FM BOOSTER BATCH 111

CHAPTER 8 - COST OF CAPITAL

1. Cost of Capital: Cost of capital is the return expected by the providers of capital (i.e. shareholders,
lenders and the debt-holders) to the business as a compensation for their contribution to the total
capital. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.

2. Components of Cost of Capital:

3. Cost of Debt (Kd):

 FM BOOSTER BATCH 112
(a) Cost of Irredeemable Debenture:
𝐈 (𝟏 − 𝐭)
Kd = 𝐍𝐏
× 100

Where,
I = Amount of Interest
t = Tax rate
NP = Net Proceeds of Debenture or Current Market Price

Note: If Face Value of Debenture equal to Net Proceeds then

Kd = 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 (𝟏 − 𝒕)

(b) Cost of Redeemable Debenture (in Lump sum):

Approximation Method:
𝐑𝐕 − 𝐍𝐏 𝐑𝐕 − 𝐍𝐏
𝐈 (𝟏 − 𝐭)+ ( ) (𝐈 + )(𝟏 − 𝐭)
Kd = 𝐑𝐕 + 𝐍𝐏
𝐧
× 𝟏𝟎𝟎 Or = 𝐧
𝐑𝐕 + 𝐍𝐏 × 100
𝟐 𝟐

Where, I = Amount of Interest.

RV = Redemption value of Debenture
NP = Net Proceeds of Debenture or Current Market Price
n = Life of Debenture

Present Value Method (PV) / Yield to Maturity Method (YTM):

𝐍𝐏𝐕𝐋
Kd = IRR = L + 𝐍𝐏𝐕 × (H - L)
𝐋 − 𝐍𝐏𝐕𝐇

(c) Cost of Redeemable Debenture (in Instalments):

𝐍𝐏𝐕𝐋
Kd = IRR = L + 𝐍𝐏𝐕 × (H - L)
𝐋 − 𝐍𝐏𝐕𝐇

(d) Cost of Zero Coupon Bonds (ZCB):

𝐧 𝐑𝐕
Kd = √
𝐈𝐏
− 𝟏

Where, I = Amount of Interest.

RV = Redemption value of Debenture
IP = Issue Price of Bond
n = Life of Bond

Notes:

 In case of convertible debenture use convertible value in place of redemption value of debenture.

 If nothing is specified, issue price assumed to be equal to Market value or face value.

 If nothing is specified, redemption value assumed to be equal to face value.

 If nothing is specified, floatation cost assumed to be linked with “face value or issue price whichever
is higher”.

4. Cost of Preference Share Capital (Kp):

 FM BOOSTER BATCH 113

(a) Cost of Irredeemable Preference Share:

𝐏𝐃
Kp = × 100
𝐍𝐏

Where,
PD = Amount of Preference Dividend
NP = Net Proceeds of Preference Share or Current Market Price

Note: If Face Value of Preference Share equal to Net Proceeds then

Kp = 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

(b) Cost of Redeemable Preference Share (in Lump sum):

Approximation Method:
𝐑𝐕 − 𝐍𝐏
𝐏𝐃 + ( )
Kp = 𝐧
𝐑𝐕 + 𝐍𝐏 × 100
𝟐
Where,
PD = Amount of Preference Dividend
RV = Redemption value of Preference Share
NP = Net Proceeds of Preference Share or Current Market Price
n = Life of Preference Share

Present Value Method (PV) / Yield to Maturity Method (YTM):

𝐍𝐏𝐕𝐋
Kp = IRR = L + 𝐍𝐏𝐕 × (H - L)
𝐋 − 𝐍𝐏𝐕𝐇

(c) Cost of Redeemable Preference Share (in Instalments):

𝐍𝐏𝐕𝐋
Kd = IRR = L + 𝐍𝐏𝐕 × (H - L)
𝐋 − 𝐍𝐏𝐕𝐇
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Note:
 In case of convertible preference share use convertible value in place of redemption value.
 If nothing is specified, issue price assumed to be equal Market value or face value.
 If nothing is specified, redemption value assumed to be equal to face value.
 If nothing is specified, floatation cost assumed to be linked with “face value or issue price whichever
is higher”.

5. Cost of Equity Share Capital (Ke):

(a) Dividend Price/Yield Approach:

𝐃
Ke = 𝐏𝟎
× 100

Where,
D = Expected/ Current Dividend
P0 = Current Market Price of Equity Share

Assumption: Constant Dividend

(b) Earning Price/Yield Approach:

𝐄
Ke = 𝐏𝟎
× 100

Where,
E = Expected/ Current EPS
P0 = Current Market Price of Equity Share

Assumption: Constant EPS

(c) Growth Approach or Gordon’s Model:

𝐃𝟏 𝐃𝟎 (𝟏 + 𝐠)
Ke = 𝐏𝟎
+g or 𝐏𝟎
+g

Where,
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D1 = D0 (1 + g) = Expected DPS
P0 = Current Market Price of Equity Share
g = Constant Growth Rate of Dividend

Note:
 In case of fresh issue of Equity shares (New Shares), Net Proceeds from equity share {(Issue price –
Issue expenses/ Floatation cost) or (Po - F)} is used in place of current price of share.

 If nothing is specified, floatation cost assumed to be linked with “face value or issue price whichever
is higher”.

 Estimation of Growth Rate:

(a) Average Method:

𝐧 𝐃
Growth rate = √𝐃𝟎 - 1
𝐧

Where,
D0 = Current Dividend
Dn = Dividend in n years ago

(b) Gordon’s Growth Model:

g = b×r

Where,
r = Rate of return on fund invested
b = Earning retention ratio

(d) Realised Yield Approach:

IRR Method:

𝐍𝐏𝐕𝐋
Ke = IRR = L + 𝐍𝐏𝐕 × (H - L)
𝐋 − 𝐍𝐏𝐕𝐇

Geometric Mean Method:

𝐧
Ke = √(𝟏 + 𝐘𝟏) × (𝟏 + 𝐘𝟐) … . . (𝟏 + 𝐘𝐧) – 1

Where,
n = Number of years

𝐃𝟏+𝐏𝟏
(1+Y1) =
𝐏𝟎

Note: Geometric mean method can be used when MPS is given for each year.

(e) Capital Asset Pricing Model (CAPM):

Ke = Rf + ß (Rm - Rf)

Where, Rf = Risk Free Rate of Return

Rm = Rate of Return on Market Portfolio
Rm - Rf = Market Risk Premium
ß = Beta coefficient
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6. Cost of Retained Earnings (Kr): After tax return to shareholder if he invest elsewhere.

Formulae:
Kr = Ke (of existing investors)

Kr = Ke (1 - tp) (In case of personal tax)

Kr = Ke (1 - tp) (1 - f) (f is rate of floatation cost)

7. Weighted Average Cost of Capital (K0): WACC is also known as the overall cost of capital of
having capitals from the different sources as explained above. WACC of a company depends on the
capital structure of a company. Weighted average cost of capital is the weighted average after tax
costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt
and equity is calculated separately and added together to a single overall cost of capital. It can be
calculated by using either Book Value weights or Market Value weights.

Proforma Statement of WACC

Capital Structure Amount Weight Specific Cost Cost of Capital
(a) (b) (c) (d) (e) = c × d
Equity Share Capital XXX 0.XXX 0.XX 0.XXX
Retained Earnings XXX 0.XXX 0.XX 0.XXX
Preference Share Capital XXX 0.XXX 0.XX 0.XXX
Debentures XXX 0.XXX 0.XX 0.XXX
Total XXX 1.000 WACC 0.XXX

Note: Market Value of equity has been apportioned in the ratio of Book Value of equity and retained
earnings when Market Value weights are used.

8. Marginal Cost of Capital (MCC): The marginal cost of capital may be defined as the cost of raising
an additional rupee of capital. Marginal cost of capital is derived, when the average cost of capital
is calculated using the marginal weights.
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PRACTICAL PROBLEMS
BBQ 73
Calculate the cost of capital in the following cases:

(i) X Ltd. issues 12% debentures of face value `100 each and realizes `95 per debenture. The debentures
are redeemable after 10 years at a premium of 10%.
(ii) Y Ltd. issues preference shares of face value `100 each carrying 14% dividend and it realizes `92 per
share. The shares are repayable after 12 years at par.

Note: Both companies are paying Income tax at 50%.

Answer
(i) Cost of debt (Kd)
 RV  NP   110  95 
I 1  t     12 1  0.50    
Kd =  n  × 100 =  10  × 100
RV  NP 110  95
2 2
= 7.32%

(ii) Cost of preference capital (Kp):

 RV  NP   100  92 
PD    14   
Kp =  n  × 100 =  12  × 100 = 15.28%
RV  NP 100  92
2 2

BBQ 74
Institutional Development Bank (IDB) issued Zero interest deep discount bonds of face value of `1,00,000 each
issued at `2,500 & repayable after 25 years.

Compute the cost of debt if there is no corporate tax.

Answer
n Redemption Value 25 1,00,000
Kd = √
Issue Price
–1 = √ 2,500
–1 = 15.91

BBQ 75
A company issued 10,000, 15% Convertible debentures of `100 each with a maturity period of 5 years. At
maturity the debenture holders will have the option to convert the debentures into equity shares of the
company in the ratio of 1:10 (10 shares for each debenture). The current market price of the equity shares is
`12 each and historically the growth rate of the shares are 5% per annum.

Compute the cost of debentures assuming 35% tax rate.

Answer
Determination of Redemption value:
Higher of
(i) The cash value of debentures = `100
(ii) Value of equity shares = 10 shares × `12(1 + 0.05)5
= 10 shares × `12 × 1.276 = `153.12
`153.12 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Calculation of Cost of Convertible debenture:

 FM BOOSTER BATCH 118
Alternative 1: Using approximation method:

RV−NP 153.12−100
I (1 − t) + 15 (1 − 0.35) +
n 5
Kd = RV+NP × 100 = 153.12+100 × 100 = 16.09%
2 2

Alternative 2: Using present value method:

Calculation of NPV at two discount rates:

Present Value Present Value
Year Cash Flow
15% DCF 20% DCF
0 100 1.000 (100) 1.000 (100)
1-5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV +8.78 -9.29

NPVL 8.78
IRR/Kd = LR + × (H - L) = 15% + × (20% - 15%)
NPVL  NPVH 8.78  ( 9.29 )
= 17.43%

BBQ 76
RBML is proposing to sell a 5-year bond of ` 5,000 at 8 per cent rate of interest per annum. The bond amount
will be amortised equally over its life.

What is the bond’s present value for an investor if he expects a minimum rate of return of 6 per
cent?

Answer
The amount of interest will go on declining as the outstanding amount of bond will be reducing due to
amortisation. The amount of interest for five years will be:
First year : `5,000 × 0.08 = `400
Second year : (`5,000 – `1,000) × 0.08 = `320
Third year : (`4,000 – `1,000) × 0.08 = `240
Fourth year : (`3,000 – `1,000) × 0.08 = `160; and
Fifth year : (`2,000 – `1,000) × 0.08 = `80.

The outstanding amount of bond will be zero at the end of fifth year. Since RBML will have to return `1,000
every year, the outflows every year will consist of interest payment and repayment of principal:
First year : `1,000 + `400 = `1,400
Second year : `1,000 + `320 = `1,320
Third year : `1,000 + `240 = `1,240
Fourth year : `1,000 + `160 = `1,160; and
Fifth year : `1,000 + `80 = `1,080.

The above cash flows of all five years will be discounted with the cost of capital. Here the expected rate i.e. 6%
will be used. Value of the bond is calculated as follows:
1,400 1,320 1,240 1,160 1,080
VB = + 2
+ 3
+ 4
+
(1.06 )1
(1.06 ) (1.06 ) (1.06 ) (1.06 )5
= `1,320.75 + `1,174.80 + `1,041.14 + `918.88 + `807.05 = ` 5,262.62

BBQ 77
The Beta coefficient of Computech Ltd. is 1.2. The company has been maintaining 5% rate of growth in
dividends and earnings. Current year expected dividend is `2.40 per share. Return on Government securities
 FM BOOSTER BATCH 119
is 10%. Return on Market portfolio is 14%. The current market price of one share of Computech Ltd. is `28.
The earnings per share is `3.90.

Calculate the cost of equity capital basing on:

(i) Dividend yield method,
(ii) Dividend growth model,
(iii) Capital asset pricing Model.

Answer
(i) Dividend yield method:
D1 2.40
Ke = × 100 = × 100 = 8.57%
P0 28.00

(ii) Dividend growth model:

D1 2.40
Ke = +g = + .05 = 13.57%
P0 28.00

(iii) Capital Asset Pricing Model:

Ke = Rf +  (Rm - Rf) = 10% + 1.2 × (14% - 10%) = 14.80%

BBQ 78
Mr. Mehra had purchased a share of Alpha Limited for `1,000. He received dividend for a period of five years
at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for `1,128.

You are required to compute the cost of equity as per realised yield approach.

Answer
Calculation of NPV at two discount rates:
Present Value Present Value
Year Cash Flow
11% DCF 13% DCF
0 1,000 1.000 (1,000) 1.000 (1,000)
1-5 100 3.696 369.60 3.517 351.70
5 1,128 0.593 668.90 0.543 612.50
NPV +38.50 -35.80

Calculation of IRR/Ke:

NPVL 38 .50
Ke = LR + × (H - L) = 11% + × (13% - 11%) = 12.04%
NPVL  NPVH 38 .50  ( 35 .80 )

BBQ 79
Calculate the cost of equity from the following data using realized yield approach:

Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60

Answer
In this questions we will first calculate yield for last 4 years and then calculate it geometric mean as follows:

D1 + P1 1+9.75
1 + Y1 = = = 1.1944
P0 9
 FM BOOSTER BATCH 120
D2 + P2 1+11.50
1 + Y2 = = = 1.2821
P1 9.75
D3 + P3 1.2+11
1 + Y3 = = = 1.0609
P2 11.50
D4 + P4 1.25+10.60
1 + Y4 = = = 1.0772
P3 11

Geometric mean:
Ke = [(1 + Y1) × (1 + Y2) ×……(1 + Yn)]1/n – 1

Ke = [1.1944 × 1.2821 × 1.0609 × 1.0772]1/4 – 1 = 0.15 or 15%

BBQ 80
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of `20 and proposes to pay
60% dividend at the current year end with a P/E ratio 6.25, it wants to offer the issue at market price. The
flotation cost is expected to be 4% of the issue price.

You are required to determine rate of return for equity share (cost of equity) before the issue and
after the issue.

Answer
Market price of share (MPS/P0) = EPS × PE = `20 × 6.25 = `125
Net proceeds = 125 – 4% = `120
Return on Equity (ROE) = 1/PE = 1/6.25 = 16%
Growth rate = r×b = 16% × 40% = 6.40%
D1 60% of 20
Ke (before issue) = +g = + 6.40% = 16%
P0 125
D1 60% of 20
Ke (after issue) = +g = + 6.40% = 16.40%
NP 120

BBQ 81
The following is the capital structure of Simons Company Ltd. as on 31.12.1998:
Equity shares (10,000 shares of `100 each) `10,00,000
10% Preference shares of `100 each `4,00,000
12% Debentures `6,00,000
`20,00,000
The market price of the company’s share is `110 and it is expected that a dividend of `10 per share
would be declared for the year 1998. The dividend growth rate is 6%.

(i) If the company is in the 50% tax bracket, compute the WACC.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of
`10,00,000 bearing 14% rate of interest, What will be the company’s revised weighted average cost of
Capital? This financing decision is expected to increase dividends from `10 to `12 per share. However,
the market price of equity share is expected to decline from `110 to `105 per share.

Answer
(i) Calculation of Weighted Average Cost of Capital
WACC (Ko) = KeWe + KpWp + KdWd
= 15.09% × 10 + 10% × 4 + 6% × 6 = 11.35%
20 20 20
 FM BOOSTER BATCH 121
D1 10
Ke = +g = + .06 = 15.09%
P0 110

Kp = Rate of preferential dividend [FV = NP] = 10%

Kd = I (1 - t) = 12% (1 – 0.50) = 6%

(ii) Calculation of Revised WACC

Revised WACC (Ko) = KeWe + KpWp + KdWd + KTLWTL
= 17.43% × 10 + 10% × 4 + 6% × 6 + 7% × 10 = 10.68%
30 30 30 30

D1 12
Revised Ke = +g = + .06 = 17.43%
P0 105

KTL = I (1 - t) = 14% (1 – 0.50) = 7%

BBQ 82
Following are the information of TT Ltd.:
Particulars
Earnings per share `10
Dividend per share `6
Expected growth rate in dividend 6%
Current market price per share `120
Tax rate 30%
Requirement of additional finance `30,00,000
Debt Equity ratio (for additional finance) 2:1
Cost of Debt:
0 – 5,00,000 10%
5,00,001 – 10,00,000 9%
Above 10,00,000 8%

Assuming that there is no Reserve and Surplus available in TT Ltd.

You are required to:

(a) Find the pattern of finance for additional requirement.
(b) Calculate post tax average cost of additional debt.
(c) Calculate cost of equity.
(d) Calculate overall weighted average after tax cost of additional finance.

Answer
(a) Pattern for additional requirement: Total requirement of additional fund is `30,00,000. With a Debt
Equity ratio of 2 : 1. It means `20,00,000 is to be raised through debt and `10,00,000 through equity. Out
of `20,00,000 debt, first `5,00,000 @10%, next `5,00,000 @9% and remaining `10,00,000 @8%. Entire
equity finance of `10,00,000 through issuing equity shares.

(b) Post tax average cost of additional debt:

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 9% (1 – 0.30) = 6.30%

Kd3 = I (1 - t) = 8% (1 – 0.30) = 5.60%

Average Kd = Kd1Wd1 + Kd2Wd2 + Kd3Wd3

= 7% × 5/20 + 6.30% × 5/20 + 5.60% × 10/20 = 6.125%
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(c) Cost of Equity:
D1 6 (1 + 0.06 )
Ke = +g = + 0.06 = 11.30%
P0 120

(d) Overall WACC after tax of additional finance:

Ko = KeWe + KdWd = 11.30% × 10

+ 6.125% × 20
30 30
= 7.85%
Assumption: DPS is treated at Do.

BBQ 83
As a financial analyst of a large electronics company, you are required to determine the weighted average cost
of capital of the company using (a) book value weights and (b) market value weights. The following
information if available for your perusal.

The company’s present book value capital structure is:

Debentures (`100 per debenture) `8,00,000
Preference shares (`100 per share) `2,00,000
Equity shares (`10 per share) `10,00,000

All these securities are traded in capital markets. Recent price are:
Debentures `110 per debenture
Preference shares `120 per share
Equity shares `22 each

Anticipated external financing opportunities are:

(i) `100 per debenture redeemable at par, 11% coupon rate, 4% floatation cost, 10 years of maturity, sale
price, `100.
(ii) `100 per preference share redeemable at par, 12% dividend rate, 5% floatation cost, 10 years of
maturity, sale price, `100.
(iii) Equity share has `2 floatation cost and sale price per share of `22.

In addition, the dividend expected on the equity share at the end of the year is `2 per share with annual growth
of 7%. The firm has a practice of paying all earnings in the form of dividends. Corporate Income-tax rate is
35%.

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particular Book Value Weight Cost (K) Weighted cost
11% Debenture 8,00,000 0.40 7.70% 3.080%
12% Preference share 2,00,000 0.10 12.82% 1.282%
Equity Share Capital 10,00,000 0.50 17.00% 8.500%
Total 20,00,000 1.00 WACC 12.862%

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost (K) Weighted cost
11% Debenture 8,80,000 0.265 7.70% 2.041%
12% Preference share 2,40,000 0.072 12.82% 0.923%
Equity Share Capital 22,00,000 0.663 17.00% 11.271%
Total 33,20,000 1.000 WACC 14.235%

Working notes:
 FM BOOSTER BATCH 123
D1 2
Ke = g =  0.07 = 17%
P0  F 22  2

 RV  NP   100  96 
I 1  t     11 1  0.35    
Kd =  n  × 100 =  10  × 100 = 7.70%
RV  NP 100  96
2 2
 RV  NP   100  95 
PD    12   
Kp =  n  × 100 =  10  × 100 = 12.82%
RV  NP 100  95
2 2

BBQ 84
Calculate the WACC using the following data by using:
(a) Book value weights
(b) Market value weights

The capital structure of the company is as under:

Debentures (`100 per debenture) `5,00,000
Preference shares (`100 per share) `5,00,000
Equity shares (`10 per share) `10,00,000

The market prices of these securities are:

Debentures `105 per debenture
Preference shares `110 per share
Equity shares `24 each

Additional information:
(i) `100 per debenture redeemable at par, 10% coupon rate, 4% floatation cost, 10 years of maturity. The
market price per debenture is `105.
(ii) `100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost, 10 years of maturity.
(iii) Equity share has `4 floatation cost and market price per share of `24.

The next year expected dividend is `1 per share with annual growth of 5%. The firm has a practice of paying
all earnings in the form of dividends. Corporate tax rate is 30%. Use YTM method to calculate cost of
debentures and preference shares.

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particular Book Value Weight Cost (K) Weighted cost
10% Debenture 5,00,000 0.25 6.89% 1.72%
5% Preference share 5,00,000 0.25 4.09% 1.02%
Equity Share Capital 10,00,000 0.50 10.00% 5.00%
Total 20,00,000 1.00 WACC 7.74%

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost Weighted cost
10% Debenture 5,25,000 0.151 6.89% 1.04%
5% Preference share 5,50,000 0.158 4.09% 0.65%
Equity Share Capital 24,00,000 0.691 10.00% 6.90%
Total 34,75,000 1.000 WACC 8.59%

Working notes:
 FM BOOSTER BATCH 124
D1 1
(a) Ke = g =  0.05 = 10%
P0  F 24  4

(b) Cost of Debt (Kd):

Calculation of IRR/Kd
NPVL 14 .65
IRR/Kd = LR + × (H - L) = 5% + × (7% - 5%)
NPVL  NPVH 14 .65  (  0.83)
= 6.89%

Calculation of NPV at discount rate of 5% and 7%

Present Value Present Value
Year Cash Flow
5% DCF 7% DCF
0 105 – 4% of 105 1.000 (100.80) 1.000 (100.80)
1 - 10 10 (1 – 0.30) 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83

(c) Cost of Preference shares (Kp):

Calculation of IRR/Kd
NPVL 9.25
IRR/Kd = LR + × (H - L) = 3% + × (5% - 3%)
NPVL  NPVH 9.25  ( 7.79 )
= 4.09%

Calculation of NPV at discount rate of 3% and 5%

Present Value Present Value
Year Cash Flow
3% DCF 5% DCF
0 110 – 2% of 110 1.000 (107.80) 1.000 (107.80)
1 - 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79

BBQ 85
Determine the cost of capital of Best Luck Limited using the book value (BV) and market value (MV) weights
from the following information:
Sources of Fund Book Value Market Value
Equity Shares `1,20,00,000 `2,00,00,000
Retained Earnings `30,00,000 Nil
Preference Shares `36,00,000 `33,75,000
Debentures `9,00,000 `10,40,000

Additional Information:
1. Equity: Equity shares are quoted at `130 per share and a new issue priced at `125 per share will be fully
subscribed; flotation costs will be `5 per share.

2. Dividend: During the previous 5 years, dividends have steadily increased from `10.60 to `14.19 per share.
Dividend at the end of the current year is expected to be `15 per share.

3. Preference Shares: 15% Preference shares with face value of `100 would realise `105 per share.

4. Debentures: The company proposes to issue 11 year 15% debentures but the yield on debentures of
similar maturity and risk class is 16%; flotation cost is 2%.

5. Tax: Corporate tax rate is 35%. Ignore dividend tax.

 FM BOOSTER BATCH 125
Floatation cost would be calculated on face value.

Answer
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares `1,20,00,000 0.615 0.1850 0.1138
Retained Earnings `30,00,000 0.154 0.1754 0.0270
Preference Shares `36,00,000 0.185 0.1429 0.0264
Debentures `9,00,000 0.046 0.1095 0.0050
Total `1,95,00,000 1.000 WACC 0.1722

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particulars Market Value Weight (W) Cost (K) Weighted cost
*Equity Shares `1,60,00,000 0.655 0.1850 0.1212
*Retained Earnings `40,00,000 0.164 0.1754 0.0288
Preference Shares `33,75,000 0.138 0.1429 0.0197
Debentures `10,40,000 0.043 0.1095 0.0047
Total `2,44,15,000 1.000 WACC 0.1744

Working notes:
D1 15
Ke = g = + 6% = 18.50%
P0  F 125 −5

5 14.19
g = √ = 6%
10.60

D1 15
Kr = +g = + 6% = 17.54%
P0 130

RV−NP 100−91.75
I (1−t) + ( ) 15 (1−0.35) + ( )
n 11
Kd = RV + NP × 100 = 100 + 91.75 × 100
2 2
= 10.95%

PD 15
Kp = × 100 = × 100 = 14.29%
NP 105

Interest 15% of 100

MV of Debenture = = × 100 = `93.75
Market rate of Interest 16%

NP of Debenture = MV of Debenture – Floatation Cost

= `93.75 - `2 (2% of `100) = `91.75

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures
at discount.

Market value of Equity Shares = `2,00,00,000 × 120/150 = `1,60,00,000

Market value of Retained Earnings = `2,00,00,000 × 30/150 = `40,00,000

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

BBQ 86
ABC Ltd. has the following capital structure, which is considered to be optimum at on 31st March, 2022:
14% debenture `30,000
 FM BOOSTER BATCH 126
11% preference share capital `10,000
Equity share capital (10,000 shares) `1,60,000

The company's share has a current market price of `23.60 per share. The expected dividend per share
in next year is 50 percent of the 2021 EPS. The EPS of last 10 years is as follows. The past trends are expected
to continue:

Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
EPS (`) 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.15 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is `96. Preference shares `9.20 (with dividend of `1.1 per share) were also issued. The company is
in 50% tax bracket.

(i) Calculate the after tax (a) Cost of New Debts, (b) Cost of New Preference Share, and (c) Cost of New
Equity Share (assuming new equity from retained earnings).
(ii) Calculate the marginal cost of capital when no new share was issued.
(iii) Determine the amount that can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year's investment are 50% of 2021.
(iv) Compute marginal cost of capital when the fund exceeds the amount calculated in (iii), assuming new
equity is issued at `20 per share?

Answer
(i) (a) After tax cost of new debt
I(1  t ) 16(1  .50)
Kd = × 100 = × 100 = 8.33%
NP 96

(b) After tax cost of new preference shares

PD 1.10
Kp = × 100 = × 100 = 11.96%
NP 9.20

(c) Cost of new equity or cost of retained earnings

D1 2.36  50%
Kr = +g = + 0.10 = 15%
P0 (old ) 23.60

(ii) MCC (Ko) when no new equity share was issued:

KdWd + KpWp + KrWr = 8.33% × .15 + 11.96% × .05 + 15% × .80 = 13.85%

(iii) The company can pay the following amount before issue of new shares:

Equity (retained earnings in this case) = 80% of the total capital

11 ,800
Therefore, investment before new issue = = `14,750
80 %
Retained earnings = `2.36 × 50% × 10,000 = `11,800

(iv) MCC (Ko) when funds exceeds `14,750

KdWd + KpWp + KeWe = 8.33% × .15 + 11.96% × .05 + 15.90% × .80 = 14.57%

If the company pay more than `14,750, it will have to issue new shares. The cost of new issue of
ordinary share is:
 FM BOOSTER BATCH 127
D1 1.18
Ke = +g = + 0.10 = 15.90%
P0 ( new ) 20

WN: Calculation of growth:

Growth from year 2012 to 2013 = (1.10 – 1.00) ÷ 1.00 = 10%
[Same rate of growth is found in future years]
 FM BOOSTER BATCH 128

IMPORTANT NOTES