes easier for the firm to pay return expected by investors and such firms are most preferred where investors should invest their money. The excess portion of the return can be used by firm in several ways such as distributing among the shareholders in the form of higher than expected dividends, or for reinvestment within the firm increasing further the subsequent returns. In both the cases, the market price of the share of the firm will tend to increase and consequently will result in increase in shareholders’ wealth. The overall cost of capital of the firm may be ascertained as the weighted average cost of capital of different sources of funds. The Weighted Average Cost of Capital. WACC. may be ascertained by applying book value weights or market value weights of different sources of funds.  Categories: Financial Management, MBA Tags: b.com financial management tuition, b.com home tutor, bba financial management tuition, bba home tuotr, ca ipcc home tutor, corporate finance notes, corporate finance online tutor, corporate finance tuition, cost of capital solved problems, financial management, financial management home tutor, Financial Management notes, financial management notes pdf download, financial management online tuition, financial management online tutor, MBA financial management tuition, mba home tutor