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EDU-CARE PROFESSIONAL ACADEMY (THE BEST FOR MBA)

COST OF CAPITALEvery profit seeking company has its own risk-return characteristics. Each group of investor in a company requires a minimum rate of return according to risk it accepts by investing in the firm.For example:

From the stand point of company these groups provide the capital needed to finance the firm’s investments. The minimum rate of return that the company must earn in order to satisfy the overall rate of return required by its investors is called company’s cost of capital.

NOTE: The cost of capital of a company is calculated on the basis of long term funds only (e.g. equity share capital, preference share capital, debentures etc.). The short term sources of funds (e.g. bank credit, trade credit etc.) are generally considered to be temporary in nature and are subject to repayment in short run and hence they are not relevant for computation of cost of capital.

COST OF CAPITAL

Compiled By: CA GOURAV KUMAR JASHNANI (B.Com, CA FINAL, CS FINAL) 99269-55326, 94071-21248 ADDRESS: 2nd floor , sundaram complex, bhanwerkuan, Indore.

Type of Investor Return In the form of:

Equity share (Common stock) holders Dividends

Preference share (Preferred stock) holders Preference dividends

Debenture (Bond) holders Interest

Bank loans and other loans Interest


1. ABC Ltd. has the following capital structure:Equity Capital (Expected Dividend 15%) Rs. 5,00,00010% Preference Capital Rs. 2,50,0009% Loan Rs. 7,50,000You are required to calculate WACC. (Assume Tax Rate 60%).

2. X Ltd. has the following Capital structure:Equity Capital (Expected Dividend 12%) Rs. 10,00,00010% Preference Capital Rs. 5,00,0008% Loan Rs. 15,00,000You are required to calculate the weighted average cost of capital before tax and after tax assuming tax rate of 50%.

3. PQR & Co. has the following capital structure as on Dec. 31, 2011.Equity Share Capital (5,000 shares of 100 each) Rs. 5,00,0009% Preference Capital Rs. 2,00,00010% Debentures Rs. 3,00,000The equity shares of the company are quoted at Rs. 102 and company expected to declare a dividend of Rs. 9 per share for the next year. The company has registered a dividend growth rate of 5% which is expected to be maintained.(i) Assuming the tax applicable to the company at 50%, calculate the

weighted average cost of capital and(ii) Assuming that the company can raise additional term loan at 12% for

Rs. 5,00,000 to finance its expansion, calculate the revised WACC. The company’s expectation is that the business risk associated with new financing may bring down the market price from Rs. 102 to Rs. 96 per share.

4. A company has on its books the following amounts and specific cost of each type of capital:Type of capital Book

Value(Rs.)Market Value(Rs.)

Specific cost

DebenturesPreference share capitalEquity share capitalRetained earnings

4,00,0001,00,0006,00,0002,00,000

3,80,0001,10,000

--12,00,000

5.00%8.00%

--13.00%

Total 13,00,000 16.90,000Determine the weighted average cost of capital using:

(a) Book value weights(b) Market value weights



5. International funds has the following capital structure:Particulars Book value

(Rs.)Mkt value (Rs.)

Equity capital (25 lakh shares of Rs. 10 par) 2,50,00,000 4,50,00,000Preference capital (50,000 shares of Rs. 100 par, carrying 13% dividend)

50,00,000 45,00,000

Reserve and Surplus 1,50,00,000 -Debentures (1,50,000 debentures of Rs. 100 par carrying 14% interest)

1,50,00,000 1,45,00,000

Total 6,00,00,000 6,40,00,000The expected dividend per share is Rs. 1.40. The dividend per share is expected to grow at a rate of 8% forever. Preference share are redeemable after 5 years, whereas the debentures are redeemable after 6 years. The tax rate of the Co. is 50%. Calculate the WACC for the existing capital structure using market value proportions as weights.

6. The ABC Co. has the total capital structure of Rs. 80,00,000 consisting of :

Ordinary Shares (2,00,000 shares) 50%10% Preference Share 12.5%14% Debentures 37.5%The shares of the Co. sell for Rs. 20. It is expected that Co. will pay next year a dividend of Rs. 2 per share which will grow at 7% forever. Assume 50% tax rate. You are required to:(a) Computed the WACC based on existing capital structure.(b) Compute the new WACC if the Co. raises an additional debt of

Rs.20,00,000 by issuing 15% debenture. This would result in increasing expected dividend to Rs.3 and leave growth rate unchanged, but the price of the share will fall to Rs.15 per share. [MBA 2004]

7. A company has equity shares of Rs.100 each, 10% Preference share and 12% Debenture in the proportion of 3:2:5. The company needs further capital to be available from financial institution @ 14% interest. The new proportion would be 3:2:5:5 for equity capital, preference capital, debenture and loans from financial institution respectively. The company pays 40% tax on income. The market price of equity shares is Rs.120 per share. Expected dividend at the end the year is Rs.6 per share. Dividends are expected to grow every year @ 5%.How will cost of capital change on borrowing fund from financial institution?

[MBA 2005]



8. The capital structure of XYZ Ltd comprising of 12% debenture, 9% preference shares and some equity shares of Rs.100 each in the ratio of 3:2:5. The company is considering introduce additional capital to meet the needs of expansion plan by raising 14% term loan from financial institutions. As a result of this proposal, the proportions of above mentioned would go down by 1/10, 1/15, and 1/6 respectively.In the light of above proposal, find out the impact on WACC of the firm given that (i) Tax rate is 50%, (ii) expected dividend of Rs.9 at the end of the year and (iii) the growth rate may be taken at 5%. No change is expected in dividends, growth rate, market price of the share etc. after availing proposed loan.

9. The following is the capital structure of Sakshi Ltd. as on 31-12-2005: Amount (Rs.)

Equity Shares: 20,000 shares of Rs. 100 each 20,00,00010% Preference Shares of Rs. 100 each 8,00,00012% Debentures 12,00,000Total 40,00,000

The market price of the company’s share is Rs. 110 and it is expected that a dividend of Rs. 10 per share would be declared after 1 year. The dividend growth rate is 6%.(a) If the company is in the 50% tax bracket, compute the weighted average

cost of capital.(WACC)(b) Assuming the in order to finance an expansion plan, the company intends

to borrow a fund of Rs. 20 lakhs bearing 14% rate of interest, what will be the company’s revised weighted average cost of capital ? This financing decision is expected to increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs.110 to 105 per share.

10. A Ltd. has the following capital structure:Amount (Rs.)

Equity Shares Capital (2,00,000) 40,00,0006% Preference Shares 10,00,0008% Debentures 30,00,000Total 80,00,000

The market price of the company’s equity share is Rs. 20. It is expected that company will pay a dividend of Rs. 2 per share at the end of the current year, which will grow at 7% forever. The tax rate may be presumed at 50 percent. You are required to compute the following:(a) A weighted average cost of capital based on existing capital structure.



(b) The new weighted average cost of capital if the company raises an additional Rs.20,00,000 debt by issuing 10 percent debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of the share will fall Rs. 15 per share.

(c) The cost of capital is in (b) above, growth rate increases to 10 percent.


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