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PRACTICE QUESTIONS
COST OF CAPITAL

QUESTION 1
Karatasi Ltd. had the following capital structure as at 31 December 2008.
“sh. “000”
Ordinary share capital (sh. 20 par value) 10,000
Retained earnings 12,000
12% preference share capital (sh. 10 par value) 4,800
10% debentures (sh. 1,000 par value) 7,200
34000

Additional information:
1. The current market price per ordinary share, preference share and debenture is Sh.50, Sh.24 and
Sh.1,200 respectively.
2. For the year ended 31 December 2008, the company paid an ordinary dividend of Sh. 6.00 per
share. Analysts estimate that the company’s earnings and dividends will grow at an annual rate of
15 per cent indefinitely.
3. The corporation tax rate is 30 per cent.

Required;-
The company’s market weighted average cost of capital.

QUESTION 2
Jasmin Ltd. a quoted company intends to raise Sh. 14,000,000 to finance a capital project. The company
is considering issuing the following securities in order to raise the required amount.
 200,000 ordinary shares at the ex- div market price subject to a 10% floatation cost per share. The
company’s issued shares are currently trading at sh. 32.40 per share cum – div. Dividends for the
year ended 31 December 2008 have not yet been paid to shareholders.
 40,000 12% debentures at the current market price of sh. 80 per debenture. The par value of each
debenture is sh. 100.
 100,000 10% preference shares at the current par value of sh. 20 per share.

The balance of the capital required would be obtained from retained earnings.

Additional information:
1. The company declared ordinary dividends over the past five years as follows:
Year ended 31 December Dividend declared
Sh. “000”
2008 24,000
2007 22,320
2006 20,500
2005 19,000
2004 18,310
2. Ordinary dividends are expected to grow into future at a rate equivalent to the average annual
growth rate over the past five years.
3. The current number of issued ordinary shares is 10 million.
4. Corporation rate of tax 30%.

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Required:
i) Ex – div market price per ordinary share.
ii) Cost of capital for each component of additional finance.
iii) Marginal cost of capital of the company.
iv) Comment on the application of the marginal cost of capital obtained in b(iii) above.

QUESTION 3
a) Distinguish between weighted average cost and marginal cost of capital.
b) The following was the capital structure of Fahari Ltd. as at 31 October 2007.

Sh.
Ordinary share capital 10.0 million
12% preference share capital (sh. 20 par) 4.8 million
10% debentures (sh. 1,000 par) 3.6 million

Additional information:
1. The market prices per ordinary share, preference share and debenture were sh. 45, and sh. 30 and
sh. 1,200 respectively on 31 October 2007.
2. The dividend per ordinary share for the year ended 31 October 2006 was sh. 8.00. Dividends are
expected to grow at an annual rate of 12 percent.
3. The rate of corporation tax is 30 per cent.

Required:
The weighted average cost of capital (WACC) of fahari Ltd. Use market value weights

QUESTION 4
a) Distinguish between the marginal cost of capital and the weighted average cost of capital.
b) Upendo Ltd. is in the process of raising additional finance. The company’s financial structure
comprises ordinary share capital, reference share capital, debenture capital and retained earnings.
Each of these sources of finance is analyzed below:

Ordinary Share Capital

 The current market price per share is Sh.80
 The company expects to pay a cash dividend of Sh.6 per share in the next financial year
 The annual rate of growth in dividend per share is 6%
 Flotation costs amounting to Sh8 per share

11% Preference Share Capital

 The par value per share is Sh.100
 The share are currently trading at par
 Flotation costs amounting to Sh.4 per share

10% Debenture Capital

 The per value is Sh1,000 for each debenture stock
 The debenture have ten-year maturity period
 The flotation cost for each debenture stock is Sh.50

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Retained Earnings
 The company expects to have Sh.225,000 of retained earnings available for the next financial
year.
 Should the retained earnings balance to exhausted, the company will use common stock as the
form of equity financing

Additional Information;-
1. The target capital structure is as follows
Source of Capital Weight
Debentures 40%
Preference Shares 15%
Equity 45%
100%

2. The corporation tax rate is 30%

Required:
i) Calculate the cost of Capital for ordinary share capital, preference share capital, debenture capital
and retained earnings
ii) Calculate the marginal cost of capital applying the target capital proportions and using retained
earnings to represent equity finance
iii) Comment on the relevance of the marginal cost of capital in (ii) above to Upendo Ltd.

QUESTION 5
a) Distinguish between compounding and discounting of cash flows.
b) Mount Elgon Ltd. is considering the launch of a new product. Exel, for which an investment of
Sh.6,000,000 in plant and machinery will be required. The production of Exel is expected to last five
years after which the plant and machinery would be sold for Sh. 1,500,000.

Additional Information:
1) Exel would be sold at Sh.600 per unit with a variable cost of Sh240 per unit
2) Fixed production costs (excluding depreciation) would amount to Sh.600,000 per annum
3) The Company applies the straight line method of depreciation
4) The cost of capital is 10% per annum
5) The units of Exel expected to be sold per annum for the next five years as shown below
Year: Units expected to be sold
1 8,000
2 7,000
3 7,000
4 5,000
5 3,000
6) The corporation tax rate is 30%

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Required:
i) Calculate the net present value (NPV) of the project and advise the management on the
appropriate course of action.
ii) Calculate the internal rate of return (IRR) of the project and advise the management on
the appropriate course of action.
iii) Outline the main drawbacks of the IRR method of investment.

QUESTION 6
a) Explain the advantages of using market value weights over book value weights in computing the
weighted average cost of capital
b) The following information was extracted from the books of Faida Limited as at 31 December 2005.
Sh.
Ordinary Share capital (par value Sh. 25) 800,000
8% Preference share capital (par value Sh.24) 600,000
10% Preference Share capital (par value Sh. 20) 400,000
10% Debenture 400,000
2,200,000

Additional Information
1. The Share prices as at 31 December 2005 were as follows:-
Market Price per share
(Sh.)
Ordinary shares 30
8% Preference Shares 20
10% Preference Shares 25
The market value of the 10% debenture on 31 December 2005 was Sh. 500,000
2. The corporation tax rate is 30%
3. The company has maintained payment of an ordinary dividend per share of Sh. 3.80 over the past
five years.

Required:
i) Cost of ordinary share capital.
ii) Cost of 8% preference share capital.
iii) Cost of 10% preference share capital.
iv) Cost of 10% debentures.
v) Market –weighted average cost of capital

QUESTION 7
a) Distinguish between the following terms.
i) Weighted average cost of capital and marginal cost of capital
ii) Finance lease and operating lease

QUESTION 8
a) Define the following finance terms
i) Term of structure of interest rates
ii) Script dividends
iii) Shares splits

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b) Zatex ltd, had the following capital structure as at 31 March 2005

Sh.
Ordinary share capital (200,000 Shares) 4,000,000
10% Preference Share Capital 1,000,000
14% Debenture Capital 3,000,000
8,000,000

Additional Information;-
1. The market price of each of ordinary share as at 31 March 2005 was Sh.20
2. The company paid a dividend of Sh.2 for each ordinary share for the year ended 31 March 2005
3. The annual growth rate in dividends is 7%
4. The corporation tax rate is 30%

Required:
i) Compute the weighted average cost of capital of the company as at 31 March 2005.
ii) The company intends to issue a 15% Sh.2 million debenture during the year ending 31 March 2006.
The existing debentures will not be affected by this issue. The dividend per share for the year
ending 31 March 2006 is expected to be Sh.3 While the average market price per share over the
same period is estimated to be Sh.15. The average annual growth rate in dividend is expected to
remain at 7%.
Compute the expected weighted average cost of capital as at 31 March 2006.

QUESTION 9
a) Highlight four uses of the cost of capital to Limited Liability Company.
b) The finance manager of Mapato limited has compiled the following information regarding the
company’s capital structure.

Ordinary Shares
The company’s equity shares are currently selling at Sh. 100 per share. Over the past five years, the
company’s dividend pay-outs which have been approximately 60% of the earnings per share, were as
follows
Year ended 30 September Dividend per Share
Sh.
2004 6.60
2003 6.25
2002 5.85
2001 5.50
2000 5.23

The dividend for the year ended 30 September 2004 was recently paid.
The average growth rate of dividend is 6% per annum
To issue additional ordinary shares, the company would have to issue at a price of Sh.3 per share and
it would cost Sh.5 in floating costs per share.

Debt
The company can raise funds by selling Sh.100, 8% coupon interest rate, 20-year bonds, on which
annual interest will be made.
The bonds will be issued at a discount of Sh.3 per bond and a floatation cost of an equal amount per
bond will be incurred.

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Capital Structure
The company’s current capital structure, which is considered optimal, is:
Sh.
Long term debt 30,000,000
Preference Shares 20,000,000
Ordinary Shares 45,000,000
Retained Earnings 5,000,000
100,000,000
The company is in the 30% tax bracket.

Required:
i) The specific cost of each source of financing.
ii) The level of total financial at which a break-even point will occur in the company’s weighted
marginal cost of capital.

QUESTION 10
a) Explain the meaning of the term “Cost of capital” and explain why a company should calculate its
cost of capital with care.
b) Identify and briefly explain three conditions, which have to be, satisfy before the use of the weighted
average cost of capital (WACC) can be justified.
c) Biashara Ltd, has the following capital structure

Sh.‘000’
Long-term debt 3,600
Ordinary Share Capital 6,500
Retained earning 4,000

The finance manager of Biashara Ltd. has a proposal for a project requiring Sh.45 million. He has
proposed the following method of raising the funds.
 Utilise all the existing retained earning.
 Issue ordinary share at the current market price.
 Issue 100,000 10% preference shares at the current market price of Sh.100 per share which is
the same as par value.
 Issue 10% debentures at the current market price of Sh.1,000 per debenture

Additional Information:
1. Currently Biashara Ltd. Pays a dividend of Sh5 per share which is expected to grow at the rate of 6%
due to increased returns from the intended project. Biashara Ltd.’s. price/earnings (P/E) ratio and
earnings per share (EPS) are Sh5 and Sh.8 respectively.
2. The ordinary share would be issued at a floatation cost of 10% based on the market price
3. The debenture par value is Sh.1,000 per debenture
4. The corporate tax rate is 30%

Required:
Biashara Ltd.’s weighted average cost of capital (WACC)

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QUESTION 11
a) Explain why the weighted average cost of capital of a firm that uses relatively more debt capital is
generally lower than that of a firm that uses relatively less debt capital.
b) The total of the net working capital and fixed assets of Faida Ltd. As at 30 April 2003 was
Sh.100,000,000. The company wishes to raise additional funds to finance a project within the next
one year in the following manner:
Sh. 30,000,000 from debt
Sh. 20,000,000 from selling new ordinary shares

The following items make up the equity of the company:

3,000,000 fully paid up ordinary shares 30,000,000

Accumulated retained earning 20,000,000
1,000,000 10% Preference shares 20,000,000
200,000 6% long term debenture 30,000,000

The current market value of the company’s ordinary shares is Sh. 30. The expected dividend on
ordinary shares by 30 April 2004 is forecast at Sh. 1.20 per share. The average growth rate in both
earnings and dividends has been 10% over the last 10 years this growth rate is expected to be
maintained in the foreseeable future

The debenture of the company has a face value of Sh. 150. However, they currently sell at their face
value.
Assume a tax rate of 30%

Required:
i) The expected rate of return on ordinary share
ii) The effective cost to the company of:
 Debt capital
 Preference share capital
iii) The company existing weighted average cost of capital.
iv) The company’s marginal cost of capital if it raised the additional Sh. 50,000,000 as intended.

QUESTION 12
(a) Explain the term “agency costs” and give any three examples of such costs.
(b) On 1 November 2002, Malaba Limited was in the process of raising funds to undertake four
investment projects. These projects required a total of Sh.20 million.

Given below are details in respect of the projects:

Project Required Initial Investment Internal Rate of Return

Shs. million (IRR)
A 7 24%
B 6 16%
C 5 18%
D 2 20%

You are provided with the following additional information:

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1. The company had Sh.5.4 million available from retained earnings as at 1 November 2002. Any
extra equity finance will have to be sourced through an issue of new ordinary shares.
2. The current market price per share on 1 November 2002 was Sh.22.40, ex-dividend information on
Earnings Per Share (EPS) and Dividends Per Share (DPS) over the last 6 years is as follows:

Year ended 31 October 1997 1998 1999 2000 2001 2002

EPS (Sh.) 4.20 4.40 4.65 4.90 5.15 5.26

DPS (Sh.) 2.52 2.65 2.80 2.95 3.10 3.22

3. Issue of new ordinary share would attract floatation costs of Sh.3.60 per share.
4. 9% Irredeemable debentures (par value Sh.1,000) could be sold with net proceeds of 90% due to a
discount on issue of 8% and floatation costs of Sh.20 per debenture. The maximum amount
available from the 9% debentures would be Sh.4 million after which debt could be obtained at 13%
interest with net proceeds of 91% of par value.
5. 12% preference shares can be issued at par value Sh.80.
6. The company’s capital structure as at 1 November 2002 which is considered optimum is:
Ordinary share capital (equity) 45%
Preference share capital 30%
Debentures 25%

5. Tax rate applicable is 30%.

6. The company has to use internally generated funds before raising extra funds from external
sources.

Required:
(i) The levels of total new financing at which breaks occur in the Weighted Marginal Cost of
Capital (WMCC) curve.
(ii) The weighted marginal cost of capital for each of the 3 ranges of levels of total financing as
determined in (i) above.
(iii) Advise Malaba Limited on the projects to undertake assuming that the projects are not
divisible.

QUESTION 13
(a) Explain fully the effect of the use of debt capital on the weighted average cost of capital of a
company.
(b) Millennium Investments Ltd. wishes to raise funds amounting to Sh.10 million to finance a
project in the following manner:
Sh.6 million from debt; and
Sh.4 million from floating new ordinary shares.

The present capital structure of the company is made up as follows:

1) 600,000 fully paid ordinary shares of Sh.10 each

2) Retained earnings of Sh.4 million
3) 200,000, 10% preference shares of Sh.20 each.
4) 40,000 6% long term debentures of Sh.150 each.

The current market value of the company’s ordinary shares is Sh.60 per share. The expected
ordinary share dividends in a year’s time is Sh.2.40 per share. The average growth rate in both

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dividends and earnings has been 10% over the past ten years and this growth rate is expected to
be maintained in the foreseeable future.

The company’s long term debentures currently change hands for Sh.100 each. The debentures
will mature in 100 years. The preference shares were issued four years ago and still change hands
at face value.

Required:
(i) Compute the component cost of:
Ordinary share capital;
- Debt capital
- Preference share capital
(ii) Compute the company’s current weighted average cost of capital.
(iii) Compute the company’s marginal cost of capital if it raised the additional Sh.10 million as
envisaged. (Assume a tax rate of 30%).

QUESTION 14
(a) Kitunda Ltd. has estimated the cost of debt and equity for various financing gearing levels as follows:
(b)
Proportion of debt Required rate of return
Capital Debt % Equity %
0.9 9.4 37
0.8 8.2 36
0.7 7.4 35.5
0.6 6.9 29.1
0.5 6.6 25.2
0.4 6.4 20.4
0.3 6.2 15.6
0.2 6.1 13.5
0.1 6 13.1
0 - 13

Required:
(i) The optimal capital structure.
(ii) Kitunda Ltd. wishes to transform from its optimal gearing level to all-equity financed firm.
Modigliani and Miller's model with no taxes to determine the equity cost of capital.

(c) Explain the meaning of the “pecking order theory”.

QUESTION 15
b) Baba Ltd and Toto Ltd are firms operating in the same industry and are considered to be in the same
risk class. Each firm has an operating profit of sh. 250,000,000 per annum. The capital structures of
the firms are as follows:

Baba Ltd Toto Ltd

Sh. “million” Sh. “million”
Equity (market value) 1,750 1,000
8% debt (Trading at par) - 1000
1,750 2,000

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The two companies have a 100% dividend payout ratio.

Required:
i) The weighted average cost of capital (WACC) of each of the two firms
ii) Comment of the equilibrium position of the equity shares, of the two firms.
iii) Advise Alusa, who holds 4% of Toto Ltd’s equity shares, on the arbitrage opportunities available
to him (ignore taxation).

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