Topic Cost Of Capital.pdf

c The entire share capital of a company consists of 1,00,000 equity shares of Rs.. Estimate the weighted average cost of capital WACC based on market values.. b Recalculate WACC if the e

Capital

16.1 i) Cost of Debt (X Ltd.) 8 16.2 ii) Cost of Preference Capital (Y Ltd.) 9

17.1 a) Cost of Preference Share Capital 9 17.2 b) Cost of Preference Share Capital 9 17.3 c) Cost of Equity Capital 10

20 Problem 5 11

20.1 a) WACC (Book Value, No Tax) 11 20.2 b) WACC (Market Value) 11 20.3 c) WACC with 40% Tax 11

22.1 a) Existing WACC 12 22.2 b) New WACC 13 22.3 c) WACC with 10% Growth 13

23.1 i) Earnings Per Share 13 23.2 ii) Cost of Capital 14

25.1 a) Existing WACC 14 25.2 b) New WACC 15 25.3 c) WACC with 10% Growth 15

26.1 i) Cost of Equity and WACC 15 26.2 ii) New WACC 16

28.1 a) Current WACC 17 28.2 b) New WACC 17

Part I

Questions

1 Problem 1

i) X Ltd issues 12% Debentures of face value Rs 100 each and realizes Rs

95 per Debenture The Debentures are redeemable after 10 years at a pre-mium of 10% Calculate the cost of debt

ii) Y Ltd issues 14% preference shares of face value Rs 100 each at Rs 92 per share The shares are repayable after 12 years at par Calculate the cost of preference capital

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

2 Problem 2

a) A company raised preference share capital of Rs 1,00,000 by issuing 10% preference shares of Rs 10 each Find the cost of preference share capital when issued at (i) 10% premium, and (ii) 10% discount

b) A company has 10% redeemable preference shares redeemable at the end

of the 10th year from the date of issue Underwriting expenses are expected

to be 2% Find the effective cost of preference share capital

c) The entire share capital of a company consists of 1,00,000 equity shares

of Rs 100 each Its current earnings are Rs 10,00,000 p.a The company wants to raise additional funds of Rs 25,00,000 by issuing new shares with

a 10% flotation cost Find the cost of equity capital given that earnings are expected to remain constant

3 Problem 3

A company is considering raising Rs 100 lakhs by one of two methods: 14% institutional term loan or 13% non-convertible debentures (NCDs) issued at a 2.5% discount with Rs 1,00,000 issue costs Advise the better option based on effective cost of capital, assuming a 50% tax rate

4 Problem 4

The balance sheet of Delaware & Co includes:

• Capital: Rs 8,00,000

• Share Premium: Rs 2,00,000

• Reserves: Rs 6,00,000

• 12% Irredeemable Debentures: Rs 4,00,000

An annual dividend of Rs 2 per share has been paid, with a 10% growth rate expected to continue Ordinary shares are quoted at Rs 27.5, and debentures at 80% of face value Ignore taxation Estimate the weighted average cost of capital (WACC) based on market values

5 Problem 5

Fashions Ltd balance sheet as on 31-12-1998 (Rs in Lacs):

• Equity Share Capital: 400

• 12% Debentures: 400

• 18% Term Loan: 1,200

a) Determine the WACC, given a consistent 20% dividend rate

b) Recalculate WACC if the equity share’s market price is Rs 160 (face value

Rs 100)

c) Determine the effect of a 40% income tax rate on WACC under both scenar-ios

6 Problem 6

The balance sheet of a company includes:

• Equity share capital – 20,000 shares of Rs 10 each: Rs 2,00,000

• Reserves and Surplus: Rs 1,30,000

• 8% Debentures: Rs 1,70,000

The tax rate is 50%, and the current equity dividend is 12% Calculate the weighted average cost of capital using these figures

7 Problem 7

A Limited has the following capital structure:

• Equity share capital (2,00,000 shares): Rs 40,00,000

• 6% preference shares: Rs 10,00,000

• 8% Debentures: Rs 30,00,000

The equity share’s market price is Rs 20, with an expected dividend of Rs 2 per share growing at 7% forever The tax rate is 50% Compute:

a) WACC based on existing capital structure

b) New WACC if the company raises Rs 20,00,000 by issuing 10% debentures, increasing the dividend to Rs 3, with the share price falling to Rs 15 c) Cost of capital if the growth rate in (b) increases to 10%

8 Problem 8

Financial statement extract of ABC Ltd.:

• Operating profit: Rs 105 lacs

• Interest on debentures: Rs 33 lacs

• Income tax: Rs 36 lacs

• Net Profit: Rs 36 lacs

• Equity Share Capital (Rs 10 each): Rs 200 lacs

• Reserves and Surplus: Rs 100 lacs

• 15% Debentures (Rs 100 each): Rs 220 lacs

The market price of equity shares and debentures is Rs 12 and Rs 93.75, respec-tively Find:

i) Earnings per share (EPS)

ii) % cost of capital of equity and debentures

9 Problem 9

As a financial analyst, determine the WACC of a large electronics company using (i) book value weights and (ii) market value weights The capital structure is:

• Preference shares (Rs 100 per share): Rs 2,00,000

• Equity shares (Rs 10 per share): Rs 10,00,000

• Debentures (Rs 100 per debenture): Rs 8,00,000

Market prices: Debentures Rs 110, Preference shares Rs 120, Equity shares Rs

22 Anticipated financing opportunities:

i) Rs 100 debenture, redeemable at par, 10-year maturity, 13% coupon rate, 4% flotation costs

ii) Rs 100 preference share, redeemable at par, 10-year maturity, 14% divi-dend rate, 5% flotation costs

iii) Equity shares: Rs 2 flotation costs, sale price Rs 22

The expected dividend on equity shares is Rs 2, growing at 7% p.a All earnings are paid as dividends The tax rate is 50%

10 Problem 10

ABC Company’s capital structure (Rs 80,00,000):

• Ordinary shares (2,00,000 shares): 50.0%

• 10% preference shares: 12.5%

• 14% debentures: 37.5%

Shares sell for Rs 20, with an expected dividend of Rs 2 per share growing at 7% forever Tax rate is 50% Compute:

a) WACC of the existing capital structure

b) New WACC if the company raises Rs 20,00,000 by issuing 15% debentures, increasing the dividend to Rs 3, with the share price falling to Rs 15 c) Cost of capital if the growth rate in (b) increases to 10%

11 Problem 11

ABC Ltd.’s capital structure:

• 4,000 Equity shares of Rs 100 each: Rs 4,00,000

• 10% preference shares: Rs 1,00,000

• 11% Debentures: Rs 5,00,000

The equity share’s market price is Rs 102, with an expected dividend of Rs 10 growing at 10% The tax rate is 50% Compute:

i) Cost of equity capital and WACC

ii) New WACC if the company raises Rs 3,00,000 via 12% debentures, with the dividend rate increasing to 12%, growth rate reducing to 8%, and market price falling to Rs 98

12 Problem 12

An electric equipment manufacturing company wishes to determine the WACC for capital budgeting Balance sheet:

• Equity share capital: Rs 12,00,000

• Preference share capital: Rs 4,50,000

• Retained Earnings: Rs 4,50,000

• Debentures: Rs 9,00,000

• Current Liabilities: Rs 10,00,000

Additional information:

i) 20-year 14% debentures of Rs 2,500 face value, redeemable at 5% pre-mium, sold at par, 2% flotation costs

ii) 15% preference shares: Sale price Rs 100, 2% flotation costs

iii) Equity shares: Sale price Rs 115, flotation costs Rs 5

The tax rate is 55%, and the expected equity dividend is Rs 11, growing at 8% p.a The company intends to maintain its current capital structure

13 Problem 13

Hindustan Traders Ltd.’s capital structure as on 31-3-1999:

• Equity capital: 100 lacs shares of Rs 10 each (Rs 10 crores)

• Reserves: Rs 2 crores

• 14% debentures of Rs 100 each: Rs 3 crores

The company paid a 20% equity dividend, expected to grow at 5% p.a Equity shares trade at Rs 80 The tax rate is 50% Compute:

a) Current WACC

b) New WACC if the company raises Rs 5 crores via a 16% long-term loan, with equity share price falling to Rs 50

14 Problem 14

A company has the following capital structure:

• Equity shares (50,000 shares of Rs 50 each): Rs 25,00,000

• 9% preference shares: Rs 10,00,000

• 12% debentures: Rs 15,00,000

The equity shares trade at Rs 75, with an expected dividend of Rs 5 per share growing at 6% p.a The tax rate is 40% Compute the WACC based on market values

15 Problem 15

A manufacturing firm plans to issue 11% debentures of Rs 100 each at a 3% dis-count with Rs 50,000 issue costs to raise Rs 50 lakhs Alternatively, it can issue 10% preference shares of Rs 100 each at par with 2% flotation costs, redeemable after 8 years at a 5% premium The tax rate is 50% Determine which option has the lower cost of capital

Part II

Solutions

16 Problem 1

16.1 i) Cost of Debt (X Ltd.)

Formula:

kd=

[

Int + (RV N −SV )

] (1− t)

(RV +SV )

2

Where:

• Int = 12, t = 0.50, RV = 110, N = 10, SV = 95

Calculation:

k d=

[

12 + (11010−95)

] (1− 0.5)

(110+95) 2

= [12 + 1.5](0.5)

97.5 =

6.75 97.5 = 0.0743 or 7.43%

16.2 ii) Cost of Preference Capital (Y Ltd.)

Formula:

k p = D +

(RV −SV ) N

(RV +SV )

2

Where:

• D = 14, SV = 92, N = 12, RV = 100

Calculation:

k p = 14 +

(100−92)

12 (100+92) 2

= 14 + 0.67

96 =

14.67

96 = 0.1528 or 15.28%

17 Problem 2

17.1 a) Cost of Preference Share Capital

Formula:

k p = D

P0

i) At 10% Premium: D = 1, P0 = 11

k p = 1

11 × 100 = 9.09%

ii) At 10% Discount: P0 = 9

kp = 1

9 × 100 = 11.11%

17.2 b) Cost of Preference Share Capital

Formula:

k p = D +

(RV −SV ) N

(RV +SV )

2

Where:

• D = 10, RV = 100, SV = 98, N = 10

Calculation:

k p = 10 +

(100−98)

10 (100+98) 2

= 10 + 0.2

99 =

10.2

99 = 0.103 or 10.3%

17.3 c) Cost of Equity Capital

Formula:

ke = D1

P0

Where:

• D1 = 10, P0 = 90

Calculation:

k e = 10

90 × 100 = 11.11%

18 Problem 3

Effective Cost of 14% Term Loan:

k d= 14× (1 − 0.5) = 7%

Effective Cost of 13% NCD: Formula:

k d = Int(1 − t)

SV

Where:

• Int = 13, t = 0.5, SV = 96.5

Calculation:

kd= 13× (1 − 0.5)

96.5 =

6.5 96.5 = 0.0674 or 6.74%

Recommendation: The 13% NCD (6.74%) is better than the 14% term loan

(7%)

19 Problem 4

Cost of Equity Capital: Formula:

k e = D1

P0 + g

Where:

• D1 = 2× 1.10 = 2.2, P0 = 27.5 , g = 0.10

Calculation:

k e= 2.2

27.5 + 0.10 = 0.18or 18%

Market Value: 80,000 × 27.5 = Rs 22,00,000

Cost of Debt:

kd= 12

80 = 0.15or 15%

Market Value: 4,00,000 × 0.80 = Rs 3,20,000

WACC: WACC = 17.61%

Source Market Value (Rs.) Weight Cost Weighted Cost

20 Problem 5

20.1 a) WACC (Book Value, No Tax)

Source Amount (Rs Lacs) Proportion Cost Weighted Cost

20.2 b) WACC (Market Value)

k e = 20

160 = 0.125 or 12.5%

Source Amount (Rs Lacs) Proportion Cost Weighted Cost

20.3 c) WACC with 40% Tax

After-tax costs:

• Debenture: 12 × 0.6 = 7.2%

• Term Loan: 18 × 0.6 = 10.8%

Premise a:

Premise b:

Source Amount (Rs Lacs) Proportion Cost Weighted Cost

Source Amount (Rs Lacs) Proportion Cost Weighted Cost

21 Problem 6

Capital Structure:

• Equity share capital: Rs 2,00,000 (40%)

• Reserves and surplus: Rs 1,30,000 (26%)

• 8% Debentures: Rs 1,70,000 (34%)

Cost of Equity and Reserves: k e = k r = 10012 = 12% Cost of Debentures: k d =

8× (1 − 0.5) = 4%

Source Amount (Rs.) Proportion Cost Weighted Cost

22 Problem 7

22.1 a) Existing WACC

k e= 2

20+ 0.07 = 0.17or 17%

k d= 8× (1 − 0.5) = 4%

k p = 6% (assumed irredeemable) WACC = 10.75%

Source Amount (Rs.) Weight Cost Weighted Cost

Preference 10,00,000 0.125 6% 0.0075

Debentures 30,00,000 0.375 4% 0.0150

22.2 b) New WACC

k e= 3

15+ 0.07 = 0.27or 27%

k d (new) = 10 × (1 − 0.5) = 5%

WACC = 13.6%

Source Amount (Rs.) Weight Cost Weighted Cost

8% Debentures 30,00,000 0.30 4% 0.012

10% Debentures 20,00,000 0.20 5% 0.010

22.3 c) WACC with 10% Growth

k e= 3

15+ 0.10 = 0.30or 30%

WACC = 14.8%

Source Amount (Rs.) Weight Cost Weighted Cost

8% Debentures 30,00,000 0.30 4% 0.012

10% Debentures 20,00,000 0.20 5% 0.010

23 Problem 8

23.1 i) Earnings Per Share

EPS = 36, 00, 000

20, 00, 000 = 1.80Rs

23.2 ii) Cost of Capital

Debentures (Market Value):

k d= 15× (1 − 0.5)

93.75 = 0.08or 8%

Debentures (Face Value):

k d= 15× (1 − 0.5)

100 = 0.075 or 7.5%

Equity:

k e = 1.80

12 = 0.15or 15%

24 Problem 9

Cost of Debenture:

k d =

[

13 +(10010−96)

] (1− 0.5)

(100+96) 2

= 6.7

98 = 0.068 or 6.8%

Cost of Preference Shares:

k p = 14 +

(100−95)

10 (100+95) 2

= 14.5

97.5 = 0.149 or 14.9%

Cost of Equity Shares:

k e= 2

20+ 0.07 = 0.17or 17%

WACC (Book Value): WACC = 12.71%

Source Amount (Rs.) Weight Cost Weighted Cost

Preference 2,00,000 0.10 14.9% 0.0149

Debentures 8,00,000 0.40 6.8% 0.0272

WACC (Market Value): WACC = 14.14%

25 Problem 10

25.1 a) Existing WACC

k e= 2

20+ 0.07 = 0.17or 17%

WACC = 12.37%

Source Amount (Rs.) Weight Cost Weighted Cost

Preference 2,40,000 0.072 14.9% 0.0107

Debentures 8,80,000 0.265 6.8% 0.0180

Source Weight Cost Weighted Cost Ordinary Shares 0.500 17% 0.0850 10% Preference 0.125 10% 0.0125 14% Debentures 0.375 7% 0.0262

25.2 b) New WACC

k e= 3

15+ 0.07 = 0.27or 27%

k d (new) = 15 × (1 − 0.5) = 7.5%

WACC = 15.4%

Source Weight Cost Weighted Cost Ordinary Shares 0.40 27% 0.108

14% Debentures 0.30 7% 0.021 15% Debentures 0.20 7.5% 0.015

25.3 c) WACC with 10% Growth

k e= 3

15+ 0.10 = 0.30or 30%

WACC = 16.6%

26 Problem 11

26.1 i) Cost of Equity and WACC

k e = 10

102 + 0.10 = 0.198 or 19.8%

k d = 11× (1 − 0.5) = 5.5%

k p = 10% (assumed irredeemable) WACC = 11.67%

Source Weight Cost Weighted Cost Ordinary Shares 0.40 30% 0.120

14% Debentures 0.30 7% 0.021 15% Debentures 0.20 7.5% 0.015

Source Amount (Rs.) Weight Cost Weighted Cost

Debentures 5,00,000 0.5 5.5% 0.0275

26.2 ii) New WACC

k e = 12

98 + 0.08 = 0.202 or 20.2%

k d (new) = 12 × (1 − 0.5) = 6%

WACC = 10.49%

Source Amount (Rs.) Weight Cost Weighted Cost

11% Debentures 5,00,000 0.385 5.5% 0.0212

12% Debentures 3,00,000 0.230 6% 0.0138

27 Problem 12

Cost of Debentures:

k d=

[

14 + (262520−2450)

] (1− 0.55)

(2625+2450) 2

= 10.525

2537.5 × 0.45 = 0.0655 or 6.55%

Cost of Preference Shares:

kp = 15 +

(100−98)

10 (100+98) 2

= 15.2

99 = 0.153 or 15.3%

Cost of Equity:

k e = 11

110 + 0.08 = 0.18or 18%

WACC = 14.15%

Source Weight Cost Weighted Cost

Preference 0.15 15.3% 0.0229 Debentures 0.30 6.55% 0.0196

28 Problem 13

28.1 a) Current WACC

kd= 14× (1 − 0.5) = 7%

k e= 2× 1.05

80 + 0.05 = 0.0763 or 7.63%

WACC = 7.50%

Source Amount (Rs Cr.) Weight Cost Weighted Cost

28.2 b) New WACC

k d (new) = 16 × (1 − 0.5) = 8%

ke= 2× 1.05

50 + 0.05 = 0.092 or 9.2%

WACC = 8.57%

Source Amount (Rs Cr.) Weight Cost Weighted Cost

29 Problem 14

Cost of Equity:

k e = 5× 1.06

75 + 0.06 = 0.1307 or 13.07%

Cost of Preference Shares: k p = 9% (assumed irredeemable) Cost of Deben-tures:

k d = 12× (1 − 0.4) = 7.2%

Market Values:

• Equity: 50,000 × 75 = Rs 37,50,000

• Preference: Rs 10,00,000

• Debentures: Rs 15,00,000

• Total: Rs 62,50,000

Source Market Value (Rs.) Weight Cost Weighted Cost

WACC = 11.01%

30 Problem 15

Cost of 11% Debentures:

k d= 11× (1 − 0.5)

100− 3 − 1 =

5.5

96 = 0.0573 or 5.73%

Cost of 10% Preference Shares:

k p = 10 +

(105−98)

8 (105+98) 2

= 10.875

101.5 = 0.1071 or 10.71%

Recommendation: The 11% debentures (5.73%) have a lower cost of capital

than the 10% preference shares (10.71%)