Question 1

XYZ Ltd. has the following book value capital structure:

Equity Capital in shares of !s. "# each$ fully paid up% at par& !s. "' crores
""( )reference Capital in shares of !s. "## each$ fully paid
up% at par&
!s. " crore
!etained Earnings !s. *# crores
"+.'( ,ebentures of !s. "## each& !s. "# crores
"'( -er. Loans !s. "*.' crores
The next expected dividend on equity shares per share is Rs. 3.60; the dividend per share is
expected to grow at the rate of 7%. The maret price per share is Rs. !0.
"reference stoc# redeema$%e after ten years# is current%y se%%ing at Rs. 7& per share.
'e$entures# redeema$%e after six years# are se%%ing at Rs. (0 per de$enture.
The )ncome tax rate for the company is !0%.
!equired
i& Calculate the weighted average cost of capital using:
a& book value proportions/ and
b& .arket value proportions.
ii& ,efine the weighted .arginal cost of capital schedule for the co.pany$ if it raises !s. "#
crores ne0t year$ given the following infor.ation:
a& the a.ount will be raised by equity and debt in equal proportions;
b& the co.pany e0pects to retain !s. ".' crores earnings ne0t year/
c& the additional issue of equity shares will result in the net price per share being fi0ed at
!s. +*/
d& the debt capital raised by way of ter. loans will cost "'( for the first !s. *.' crores and
"1( for the ne0t !s. *.' crores. 2inal% 3ov. *###& "* .arks&
Answer
(i) (a) Statement showing computation of weighted average cost of capital by using Bookvalue
proportions
Source of finance Amount
(Book
value)
(Rs. in
crores)
Weight
(Book value
proportion)
Cost of
capital
Weighted
cost of
capital
(a) (b) (c)= (a)(b)
Equity capital 15 0.256 0.16 0.04096
(Refer to !orking note ")
11% Preference
capital
1 0.017 0.1543 0.00262
(Refer to !orking note #)
Retained earnings 20 0.342 0.16 0.05472
(Refer to !orking note ")
13.5% e!entures 10 0.171 0.127 0.02171
(Refer to !orking note $)
15% ter" l#ans 12.5 0.214 0.09 0.01926
$$$$ (Refer to !orking note %)
%eig&ted a'erage
c#st #f capital
5(.5 1.00 0.1393 )R
13.93%
(b) Statement showing computation of weighted average cost of capital by using market value
proportions
Source of finance Amount
(Rs. in crores)
Weight
(&arket value
proportions)
Cost of
capital
Weighted cost of
capital
(a) (b) (c)=(a)(b)
Equity capital 60.00 0.739 0.16 0.11(24
(Rs. ".' crores Rs. %() (Refer to !orking note ")
11% Preference capital 0.75 0.009 0.1543 0.0013(
(Rs. " lakh Rs. )') (Refer to !orking note #)
13.5% e!entures (.00 0.09( 0.127 0.01245
(Rs. "( lakhs Rs. *() (Refer to !orking note $)
15% *er" l#ans 12.50 0.154 0.09 0.013(6
(Refer to !orking note %)
%eig&ted a'erage c#st
#f capital
(1.25 1.00 0.14593 #r
14.59%
*ote+ ,ince retained earnings are treated as equity capita% for purposes of ca%cu%ation of cost of
specific source of finance# the maret va%ue of the ordinary shares may $e taen to represent the
com$ined maret va%ue of equity shares and retained earnings. The separate maret va%ues of
retained earnings and ordinary shares may a%so $e wored out $y a%%ocating to each of these a
percentage of tota% maret va%ue equa% to their percentage share of the tota% $ased on $oo va%ue.
-ii. ,tatement showing weighted margina% cost of capita% schedu%e for the company# if it
raises Rs. /0 crores next year# given the fo%%owing information+
Chun
k
Source of
finance
Amount
(Rs. in
crores)
Weight Cost of
capital
Weighted cost of
capital
a& b& c&4a&0b&
/. Retained earnings /.& 0.& 0./6 0.0(
!efer to working note "&
'e$t /.& 0.& 0.00 0.0!&
!efer to working note 1&
1eighted average cost of
capita%
0./2& or /2.&%
2. 3quity shares / 0.& 0./(2& 0.00/2&
!efer to working note '&
'e$t / 0.& 0.00 0.0!&
!efer to working note 1&
1eighted average cost of
capita%
0./362& or /3.62&%
3. 3quity shares 2.& 0.& #."5*' 0.00/2&
!efer to working note '&
'e$t 2.& 0.& 0.006 0.0!(
!efer to working note 1&
1eighted average cost of
capita%
0./302& or /3.02&%
Working Notes:
1. Cost of equity capital and retained earnings (Ke)
4e 5
g
+
,
+
0
1
1here# 4e 5 6ost of equity capita%
'/ 5 3xpected dividend at the end of year /
"0 5 6urrent maret price of equity share
g 5 7rowth rate of dividend
*ow# it is given that '/ 5 Rs. 3.60# "0 5 Rs. !0 and g5 7%
Therefore# 4e 5 07 . 0
40 Rs.
3.60 Rs.
+
or 4e 5 /6%
. Cost of preference capital (Kp)
4p 5
1
]
1

+
1
]
1

+
n
+ -
n
+ -
,
1here# ' 5 "reference dividend
8 5 8ace va%ue of preference shares
" 5 6urrent maret price of preference shares
* 5 Redemption period of preference shares
*ow# it is given that '5 //%# 85Rs. /00# "5 Rs. 7& and n5 /0 years
Therefore 4p 5
/00
2
7& . /00 .
/0
7& Rs. 9 /00 Rs.
//

1
]
1

+
1
]
1

+
n
!s !s
5 /&.!3 %
!. Cost of debentures (Kd)
4d 5
1
]
1

+
1
]
1

n
+ -
n
+ -
t r + 1 ,
Where, r = Rate of interest
t = Tax rate applicable to the company
F = Face value of debentures
P = Current market price of debentures
n = Redemption period of debentures
*ow it is given that r5 /3.&%# t5!0%# 85Rs. /00# "5Rs. (0 and n56 years
Therefore# 4d 5
100
6
(0 Rs. 100 Rs.
6
(0 Rs. - 100 Rs.
+ 40 . 0 1 , 5 . 13

1
]
1

+
1
]
1

+
5 /2.70%
". Cost of ter# loans(Kt)
4t 5 r-/:t.
1here# r 5 Rate of interest on term %oans
t 5 Tax rate app%ica$%e to the company
*ow# r 5 /&% and t5 !0%
Therefore# 4t 5 /&% -/:0.!0.
5 0%
$. Cost of fres% equity s%are (Ke)
4e 5
g
+
+
1
]
1

*ow# '/ 5 Rs. 3.60# "5 Rs. 32 and g50.07

Therefore# 4e 5
07 . 0
32 Rs.
3.60 Rs.
+
1
]
1

5 /(.2&%
&. Cost of de't (Kd)
4d 5 r-/:t.
-8or first Rs. 2.& crores.
r 5 /&% and t5 !0%
Therefore# 4d 5/&% -/:!0%.
5 0%
-8or the next 2.& crores .
r 5 /6% and t5 !0%
Therefore# 4d 5 /6% -/:!0%.
5 0.6%
Question 2
A Company earns a prot of Rs!",##,### per annum after meetin$ its %nterest
liability of Rs!&,'#,### on &'( debentures! The Tax rate is )#(! The number
of *+uity ,hares of Rs!&# each are -#,### and the retained earnin$s amount
to Rs!&',##,###! The company proposes to take up an expansion scheme for
.hich a sum of Rs!/,##,### is re+uired! %t is anticipated that after expansion,
the company .ill be able to achieve the same return on investment as at
present! The funds re+uired for expansion can be raised either throu$h debt
at the rate of &'( or by issuin$ *+uity ,hares at par.
Required:
(i) Compute the Earnings Per Share (EPS), if:
the additional funds were raised as debt
the additional funds were raised by issue of equity shares.
(ii) d!ise the "ompany as to whi"h sour"e of #nan"e is preferable.
0P*1%%1 2ov! '##'3 04 marks3
Answer
Working Notes +
1.Capital e#ployed 'efore e(pansion plan :
Rs.
*+uity shares -,##,###
5ebentures
(Rs.$,%&,&&&'$%) $&&
&#,##,##
#
Retained earnin$s &',##,##
#
*#tal capital e"pl#yed 30.00.000
2. Earnings before the payment of interest and tax (EBIT)
Rs.
Prot ",##,##
#
%nterest &,'#,##
#
*6%T /,'#,##
#
3. Return on investment (ROI)
R7% =
100
00 Rs.30.00.0
0 Rs.4.20.00
100
e"pl#yed

Capital
.B/0
= &/(
. Earnings before the payment of interest and tax (EBIT) after
expansion
After expansion, capital employed = Rs!"/,##,###
5esired *6%T = &/( Rs!"/,##,### = Rs!/,84,###
(i) )tate#ent s%owing *arning +er )%are (*+))
(Under present and anticipated expansion scheme)
Present
situation
E(pansion s"heme
dditional funds raised as
)ebt Equity
Rs. Rs. Rs.
*6%T9 0A3 /,'#,### /,84,### /84,###
(Refer to *or+ing
note % %)
(Refer to *or+ing note ,)
%nterest 7ld capital &,'#,### &,'#,### &,'#,###
2e. capital 1111111111 /-,### 111111111
(Rs.,,&&,&&&
$%-)
Total interest 9 063 &,'#,### &,4-,### &,'#,###
*6T9:0A3
063;
",##,### ",#-,### ",)4,###
.ess9 Tax &,)#,### &,)/,### &,8-,###
(/&- of
E01)
PAT &,)#,### &,)/,### &,8-,###
*P, &!-8) &!<') &!/-

(Rs.$,/&,&&&'
2&,&&&)
(Rs.$,/,,&&&'
2&,&&&)
(Rs.$,32,&&&'
$,%&,&&&)
(ii) Ad,ise to t%e Co#pany+ ,ince 3", is greater in the case when company arranges
additiona% funds as de$t. Therefore# de$t scheme is $etter.
Question 3
6a%cu%ate the %eve% of earnings $efore interest and tax -3;)T. at which the 3", indifference point
$etween the fo%%owing financing a%ternatives wi%% occur.
i& Equity share capital of !s.1$##$### and "*( debentures of !s.6$##$###
<r
ii& Equity share capital of !s.6$##$###$ "6( preference share capital of !s.*$##$### and
"*( debentures of !s.6$##$###.
7ssu.e the corporate ta0 rate is +'( and par value of equity share is !s."# in each case
. )E%88% 9ay. *##+& + .arks&
Answer
Computation of level of earnings before interest and tax (EB!)
4n "ase alternati!e (i) is a""epted, then the EPS of the #rm would be:
s&ares equity #f /#.
rate+ ta0 ,1 1nterest+ ,E21*

e,i+ 3lternati'
EP4

5
000 . 60
+ 35 . 0 1 , + 000 . 00 . 4 . 12 . 0 , Rs .B/0
%n case the alternative 0ii3 is accepted, then the *P, of the rm .ould be
40.000
0+ Rs.2.00.00 ,0.14 5 + 35 . 0 ,1 + 000 . 00 . 4 . Rs 12 . 0 ,E21*

e,ii+ 3lternati'
EP4

4n order to determine the indi6eren"e le!el of E041, the EPS under the two
alternati!e plans should be equated as follows:
40.000
0+ Rs.2.00.00 ,0.14 0.35+ ,1 0+ Rs.4.00.00 0.12 ,E21*
60.000
0.35+ ,1 0+ Rs.4.00.00 0.12 ,E21*

7r
2
Rs.59.200 E21* 0.65

3
Rs.31.200 E21* 0.65

7r $.8& E041 Rs.9%,,&& 5 $.:/ E041 Rs.$,33,9&&

7r ($.:/ $.8&) E041 5 Rs.$,33,9&& Rs.9%,,&& 5 Rs.$,$/,%&&
7r E041 5
0.65
0 Rs.1.15.20
7r E041 5 Rs.$,33,%8$
Question 4
=4> >td. has the fo%%owing $oo:va%ue capita% structure as on ?arch 3/# 2003.
Rs.
Equity share "apital (%,&&,&&& shares) ,&,&&,&&&
$$./- preferen"e shares $&,&&,&&&
$&- debentures 8&,&&,&&&
2&,&&,&&&
The e+uity share of the company sells for Rs!'#! %t is expected that the company .ill
pay next year a dividend of Rs!' per e+uity share, .hich is expected to $ro. at )(
p!a! forever! Assume a ")( corporate tax rate!
Re+uired9
(i) Compute weighted a!erage "ost of "apital (*CC) of the "ompany
based on the e(isting "apital stru"ture.
(ii) Compute the new *CC, if the "ompany raises an additional Rs.%&
la+hs debt by issuing $%- debentures. 1his would result in in"reasing the
e(pe"ted equity di!idend to Rs.%.,& and lea!e the growth rate un"hanged,
but the pri"e of equity share will fall to Rs. $9 per share.
(iii) Comment on the use of weights in the "omputation of weighted
a!erage "ost of "apital.
0P*1%%1 =ay! '##"3 0- marks3
Answer
(i) Weig%ted A,erage Cost of Capital of t%e Co#pany
(0ased on E(isting Capital Stru"ture)
Parti"ulars fter ta(
"ost
*eights
(Refer to
wor+ing
note ,)
*eighted
"ost
(a) (b) (a) (b)
*+uity share capital
cost
#!&) #!)# #!#8)
(Refer to wor+ing note
$)
Cost of preference
share capital >&&!)(
(Refer to wor+ing note
%)
#!&&) #!&') #!#&/"8)
Cost of debentures
(Refer to wor+ing note
8)
#!#4) #!"8) #!#'/"8
Wei$hted avera$e cost
of capital
&&!"8)(
Working Notes:
1. !ost of e"uity #apita$%
g
s&are #f price "ar6et 7urrent
i'idend
e
8 +
= 0.15 #r 15% 5%
Rs.20
Rs.2
+
'! !ost of preferen#e share #apita$%
=
s&are preference #f issue t&e in pr#ceeds /et
di'idend s&are preference 3nnual
=
00 Rs.10.00.0
0 Rs.1.15.00
= #!&&)
"! !ost of &ebentures:
=
( ) *a0 1nterest
pr#ceeds /et
1

=
( ) 0 Rs.1.05.00 5 0 Rs.3.00.00
00 Rs.30.00.0
1

= #!#4)
4. "eights of e#uity share capital$ preference share capital and debentures in total investment
of %s&'($(($((()
Wei$ht of e+uity share capital =
s in'est"ent *#tal
capital s&are equity *#tal
=

00 Rs.(0.00.0
00 Rs.40.00.0
= #!)#
Wei$ht of preference share capital =

s in'est"ent *#tal
a"#unt s&are preference *#tal
9

00 Rs.(0.00.0
00 Rs.10.00.0
9 0.125
%eig&t #f de!entures 9
s in'est"ent *#tal
de!entures *#tal
9

00 Rs.(0.00.0
00 Rs.30.00.0
9 0.375
(ii) New Weig%ted A,erage Cost of Capital of t%e Co#pany
(0ased on new "apital stru"ture)
fter ta(
"ost
*eights *eighted
"ost
(Refer to
wor+ing
note ,)
(a) 0b3 (a) (b)
Cost of e+uity share
capital
#!'# #!/# #!#-#
(Refer to wor+ing note
%)
Cost of preference
share
#!&&) #!&# #!#&&)
Cost of debentures >
&#(
#!#4) #!"# #!#&<)
Cost of debentures
>&'(
#!#8- #!'# #!#&)4
Wei$hted avera$e cost
of capital
&'!44(
'or(ing )otes%
0&3 'eights of e"uity share #apita$* preferen#e share and
debentures in total
investment of %s&*(($(($(((
Wei$ht of e+uity share capital =
0.4
.000 Rs.1.00.00
00 Rs.40.00.0

Wei$ht of preference share capital =

1 . 0
000 . 00 . 00 . 1 . Rs
000 . 00 . 10 . Rs

Wei$ht of debentures >&#( =

30 . 0
000 # 00 # 00 # / . Rs
000 # 00 # 30 . Rs

Wei$ht of debentures >&'( =
20 . 0
000 # 00 # 00 # / . Rs
000 # 00 # 20 . Rs

0'3! !ost of e"uity #apita$%
g
s&are #f price "ar6et 7urrent
i'idend
e
8 +
9 20% 5%
Rs.16
Rs.2.40
+
(iii) Co##ent+ )n the computation of weighted average cost of capita% weights are
preferred to $oo va%ue. 8or examp%e# weights representing the capita% structure under a
corporate financing situation# its cash f%ows are preferred to earnings and maret. ;a%ance sheet
is preferred to $oo va%ue $a%ance sheet.
Question 5
@;6 >imited has the fo%%owing $oo va%ue capita% structure+
Equity Share Capital ($/& million shares,
Rs.$& par)
Rs.$,/&& million
Reser!es and Surplus Rs.%,%/& million
$&./- Preferen"e Share Capital ($ million
shares, Rs.$&& par)
Rs.$&& million
:./- )ebentures ($./ million debentures,
Rs.$&&& par)
Rs.$,/&& million
2./- 1erm .oans from ;inan"ial
4nstitutions
Rs./&& million
1he debentures of 0C .imited are redeemable after three years and are
quoting at Rs.:2$.&/ per debenture. 1he appli"able in"ome ta( rate for the
"ompany is 8/-.
1he "urrent mar+et pri"e per equity share is Rs.9&. 1he pre!ailing default<
ris+ free interest rate on $&<year =74 1reasury 0onds is /./-. 1he a!erage
mar+et ris+ premium is 2-. 1he beta of the "ompany is $.$23/.
1he preferred sto"+ of the "ompany is redeemable after / years is "urrently
selling at Rs.:2.$/ per preferen"e share.
!equired:
i& Calculate weighted average cost of capital of the co.pany using .arket value weights.
ii& ,efine the .arginal cost of capital schedule for the fir. if it raises !s.:'# .illion for a
new pro;ect. -he fir. plans to have a target debt to value ratio of *#(. -he beta of new pro;ect
is ".6+:'. -he debt capital will be raised through ter. loans. 8t will carry interest rate of <.'(
for the first "## .illion and "#( for the ne0t !s.'# .illion.
-"3:)): ?ay 200!. -0 mars.
Answer
Working Notes:
1) Co#putation of cost of de'entures (Kd) :
0(/.0& 5
3 2 1
yt"+ ,1
1095
yt"+ ,1
95
yt"+ ,1
95
+
+
+
+
+
Aie%d to maturity -ytm. 5 /0% -approximate%y.
4d 5 ytm -/ Tc.
5 /0% -/ 0.3&.
5 6.&%
) Co#putation of cost of ter# loans (K-) :
5 i - / Tc.
5 (.&% - / 0.3&.
5 &.&2&%
!) Co#putation of cost of preference capital (K+) :
0(.& 5
5 4 3 2 1
:*;+ ,1
10.5
:*;+ ,1
10.5
:*;+ ,1
10.5
:*;+ ,1
10.5
:*;+ ,1
10.5
+
+
+
+
+
+
+
+
+
AT? 5 //% -approximate%y.
4p 5 //%
") Co#putation of cost of equity (K*) :
5 rf B @verage maret ris premium ;eta
5 &.&%B (% /./(7&
5 /&%
$) Co#putation of proportion of equity capital. preference s%are. de'entures and ter#
loans in t%e #arket ,alue of capital structure:

(Rs. in million& &arket value of
capital structure
Rs.
)roportion
Equity s&are capital
("'( million share Rs.1()
9.000 (1.3000
10.5% Preferential s&are capital
(" million shares 2*."')
9(.15 0.((9
9.5 % e!entures
(".' million debentures Rs.2*".(')
1.471.575 13.294
(.5% *er" l#ans &00 !.&/7
""3(12.)#' "((
(i) Weig%ted A,erage cost of capital (WACC) : =sing .arket value weights&
1@66 5 4d
<
E
8
<
P
8
<
*
8
<

E P *
+ + +
5 6.&% 0./320 B &.2&% 0.0!&/7 B //% 0.00(0 B /&% 0.(/3
5 0.00(63( B 0.002!0& B 0.00007 B 0./2/0&
5 /3.!/%
C 8or the va%ues of 4d# 4T# 4" and 43 and weights refer to woring notes / to & respective%y.
(ii) /arginal cost of capital (/CC) sc%edule :
43 -*ew "roDect. 5 &.&% B (% /.!37& 5 /7%
4d 5 0.&% - /0.3&. 5 6./7&%
5 /0% -/0.3&. 5 6.&%
?66 5 /7% x 0.(0 B 6./7&%
750
50
% 5 . 6
750
100
+
5 /!.(6% -@pproximate%y.
Question 6
Consider a firm that has existing assets in which it has capital invested of Rs. 100 crors. The
after- tax operating income on asets in place is Rs.15 crores,. The return on capital
emploed of 15! is expectd to "e sustained on perpetunit, and compan has a cost of capital
of 10!. #stimate the present valuse of economic value added $#%#& of the firm from its assets-
in-place. 'C.( )# ** + 0,-
Answer :
7perating pro#t after ta( 5 Rs.$/ Crores
.ess: "apital employes >*CC 5$&& > $&- 5 Rs.$& Crores
E"onomi" ?alue dded (E?) 5 Rs. / Crores
Sin"e this E? is sustained till perpunity,
Present !alue of E? 5 E? @ Cost of "apital
5 Rs. $/ Crores
$&-
5 Rs.$/& Crores
Question 7
, Ltd. is foreseeing a growth rate of "*( per annu. in the ne0t two years. -he growth rate is
likely to be "#( for the third and fourth year. 7fter that the growth rate is e0pected to stabilise
at 5( per annu.. 8f the last dividend was !s. ".'# per share and the investor>s required rate of
return is "1($ deter.ine the current value of equity share of the co.pany.
-he ).?. factors at "1(
Year " * + 6
).?. 2actor .51* .:6+ .16" .''*
(PE!!"a# $%%&) (' marks)
Answer
The current va%ue of equity share of ' >td. is sum of the fo%%owing+
-i. "resent%y va%ue -"E. of dividends payments during /:! years; and
-ii. "resent va%ue -"E. of expected maret price at the end of the fourth year $ased on
constant growth rate of ( per cent.
"E of dividends 9 year /:!
4ear 'ividend +5 factor at "16 0otal +5 (in Rs.)
1 1.50,1 = 0.12+91.6( 0.(62 1.45
2 1.6( ,1=0.12+9 1.(( 0.743 1.40
3 1.(( ,1 = 0.10+92.07 0.641 1.33
4 2.07 ,1 = 0.10+9 2.2( 0.552 1.26
*#tal 5.44
"resent va%ue of the maret price -"
4
.+ end of the fourth year 9
"
4
5 '
5
F -4e:g. 5 Rs. 2.2( -/.0(. F -/6% (%. 5 Rs. 30.7(
"E of Rs. 30.7( 5 Rs. 30.7(0.&&2 5 Rs. /6.00
Gence#
Ea%ue of equity shares Rs. &.!! + Rs. /6.00 5 Rs. 22.!3
Question 8
-he !@A Co.pany has following capital structure at +"
st
9arch *##6$ which is considered to be
opti.u.:
!s.
"+( debenture +$1#$###
""( preference share capital "$*#$###
Equity share capital *$##$###
shares&
"<$*#$###
-he co.pany>s share has a current .arket price of !s. *:.:' per share. -he e0pected dividend
per share in ne0t year is '# percent of the *##6 E)B. -he E)B of last "# years is as follows. -he
past trends are e0pected to continue:
Year "<<' "<<1 "<<: "<<5 "<<< *### *##" *##* *##+ *##6
3",
-Rs..
/.00 /./20 /.2&! /.!0& /.&7! /.762 /.07! 2.2// 2.!76 2.773
-he co.pany can issue "6 percent new debenture. -he co.pany>s debenture is currently selling
at !s. <5. -he new preference issue can be sold at a net price of !s. <.5#$ paying a dividend of
!s. ".*# per share. -he co.pany>s .arginal ta0 rate is '#(.
i& Calculate the after ta0 cost a& of new debts and new preference share capital$ b& of
ordinary equity$ assu.ing new equity co.es for. retained earnings.
ii& Calculate the .arginal cost of capital.
iii& Cow .uch can be spent for capital invest.ent before new ordinary share .ust be sold D
7ssu.ing that retained earning available for ne0t year>s invest.ent are '#( of *##6 earnings.
iv& Ehat will be .arginal cost of capital cost of fund raised in e0cess of the a.ount
calculated in part iii&&if the co.pany can sell new ordinary shares to net !s. *# per share D -he
cost of debt and of preference capital is constant.
)E%88%9ay *##'& *F"F*F*4: .arks&
Answer
The existing capita% structure is assumed to $e optimum.
E(isting Capital Structure Anal#sis
1ype of "apital mount (Rs) Proportions
&"( debentures ",4#,### #!&)
&&( Preference &,'#,### #!#)
*+uity &<,'#,### #!-#
Total '/,##,### &!##
(i) (a) @fter tax cost of de$t 5 4 d 5
9(
14
-/ 9 0.&.
5 0.07/!3
@fter tax cost of preference capita% -new.
4p5
(0 . 9
20 . 1
5 0./22!!0
(') @fter tax cost of retained earnings
4
e
5
75 . 27
3(65 . 1
B g
-here HgI is the growth rate.
5 0.0& B 0./2 5 0./7
(ii)
Types of
capital
(1)
Proportion
(2)
Specifc
cost
(3)
Product
(2) (3)
5ebt !&) !#8&/" !#&#8
Preference !#) !&''//< !##4&
*+uity !-# !&8 !&"4#
=ar$inal cost of
capital at
existin$ capital
structure
!&)'- or
&)!'-(
(iii) The company can spend the follo.in$ amount .ithout increasin$ its
=CC and .ithout sellin$ the ne. shares!
Retained earnin$s = &!"-4) ',##,### =',88,"##
The ordinary e+uity 0retained earnin$s in this case3 is -#( of the total
capital! Thus investment before issuin$ e+uity 0
(0
300 . 77 . 2
&## 3 = Rs
",/4,4')
(i,) if the company spends more than Rs", /4,4') , it .ill have to issue
ne. shares ! The cost of ne. issue of ordinary share is 9
?
e
=
20
3(65 . 1
@ #!&' = #!&-<"
The mar$inal cost of capital of Rs ",/4,4')
Types of capital
(1)
Proportion
(2)
Specifc cost
(3)
Product
(2) (3)
5ebt !&) !#8&/" !#&#8
Preference !#) !&''//< !##4&
*+uity0ne.3 !-# !&-<" #!&)&//
=ar$inal cost of
capital at existin$
capital structure
#!&4-'/ or &4!-' (

+uestion ,
Company needs Rs. 8$,%/,&&& for the "onstru"tion of new plant. 1he
following three plans are feasible:
4 1he Company may issue 8,$%,/&& equity shares at Rs. $& per share.
44 1he Company may issue $,/9,%/& ordinary equity shares at Rs. $& per
share and $/,9%/ debentures of Rs,. $&& denomination bearing a 2- rate of
interest.
444 1he Company may issue $,/9,%/& equity shares at Rs. $& per share
and $/,9%/ preferen"e shares at Rs. $&& epr share bearing a 2- rate of
di!idend.
(i) if the CompanyAs earnings before interest and ta(es are Rs. 9%,/&&, Rs.
$,%/,&&&, Rs. %,/&,&&&, Rs. 8,3/,&&& and Rs. 9,%/,&&&, what are the earnings
per share under ea"h of three #nan"ial plans B ssume a Corporate 4n"ome
ta( rate of ,&-.
0ii3 Which alternative .ould you recommend and .hyA
(iii) )etermine the E041<EPS indi6eren"e points by formulae between
;inan"ing Plan 4 and Plan 44 and Plan 4 and Plan 444. (PE<44<Co!.%&&/)
(9D$D85$& mar+s)
Answer
(i) Co#putation of *+) under t%ree0financial plans.
+lan 1: *quity 2inancing
*6%T Rs! 4',)## Rs!
&,'),###
Rs!
',)#,###
Rs!
",8),###
Rs!
4,'),###
%nterest # # # # #
*6T Rs! 4',)## Rs!
&,'),###
Rs!
',)#,###
Rs!
",8),###
Rs!
4,'),###
.ess9 Taxes
/#(
'),### )#,### &,##,### &,)#,### ',)#,###
PAT Rs! "8,)## Rs! 8),### Rs!
&,)#,###
Rs!
','),###
Rs!
",8),###
2o! of
e+uity
shares
",&',)## ",&',)## ",&',)## ",&',)## ",&',)##
*P, Rs! #!&' #!'/ #!/- #!8' &!'#
+lan 11: 3e't 4 *quity /i(
*6%T Rs!
4',)##
Rs!
&,'),###
Rs!
',)#,###
Rs!
",8),###
Rs!
4,'),###
.ess9
%nterest
&,'),### &,'),### &,'),### &,'),### &,'),###
*6T 04',)##3 # &,'),### ',)#,### ),##,###
.ess9
Taxes
/#(
'),###B # )#,### &,##,### ',##,###
PAT 0"8,)##3 # 8),### &,)#,### ",##,###
2o! of
e+uity
shares
&,)4,')# &,)4,')# &,)4,')# &,)4,')# &,)4,')#
3", -Rs. 0.2!. 0 0.!( 0.06 /.02
C The Company .ill be able to set oC losses a$ainst other prots! %f the
Company has no prots from operations, losses .ill be carried for.ard!
+lan 111 : +reference )%ares 4 *quity /i(
3;)T Rs. 62#&00 Rs /#2&#000 Rs. 2#&0#000 Rs. 3#7&#000 Rs. 6#2&#000
Less: )nterest 0 0 0 0 0
3;T 62#&00 /#2&#000 2#&0#000 3#7&#000 6#2&#000
Less: Taxes
-!0%.
2&#000 &0#000 /#00#000 /#&0#000 2#&0#000
"@T 37#&00 7&#000 /#&0#000 2#2&#000 3#7&#000
Less: "ref.
dividend
/#2&#000 /#2&#000 /#2&#000 /#2&#000 /#2&#000
"@T for
ordinary
shareho%ders
-(7#&00. -&0#000. 2&#000 /#00#000 2#&0#000
*o. of 3quity
shares
/#&6#2&0 /#&6#2&0 /#&6#2&0 /#&6#2&0 /#&6#2&0
3", -0.&6. -0.32. 0./6 0.6! /.60
(ii) The choice of the financing p%an wi%% depend on the state of economic conditions. )f the
companyIs sa%es are increasing# the 3", wi%% $e maximum under "%an ))+ 'e$t 9 3quity ?ix.
Jnder favoura$%e economic conditions# de$t financing gives more $enefit due to tax shie%d
avai%a$i%ity than equity or preference financing.
(iii) *51- 4 *+) 1ndifference +oint : +lan 1 and +lan 11
2
7
1
7
/
+ * 1 , + 1nterest > E21* ,
/
+ * 5 ,1 ,E21*>+

250 . 56 . 1
+ 40 . 0 1 , + 000 . 25 . 1 > E21* ,
500 . 12 . 3
+ 40 . 0 1 , > E21*

3;)TC 5
000 . 25 . 1
250 . 56 . 1 500 . 12 . 3
500 . 12 . 3

5 Rs. 2#&0#000
*51- 4 *+) 1ndifference +oint: +lan 1 and +lan 111
( )
2
c
1
c
/
i'. Pref. * 1 > E21*
/
+ * 1 , > E21*

3;)TC 5
7 2 1
1
* 5 1
i'. Pref.
/ /
/

5
4 . 0 1
000 . 25 . 1
250 . 56 . 1 500 . 12 . 3
500 . 12 . 3

6 7s. ".1&.&&&.&8
Question 10
A Company issues Rs! &#,##,### &'( debentures of Rs! &## each! The
debentures are redeemable after the expiry of xed period of 8 years! The
Company is in ")( tax bracket!
Required:
(i) Cal"ulate the "ost of debt after ta(, if debentures are issued at
(a) )ar
$"& 10! .iscount
$c& 10! )remium.
(ii) %f brokera$e is paid at '(, .hat .ill be the cost of debentures, if
issue is at parA
0P*1%%1=ay '##4304 marks3
Answer

,
_

2
/P R<
/
/P+ ,R<
+ * ,1 1
8
c
d
Where,
% = Annual %nterest Payment
2P= 2et proceeds of debentures
RD = Redemption value of debentures
Tc = %ncome tax rate
2 = Eife of debentures
(i) (a) Cost of de'entures issued at par.

,
_

2
10.00.000 10.00.000
7
10.00.000+ ,10.00.000
+ 0.35 ,1 1.20.000


7.(%
000 . 00 . 10
7(.000

(') Cost of de'entures issued at 19: discount

,
_

2
9.00.000 10.00.000
7
9.00.000+ ,10.00.000
+ 0.35 ,1 1.20.000


9.71%
000 . 50 . 9
14.2(6 7(.000

+

(c) Cost of de'entures issued at 19: +re#iu#

,
_

2
11.00.000 10.00.000
7
11.00.000+ ,10.00.000
+ 0.35 ,1 1.20.000
8
d
6.07%
000 . 50 . 10
14.2(6 7(.000

0ii3 !ost of debentures* if bro(erage is paid at 2+ and debentures are

issued at par

,
_

2
10.00.000 20.000+ ,10.00.000
7
9.(0.000+ ,10.00.000
+ 0.35 ,1 1.20.000
8
d

(.17%
000 . 90 . 9
(0.(57

Question 11
E .td.Fs operating in"ome (before interest and ta() is Rs. :,&&,&&&. 1he
#rmFs "ost of debts is $&- and "urrently #rm employs Rs. 8&,&&,&&& of
debts.
Required:
Cal"ulate "ost of equity
Answer
!a$#u$ation of #ost of E"uity
Calculation of value of rm 0v3 = *6%T 7verall cost of capital 0?
#
3
= <,##,####!&' = Rs! 8),##,###
=arket value of e+uity 0,3 = D F 5ebts
= 8),##,###1 "#,##,###
= Rs! /),##,###
=arket value of debts 053 = "#,##,###
?
e
0cost of e+uity3 = ?
#
0D,3 1 ?
d
005,3
Question 12
(a) A6C Etd! .ishes to raise additional nance of Rs! '# lakhs for meetin$ its
investment plans! The company has Rs! /,##,### in the form of retained
earnin$s available for investment purposes! The follo.in$ are the further
details!
5ebt e+uity ') 9 8)!
Cost of debt at the rate of &#( 0before tax3 up to Rs! ',##,### G &"(
0before tax3 beyond that!
*arnin$ per share, Rs! &'!
5ividend payout )#( of earnin$s!
*xpected $ro.th rate in dividend &#(!
Current market price per share, Rs! 4#
CompanyHs tax rate is "#( and shareholderHs personal tax rate is '#(!
Re+uired9
i3 Calculate the post tax avera$e cost of additional debt!
ii3 Calculate the cost of retained earnin$s and cost of e+uity!
iii3 Calculate the overall .ei$hted avera$e 0after tax3 cost of additional
nance!
Answer :
Pattern of raisin$ capital = #!')I '#,##,###
5ebt = ),##,###
*+uity = &),##,###
E"uity fund 0Rs! &),##,###3
Retained earnin$ = Rs! /,##,###
*+uity 0additional3 = Rs! &&,##,###
Total = Rs! &),##,###
&ebt fund 0Rs! ),##,###3
&#( debt = Rs! ',##,###
&"( debt = Rs! ",##,###
Total = Rs! ),##,###
0i3 ?d = Total %nterest 0&1t3 J Rs! ),##,###
= K'#,### @ "<,###L 0& 1#!"3J ),##,### or 0/&,"## J
),##,###3I&## = -!'4(
0ii3 ?e = *P,I payout J mp @ $ = &' 0)#(3 J 4#I&## @ &#(
&#( @ &#( = '#(
?r = ?e 0& F tp3 = '# 0&1#!'3 = &4(
0iii3 Weighted average cost of capital
,arti#u$ar -mount -fter tax !ost
*+uity Capital &&,##,### '#!##( ','#,###
Retained earnin$ /,##,### &4!##( 4/,###
5ebt ),##,### -!'4( /&,"##
Total '#,##,### ",'),"##
?o = 0",'),"## J '#,##,###3I &## = &4!'8(
Question 13
1he data relating to two "ompanies are as gi!en below
Company Company 0
Equity Captal Rs. 9,&&,&&& Rs. 8,/&,&&&
$%- )ebentures Rs. ,,&&,&&& Rs.9,/&,&&&
7utput (units) per annum 9&,&&& $/,&&&
Selling pri"e per unit Rs. 8& Rs. %/&
;i(ed "ost per annum Rs.3,&&,&&& Rs.$,,&&,&&&
?ariable "ost per unit Rs. $& Rs.3/
/ r re0uried to calculate the operating leverage, financial leverage and com"ined leverage of
two compnies.
Answer :
Computation of degree of -perating leverage$ .inancial leverage
and Combined leverage of two companies
Company Company 0
)utput units per annu" 60.000 15.000
Rs. Rs.
4elling price ? unit 30 250
4ales re'enue 1(.00.000 37.50.000
(1(3((( units Rs.$() ("'3((( units Rs.#'()
7ess8 <aria!le c#sts 6.00.000 11.25.000
(1(3((( units Rs."() ("'3((( units Rs.)')
7#ntri!uti#n ,7+ 12.00.000 26.25.000
7ess8 @i0ed c#sts 7.00.000 14.00.000
E21* 5.00.000 12.25.000
7ess8 1nterest A 12% #n de!entures 4(.000 7(.000
P2* 4.52.000 11.47.000
DOL =
E21*
7

2.4
(Rs."#3((3((( 9 Rs.'3((3((()
2.14
(Rs.#13#'3((( 9 Rs."#3#'3((()
DFL =
P2*
E21*

1.11
(Rs.'3((3((( 9 Rs.%3'#3((()
1.07
(Rs."#3#'3((( 9 Rs.""3%)3((()
DCL = DOL
DFL
2.66
(#.%".""
#.#2
(#."%".())
Question 14
Gou are analysing the beta for 0C Computers .td. and ha!e di!ided the
"ompany into four broad business groups, with mar+et !alues and betas for ea"h
group.
0usiness group Har+et !alue of equity Inle!eraged
beta
Hain frames Rs. $&& billion $.$&
Personal
Computers
Rs. $&& billion $./&
Software Rs. /& billion %.&&
Printers Rs. $/& billion $.&&
0C Computers .td. had Rs. /& billion in debt outstanding.
Required:
(i) Estimate the beta for 0C Computers .td. as a Company. 4s this beta going
to be equal to the beta estimated by regressing past returns on 0C
Computers sto"+ against a mar+et inde(. *hy or why not B
(ii) 4f the treasury bond rate is 3./-, estimate the "ost of equity for 0C
Computers .td. Estimate the "ost of equity for ea"h di!ision. *hi"h "ost of
equity would you use to !alue the printer di!ision B 1he a!erage mar+et ris+
premium is 2./-.
(PE<44<Co!. %&&,) (9 mar+s)
Answer
(i) Beta of /BC Computers
9 1.10 2?( = 1.502?( = 21?( = 13?(
9 1.275
1eta coefficient is a measure of volatilit of securities return relative to the returns of
a "road "ased mar2et portfolio. 3ence "eta measures volatilit of (1C Computers
stoc2 return against "road "ased mar2et portfolio. *n this case we are considering
four "usiness groups in computer segment and not a "road "ased mar2et portfolio ,
therefore "eta calculations will not "e the same.
(ii) Cost of equity
9 rf = a' "6t ris6 pre"iu"
9 7.5% = 1.275 (.5% 9 1(.34%
;ain fra"e 8E 9 7.5% = 1.10 (.5% 9 16.(5%
P7 8E 9 7.5% = 1.5 (.5% 9 20.25%
4#ftBare 8E 9 7.5% = 2(.5% 9 24.5%
Printers 8E 9 7.5% = 1(.5% 9 16%
To va%ue printer division# the use of /6% 43 is recommended
Question 15
0he follo!ing summarises the percentage changes in operating income3 percentage changes in revenues3 and
betas for four pharmaceutical firms.
;irm Change in
re!enue
Change in operating
in"ome
0eta
PJR .td. %3- %/- $.&&
RS1 .td. %/- 8%- $.$/
1I? .td. %8- 89- $.8&
*KG
.td.
%$- ,&- $.,&
Re:uired8
(i) Calculate the degree of operating leverage for each of these firms. Comment also.
(ii) ;se the operating leverage to eplain !h< these firms have different beta.
(+.=//=>ov. #((%) (1 marks)
Answer
(i) egree #f #perating le'erage 9
Re'enues in 7&ange %
inc#"e )perating in 7&ange %
PCR Dtd . 9 25% ? 27% 9 0.9259
R4* Dtd. 9 0.32 ? 0.25 9 1.2(
*E< Dtd. 9 0.36 ? 0.23 9 1.5652
%F: Dtd. 9 0.40 ? 0.21 9 1.904(
1t is le'el specific.
(ii) Gig& #perating le'erage leads t# &ig& !eta. *&e s#urces #f ris6 are t&e cyclic nature re'enues. #perating
ris6 and financial ris6.
Question 16
Company had the following 0alan"e Sheet as on Har"h 8$, %&&9:
.iabilities and Equity
Rs. (in "rores)
ssets Rs. (in
"rores)
Equity Share Capital
(one "rore shares of Rs.
$& ea"h)
$&
;i(ed ssets
(Cet)
Current ssets
%/
$/
Reser!es and Surplus %
$/- )ebentures %&
Current .iabilities 2 LLL
,& ,&
1he additional information gi!en is as under:
;i(ed Costs per annum (e("luding interest) :Rs. 2 "rores
?ariable operating "osts ratio : 9/-
1otal ssets turno!er ratio : %./
4n"ome<ta( rate : ,&-
Required:
Cal"ulate the following and "omment:
(i) Earnings per share
(ii) 7perating .e!erage
(iii) ;inan"ial .e!erage
(i!) Combined .e!erage. (PE<44<Co!. %&&9)(2 mar+s)
Answer
Total Assets = Rs! /# crores
Total Asset Turnover Ratio = '!)
Mence, Total ,ales = /# '!) = Rs! &## crores
!omputation of ,ro.ts after Tax (,-T)
(Rs. in crores)
,ales &##
.ess9 Dariable operatin$ cost > 4)( 4)
Contribution ")
.ess9 Fixed cost 0other than %nterest3 -
*6%T '8
.ess9 %nterest on debentures 0&)( '#3 "
P6T '/
.ess9 Tax /#( <!4
PAT &/!/
(i) Earnings per share

Rs. 14.4 cr#res

EP4 9
1cr#re equity s&ares
= Rs! &/!/#
(ii) Operating /everage
7#ntri!uti#n 35
)perating le'erage 9 9 9 1.296
E21* 27
%t indicates the choice of technolo$y and xed cost in cost structure! %t is
level specic! When rm operates beyond operatin$ break1even level, then
operatin$ levera$e is lo.! %t indicates sensitivity of earnin$s before interest
and tax 0*6%T3 to chan$e in sales at a particular level!
(iii) 0inan#ia$ /everage
E21* 27
@inancial De'erage 9 9 9 1.125
P2* 24

The nancial levera$e is very comfortable since the debt service obli$ation is
small vis1N1vis *6%T!
(iv) !ombined /everage

7#ntri!uti#n E21*
7#"!ined De'erage 9
E21* P2*

= &!'<4 &!&')
= &!/)-
The combined levera$e studies the choice of xed cost in cost structure and
choice of debt in capital structure! %t studies ho. sensitive the chan$e in *P,
is vis1N1vis chan$e in sales!
The levera$es operatin$, nancial and combined are measures of risk
Question 17
0C .imited has an a!erage "ost of debt at $& per "ent and ta( rate is ,& per "ent.
1he
;inan"ial le!erage ratio for the "ompany is &.9&. Cal"ulate Return on Equity (R7E)
if its
Return on 4n!estment (R74) is %& per "ent.
Answer
= R7* = KR7% @ :0R7% F r3 O5J*;L 0& F t3
= K#!'# @ :0#!'# F #!&#3 O#!4#;L 0& F #!/#3
=K #!'# @ #!#4L O#!4# = #!&)4#
R7* = &)!4#(
Question 18
(a) 1he following details of RS1 .td. for the year ended 8$
st
Har"h, %&&9 are
gi!en below:
7perating le!erage $.,
Combined le!erage %.2
;i(ed "ost (E("luding interest) Rs. %.&, la+hs
Sales Rs. 8&.&& la+hs
$%- )ebentures of Rs. $&& ea"h Rs. %$.%/ la+hs
Equity Share Capital of Rs. $& ea"h Rs. $3.&& la+hs
4n"ome 1a( rate 8&-
Required:
i) Cal"ulate ;inan"ial le!erage
ii) Cal"ulate P'? ratio and Earning per Share (EPS)
iii) 4f the "ompany belongs to an industry, whose assets turno!er is $./, does
it ha!e a high or low assets le!erageB
i!) t what le!el of sales the Earning 0efore 1a( (E01) of the "ompany will be
equal to MeroB

Answer
(a) (i) Financial Leverage
Combined Leverage = Operating Leverage (OL) Financial Leverage (FL)
2.8 = 1.4 FL
FL = 2
Financial Leverage = 2
(ii) P/V ratio and EPS
P/V ratio = {(CS) 100}
Operating Leverage = {C (C-F) 100}
1.4 = {C- (C-!04!000)}
1.4 (C-!04!000) = C
1.4C -!"#!$00 = C
C = !"#!$000.4
C = %!14!000
P/V = {(%!14!000&0!00!000)100} = &."'
()ere*ore! P/V ratio = &."'
+PS = (Pro*it a*ter ta, -o. o* e./it0 1)are1)
+2( = Sa3e1 4V- FC- 5ntere1t
= &0!00!000- !"$!000- !04!000 -!##!000
= !##!000
P6( = +2( 4(a,
= !##!000-%$!#00
= 1!%"!#00
+PS = (1!%"!#001!%0!000)
= 1.0#
(iii) Assets turnover
Assets turnover = (Sales Total Assets)
= (&0!00!000&"!#!000)
= 0.%"4
0.%"4 71.# means lower than industry turnover.
(iv) ET !ero means "##$ redu%tion in ET. Sin%e %om&ined levera'e is (.)* sales have to
&e dro++ed &y 100/." = &#.%1'. ,en%e new sales will &e
&0!00!000(100 -&#.%1) = 18!"!%00
There-ore* at ".*()*/## level o- sales* the earnin's &e-ore ta0 o- the %om+any will &e e1ual to
!ero.
Question 19
A -irm has Sales o- 2s. 3# la4hs5 6aria&le %ost o- 2s. (7 la4hs5 Fi0ed Costs o- 2s. 8 la4hs5 "#$
de&ts o- 2s. 9# la4hs5 and E1uity Ca+ital o- 2s. 37 la4hs. 7(
2e1uired:
Cal%ulate o+eratin' and -inan%ial levera'e
Answer:
Calculation of operating and Financial Leverage
2s.
Sales 3#*##*###
Less: 6aria&le %ost (7*##*###
Contri&ution (C) "7*##*###
Less: Fi0ed Cost 8*##*###
E;T .*##*###
Less: ;nterest 9*##*###
ET 8*##*###
O+eratin' levera'e = C E;T = "7*##*###.*##*### = ".8/
Finan%ial levera'e = E;T ET = .*##*###8*##*### = ".7#
Question 20
The following data relate to RT 4td5
Rs.
#arning "efore interest and tax $#1*T& 10,00,000
6ixed cost 70,00,000
#arning 1efore Tax $#1T& 8,00,000
Re0uired5 Calculate com"ined leverage
Answer
(iii) ontri!ution"
C = S < 6 and
E;T = C < F
"#*##*### = C < (#*##*###
C = 9#*##*###
O+eratin' levera'e = C = E;T = 9#*##*###="#*##*### = 9 times
Finan%ial levera'e = E;T=ET = "#*##*###=)*##*### = ".(7 times
Com&ined levera'e = OL 0 FL = 9 0 ".(7 = 9./7 times
Question #1
$ii& ( compan operates at a production level of 1,000 units. The contri"ution is Rs. 90 per
unit, operating leverage is 9, and com"ined leverage is 7,. *f tax rate is :0!, what would
"e its earnings after tax;
Answer
o$putation of Earnings after ta%
Contri&ution = 2s. 8# "*### = 2s. 8#*###
O+eratin' Levera'e (OL) >Finan%ial Levera'e (FL) = Com&ined Levera'e (CL)
8Finan%ial Levera'e = (3
Finan%ial Levera'e = 3
O+eratin' Levera'e = Contri&ution E;T = 8#*### E;T = 8
E;T = 8#*### 8 = "#*###
FL = E;TET = 3
ET = E;T 3 = "#*### 3 = (*7##
Sin%e ta0 rate = 9#$
Earnin's a-ter Ta0 (EAT) = ET (" ? #.9#)
= (*7## (#./#)
Earnin' A-ter Ta0 (EAT) = "*/7#
Extra sus!
+uestion *
< 4td. a widel held compan is considering a ma=or expansion of its production facilities and the
following alternatives are availa"le5
(lternatives $Rs. in
la2hs&
( 1 C
>hare Capital 5
0
70 10
1,! .e"entures - 70 15
4oan from a 6inancial *nstitution ? 18! p.a. Rate
of *nterest.
- 10 75
#xpected rate of return "efore tax is 75!. The rate of dividend of the compan is not less
than 70!. The compan at present has low de"t. Corporate taxation 50!
@hich of the alternatives ou would choose; $6inal- +ov.1AAB& $8 mar2s&
-ns1er
(Rs. in lakhs)
A B C
Return #n Rs. 50 la6&s A 25% 12.50 12.50 12.50
7essH 1nterest #n e!entures 5 2.(0 2.10
1nterest #n l#an 5 1.(0 4.50
*a0a!le pr#fit 12.50 7.90 5.90
1nc#"e ta0 50% 6.25 3.95 2.95
Pr#fit after ta0 a'aila!le t# s&are &#lders 6.25 3.95 2.95
Rate #f return #n s&are capital 12.5% 19.75% 29.5%
@r#" t&e s&are&#lders p#int #f 'ieB 3lternati'e 7 ,&ig&est+ is t# !e c&#sen.
2uestion 2
The following figures are made availa"le to ou5
91.
+et profits for the ear
1"!00!00
0
4ess5 *nterest on secured de"entures at 15! p.a.
$.e"entures were issued : months after the
commencement of the ear&
1!1!#00
1$!"%!#0
0
4ess5 *ncome tax at :5! and dividend distri"ution tax
"!4&!%#0
)rofit after tax
"!4&!%#0
+um"er of e0uit shares $Rs. 10 each&
1!00!000
Car2et 0uotation of e0uit share
91. 108.%
The compan has accumulated revenue reserves of Rs. 17 la2hs. The compan is examining
a pro=ect calling for an investment o"ligation of Rs. 10 la2hsD this investment is expected to
earn the same rate of return as funds alread emploed.
Eou are informed that a de"t e0uit ratio $.e"t divided " de"t plus e0uit& higher than
90! will cause the price earning ratio to come down " 75! and the interest rate on
additional "orrowals will cost compan :00 "asic points more than on the current
"orrowal on secured de"entures.
Eou are re0uired to advise the compan on the pro"a"le price of the e0uit share, if
$a& the additional investment were to "e raised " wa of loansD or
$"& the additional investment were to "e raised " wa of e0uit.
$6inal-Ca 1AA8& $10 mar2s&
-ns1er
"orking 0ote)
+resent earning9share8
Rs.
Pr#fit !ef#re ta0es 16.(7.500
7ess8 *a0es at 35% 5.90.625
Pr#fit after ta0 10.96.(75
/#. #f equity s&ares 1.00.000
E.P.4. 9
E.P.4. 9 Rs. 10.97
;ar6et Price 9 Rs. 109.70
Gence. P?E 9 9 10
Rs. 10.96.(75
1.00.000
Rs. 10.96.(75
1.00.000
(a) 1robable 1rice2share$ if the additional investment were to be raised by way of loans
)resent capital emploed5
Rs.
E1uity "#*##*###
De&enture (Lon' term) "#*##*###
2evenue reserves "(*##*###

Total 9(*##*###
@reAinterest and +reAta0 +ro-its 'iven 2s. ") la4hs
9ate o* ret/rn +25( = = #$.#%
.e"t e0uit ratio, if Rs. 10 lacs $additional investment& were to "e "orrowed $.e"t Rs. 70
lacs and e0uit Rs. 77 lacs&, will "e
= 3/.8$
Sin%e* the de&t e1uity ratio will not e0%eed 8#$ @=E will remain same.
;- 2s. "# la%s is to &e &orrowed* the earnin' will &e as under:
91. 91.
2eturn o- 78.(7$ on 2s. 3( la%s
&!$!#00
4ess5 ;nterest at "7$ on e0istin' 2s. "# la%s
de&entures
1!#0!000
;nterest on -resh &orrowed amount o- 2s. "# la%s
at ")$
1!"0!000 &!&0!000
@ro-it a-ter interest &e-ore ta0
0!&!#00
4ess5 Ta0 at 97$
%!11!&%#
@ro-it a-ter ta0
1&!1!1#
Bo. o- e1uity shares
1!00!000
E.@.S. = = 2s. "9.("
@ro&a&le +ri%e o- e1uity share = 2s. "9.(" 0 "#
(2e-er to wor4in' note)
= 2s. "9(."#
(b) Probable Price/sare! if additional invest"ent were to be raised b# wa# of
e$uit#%
Rs. 1( lakhs 0 100
Rs. 32 lakhs
Rs. 20 lacs 0 100
Rs. 42 lacs
Rs. 13.21.125
1.00.000
;- 2s. "# la%s were to &e raised &y way o- e1uity shares to &e raised at mar4et rates. The
e0istin' mar4et +ri%e o- 2s. "#../# may %ome down a little and may +ossi&ly settle at
2s. "##. ,en%e* new e1uity shares to &e raised will &e :
2s. "#*##*### =2s. "## = "#*### shares
*f Rs. 10 lacs is to "e raised " wa of e0uit shares, the earning will "e as under8=
Rs.
Prot before interest and tax '",4',)##
.ess: %nterest on debentures &,)#,###
Prot after interest before tax '',&',)##
.ess: Tax > ")( 8,8/,"8)
Prot after tax &/,"-,&')
2o! of e+uity shares &,&#,###
*!P!,!= = Rs! &"!#8
Probable price of e+uity share = Rs!&"!#8 x &#
0Refer to .orkin$ note3
= Rs! &"#!8#
The su$$ested solution .ill be to issue fresh debentures to nance expansion
2uestion 3
The Codern Chemicals 4td. re0uires Rs. 75,00,000 for a new plant. This plant is expected
to ield earnings "efore interest and taxes of Rs. 5,00,000. @hile deciding a"out the
financial plan, the compan considers the o"=ective of maximising earnings per share. *t
has three alternatives to finance the pro=ect- " raising de"t of Rs. 7,50,000 or Rs.
10,00,000 or Rs. 15,00,000 and the "alance, in each case, " issuing e0uit shares. The
companFs share is currentl selling at Rs. 150, "ut is expected to decline to Rs. 175 in case
the funds are "orrowed in excess of Rs. 10,00,000. The funds can "e "orrowed at the rate
of 10! upto Rs. 7,50,000, at 15! over Rs. 7,50,000 and upto Rs. 10,00,000 and at 70!
over Rs. 10,00,000. The tax rate applica"le to the compan is 50!. @hich form of
financing should the compan choose; $6inal- +ov. 1AAA& $B mar2s&
Answer
!a$#u$ation of Earning per share for three a$ternatives to .nan#e the
pro3e#t
Alternatives
+articulars /
0o raise debt of
Rs.#3'(3((( and
e:uit< of Rs.
##3'(3(((
Rs.
//
0o raise debt of Rs.
"(3((3((( and e:uit< of
Rs. "'3((3(((
Rs.
///
0o raise debt of Rs.
"'3((3((( and e:uit< of
Rs. "(3((3(((
Rs.
Earnings !ef#re interest and ta0 5.00.000 5.00.000 5.00.000
Rs. 14.3(.125
1.10.000
7ess8 1nterest #n de!t
at t&e rate #f
25.000
,10% #n Rs.
2.50.000+
1.37.500
,10% #n Rs. 2.50.000+
,15% #n Rs. 7.50.000+
2.37.500
,10% #n Rs. 2.50.000+
,15% #n Rs. 7.50.000+
,20% #n Rs. 5.00.000+
Earnings !ef#re ta0 4.75.000 3.62.500 2.62.500
7ess8 *a0 ,A 50%+ 2.37.500 1.(1.250 1.31.250
Earnings after ta0H ,3+ 2.37.500 1.(1.250 1.31.250
/u"!er #f s&ares H,2+ 15.000 10.000 (.000
(Refer to !orking note)
Earning per s&are H ,3+?,2+ 15.(33 1(.125 16.406
Decision: ()e earning per 1)are i1 )ig)er in a3ternative 55 i.e. i* t)e :o;pan0 *inan:e t)e
pro<e:t =0 rai1ing >e=t o* 91. 10!00!000 an> i11/e e./it0 1)are1 o* 91. 1#!00!000.
()ere*ore t)e :o;pan0 1)o/3> :)oo1e t)i1 a3ternative to *inan:e t)e pro<e:t.
Working Note:
63ternative1
5 55 555
+./it0 *inan:ing ?
(6)
91.
!#0!000
91.
1#!00!000
91.
10!00!000
@arAet pri:e per 1)are?
(2)
91. 1#0 91. 1#0 91. 1#
-/;=er o* e./it0 1)are?
(6)/(2)
1#!000 10!000 "!000
+uestion 3
1he following is the "apital stru"ture of Simons Company .td. as on 8$.$%.$::2:
Rs.
Equity shares : $&,&&& shares (of Rs. $&& ea"h) $&,&&,&&&
$&- Preferen"e Shares (of Rs. $&& ea"h) ,,&&,&&&
$%- )ebentures 9,&&,&&&
%&,&&,&&&
The market price of the companyHs share is Rs! &&# and it is expected that a
dividend of Rs! &# per share .ould be declared for the year &<<-! The dividend
$ro.th rate is 4(9
(i) 4f the "ompany is in the /&- ta( bra"+et, "ompute the weighted a!erage
"ost of "apital.
(ii) ssuming that in order to #nan"e an e(pansion plan, the "ompany intends to
borrow a fund of Rs. $& la+hs bearing $,- rate of interest, what will be the
"ompanyFs re"ei!ed weighted a!erage "ost of "apitalB 1his #nan"ing de"ision
is e(pe"ted to in"rease di!idend from Rs. $& to Rs. $% per share. Nowe!er,
1he mar+et pri"e of equity share is e(pe"ted to de"line from Rs. $$& to Rs.
$&/ per share. (;inal< Co!. $:::) ($& mar+s)
/nswer
,i+ !omputation of the 1eighted average #ost of #apita$
Sour"e of
#nan"e
Proportion fter ta( "ost (-)
($<ta( rate i.e.
/&-)
*eighted
a!erage "ost
of "apital (-)
(a) (b) (") (d)5(b)((")
*+uity share #!) &)!#< 8!)/
(Refer to wor+ing
note $)
&#( Preference
share
#!' &#!## '!##
&'(
5ebentures
#!" 4!## &!-#
Wei$hted avera$e cost of
capital
&&!"/
(ii) !omputation of Revised 'eighted -verage !ost of !apita$
Sour"e of
#nan"e
Proportion fter ta( "ost (-)
($<ta( rate i.e.
/&-)
*eighted
a!erage "ost
of "apital (-)
(a) (b) (") (d) 5 (b)>(")
*+uity shares #!""" &8!/' )!-#
(Refer to wor+ing
note %)
&#( Preference
shares
#!&"" &#!## &!""
&'( 5ebentures #!'## 4!## &!'#
&/( Eoan #!""" 8!## '!""
Revised .ei$hted avera$e
cost of capital
&#!44
'or(ing )otes%
($) Cost of equity shares (+e)
ke =
e ?ro!th rat
re ce per sha &arket pri
er share ,ividend p
+

= 06 . 0
100
10
+
= #!&)#< or &)!#<(
0'3 Re!ised "ost of equity shares (+e)
Revised ke = 06 . 0
105
12
+
= #!&8/' or &8!/'(
Question 4
1he following is the "apital stru"ture of a Company:
Sour"e of "apital 0oo+ !alue Har+et !alue
Rs. Rs.
Equity shares O Rs. $&&
ea"h
2&,&&,&&& $,9&,&&,&&&
: per "ent "umulati!e
preferen"e
shares O Rs. $&& ea"h
%&,&&,&&& %,,&&,&&&
$$ per "ent debentures 9&,&&,&&& 99,&&,&&&
Retained earnings ,&,&&,&&&
%,&&,&&,&&& %,/&,&&,&&&
1he "urrent mar+et pri"e of the "ompanyFs equity share is Rs. %&&. ;or the last
year the "ompany had paid equity di!idend at %/ per "ent and its di!idend is li+ely
to grow / per "ent e!ery year. 1he "orporate ta( rate is 8& per "ent and
shareholders personal in"ome ta( rate is %& per "ent.
Gou are required to "al"ulate:
(i) Cost of "apital for ea"h sour"e of "apital.
(ii) *eighted a!erage "ost of "apital on the basis of boo+ !alue weights.
(iii) *eighted a!erage "ost of "apital on the basis of mar+et !alue weights.
(PE<
44<Co!. %&&2) (3 mar+s)
Answer
(i) Calculation of Cost of Capital for each source of capital H
1. 7#st #f Equity 7apitalH
g 100
;P
g+ ,1 P4
8
e
+
+

5 100
200
0.05+ ,1 25
+
+

5 100
200
26.25
+
9 13.125 = 5
9 1(.125%.
2. 7#st #f preference capital #r 8p 9 9%.
3. 7#st #f e!enturesH 8d ,after ta0+ 9 r ,1 - *+
9 11 ,1 - 0.3+
9 7.7%.
4. 7#st #f Retained EarningsH 8r 9 8e ,1 - *p+
9 1(.125 ,1 - 0.2+
9 14.5%.
(ii) "eighted average cost of capital
(-n the basis of Book 4alue "eights)
Sour"e mount
(0oo+
?alue) (Rs.)
*eight
s
Cost of
Capital (after
ta()
(-)
*CC
(-)
0&3 0'3 0"3 0/3 0)3 = 0"3
0/3
*+uity Capital -#,##,### #!/ &-!&') 8!')
Preference
Capital
'#,##,### #!& < #!<#
5ebentures 4#,##,### #!" 8!8 '!"&
Retained
earnin$s
/#,##,### #!' &/!) '!<#
',##,##,### &!## &"!"4
Mence, WACC on the basis of 6ook Dalue Wei$hts = &"!"4(!
(iii) 'eighted -verage !ost of !apita$
(On the basis of 4ar(et va$ue 1eights)
Sour"e mount
(Har+et
?alue) (Rs.)
*eigh
ts
Cost of
Capital
(after ta()
(-)
*CC
(-)
0&3 0'3 0"3 0/3 0)3 = 0"3
0/3
*+uity Capital &,4#,##,### #!4/# &-!&') &&!4##
Preference
Capital
'/,##,### #!#<4 < #!-4/
5ebentures 44,##,### #!'4/ 8!8 '!#""
Retained
earnin$s

',)#,##,### &!### &/!/<8
Gence# 1@66 on the $asis of ?aret Ea%ue 1eights 5 /!.!07%
Question 5
new proPe"t is under "onsideration in Eip .td., whi"h requires a "apital in!estment
of Rs. ,./& "rore. 4nterest on term loan is $%- and Corporate 1a( rate is /&-. 4f the
)ebt Equity ratio insisted by the #nan"ing agen"ies is % : $, "al"ulate the point of
indi6eren"e for the proPe"t.
(PE<44<Hay %&&2) (, mar+s)
Answer
%f nancin$ a$encies insist ' 9 & 5ebt e+uity ratio then company has t.o options9
0i3 To Arran$e .hole amount the company can issue e+uity shares!
0ii3 Company should arran$e " crores by &'( term loan and &!)# crore throu$h
e+uity share so that '9& 5ebt1e+uity ratio can be maintained!
1n rst option interest .ill be Pero and in second option the interest .ill be Rs!
"4,##,###
Point of %ndiCerence
( ) ( )
1
1
/
* 1 R 0
=
( ) ( )
2
2
/
* 1 R 0
or
( ) ( )
Da6&s 450
0.5 1 0 0
=
( ) ( )
Da6&s 150
0.5 1 Da6&s 36 0
or
150
1( 0.50
450
0.50

or 8)x = '')x F -&##

or -&## = '')x F 8)x
or -&## = &)#x
x = Da6&s 54
150
(100

*6%T at point of %ndiCerence .ill be Rs!)/ Eakhs!

)ote% The aforesaid solution is based on the assumption that the face value of
a share is Re! &! Mence, the number of shares in denominator bein$ /)# lakhs
and &)# lakhs respectively! Mo.ever, if a student assumes face values bein$ Rs!
&# per share and Rs! &## per share, the conclusion .ill remain the same!
Alternati"e presentations are as follows!
0A3 Point of %ndiCerence at share value bein$ Rs! &#!
( ) ( )
1
1
/
* 1 R 0
=
( ) ( )
2
2
/
* 1 R 0
or
( ) ( )
Da6&s 45
0.5 1 0 0
=
( ) ( )
Da6&s 15
0.5 1 Da6&s 36 0
or
15
1( 0.50
45
0.50

or 8!)x = ''!)x F -&#

or -&# = ''!)x F 8!)x
or -&# = &)x
x = Da6&s 54
15
(10

*6%T at point of %ndiCerence .ill be Rs!)/ Eakhs!

063 Point of %ndiCerence at share value bein$ Rs! &##!
( ) ( )
1
1
/
* 1 R 0
=
( ) ( )
2
2
/
* 1 R 0
or
( ) ( )
Da6&s 4.50
0.5 1 0 0
=
( ) ( )
Da6&s 1.50
0.5 1 Da6&s 36 0
#r
1.50
1( 0.50
4.50
0.50

#r 0.750 9 2.250 - (1
#r (1 9 2.250 - 0.750
#r (1 9 1.50
0 9 Da6&s 54
1.5
(1

E21* at p#int #f 1ndifference Bill !e Rs.54 Da6&s.

Question 6
Gou are required to determine the weighted a!erage "ost of "apital of a #rm using
(i) boo+<!alue weights and (ii) mar+et !alue weights. 1he following information is
a!ailable for your perusal:
Present boo+ !alue of the #rmFs "apital stru"ture is:
Rs.
)ebentures of Rs. $&& ea"h 2,&&,&&&
Preferen"e shares of Rs. $&&
ea"h
%,&&,&&&
Equity shares of Rs. $& ea"h $&,&&,&&&
%&,&&,&&&
ll these se"urities are traded in the "apital mar+ets. Re"ent pri"es are:
)ebentures O Rs. $$&, Preferen"e shares O Rs. $%& and Equity shares O Rs. %%.
nti"ipated e(ternal #nan"ing opportunities are as follows:
(i) Rs. $&& per debenture redeemable at par : %& years maturity 2- "oupon
rate, ,- Qoatation "osts, sale pri"e Rs. $&&.
(ii) Rs. $&& preferen"e share redeemable at par : $/ years maturity, $&-
di!idend rate, /- Qoatation "osts, sale pri"e Rs. $&&.
(iii) Equity shares : Rs. % per share Qoatation "osts, sale pri"e Rs. %%.
4n addition, the di!idend e(pe"ted on the equity share at the end of the year
is Rs. % per shareR the anti"ipated growth rate in di!idends is /- and the #rm
has the pra"ti"e of paying all its earnings in the form of di!idend. 1he
"orporate ta( rate is /&-.
(PE<44<Hay %&&3) (: mar+s)
Answer
(a) 'or(ing )otes%
)etermination of Spe"i#" Costs:
0i3 Cost of 5ebentures before tax 0kd 3
kd =
2
/P+ ,P
n
/P+ ,P
1
+

+
Where,
% = Annual interest payment
P = RedeemableJpayable value of debenture at maturity
2P = 2et sale value from issue of debentureJface value F
expenses
kd =
2
96+ ,100
20
96+ ,100
(
+

+
= (.36% #r .0(36
9(
.20 (

+
Cost of debenture after tax = ?d 0&F t3
= -!"4 0&F!)#3 = /!&-(!
0ii3 Cost of Preferen"e Shares (+p )
kp =
2
/P+ ,P
n
/P+ ,P

+
Where,
5 = Fixed annual dividend
P = Redeemable value of preference shares
n = 2umber of years to maturity!
?p =
2
95+ ,100
15
95+ ,100
10
+

+
= 10.59% #r .1059
97.5
10.33

0iii3 Cost of Equity (+e )

ke = g
/P

+
Where,
5 = *xpected dividend per share
2P = 2et proceeds per share
$ = Qro.th expected in dividend
ke = 15%. #r .15 .05 .10 .05
20
2
.05
2 22
2
+ + +

(i) !omputation of 'eighted -verage !ost of !apita$

based on Boo( 5a$ue 'eights
Sour"e of Capital 0oo+
?alue
Rs.
*eights
to 1otal
Capital
Spe"i#"
Cost
1otal
Cost
5ebentures 0Rs! &## per
debenture3
-,##,##
#
#!/# #!#/&- #!#&4
8
Preference ,hares 0Rs!
&## per share3
',##,##
#
#!&# #!&#)< #!#&#
4
*+uity ,hares 0Rs! &#
per share3
&#,##,#
##
#!)# #!&)## #!#8)
#
'#,##,#
##
&!## #!&#'
"
!ost of !apita$ 6 78.23+
(ii) !omputation of 'eighted -verage !ost of !apita$
based on 4ar(et 5a$ue 'eights
Sour"e of Capital Har+et
?alue
Rs.
*eights
to 1otal
Capital
Spe"i
#"
Cost
1otal
Cost
5ebentures 0Rs! &&# per
debenture3
-,-#,### #!'4)& #!#/&
-
#!#&&#
-
Preference ,hares 0Rs!
&'# per share3
',/#,### #!#8'" #!&#)
<
#!##84
4
*+uity ,hares 0Rs! '' per
share3
'',##,### #!44'4 #!&)#
#
#!#<<"
<
"",'#,### &!## #!&&-&
"
Cost of Capital = &&!-&(