Unit 5 Cost of Capital

Structure:
5.1 Introduction Objectives
5.2 Meaning of Cost of Capital
5.3 Cost of Different Sources of Finance Cost of debentures Cost of term loans
Cost of preference capital Cost of equity capital
Dividend forecast approach Capital Asset Pricing Model approach
Earnings price ratio approach
Cost of retained earnings
5.4 Weighted Average Cost of Capital Assignment of weights
5.5 Summary
5.6 Glossary
5.7 Solved Problems
5.8 Terminal Questions
5.9 Answers
5.10 Case Study

5.1 Introduction
In the last unit, we discussed about the valuation of bonds and shares. In this unit,
we will learn about the meaning of cost of capital, cost of different sources of
finance, and weighted average cost of capital. Capital structure is the mix of long-
term sources of funds like debentures, loans, preference shares, equity shares, and
retained earnings in different ratios.
It is always advisable for companies to plan their capital structure. We have
discussed in the previous units that all the financial decisions taken by not
assessing things in a correct manner may jeopardise the very existence of the
company. Firms may prosper in the short run by not indulging in proper planning but
ultimately may face problems in the future. With unplanned capital structure, they
may also fail to economise the use of their funds and adapt to the changing
conditions.
Objectives:
After studying this unit, you should be able to:  define cost of capital  explain how
cost of different source of finance is determined  compute weighted average cost
of capital

5.2 Meaning of Cost of Capital

Capital, like any other factor of production, involves a cost. The cost of capital is a
significant element in capital expenditure management. The cost of capital of a
company is the average cost of different components of capital of all long-term
sources of finance. Understanding the cost of capital concept is very helpful in
making investment and financing decision. A combination of debt and equity is used
to fund the activities of a company. What should be the proportion of debt and
equity? This depends on the costs associated with raising various sources of funds.
The cost of capital is the minimum rate of return of a company which it must earn to
meet the expenses of the various categories of investors who have made
investment in the form of loans, debentures, equity, and preference shares.
A company being able to meet these demands may face the risk of investors taking
back their investments thus leading to bankruptcy.
Loans and debentures come with a predetermined interest rate. Preference shares
also have a fixed rate of dividend while equity holders expect a minimum return of
dividend based on their risk perception and the company’s past performance in
terms of payout dividends.
Figure 5.1 depicts the risk-return relationship of various securities.

Risk-Return relationship of various securities

The concept of cost of capital is a very important concept in financial management

decision making. Any efficient management team will take cost of capital into
consideration while taking any financial decisions. This concept is rather relevant in
the following managerial decisions:  Capital budgeting decision  Designing the
capital/ financial structure of the firm  Ascertaining the best method/mode of
financing  Performance of top management  Other areas include dividend
decisions, working capital policy, etc.

5.3 Cost of Different Sources of Finance

In making investment decisions, cost of different types of capital is measured and
compared. The source, which is the cheapest, is chosen and capital is raised.
The area to be focussed on is how to measure the cost of different sources of
capital. It is based largely on forecasts and is subject to various margins of error.
While computing the cost of capital, care should be taken for factors like needs and
requirements of the company, the conditions under which it is raising its capital,
corporate policy constraints, and level of expectations of investors.
A company raises funds from different sources, and therefore, composite cost of
capital can be determined after specific cost of each type of fund has been
obtained. It is, therefore, necessary to determine the specific cost of each source in
order to determine the minimum obligation of a company, i.e., composite cost of
raising capital.
In order to determine the composite cost of capital, the specific costs of different
sources of raising funds are calculated. The weighted arithmetic average of the cost
of different financial resources that a company uses is termed as its cost of capital.
The various sources of finance and their costs are explained in this section.
5.3.1 Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds from
issue of debentures to the expected cash outflows.
The expected cash outflows relate to the interest and principal repayments.

K d=

Where Kd is post tax cost of debenture capital

I is the annual interest payment per unit of debenture
T is the corporate tax rate
F is the redemption price per debenture
P is the net amount realised per debenture
n is maturity period

Solved Problem – 1
Lakshmi Enterprise wants to have an issue of non-convertible debentures (NCD) for
Rs. 10 crore. Each debenture is of a par value of Rs. 100 having an interest rate of
15%. Interest is payable annually and they are redeemable after 8 years at a
premium of 5%. The company is planning to issue the NCD at a discount of 3% to
help in quick subscription. If the corporate tax rate is 50%, what is the cost of
debenture to the company?

5.3.2 Cost of term loans

Term loans are loans taken from banks or financial institutions for a specified
number of years at a predetermined interest rate. The cost of term loans is equal to
the interest rate multiplied by (1-tax rate).
The interest is multiplied by (1-tax rate) as interest on term loans is also tax
deductible.
Kt = I(1—T)
Where I is interest rate, T is
tax rate

Solved Problem – 2
Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9% interest. What is
the cost of term loan if the tax rate is 40%?
Solution:
Kt = I (1—T) = 9(1—0.4) = 5.4% The cost of term loan is 5.4%

5.3.3 Cost of preference capital

The cost of preference share Kp is the discount rate which equates the proceeds
from preference capital issue to the dividend and principal repayments. It is
expressed as:
Kp= (D+{(F – P)/ n}/((F +P)/ 2)
Where Kp is the cost of preference capital D is the preference dividend per share
payable F is the redemption price P is the net proceeds per share n is the
maturity period

Solved Problem – 3
C2C Ltd. has recently come out with a preference share issue to the tune of Rs. 100
lakh. Each preference share has a face value of 100 and a dividend of 12%
payable. The shares are redeemable after 10 years at a premium of Rs. 4 per
share. The company hopes to realise Rs. 98 per share now. Calculate the cost of
preference capital.
Solution:

Kp = 0.1247 or 12.47%
The cost of preference capital now will be 12.47%

5.3.4 Cost of equity capital

Equity shareholders, unlike preference shareholders, do not have a fixed rate of
return on their investment. There is no binding legal requirement (unlike in the case
of loans or debentures where the rates are governed by the deed) to pay regular
dividends to them. Measuring the rate of return to equity holders is always a difficult
and complex exercise.
There are many approaches for estimating return – the dividend forecast approach,
capital asset pricing approach, realised yield approach, earnings – price ratio
approach, and bond yield plus risk premium approach. We will have a brief look at
some of these models in the following pages.
5.3.4.1 Dividend forecast approach
According to dividend forecast approach, the intrinsic value of an equity share is the
sum of present values of dividends associated with it.
Dividends cannot be accurately forecasted as they may sometimes be nil or have a
constant growth or sometimes have supernormal growth periods. Hence, it is not
possible to arrive at the price per equity share on the basis of forecast of future
streams of dividends.
The following is a simplified equation that arrives at the rate of return required by the
equity shareholders.
Ke = (D1/Pe) + g
This equation is modified from the equation, P e= {D1/Ke-g}. This equation is arrived
at with the assumption that there is a constant growth in dividends. If the current
market price of the share is given (P e), and the values of D1 and ‘g’ are known, the
equation is then rewritten as Ke = (D1/Pe) + g
5.3.4.2 Capital asset pricing model approach
This model establishes a relationship between the required rate of return of
a security and its systematic risks expressed as “β”. According to this model,
Ke = Rf + β(Rm – Rf)
Where Ke is the rate of return on share
Rf is the risk free rate of return
β is the beta of security
Rm is rate of return on market portfolio
Beta (β ) of a security is a measure of a stock's volatility in relation to the market.
By definition, the market has a beta of 1.0, and individual stocks are ranked
according to how much they deviate from the market. A stock that swings more than
the market over time has a beta above 1.0. If a stock moves less than the market,
the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but
provide a potential for higher returns. Low-beta stocks pose less risk but also lower
returns.
Beta is a key component for the Capital Asset Pricing Model (CAPM), which is
used to calculate cost of equity. We know that the cost of capital represents the
discount rate used to arrive at the present value of a company's future cash flows.
All things being equal, the higher a company's beta, the higher its cost of capital
discount rate. The higher the discount rate, the lower the present value placed on
the company's future cash flows. In short, beta can impact a company's share
valuation.
The CAPM model is based on some assumptions, some of which are:
 Investors are risk-averse.
 Investors make their investment decisions on a single-period horizon.
 Transaction costs are low and therefore can be ignored. This translates to assets
being bought and sold in any quantity desired. The only considerations that
matter are the price and amount of money at the
investor’s disposal.
 All investors agree on the nature of return and risk associated with each
investment.

Solved Problem – 4
What is the rate of return for a company if its β is 1.5, risk free rate of
return is 8%, and the market rate or return is 20%?
Solution:
Ke= Rf+ β (Rm — Rf) = 0.08 +
1.5(0.2-0.08) = 0.08 + 0.18 =
0.26 or 26%
The rate of return is 26%

5.3.4.3 Earnings price ratio approach

Under the case of earnings price ratio approach, the cost of equity can be
calculated as:
Ke = E1/P
Where E1 = expected EPS for the next year P =
current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).
This ratio assumes that the EPS will remain constant from the next year
onwards.

Is equity capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is
not legally bound to pay dividends and also as the rate of equity dividend is not fixed
like preference dividends. This is not a correct view as equity shareholders buy
shares with the expectation of dividends and capital appreciation. Dividends
enhance the market value of shares and therefore, equity capital is not free of cost.

Solved Problem – 5
Suraj Metals are expected to declare a dividend of Rs. 5 per share and the growth
rate in dividends is expected to grow @ 10% p.a. The price of one share is currently
at Rs. 110 in the market. What is the cost of equity capital to the company?
Solution:
Ke = (D1/Pe) + g
= (5/110) + 0.10
= 0.1454 or 14.54%

Cost of equity capital is 14.54%

5.3.5 Cost of retained earnings

A company’s earnings can be reinvested in full to fuel the ever-increasing demand
of company’s fund requirements or they may be paid off to equity
holders in full or they may be partly held back and invested and partly paid off.
These decisions are taken keeping in mind the company’s growth stages.
High-growth companies may reinvest the entire earnings to grow more, companies
with no growth opportunities and return the funds earned to their owners.
Companies with constant growth invest a little and return the rest. Shareholders of
companies with high-growth prospects utilising funds for reinvestment activities
have to be compensated for parting with their earnings.
Therefore, the cost of retained earnings is the same as the cost of shareholder’s
expected return from the firm’s ordinary shares. So,
Kr = Ke
The cost of retained earnings is always less than the cost of new issue of ordinary
shares due to absence of floating costs.
Some regard that cost of retained earnings is nil but it is not so. Retained earnings
also have opportunity cost which can be computed.
If the entire earning is not distributed and the firm retains a part, then these retained
earnings are available within the firm. Companies are not required to pay any
dividend on retained earnings. It is generally observed that this source of finance is
cost free, but it is not true. If earnings were not retained, they would have been paid
out to the ordinary shareholders as dividend. This dividend forgone by the equity
shareholders is opportunity cost. The firm is required to earn on retained earnings,
at least equal to the rate that would have been earned by the shareholders, if they
were distributed to them. So the cost of retained earnings may be defined as
opportunity cost in terms of dividends forgone by withholding from the equity
shareholders.
This can be expressed as:

Where, Kr = Cost of retained earnings

Ti = Marginal income tax rate applicable to an individual
T0 = Capital gain tax
D = Dividends per share
P = Price of share
Cost of retained earnings and cost of external equity
As we have just learnt that if retained earnings are reinvested in business for growth
activities, the shareholders expect the same amount of returns and therefore
Ke=Kr
However, it should be borne in mind by the policy makers that floating of a new
issue and people subscribing to the new issue will involve huge amounts of money
towards floating costs. This need not be incurred if retained earnings are utilised
towards funding activities.
Cost of external equity comes into picture when the floatation costs arise in the
process of raising equity from the market. It is the rate of return that the company
must earn on the net funds raised in order to satisfy the equity holder’s demand for
return.
From the dividend capitalisation model, the following model can be used for
calculating cost of external equity.
Ke = {D1/P0(1—f)} + g
Where, Ke is the cost of external equity
D1 is the dividend expected at the end of year 1
P0 is the current market price per share
g is the constant growth rate of dividends
f is the floatation costs as a percentage of current market price
The following formula can be used as an approximation:
K’e = Ke/(1—f)
Where K’e is the cost of external equity
Ke is the rate of return required by equity holders
f is the floatation cost
This formula can be used for all other approaches for which there is no particular
method for accounting for the floatation costs.

Solved Problem – 6
Alpha Ltd. requires Rs. 400 crore to expand its activities in the southern
zone of India. The company’s CFO is planning to get Rs. 250 crore
through a fresh issue of equity shares to the general public and for the balance
amount; he proposes to use ½ of the reserves which are
currently to the tune of Rs. 300 crore. The equity investor’s expectations
of returns are 16%. The cost of procuring external equity is 4%. What is the cost of
external equity?
Solution:
We know that Ke= Kr, that is Kr is 16% Cost of
external equity is
K’e = Ke/(1—f)
0.16/(1– 0.04) = 0.1667 or 16.67%
Hence, cost of external equity is 16.67%
Key Point
Dividends cannot be accurately forecasted as they might sometimes become nil or
have a constant growth or sometimes have supernormal growth periods.

Activity 1:
Make a list of companies which have declared dividends and/or bonus shares in the
last 3 years. Refer: websites

5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the
overall capital of the company. The term, cost of capital, refers to the overall
composite cost of capital or the weighted average cost of each specific type of fund.
The purpose of using weighted average is to consider each component in proportion
to their contribution to the total fund available. Use of weighted average is
preferable to simple average method for the reason that firms do not procure funds
equally from various sources and therefore simple average method is not used. The
following steps are involved to calculate the WACC:
Step I: Calculate the cost of each specific source of fund, that of debt, equity,
preference capital, and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: Add these weighted costs, as calculated in Step III, to determine the
WACC as given below:
WACC= WeKe +WrKr+WpKp+WdKd+WtKt
Assignment of weights
Weights can be assigned based on any of the following methods:  The book value
of the sources of the funds in capital structure  Present market value of funds in
the capital structure  Adoption of finance planned for capital budget for the next
period As per the book value approach, weights assigned would be equal to each
source’s proportion in the overall funds. The book value method is
preferable. The market value approach uses the market values of each source, and
the disadvantage in this method is that these values change very frequently.

Solved Problem – 7
Table 5.1 depicts the capital structure of Prakash Packers Ltd.
Table 5.1: Capital Structure in Lakhs

Equity capital (Rs. 10 par value) 200

14% preference share capital Rs. 100 each 100
Retained earnings 100
12% debentures (Rs. 100 each) 300
11% term loan from ICICI bank 50
Total 750

The market price per equity share is Rs. 32. The company is expected to
declare a dividend per share of Rs. 2 per share, and there will be a
growth of 10% in the dividends for the next 5 years. The preference
shares are redeemable at a premium of Rs. 5 per share after 8 years and
are currently traded at Rs. 84 in the market. Debenture redemption will
take place after 7 years at a premium of Rs. 5 per debenture and their
current market price Rs. 90 per unit. The corporate tax rate is 40%.
Calculate the WACC.

Solution:
Step I: Determine the cost of each component.
Ke = (D1/P0)+ g

= (2/32) + 0.1
= 0.1625 or 16.25%

Kp= [D+ {(F—P)/n}] / {F+P)/2}

= [14 + (105—84)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or 17.59%
Kr = Ke which is 16.25%
Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}
= [12(1—0.4) + (105—90)/7] / (105+90)/2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6%
Kt = I(1–T)
= 0.11(1–0.4) = 0.066 or
6.6%
Step II: Calculate the weights of each source. We= 200/750 = 0.267 Wp = 100/750 =
0.133 Wr= 100/750 = 0.133 Wd = 300/750 = 0.4 Wt= 50/750 = 0.06
Step III: Multiply the costs of various sources of finance with corresponding weights,
and WACC is calculated by adding all these components
WACC= We Ke +WpKp+WrKr+ WdKd+ Wt Kt
= (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625)
+ (0.4*0.092) +
(0.06*0.066) = 0.043 +
0.023 + 0.022 + 0.0384
+ 0.004 = 0.1304 or
13.04%
The value of WACC is 13.04%
Solved Problem – 8
Johnson Cool Air Ltd. would like to know the WACC. The following
information is made available to you in this regard.
The after tax cost of capital are:
  Cost of debt 9%
 Cost of preference shares 15%
 Cost of equity funds 18%

The capital structure is as follows:  Debt Rs.

6,00,000  Preference capital Rs. 4,00,000
 Equity capital Rs. 10,00,000
Solution:
Table 5.2 depicts the calculated WACC.

Table 5.2: WACC

Fund source Amount Ratio Cost Weighted cost

Debt Rs. 600000 0.3 0.09 0.027
Preference capital Rs. 400000 0.2 0.15 0.030
Equity capital Rs. 1000000 0.5 0.18 0.090
Total Rs. 2000000 1.0 0.147

WACC is 14.7%.

Solved Problem – 9
Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds next year for
which it requires Rs. 20 crore to purchase new equipment. The CFO has made
available the following details based on which you are required to compute the
weighted marginal cost of capital.  The amount required will be raised in equal
proportions by way of debt
and equity (new issue and retained earnings put together account for 50%)
 The company expects to earn Rs. 4 crore as profits by the end of the year after
which it will retain 50% and payoff rest to the shareholders.  The debt will be
raised equally from two sources -loans from IOB
costing 14% and from the IDBI costing 15%.
 The current market price per equity share is Rs. 24 and hence the dividend
payout one year will be Rs. 2.40. Tax rate is 50%
Solution: Ke = (D1/P0) =
(2.40 / 24) =
0.1 or 10%
Cost of equity Ke = cost of retained
earnings Kt = I(1 – T)
[14% loan from IOB] =
0.14(1 – 0.5) = 0.07 or
 7% Kt = I(1 – T) [15%
IDBI loan] = 0.15(1 – 0.5)
= 0.075 or 7.5%

Table 5.3 depicts the computation of weighted marginal cost of capital.

Table 5.3 Weighted Cost of Capital

Source of funds Weights After tax cost Weighted cost

Equity capital 0.4 0.1 0.040
Retained earnings 0.1 0.1 0.010
14% loan from IOB 0.25 0.07 0.0175
15% IDBI loan 0.25 0.075 0.0188
Total 0.0863

Weighted average cost of capital 8.63%

Solved Problem – 10
Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the current year.
The dividends are growing at 6% p.a. The cost of equity
capital is 16%. The company’s top Finance Managers of various zones recently met
to take stock of the competitor’s growth and dividend policies
and came out with the following suggestions to maximise the wealth of the
shareholders. As the CFO of the company, you are required to analyse
each suggestion and take a suitable course keeping the shareholder’s
interests in mind.
Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15%
Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17%
Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15%
Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17%
Alternative 5: Increase the dividend growth rate to 7% and lower Ke to14%
Solution:
We all know that
P0 = D1/(Ke – g)
Present case = 4/(0.16-0.06) = Rs 40 Alternative 1 = 4.28/(0.15 – 0.07) = Rs. 53.5
Alternative 2 = 4.28/(0.17 – 0.07) = Rs. 42.8 Alternative 3 =
4.16/(0.15 – 0.04) = Rs. 37.8 Alternative 4 = 4.16/(0.17 – 0.04) = Rs.
 32 Alternative 5 = 4.28/(0.14 – 0.07) = Rs. 61.14
Recommendation
The last alternative is likely to fetch the maximum price per equity share thereby
increasing the wealth.

Self Assessment Questions

1. is the mix of long-term sources of funds like debentures, loans,

preference shares, equity shares, and retained earnings in different ratios.
2. The capital structure of the company should generate to the
shareholders. 3. The capital structure of the company should be within the
_____. 4. An ideal capital structure should involve _____ to the company.
5. _______ do not have a fixed rate of return on their investment. 6.
According to dividend forecast approach, the intrinsic value of an equity
share is the sum of ______ associated with it.

5.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Any organisation requires funds to run its business. These funds may be
acquired from short-term or long-term sources. Long-term funds are raised from
two important sources – capital (owner’s funds) and debt. Each of these two has
a cost factor, merits, and demerits.
 Having excess debt is not desirable as debt holders attach many conditions
which may not be possible for the companies to adhere to. It is therefore
desirable to have a combination of both debt and equity which is called the
‘optimum capital structure’. Optimum capital structure refers to the mix of
different sources of long-term funds in the total capital of the company.
 Cost of capital is the minimum required rate of return needed to justify the use of
capital. A company obtains resources from various sources – issue of
debentures, availing term loans from banks and financial institutions, issue of
preference and equity shares, or it may even withhold a portion or complete
profits earned to be utilised for further activities.
 Retained earnings are the only internal source to fund the company’s future
plans. Weighted average cost of capital is the overall cost of all sources of
finance. The debentures carry a fixed rate of interest. Interest qualifies for tax
deduction in determining tax liability. Therefore, the effective cost of debt is less
than the actual interest payment made by the firm.
 The cost of term loan is computed keeping in mind the tax liability. The cost of
preference share is similar to debenture interest. Unlike debenture interest,
dividends do not qualify for tax deductions.
 The calculation of cost of equity is slightly different as the returns to equity are
not constant. The cost of retained earnings is the same as the cost of equity
funds.

5.6 Glossary
Cost of debenture: The discount rate which equates the net proceeds from issue
of debentures to the expected cash outflows.
Term loans: Loans taken from banks or financial institutions for a specified number
of years at a predetermined interest rate.

11. Deepak Steel has issued non-convertible debentures for Rs. 5 crore. Each
debenture is of a par value of Rs. 100 carrying a coupon rate of 14%. Interest is
payable annually and they are redeemable after 7 years at a premium of 5%.
The company issued the NCD at a discount of 3%. What is the cost of debenture
to the company? Tax rate is 40%.

Solution:

= 0.094 or 9.4%

12. Supersonic industries Ltd. has entered into an agreement with Indian Overseas
Bank for a loan of Rs. 10 crore with an interest rate of 10%. What is the cost of
the loan if the tax rate is 45%?
Solution:
Kt=I(1 – T) = 10(1 – 0.45) = 5.5%
13.Prime group issued preference shares with a maturity premium of 10% and a
coupon rate of 9%. The shares have a face value of Rs. 100 and are
redeemable after 8 years. The company is planning to issue these shares at a
discount of 3% now. Calculate the cost of preference capital.
Solution:
5.8 Terminal Questions
1 The following data is available in respect of a XYZ company. The market
value of Equity is Rs. 10 lakh and the cost of equity is 18%. The market value of
debt is Rs. 5 lakh and cost of debt is 13%. Calculate the weighted average cost of
funds as weights assuming tax rate as 40%.
2 Table 5.4 depicts the capital structure of Bharat chemicals.

Table 5.4: Capital Structure

Rs. 10 face value equity shares Rs. 400000

Term loan at 13% Rs.150000
9% Preference shares of Rs. 100, currently traded at Rs. Rs. 100000
95 with 6 years maturity period
Total Rs. 650000

The company is expected to declare a dividend of Rs. 5 next year and the
growth rate of dividends is expected to be 8%. Equity shares are currently traded
at Rs. 27 in the market. Assume tax rate of 50%. What is WACC?
1 The market value of debt of a firm is Rs. 30 lakh and equity is Rs. 60 lakh.
The cost of equity and debt are 15% and 12%. What is the WACC if the tax rate is
50%?
4. A company has 3 divisions – X, Y, and Z. Each division has a capital
structure with debt, preference shares, and equity shares in the ratio
3:4:3 respectively. The company is planning to raise debt, preference
shares, and equity for all the 3 divisions together. Further, it is planning to take a
bank loan at the rate of 12% interest. The preference shares have a face value of
Rs. 100, dividend at the rate of 12%, 6 years maturity, and currently priced at Rs.
88. Calculate the cost of preference shares and debt if taxes applicable are 45%.
2 Tanishk Industries issues partially convertible debentures with face value of
Rs. 100 each and retains Rs. 96 per share. The debentures are redeemable after 9
years at a premium of 4% and taxes applicable are 40%. What is the cost of debt if
the coupon interest is 12%?

1 Capital structure
2 Maximum returns
3 Debt capacity
4 Minimum risk of loss of control
5 Equity shareholders
6 Present values of dividends

1 Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt Ans. =

14.57%
2 Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt
3 Hint: Use the equation WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt Ans. =
8.97%
4 Hint: Apply the formula
5 Hint: Apply the formula

Ans. = 8.09%

5.10 Case Study: Sources of Finance

Sources of Finance
KARE Ltd. is a healthcare concern that was established in 1993. It was founded
with the aim of manufacturing life-saving immuno-biologicals which were in shortage
in the country and imported at high prices. Thereafter, several life-saving biologicals
were manufactured in abundance at prices affordable to common man. As a result,
the country was made self-sufficient for Tetanus, Anti-toxin, and Anti-snake Venom
serum followed by DTP (Diphtheria, Tetanus, and Pertussis) group of Vaccines and
then later on MMR (Measles, Mumps, and Rubella) group of vaccines.

The company has recently set up KARE Park in Special Economic Zone
(SEZ). The Park is adjoining the company’s existing manufacturing unit and
is a sector-specific SEZ meant for biotechnology and pharmaceutical products. The
SEZ will allow the company to avail various tax benefits such as income tax, import
duty on capital goods, etc. This has encouraged a lot of foreign companies to
partner with KARE to avail and share these benefits.

The company’s financial data is given below:

Sources of Funds:
Shareholder’s funds:
Fully paid-up equity share capital 300
Reserves and Surplus 600 900
Loan funds:
Secured Loans:
12% non-convertible debentures 400
14% term loan from IDBI 528
Working Capital loan from IOB 150 1,078
Unsecured Loans:
Fixed Deposits 50 50
2,028
Application of Funds:
Fixed Assets (net) 1,250
Investments 250
Current assets – loans and advances 750
(-) current liabilities and provisions 350 400
Miscellaneous expenditures and losses 128
2,028

The following information is also provided:

1. The equity share capital consists of 30 lakh equity shares with
par value Rs. 10. The market value of the equity capital is Rs. 450 lakh.
Hence, the
dividend per share expected a year is Rs. 1.50 per share. The
dividends are expected to grow at a rate of 5% per annum.
1 12% non-convertible debentures consist of 4 lakh debentures which
were issued at par (Rs.100). The issue cost was Rs.28 lakh. The difference
between the redemption price and the net amount realised after issue will be
written off evenly over the life of the debentures; it is assumed that the
amount so written off will be a tax-deductible expense. The debentures will
be redeemed after 10 years at a premium of 3%. The market value of the
debenture capital is Rs. 384 lakh.
2 The market value of the term loan can be considered equal to its book
value.
3 The tax rate of the company is 35%.

Discussion Questions:
1. Is equity capital free of cost? What is your view on that? Draw references
from the above example. (Hint: Refer to cost of capital)
2 Calculate the cost of different long-term sources of finance employed by
KARE Ltd. (Hint: Refer to cost of sources of finance)
1 Calculate the WACC using the market values of the long-term sources
of finance as weights. (Hint: Refer to WACC)
2 Which factors, according to you, affect the WACC? (Hint: Refer to
WACC)
3 What is the use of calculating WACC? Explain and justify your answer.
You may draw inference from the example case above. (Hint: Refer to
WACC)

Source: www.moneycontrol.com
Reference:
 Pandey I. M., (2005), Financial Management, Vikas Publishing House 2005, 9th
edition
E-Reference:
 www.moneycontrol.com retrieved on 12/12/2011