WEEK 8

PGDM

SOLVED PROBLEMS COST OF CAPITAL

Problem 1

FINANCIAL MANAGEMENT

Calculate the cost of capital in the following cases:

i

ii

X Ltd. issues 12% Debentures of face value Rs. 100 each and realizes Rs.
95 per Debenture. The Debentures are redeemable after 10 years at a
premium of 10%.
Y. Ltd. issues 14% preference shares of face value Rs. 100 each Rs. 92 per
share. The shares are repayable after 12 years at par.
Note: Both companies are paying income tax at 50%.

Solution
(i) Cost of Debt
[Int + (RV SV) / N] (1 t)
kd
(RV + SV) / 2
Int
t
RV
N
SV

=
=
=
=
=

Annual interest to be paid i.e. Rs. 12

Companys effective tax rate i.e. 50% or 0.50
Redemption value per Debenture i.e. Rs. 110
Number of years to maturity = 10 years
issue price per debenture minus floatation cost i.e. Rs. 95
[12 + (110 95) / 10] (1 .5)

kd =

(110 + 95) / 2
[12 + 2.5](0.5)

7.25

=
50 97.50

ii

Cost of preference capital

D + (RV SV) / N
kp
(RV + SV) / 2
Where,
D
SV
N
RV

=
=
=
=

Dividend on Preference share i.e. Rs. 14

Issue Price per share minus floatation cost Rs. 92
No. of years for redemption i.e. 12 years
Net price payable on redemption Rs. 100
14 (100 92) / 12

kp =

(110 + 95) / 2

14 + .67

15.28%
95=

Problem 2
a) A company raised preference share capital of Rs. 1,00,000 by the issue of
10% preference share of Rs. 10 each. Find out the cost of preference share
capital when it is issued at (i) 10% premium, and (ii) 10% discount.
b) A company has 10% redeemable preference share which are redeemable at
th
6the end of 10 year from the date of issue. The underwriting expenses are
expected to 2%. Find out the effective cost of preference share capital.
c) The entire share capital of a company consist of 1,00,000 equity share of Rs. 100
each. Its current earnings are Rs. 10,00,000 p.a. The company wants to raise
additional funds of Rs. 25,00,000 by issuing new shares. The flotation cost is
expected to be 10% of the face value. Find out the cost of equity capital given that
the earnings are expected to remain same for coming years.

Solution
(a) Cost of 10% preference share capital
(i) When share of Rs. 10 is
issued at 10% premium Kp
= D / P0
= 10 / 11 x 100
= 9.09%
(ii) When share of Rs. 10 is
issued at 10% discount kp
= PD / P0

Marketing Lessons From the Freedom 251 Fiasco

By Guest Author, Published on Feb 18, 2016, 05.07 PM IST

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If you were one of those eager beavers like me who were waiting for India's $4
smart phone wonder and was madly prancing around after seeing the 2 full
page ads in your morning newspaper, and rushing to their website to book
yourself the world's cheapest smart phone you were in for a rude surprise.
Because a $4 phone was what everybody wanted and eagerly waiting for even
if you were a snobbish Iphone 6 plus user. Because a $4 smart phone even for
the snob is reverse snobbery at its best.
The first ad that appeared promised the Indian masses that it was going to
deliver them into the digital age ( even those who were denied of Free Basics a
month ago ). The headline boldy said 'Sabka Haq' which translated into
English as 'Everyone's birthright'. Followed by a sub head that said 'Sapne
Sach Hongey' or your dreams will come true. The generous use of the Indian
tri-colour was also misplaced.
Funnily enough it was sad that the name of the manufacturer was Ringing
Bells Pvt Ltd because all the wrong bells were ringing for the poor phone
manufacturer this morning. Their baseline read ' Everyone's just a call away'
but they were certainly not a click away.
= 10 / 9 x 100
= 11.11%
(b) The cost of preference share (face value = Rs. 100) may be found as follows:
D + (RV SV) / N
kp =

(RV+ SV) / 2
In this case D
=
RV
=
SV
=
=
kp

10
100
100 2 = Rs. 98
10 + (100 98) / 10

(100 + 98) / 2
= 10.3%
(c) In this case, the net proceeds on issue of equity shares are Rs. 100 10 =
Rs. 90 and earnings per share is Rs. 10.
Cost of new equity is:
ke

D1 / p0

10 / 90 11.%

Problem 3
A company is considering raising of funds of about Rs. 100 lakhs by one
of two alternative method, viz., 14% institutional term loan or 13% nonconvertible debentures. The term loan option would attract no major
incidental cost. The debentures would have to be issued at a discount of
2.5% and would involve cost of issue of Rs. 1,00,000.
Advise the company as to the better option based on the effective cost of
capital in each case. Assume a tax rate of 50%.
Solution
Effective cost of 14% loan: In this case, there is no other cost involved and
the company has to pay interest at 14%. This interest after tax shield @
50% comes to 7% only.

Effective cost of 13% NCD : In this case,

Annual Interest, I
SV

=
=
=

kd

Rs. 13
100 2.50 1.00
96.50
13 (1 5)
96.50%

6.74%

The effective cost of capital is lesser in case of 13% NCD.

Problem 4

The following figures are taken from the current balance sheet of Delaware & Co.
Capital
Share Premium
Reserves
Shareholders funds
12% irredeemable debentures

Rs. 8,00,000
2,00,000
6,00,00
16,00,000
4,00,00

An annual ordinary dividend of Rs. 2 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. 27.5 and the debentures at 80 per cent. Ignore taxation.
You are required to estimate the weighted average cost of capital
(based on marker values) for Delaware & Co.
Solution
In order to calculate the WACC, the specific cost of equity capital and debt
capital are to be calculated as follows:
D1
ke =

Rs. 2 x 1.10
+g=

P0

+ 10 = 18%
Rs. 27.50

The market value of equity is 80,000 x Rs. 27.50 = Rs. 22,00,000

I
kd =

Rs. 12
=

SV

= 15%
Rs. 80

The market value of debt is

4,00,000 x .80 = Rs. 3,20,000.
Now, the WACC is
(22,00,000 / 25,20,000) x .18 + (3,20,000/25,20,000) x .15 = .176 = 17.6%
Note: In this case, the dividend of Rs. 2 has just been paid. So, D 0 = Rs. 2
and the D1, i.e. dividend expected after one year from now will be D0 x (1
+ g) = Rs. 2 x 1.10.
Problem 5
The following information has been extracted from the balance sheet of Fashions
Ltd. as on 31-12-1998:
Equity share capital

Rs. in Lacs
400

12% debentures
18% term loan

400
1,200
2,00
a) Determine the weighted average cost of capital of the company. It had
been paying dividends at a consistent rate of 20% per annum.
b) What difference will it make if the current price of the Rs. 100 share is Rs.
160?
c) Determine the effect of Income Tax on the cost of capital under both premises
(Tax rate 40%).
Solution
a) Weighted average cost of capital of the company is as follows:
Sources of capital
Equity share capital
12% debenture
Term loan

Cost of capital Proportion of total Weighted cost of

capital
20%
4/20
4.00
12%
4/20
2.40
18%
12/20
10.80
WACC
17.20

Therefore, weighted cost of capital (without consideration of the market

price of Equity and not taking into consideration the effect of Income Tax)
is = 17.2% per annum.

b) When market price of equity shares is Rs. 160 (Face value Rs. 100), the cost
of capital is:
D
1

20 ke

=
p 160
= 12.5%
Weighted average cost of capital will therefore be:
Sources of capital
Equity share capital
12% debenture
18% Term loan

Cost of capital Proportion of total Weighted cost of

capital
12.5%
4/20
2.5%
12%
4/20
2.4%
18%
12/20
10.8
WACC
15.7%

The above WACC is without taking into consideration the effect of Income Tax.
c) As interest on debenture and loans is an allowable deductible expenditure
for arriving at taxable income, the real cost to the company will be interest
charges less tax benefit (assuming that the company earns taxable income).
So, interest cost will be : Rate of interest (1 t)
12% Debenture
:
12 x 0.60
=
7.2%
18% Term loan
:
18 x 0.60
=
10.8%
Problem 6
The following information is available from the Balance Sheet of a company
Equity share capital 20,000 shares of Rs. 10 each
Reserves and Surplus
8% Debentures

Rs. 2,00,000
Rs. 1,30,000
Rs. 1,70,000

The rate of tax for the company is 50%. Current level of Equity Dividend is
12%. Calculate the weighted average cost of capital using the above
figures.
Solution
Capital structure

Rs.

Equity share capital

Reserves and surplus
Net worth
8% debentures
Capital structure
Equity
Reserves and surplus
8% debentures
Total

2,00,000
1,30,000
3,30,000
1,70,000
5,00,000
Amount
Rs.
2,00,000
1,30,000
1,70,000
5,00,000

Proportion
(weight)
40%
26%
34%
100%

After tax
cost
12%
12%
4%

Proportion of capital
structure
40%
26%
66%
34%
100%
Weighted cost
12%x40%= 4.80%
12%x26%= 3.12%
4%x34%= 1.36%
9.28%

1. As the current market price of equity share is not given, the cost of capital of equity
share has been taken with reference to the rate of dividend and the face value of
the share. So, ke = 12/100 = 12%.

The opportunity cost of retained earnings is the dividends foregone by

shareholders. Therefore, the firm must earn the same rate of return on
retained earnings as on the Equity Share Capital. Thus, the minimum cost
of retained earnings is the cost of equity capital i.e. k r = ke.
Problem 7

A Limited has the following capital structure:

Equity share capital (2,00,000 shares)
6% preference shares
8% Debentures

Rs. 40,00,000
10,00,000
30,00,000
80,00,000

The market price of the companys equity share is Rs. 20. It is expected
that company will pay a dividend of Rs. 2 per share at the end of current
year, which will grow at 7 per cent for ever. The tax rate may be presumed
at 50 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 10 per cent debentures. The 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. 15 per share.
c) The cost of capital if in (b) above, growth rate increases to 10 per cent.
Solutions
a) The cost of equity capital is
D1
ke

Rs. 2
+g=

+ 0.07

P0

Rs. 20

= 0.1 + 0.07 = .17 or 17%

The cost of 8% debentures, after tax is 8 (1 5) = 4%
STATEMENT SHOWING WEIGHTED COST OF CAPITAL

Equity share capital

Preference share capital
Debentures

Existing
Amt.
40,00,000
10,00,000
30,00,000

After-tax
Cost
.17
.06
.04

So, Weighted Average cost of capital (K0) is 10.75%

b)
ke =

D1
P0

+g=

Rs. 3
Rs. 15

+ .07

Weights
.500
.125
.375

Weighted
cost
.0850
.0075
.0150
.1075

= .20 + 0.7 = .27 or 27%

The cost of capital of new debenture (after tax) is 10% (1 - .5) = 5%

STATEMENT OF SHOWING WEIGHTED AVERAGE COST OF

CAPITAL
Amt.
Equity share capital
6% preference share capital
8% debentures
10% debentures

c)

40,00,000
10,00,000
30,00,000
20,00,000

D1
ke =

Weights

Weighted
Cost
.108
.006
.012
.010
.136

.40
.10
.30
.20

Rs. 3
+g=

P0

After-tax
Cost
.17
.06
.04
0.5

+ .10
Rs. 15

= .20 + 0.7 = .30 or 30%

STATEMENT OF SHOWING WEIGHTED AVERAGE COST OF
CAPITAL
Amt.
Equity share capital
6% preference share capital
8% debentures
10% debentures

40,00,000
10,00,000
30,00,000
20,00,000

After-tax
Cost
.30
.06
.04
0.5

Weights
.40
.10
.30
.20

Weighted
Cost
.120
.006
.012
.010
.148

So, weighted average cost of capital (k 0) 14.80%

Problem 8
The following is the extract from the financial statement of ABC Ltd.
Operating profit
- Interest on debentures
- Income tax
Net Profit
Equity Share Capital (of Rs. 10 each)
Reserves and Surplus
15% debentures (Rs. 100 each)

Rs. 105 lacs

Rs. 33 lacs
Rs. 36 lacs
Rs. 36 lacs
Rs. 200 lacs
Rs. 100 lacs
Rs. 220 lacs

Total
Rs. 520 lacs
The market price of equity share and debenture is Rs. 12 and Rs. 93.75
respectively. Find out (i) EPS, (ii) % cost of capital of equity and
debentures.

Solution
(i) Earnings per share
Profit after tax
No. of equity shares
EPS

=
=
=
=
=

Rs. 36,00,000
Rs. 20,00,000
Profit after tax / No. of shares
36,00,000 / 20,00,000
Rs. 1.80

(ii) Cost of debentures, kd :

(based on market value)
kd

Interest (1 t) / Market value

= 15 (1 5) / 93.75
= 8%
(based on Face Value)
kd

Interest (1 t) / Face Value

= 15 ( 1 - .5) / 100
= 7.5%
(iii)Cost of equity capital:
ke

EPS / p0

= 1.80 / 12 = 15%
Problem 9
As a financial analyst of a large electronics company, you are required to
determine the weighted average cost of capital of the company using (i)
book value weights and (ii) market value weights. The following
information is available for your perusal:
The companys present book value capital structure is:
Preference shares (Rs. 100 per share)
Equity shares (Rs. 10 per share)
Debentures (Rs. 100 per debenture)

Rs.
2,00,000
10,00,000
8,00,000

All these securities are traded in the capital market. Recent prices are:
Debentures @ Rs. 110 per debenture
Preference shares @ Rs. 120 per share
Equity shares @ Rs. 22 per share
Anticipated external financing opportunities are:
i) Rs. 100 per debenture redeemable at par; 10 year-maturity, 13% coupon
rate, 4% flotation costs, sale price Rs. 100.
ii) Rs. 100 preference share redeemable at par; 10 year-maturity, 14% dividend
rate, 5% flotation costs, sale price Rs. 100.
iii)
Equity shares: Rs. 2 per share flotation costs, sale price @ Rs. 22.
In addition, the dividend expected on the equity share at the end of the year is Rs. 2
and the earnings are expected to increase by 7% p.a. The firm has a policy of paying
all its earnings in the form of dividends. The corporate tax rate is 50%.
Solution
In order to find out the WACC, the specific cost of capital of different sources may be
calculated as follows:
Cost to debenture:
Int, I
SV
RV
t
N

=
=
=
=
=

kd

Rs. 13
100 4 = Rs. 99
Rs. 100
.50
10 year
[I + (RV SV) / N] (1 t)
(RV + SV) / 2
[13 + (100 96) / 10] (1 .5)

=
=

(100 + 95) / 2
6.8%

Cost to Pref. Shares:

PD
RV
SV
N
kp

=
=
=
=
=

Rs. 14
100
100 5 = Rs. 95
10 years
D + (RV SV) / N
(RV + SV) / 2

14 + (100 95) / N
=
(100 + 95) / 12
=

14.9%

Cost to Equity Shares:

P0
D1
g

=
=
=

22 2 = 20
2
.07
D1

ke

+g
P0
2

ke

+ .07
20

17%

Calculation of WACC (Book Value)

Source
Pref. of shares
Equity shares
Debentures

Amount
Rs. 2,00,000
Rs. 10,00,000
Rs. 8,00,000
Rs. 20,00,000

Weight
.10
.50
.40
1.00

C/C
.149
.170
.070

WxC/C
.0149
.0850
.0280
.1279

Weight
.072
.663
.265
1.000

C/C
.149
.170
.070

WxC/C
.0107
.1127
.0186
.1420

So, WACC (BV) is 12.79 or 12.8%

Calculation of WACC (Market Value)
Source
Pref. of shares
Equity shares
Debentures

Amount
Rs. 2,40,000
Rs. 22,00,000
Rs. 8,80,000
Rs. 33,20,000

So, WACC (MV) is 14.2%

Problem 10
The ABC Company has the total capital structure of Rs. 80,00,000 consisting of:
Ordinary shares (2,00,000 shares)
50.0%
10% preference shares
12.5%

14% debentures

37.5%

The shares of the company sells for Rs. 20. It is expected that company will pay next
year a dividend of Rs. 2 per share which will grow at 7% forever. Assume a 50% tax rate.
You are required to:

a) Computed a weighted average cost of capital structure.

b) Compute the new weighted average cost of capital if the company raises an
additional Rs. 20,00,000 debt by issuing 15% debenture. 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. 15 per share.
c)
Compute the cost of capital if in (b) above, growth rate increases to 10%.

Solution
(a) WACC of the existing capital structure
ke =

D1 / P0 +g

= 2 / 20 + 0.07
= 17%
Calculation of weighted average cost of capital
Source
Ordinary shares
10% Pref. Shares
14% Debentures

W
.500
.125
.375
1.000

The WACC of the firm is 12.37%

(b) Cost of capital of additional debt
kd =

15 (1 - .5)
= 7.5%

New cost of equity share capital

ke =

D 1 / P0 + g

= 3 / 1.5 + 0.07
= 27%

C/C
.17
.10
.07

WxC/C
.0850
.0125
.0262
.1237

Source
Ordinary shares
10% Pref. Shares
14% Debentures
15% Debt.

W
.40
.10
.30
.20
1.000

C/C
.27
.10
.07
.075

WxC/C
.108
.010
.021
.015
.154

The WACC of the firm would be 15.4%

If the growth rate in (b) is increased to 10%
ke =

D 1 / P0 + g

= 3 / 15 + .10
= 30%
Calculation of WACC of the firm
Source
Ordinary shares
10% Pref. Shares
14% Debentures
15% Debt.

W
.40
.10
.30
.20
1.000

C/C
.30
.10
.07
.075

WxC/C
.120
.010
.021
.015
.166

The WACC of the firm would be of 16.6%.

Problem 11
ABC Ltd. has the following capital structure
4,000 Equity shares of Rs. 100 each
10% preference shares
11% Debentures

Rs. 4,00,000
1,00,000
5,00,000

The current market price of the share is Rs. 102. The company is expected to
declare a dividend of Rs. 10 at the end of the current year, with an expected
growth rate of 10%. The applicable tax rate is 50%.

i) Find out the cost of equity capital and the WACC, and
ii) Assuming that the company can raise Rs. 3,00,000 12% Debentures, find
our the new WACC if (a) dividend rate is increased from 10 to 12%, (b)
growth rate is reduced from 10 to 8% and (c) market price is reduced to Rs.
98.

Solution
(i) Cost of Equity Capital is
ke =

D 1 / P0 + g

= 10 / 102 + .10
= 19.8%
Calculation of Weighted Average Cost of Capital
Source
Equity capital
10% Pref. Capital
11% Debentures

Amount
Rs. 4,00,000
1,00,000
.1
5,00,000
.5
10,00,000
1.00

W
.4

C/C
.198
.100
.055

WACC = 11.67 OR 11.7%

(ii) Cost of Equity Capital is
ke =

D1 / P0 + g
= 12 / 98 + .08
= 20.2%

Calculation of Weighted Average Cost of Capital (New)

Source
Equity capital
10% Pref. Capital
11% Debentures
12% Debentures

Amount
Rs. 4,00,000
1,00,000
5,00,000
3,00,000
13,00,000

W
.308
.077
.385
.230
1.000

C/C
.202
.100
.055
.060

WxC/C
.0622
.0077
.0212
.0138
.1049

Problem 12
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:

BALANCE SHEET

WxC/C
.0792

Liabilities
Equity shares capital
Pref. share capital
Retained Earnings
Debentures
Current Liabilities

Rs. Assets
12,00,000 Fixed Assets
4,50,000 Current Assets
4,50,000
9,00,00
10,00,000
40,00,000

Rs.
25,00,000
15,00,000
________
40,00,000

Additional Information:
i) 20 years 14% debentures of Rs. 2,500 face value, redeemable at 5%
premium can be sold at par, 2% flotation costs.
ii) 15% preference shares: Sale price Rs. 100 per share, 2% flotation costs
iii) equity shares: Sale price Rs. 115 per share, flotation costs, Rs. 5 per share
The corporate tax rate is 55% and the expected growth in equity dividend is 8% per
year. The expected dividend at the end of the current financial year is Rs. 11 per
share. Assume that the company is satisfied with its present capital structure and
intends to maintain it.

Solution
Specific Costs
_______
Sources
Equity funds
15% preference shares
14% debentures

Weights
0.55
0.15
0.30

Specific cost Weighted cost

0.1800
0.09900
0.1530
0.0229
0.655
0.0196

So, weighted average cost of capital, (k 0), is 14.15%.