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Problem 1
i) 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%.
ii) 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.
Solution
D + (RV – SV) / N
kp
(RV + SV) / 2
Where,
D = Dividend on Preference share i.e. Rs. 14
SV = Issue Price per share minus floatation cost Rs. 92
N = No. of years for redemption i.e. 12 years
RV = Net price payable on redemption Rs. 100
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14 (100 – 92) / 12
kp =
(110 + 95) / 2
14 + .67
=
95
= 15.28%
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 6the end of 10th 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
Kp = D / P0
= 10 / 11 x 100
= 9.09%
= 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
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In this case D = 10
RV = 100
SV = 100 – 2 = Rs. 98
10 + (100 – 98) / 10
kp =
(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.
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% non-convertible 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.
13 (1 – 5)
kd =
96.50%
= 6.74%
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Problem 4
The following figures are taken from the current balance sheet of Delaware & Co.
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 Rs. 2 x 1.10
ke = +g= + 10 = 18%
P0 Rs. 27.50
I Rs. 12
kd = = = 15%
SV Rs. 80
Note: In this case, the dividend of Rs. 2 has just been paid. So, D0 = 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:
Rs. in Lacs
Equity share capital 400
12% debentures 400
18% term loan 1,200
2,00
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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
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:
D1 20
ke = =
p 160
= 12.5%
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).
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The cost of capital after tax benefit (as per premises – a):
The cost of capital after tax benefit (as per premises – b):
Problem 6
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
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%.
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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. kr = ke.
Problem 7
The market price of the company’s 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:
Solutions
D1 Rs. 2
ke = +g= + 0.07
P0 Rs. 20
b)
D1 Rs. 3
ke = +g= + .07
P0 Rs. 15
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c)
D1 Rs. 3
ke = +g= + .10
P0 Rs. 15
Problem 8
The following is the extract from the financial statement of ABC Ltd.
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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
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:
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
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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 = Rs. 13
SV = 100 – 4 = Rs. 99
RV = Rs. 100
t = .50
N = 10 year
[I + (RV – SV) / N] (1 – t)
kd =
(RV + SV) / 2
PD = Rs. 14
RV = 100
SV = 100 – 5 = Rs. 95
N = 10 years
D + (RV – SV) / N
kp =
(RV + SV) / 2
14 + (100 – 95) / N
=
(100 + 95) / 12
= 14.9%
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P0 = 22 – 2 = 20
D1 = 2
g = .07
D1
ke = +g
P0
2
ke = + .07
20
= 17%
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:
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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
ke = D1 / P0 +g
= 2 / 20 + 0.07
= 17%
kd = 15 (1 - .5)
= 7.5%
ke = D1 / P0 + g
= 3 / 1.5 + 0.07
= 27%
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ke = D1 / P0 + g
= 3 / 15 + .10
= 30%
Problem 11
ABC Ltd. has the following capital structure
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
ke = D1 / P0 + g
= 10 / 102 + .10
= 19.8%
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ke = D1 / P0 + g
= 12 / 98 + .08
= 20.2%
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
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.
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Solution
Specific Costs
_______
Problem 13
Equity capital: 100 lacs equity shares of Rs. 10 each Rs. 10 crores
Reserves Rs. 2 crores
14% debentures of 100 each Rs. 3 crores
For the year ended 31-3-1999 the company has paid equity dividend at 20%. As the company is a
market leader with good future, dividend is likely to grow by 5% every year. The equity shares are now
traded at Rs. 80 per share in the stock exchange. Income tax rate applicable to the Company is 50%.
Required:
a) The current weighted cost of capital
b) The company has plans to raise a further Rs. 5 crores by way of long-term loan at 16% interest.
When this takes place the market value of the equity shares is expected to fall to Rs. 50 per
share. What will be the new weighted average cost of capital of the Company?
Solution
ke = D1 / P0 +g
ke = 2 (1.05) / 80 + .05 = 7.63%
WACC = 7.50%
Weighted average cost of capital after raising further debt of Rs. 5 crores
D1 2 (1.05)
ke = +g= + 0.05 = 9.2
P0 50
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