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cost of capital questions financial management
1. 1111.tlbadon- 18
r
The following is the capital structure and the firms expected after tax component co .
various source offinance.
sts Of the
SourcesofFinance
Equity Share Capital
Retained Earnings
Amount
6,50,000
2,50,000
Preference Share Capital 1,50,000
DebtCapital 4,50,000
Calculate the weighted average costofcapital.
ExpectedAftertaxco~(%)
20
20
15
12
2. 501,,t1on:
Calculation ofWeighted Average Cost
sourceofFunds Amount Proportion Aftert.axcost Product
(f)
w X xw
Equity share capital 6,50,000
43.33 20 866.6
p.etainecl Earnings 2,50,000
16.67 20 333.4
preference Share Capital 1,50,000
10 15 150
oebtcapital 4,50,000
30 12 360
Total 15,00,000 100 1710
. :EXW 1,710
Weighted average costofcapital= :EW =
100 = 17.1o/o
~-11
Acompanyhasthe following capital structure. Find outtheweighted average cost ofcapital.
- securities Book Value Aftert.axcost
-
- Equity
10,00,000 12%
Retained earnings 4,00,000 8%
Preference capital 4,00,000 14%
Debentures 8,00,000 5%
26,00,000
-
Statement Showing Weighted Average Costofcapital
securities Proportion Aftertax WeightedAverage Cost
Equity 38 12% (38x.12) = 4.56
Retained earnings 15 8% (15x.08) =1.20
Preference Shares 15 5% (lSx.05) =0.75
Debentures 32 5% (32x.0S) =1.60
100 8.11
Weighted Average cost=8.11%
~
Afirm hasthefollowing capital structureand aftertaxcostfordifferentsourcesoffunds used.
SourceofFunds Amount AfterTax Cost
Debt 15,00,000 5%
Preference Shares 12,00,000 10%
EquityShares 18,00,000 12%
Retained Earnings 15,00,000 11%
Total 60,00,000
You arerequired to computetheweighted averagecostofcapital.
3. Solution:
calculation of Weighted Average Cost
Source ofFunds Amount Proportion After Tax Cost Product
((') w X xw
Debt 15,00,000 25 5 125
Preference Shares 12,00,000 20 10 200
Equity Shares 18,00,000 30 12 360
Retained Eamings 15,00,000 25 11 275
-
Total 60,00,000 100 960
. 1:XW 960
We,ghtedaveragecostofcapital= 1:W = 100
=9.6%
4. zzsr:·srv
~ . .
~ Yhas on Its bookstllefollowing amounts andspecificcostsofeach type ofcapital.
rypeofCiJpital Book Value MarketValue SpedficCosts(%)
oebt 4,00,000
3,80,000
preference 1,00,000
1,10,000
EQUltY 6,00,000
12,00,000
Retained Earnings 2,00,000
13,00,000 16,90,000
oetermlnethe weighted average cost of capital using:
~) eookValue Weights and
5
8
15
13
{,) MarketValue Weights
How are they differing? Can you think of a situation where the weighted average cost of capital
wouldbethe same using either ofthe weights?
Computation of Weighted Average Cost of Capital
using Book Value Weights
Type ofcapital Amount Proportion (w) SpecificCost(%) (x)
Debt 4,00,000 30.77 5
Pre.ferenCe Shares 1,00,000 7.69 8
Equity Shares 6,00,000 46.15 15
Retained Earnings 2,00,000 15.39 13
13,00,000 100
LXW 1,108
Welghtedaveragecostofcapital = "i.W =100= 11.08%
Computation ofWeighted Average Cost of Capital
using MarketValue Weights
Tn,edOJpital Amount Proportion (w) SpedficCost(%) (x)
Debt 3,80,000 22.5 5
P:nlaaa Shares 1,10,000 6.5 8
--Shares 9,00,000 53.25 15
.._lidEarnings 3,00,000 17.75 13
16,90,000 100
"f,XW ~195
'lllll4liCl~ecostofcapltal = r.w = 100 = 11.95%
Product xw
154
62
692
200
1108
Product xw
113
52
799
231
1195
5. T Ltd. has the following capitalstructure:
Equity Snares cap:tai (10 laKhsshares)
Retained Eamf.1gs
14% Debentures (70,000 Debentures)
16%Term Loan
f (lakhs)
100
130
70
--~
40Q
--
. rhl shares is t' 25. The next expected dividend per share ls~ 2 an~
The marl<e'" pnce pay per eou,...,
' ' Th d b tu'"eS are redeemable aftersix years at par and the current market
expected to grow at 8%. e e en .
. ooA
tatfon rsr 90 per debenture. The tax rate applicable to the firm rs 5 o.
QUO
.
. • hted average cost ofcapital of the company using marketvalues
You are reouired ~.o compute werg
as weignts.
Solutfon:
~ c:; (2/25}+8%=8%+8%= 16%
K =Ke= 16%
~1 (Debenture)= [14(1-0.5) + (100-90)/6] + (100 + 90)/2 =9.12%
Kd7
(Term Loan)= 16%(1-0.5) = 8%
StatementShowing WACC
CiJpitalStructure
I Amount I Weights(W) Costof WACC- LK-
w
'
(rln /akhs) I Capltal(K)
-
Equity
100 I 0.25 16% 4%
Reserves
130 I 0.325 16% 5.2%
I
9.12% 1.596%
Debentures 70 j 0.175
I
0.25 8% 2%
Tenn Loan
100 I
Total
400 1.00 - 12.796%
IU..,alfon~at
Swan Ltd. has assets off 3,20,000 whidt has been financed with t' 1,04,000 ofdebt, t' 1,80,000of
equity and a genera/ reserve oft'36,000. The company's total profit afterinterestand taxes for the year
ended 31.3.2021 were r 27,000. It pays8% interest on borrowed funds and is In the 30% tax bracket. rt
has 1800 equity shares ofr100 pershare presently selling ata market price oft' 120 per share. What ;
5
the weighted average costofcapita/ ofSwan Ltd.
Solution:
EPS =PAT/No.ofequityshares= 27,000/1800 = f 15
Therefore, CostofEquity= (EPSJMPS) = 15/120 = 12.5%
CostofDebt= Interestrate(l -Tax Rebate)= 8%(1-0.30) = 5.6%
CostofRetained Earning = CostofEquity= 12.5%
6. Statement showing WACC under Book Value
sources Amount(r) Weights(W) Cost of WACC-. W.K
Capiti3I (K)
equltY 1,04,000
0.325 12.5% 4.06%
Retained Earning 36,000 0.113 12.5% 1.41%
oebt capital 1,80,000
0.562 5.6% 3.15%
rotal 3,20,000
1.00 - 8.62%
Statementof WACC under MarketValue
sources Amount(() Weights(W) Costof WACC= W.K
Capital (K)
- 2,16,000
6.25%
EqUitY
0.50 12.5%
Retained Earning 36,000 0.08 12.5 1.00%
pebt capital 1,80,000 0.42 5.6% 2.35%
Total 4,32,000 1.00 - 9.60%
- Note: Since market value of equity shares becomes~ 2,16,000 (120 x 1800). So, increase in the
value of equity shares by f 1,12,000(2,16,000 - 1,04,000) shall be treated as securities premium and
hence may be added to the value of reserves and surplus. Hence, the market value of Equity Shares
and reserves & surplus may be taken as f 1,04,000 and~ 1,48,000 respectively while calculating WACC
and Its weights(W) may change accordingly. But as Ke and Kt are equal here, so overall cost of capital
(WACC) at market value is unaffected and remain 9.60%.
-•tM&
The capital structure ofBombayTraders Ltd. as on 31.3.2021 is as follows:
Equity capital: 100 lakh equityshares off 10 each
Retained earnings
14%debentures
~ incrores
10
2
3
Forthe year ended 31.3.2021 the company has paid aequity dividend at 20% and the growth rate
Is 5% every year. The equity shares are traded at ~ 80 per share in the stock exchange. Tax rate
applicableto the company is 40%. Calculate the current weighted average cost ofcapital.
Solution:
(a) Cost ofequity capital
01 = 20(1 +0.5)
Ke = 01 x 100 + G =
21
x 100 + 5 =26.25+5=31.250/o
MP 80
(b} Costofdebentures (afterTax)
Kd =J:....(1 - t) =14 (1-0.4) =8.4%
a NP
(c) Costof retained earnings
Kr =k (1-t )(1-b)=31.25(1-04)(1-0)=31.25(0.6)=18.75
e P
7. Oomputatlon of WACC
V" !IC
Wd{lht
r re-.
R (am 'lv
]4~0~!K' t ~
JO
0 61
2
0 13
J
02
1S
~-·~-·.
Kl !'l n um.:u~d wzs.~ to ralse edd ttonal finance oft' 20 lakh ror meeting Its in
has, 4 70 000
tn the ram, 0
1 r:ctal!led cam ngs aV"a1lablc for Investment purpose 1 ..,~unl!nt
, ,
s. hct P~
mave? .lah;.c
Ollo""'ng<I!.
1, Oclr. /equJymtx 30%: 70%
~
2. Cost of dclJt u:tu>, 3,60,000 - 10% (Beforetax)
Costa' deot beyond, 3,60,000-16% (Before tax)
3 E.am ngs pershare: 4
,=, Oh dend payo;;t~ 50% of earnings
S E.Xt>ectedgrowttirateo1 dMdend: 10%
6. Cument market p:i.ce: 44
7. Tax rate: 50%
Yov arerequired:
n) lo determine the pattern for raisfng the additional finance.
b) To determine the post-tax average costofadditional cost.
c} lo determine the cost of retained earnings and cost ofequity.
d) Compute the overall weighted average after tax cost ofadditional finance.
Solution:
a) Pattern for raising the addltlonal finance
Dcbitors 30% off 20,00,000 = 6,00,000
Equlty70% oft 20,00,000 = 14,00,000
20,00,000
The pattern offinanang with costs
Sources
Amount(()
Debt
Debt
Retained earnings
Equity (14,00,000-4,20,000)
b) Poat tax average cost of additional debt:
Formula: Kd (1-t)
Kd • 3,60,000@ 10% = 36,000
= 2.40,000@ 16% = 38,400
6,00,000 74,400
3,60,000
2,40,000
4,20,000
9,80,000
20,00,000
Cost
10%
16%
8. Cost II:?
74,1100
f>,oo,000 x Joo 12..'1%
PoS
t-tax aver c.1ge cost of debt • 12.4 (1 -0 r>) 6. I%
c) cost of retained earnInga:
D1
Ke"" R +g
o 10% Hcnc.~,atttie
The dividend payout ratio is 50% of~ 4 i.e. ~ 2.00 per share. Growth rate being .
end ofthe year, dividend wtll be-= t 2+l0% -~
2
.
20
2.20
Kr= 44 +O.lO==o.so+o.10-o.1sor1S%
d) weighted Average After tax cost of Add"tl Ifl
1 ona nance:
-
sources Amount Proportion
-
oebt 6,00,000 30.0%
Retained Earnings 4,20,000 21.0%
equity 9,80,000 49.0%
- 20,00,000 100
-
~n-27
MN Ltd. has the following capital structure:
Equityshare capital (20,000) shares , 40,00,000
10% Preference share capital t 10,00,000
14% Debentures t 30,00,000
80,00,000
WACC
Aftertax cost
0.3 X 6.2-l.86
6.2%
15.0% 0.21 X 15=3.15
15.0% 0.49 X 15""'7.35
12.36
The share of the company sells fort 20. It is expected that the company will pay next year a
dividend oft 2 per share which will grow at 7% forever. Assume 50% tax rate.
a) Compute the weighted average cost ofcapital based on the existing capital structure.
b) Compute the new Weighted Average Cost of capital if the company raises an additional t
20,00,000 debt by issuing 15% debentures. This would increase the expected dividend to~ 3 and
leave the growth rate unchanged butthe price ofshare will fall tot 15 per share.
Solution:
(a) WACC: Existing Capital Structure:
After-taxcost Weights Weighted Cost
Ordinary 0.17* 0.500 0.0850
10% Preference 0.10 0.125 0.0125
14% Debentures 0.07 0.375 0.0262
WACC 0.1237
or12.37%
*Cost of ordinary share is:
ke = (DIVl/Po) +g =(2/20) +0.07 =0.17
9. (b) W~CC: NewC.pltalStnlcture:
After- Weights Weight;;
taxcost
Amounts
______J--:-:-:-:::::--t--;:;:-:;:;;:--1-~~1--~Cost
Ordinary 40,00,000 0.27* 0.40 0,108
10% Preference 10,00,000 O.lO O.lO 0,010
14% Debentures 30,00,000 o.o
7 o.
3
o 0,021
~----1:.::.S...:%:...:D:::.:e::b.:en:t:ure=.s__..L_...:2::.:o::,o:....o.:..,o_o_o_...1---o-._o
7
_
5
_ __.____o_._
20
_t-__o.a15
WACC
0,1S4
--------------------------..L-._o_r1s,4%
*Cost ofordinary share Is.
ke = (DIVl/Po) +g= (3/15) +0.07 =0.20 +0.07 =0.27
m,,~
Klshan Limited wishes to raise additional finance of? 20 lakh for meeting its investment pl
ans It
has, 4,20,000 In the form ofretained earnings available forInvestmentpurposes. Thefollowing d ·
are available.
etaus
1. Debt/equity mix 30%: 70%
2. Costofdebtupto t 3,60,000-10% (Before tax)
Costofdebtbeyond t 3,60,000 - 16% (Before tax)
3. Earning pershare: 4
4. Dividend payout: 50% ofearning
5. Expected growth rate ofdividend: 10%
6. Current marketprice: 44
7. Tax rate: 50%
You are required:
a) To determine the pattern forraising the additional finance.
b) To determinethe post-tax average costofadditional cost.
c) To determine the costofretained earnings and costofequity.
d) Compute the overall weighted averageaftertax costofadditional finance.
•
Solution:
a) Pattern for raising the additional finance:
Debitors 30% on 20,00,000
Equity 70% on 20,00,000
The pattern offinancing with costs
Source
Debt
Debt
Retained earnings
Equity(14,00,000 -4,20,000)
Amount(()
3,60,000
2,40,000
4,20,000
9,80,000
20,00,000
= 6,00,000
= 14,00,000
20,00,ooo
-
Cost
10%
16%
10. b) Post tax average cost of additional debt:
Formula: Kd (1-t)
Kd = 3,60,000@ 10% = 36,000
= 2,40,000 @ 16% = 38,400
6,00,000 74,400
74,400
Cost= G,O0,000 X 100 = 12.4%
Post-tax average cost of debt = 12.4 (1-0.5) = 6.2 %
c) Costof retained earnings:
D1
Ke= Po+g
Toedividend pay outratio is 50% oH 4 i.e., 2.00 pershare. Growth rate being 10%.Hence, atthe
end ofthe year, dividend will be=, 2+10% = 2.20
2.20
Kr=
44
+0.10 =0.50+0.10 = 0.15 or 15%
d) Weighted Average After tax cost of Additional finance:
sources Amount Proportion A~ertax cost WACC
Debt 6,00,000 30.0% 6.2% .3x6.2=1.86
Retained Earnings 4,20,000 21.0% 15.0% .21x15=3.15
Equity 9,80,000 49.0% 15.0% .49x15=7.35
20,00,000 100
12.36
As a financial analyst of a large electronics company, you are required to determine the weighted
average cost of capital (WACC) of the company using (a) book value weight and(b) market value
weights. Toefollowing information is available for your perusal:
The company's present books value capital structure is
Preference shares Cf 100 pershare) f 2,00,000
Equity shares c,10 pershare) , 10,00,000
Debentures (f 100 pershare) f 8,00,000
Anticipated external financing opportunities are:
(I) , 100 per debenture redeemable at par; 10 years maturity, 13% coupon 4% flotation costs, sale
price~ 100
(ii) , 100 preference shares redeemable at par; 10 years maturity; 14% dividend rate, 5% floation
costs, sale price t 100.
(iii) Equityshares;, 2 persharefloation costs, sale price att' 22.
In addition, the dividend expected on the equity shares at the end of current year is f 2 and the
eamingsareexpected to increase by7% p.a. Thefirm has policy of paying all its eaming sin the form of
dividends. the company's corporate tax rate is 50%.
11. Solllf:ion:
f
I{i-t)-il_
Cost ofdebt (kd) = F·, · S'J
2
4
13{1-0.5)- ;-;;-
L ~ 6.5-0 ~ -~
iOO - 96
2
i(d = 7.04%
F
D-~
Costofprefshares (kp) = Fv - SV
2
Kp= 14.87%
= 58 - 98
= 100-95
2
3- ·G -
2
-0 07 = o.:-0.07
Cost of Equity (ke) = Po - F - - (22 - 2; ·
Ke = 0.17 or 17%
WACC using bookvalue weight
Capital Cost
Boolc-1a i..S
I
8,0G,000
Debt entry 7.04% 8,00,000 7.04X 2C.C0,03:
2,c:,eoo
Shares 14.87% 2,00,000 14·82 x 2C.GC,ODO
:0,00,000
Equity Shares 17% 10,00,000 17x 20,00,oon
WACC using book value is 12.803
-
= 2.6:5
=: .!-S/
=55
WAW using market value weight cannot be calculated as mari<e: va,...e o-- :ec-e-:-_:'E =-:
preference shares is not available in the question.
Illustration-30
From the following capital structure ofa company, calailate the overall cost ofca:,~ -S -;:
i) Book value weights and
ii) Marketvalue weights.
Source Book value Man<.e~ r'c.t.e
Equity share capita1 (~ 10 shares) ~ 45,000 ?9C.J00
Retained earnings ~ 15,000 ~:.
Preference share capital ~ 10,000 f 10,00J
Debentures t 30,000 ~ 30,000
The after tax cost of different source of finance is as follows : Equity snare ca:,itaf l .!% ~er= -e,.:
earnings 13% preference capital 10%. Debentures 5%
12. SOiution:
I) overall cost ofca 1
P tal using Book value weights
securities
Equity
Retained earnings
preference share capital
Debentures
Weighted average cost
Proportion
45
15
10
30
Aftertax(%)
14
13
10
5
II) overall cost of capital using Market value weights
securities Proportion
~~~ 69
Retained earnings
preference share capital
Debentures
~~•31
7.6
23
Aftertax(%)
14
13
10
5
WACC
45 X 0.14 == 6.3
1Sx0.13 ==
1,95
10 X 0.10 == 1
30 x0.05 == LS
10.75
WACC
9.66
0.76
1.15
11.57
Alpha Ltd. hasthe following capital structure as per its Balance Sheet as at 31.3.2021:
Equityshare capital (fully paid share of~ 10 each)
18% Preference share capital (fully paid share oft 100 each)
Reserves and surplus
12.5%debentures (fully paid debentureoft 100 each)
12% term loans
Additional information:
Inlakhs
8
6
2
16
8
40
a) The current market price of the company's share is ~ 64.25. The prevailing default risk free
interestrate on 10 yearGOI treasury bonds isS.5%. The average marketrisk premium is 8%. The
beta ofthecompany ls 1.1875.
b) The preference shares ofthe company which are redeemable after 10 years are currenty se11ing
at90 perpreferenceshare.
c) Thedebenturesofthe company which are redeemable after5 years are currently quoted at90 per
debentures.
d) Thecorporatetax rate is 30%.
Rtquireci:
Calculateweighted average cost ofcapital using
I) BookValueWeights,
MarketValue Weights
13. Solution:
w
( ACC using book value weights)
Sources of Amountof Proposition Aftertax cost
Cap{t.a/
Sources ofsources ofsources
A
B C D
Equity share capital
8 0.20 0.1500
Reserve and Surplus
2 0.05 0.1500
18% Preference shares 6 0.15 0.2000
12.5% Debentures 16 0.20 0.1000
12% Term loan 8 0.20 0.0840
40 1.00
-
Weighted averagecost ofcapital - 0.1243 or 12.43%
(WACC using marketvalue weights)
Sources of Amountof Proposition Aftertaxcost
Capital Sources ofsources ofsources
A B C D
Equity share capital 51.40 0.6425 0.1500
18% Pref. share capital 5.40 0.0675 0.2000
12.5% Debentures 15.20 0.1900 0.1000
12%Term loan 8.00 0.1000 0.0840
80 1.00
Therefore, 13.72%
(i) Costof equity (ke) = Ri+ ~ (Average market risk)
=5.5% +1.875 (8%) =15%
(ii) Costofretained earnings (kr) =Ke= 15%
(iii) Cost of 18% preference share
= Preference dividend +(Reedemable value - Net sale proced)/w
(Redeemable value + Net sale proced)/2
18 + (100 - 90) / 10 18 + 1
= (100- + 90) I 2 = 95 = 0.20 or20%
(iv) Cost of 12% term loan
Interest (1- Tax rate)
= Net sale proceeds
96,000 (1 - 0.30)
= 8,00,000 =o.oa4
Product
E=CxD
0.0300
0.0075
0.0300
0.0400
0.0168
Product
~
E=CxD
0.09637
~
0.0135
0.0190
0.0084
You are required to determine the weighted average cost of capital of M/s Vinayaka Enterprises
Ltd., Bengaluru using
(i) BookValue Weights
(ii) MarketValue Weights. The company's present book value capital structure is
14. Amount (t')
Debenture (t 100 per debenture) 16,00,000
preference shares (t 100 per share) 4,00,000
Equity shares(? 10 pershare)
20,00,000
All these securities are traded in the capital markets. Recent prices are Debentures at f 110,
preference shares att 120 and equity shares at' 22. Anticipated external financing opportunities are
i) t 100 per debenture redeemable at par, 10 years maturity, 8% coupon rate, 4% floatation cost,
sale pricer 100.
fi) t 100 preference shares, redeemable at par, 15 years maturity, l0% dividend rate, 5% floatation
cost, sale price t 100.
iii) Equity shares' 2 per share floatation cost, sale price t 22. In addition the dividend expected on
equity share at the end of the year t 2 per share, the anticipated growth rate in dividends is 5%.
Thetax rate is 50%.
soJution:
1
Kd== 8 +
20 (100 - 96) 8.2
.!:_ (100 - 96) = 98
2
x l00 = B.36% = 4.18% aftertax
10 + 0.33
10 + is(100 - 95)
Kp== ! (100 + 95)
=--- = 10.5%
2
2
Ke- - X 100 + 5 =15%
- 20
sources
Debtors
Preference Shares
Equity Shares
Sources
Debtors
Preference Shares
EquityShares
97.S
BookValue
Amount Proportion
6,00,000 40%
4,00,000 10%
20,00,000 50%
40,00,000
MarketValue
Amount Proportion
8,80,000 15.9
2,40,000 4.3
44,00,000 79.7
55,20,000
Aftertax cost
11
10.5
15
WACC
Aftertax cost
4.18
10.5
15
WACC
Weighted cost
1.672
1.05
7.5
10.22%
Weighted cost
0.66
0.45
11.9
13.065%