financial management - ssei...table (fvif) suggests that `1 compounds to `1.338 in 5 years at the...

ANSWERS

FINANCIAL MANAGEMENT

COST OF CAPITAL

Question 1

We know that as per the realised yield approach, cost of equity is equal to

the realised rate of return. Therefore, it is important to compute the internal

rate of return by trial and error method. This realised rate of return is the

discount rate which equates the present value of the dividends received in the

past five years plus the present value of sale price of ` 1,128 to the purchase price

of `1,000. The discount rate which equalises these two is 12 percent approximately.

Let us look at the table given for a better understanding:

Year Dividend

(`)

Sale Proceeds

(`)

Discount Factor

@ 12%

Present Value

(`)

1 100 - 0.893 89.3

2 100 - 0.797 79.7

3 100 - 0.712 71.2

4 100 - 0.636 63.6

5 100 - 0.567 56.7

6 Beginning 1,128 0.567 639.576

1,000.076

We find that the purchase price of puppieslimited’s share was ` 1,000 and the

present value of the past five years of dividends plus the present value of the sale

price at the discount rate of 12 per cent is `1,000.076. Therefore, the realised rate of

return may be taken as 12 percent. This 12 percent is the cost of equity.

Question 2

A.

i. Cost of new debt

d

0

I 1 tK

P

= 16 (1 - 0.5)

0.083396

ii. Cost of new preference shares

p

0

PD 1.1K 0.12

P 9.2

iii. Cost of new equity shares

1e

0

DK g

P

1.180.10 0.05 + 0.10 = 0.15

23.60

Calculation of D1

D1 = 50% of 2013 EPS = 50% of 2.36 = ` 1.18

B. Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

1 2 3 (2) × (3) = 4

Debenture 0.15 0.0833 0.0125

Preference Share 0.05 0.12 0.0060

Equity Share 0.80 0.15 0.1200

Marginal cost of capital 0.1385

C. The company can spend the following amount without increasing

marginal cost of capital and without selling the new shares:

Retained earnings = (0.50) (2.36 × 10,000) = ` 11,800

The ordinary equity (Retained earnings in this case) is 80% of total capital

11,800 = 80% of Total Capital

∴ Capital investment before issuing equity = 11,800

14,7500.80

`= `

D. If the company spends in excess of ` 14,750 it will have to issue new shares.

∴ Capital investment before issuing equity = 1.18

0.10 0.15920

`

The marginal cost of capital will be:

Type of Capital Proportion Specific Cost Product

1 2 3 (2) × (3) = 4

Debenture 0.15 0.0833 0.0125

Preference Share 0.05 0.1200 0.0060

Equity Share (new) 0.80 0.1590 0.1272

0.1457

Question 3

i. Cost of Equity (Ke) = 1

0

Dg

P F

=

150.06

125 5

`

` `(refer to working note)

Ke = 0.125 + 0.06 = 0.185

Working Note:

Calculation of 'g'

` 10.6(1+g)5 = ` 14.19 Or, (1+g)5=14.19

1.33810.6

Table (FVIF) suggests that `1 compounds to `1.338 in 5 years at the

compound rate of 6 percent. Therefore, g is 6 per cent.

iii. Cost of Retained Earnings (Ks) = 1

0

D 15g 0.06 0.18

P 125

`

`

iv. Cost of Preference shares (Kp)=0

PD 150.1429

P 105

`

`

v. Cost of Debentures (Kd) =

RV NPI 1 t

nRV NP

2

=

100 91.75 *

15 1 0.3511 years

100 91.75 *

2

` ``

` `

= 15 0.65 0.75 10.5

0.109595.875 95.875

` ` `

` `

*Since yield on similar type of debentures is 16 per cent, the company would be

required to offer debentures at discount.

Market price of debentures (approximation method) = Coupon rate ÷ Market

rate of interest= ` 15 ÷ 0.16 = ` 93.75

Sale proceeds from debentures = `93.75 – ` 2 (i.e., floatation cost) = `91.75

Market value (P0) of debentures can also be found out using the present value method:

P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11 years)

P0 = `15 × 5.029 + `100 × 0.195

P0 = `75.435 + `19.5 = ` 94.935

Net Proceeds = `94.935 – 2% of `100 = ` 92.935

Accordingly, the cost of debt can be calculated

Cost of Capital(amount in lakh of rupees)

[BV weights and MV weights]

Source of capita Weights Specific

Cost (K) Total cost

BV MV (BV × K) (MV × K)

Equity Shares 120 160* 0.1850 22.2 29.6

Retained Earnings 30 40* 0.1800 5.4 7.2

Preference Shares 9 10.4 0.1429 1.29 1.49

Debentures 36 33.75 0.1095 3.94 3.70

Total 195 244.15 32.83 41.99

*Market Value of equity has been apportioned in the ratio of Book Value of

equity and retained earnings

Weighted Average Cost of Capital (WACC):

Using Book Value = 32.83

0.1684 or 16.84%195

`

`

Using Market Value =41.99

= 0.172 or 17.2%244.15

`

`

Question 4

i. Calculation of after tax cost of the followings:

a. New 14% Debentures (Kd) =

New 12% Preference Shares (Kp) = PD 1.20

0.1224 or 12.24% NP 9.80

`

`

b. Equity Shares (Retained Earnings) (Ke)

= 1

0

Expected dividend(D )Growth rate (G)

Current market price (P )

= 50% of 2.773

0.12* 0.17 or 17% 27.75

`

`

* Growth rate (on the basis of EPS) is calculated as below :

=EPS in current year - EPS in previous year

EPS in previous year

=

(Students may verify the growth trend by applying the above formula to last

three or four years)

ii. Calculation of marginal cost of capital (on the basis of existing capital

structure):

Source of Capital Weights

(a)

After tax cost of capital (%)

(b)

WACC (%)

(a)(b)

14% Debenture 0.15 7.14 1.071

12%- Preference shares 0.05 12.24 0.612

Equity shares 0.80 17.00 13.600


iii. The company can spent for capital investment before issuing new equity

shares and without increasing its marginal cost of capital:

Retained earnings can be available for capital investment

= 50% of 2015 EPS × equity shares outstanding

= 50% of ` 2.773 × 2,00,000 shares = `2,77,300

Since, marginal cost of capital is to be maintained at the current level i.e. 15.28%,

the retained earnings should be equal to 80% of total additional capital for

investment.

Thus investment before issuing equity= 2,77,300

100 3,46,625 80

`

`

The remaining capital of ` 69,325 i.e. ` 3,46,625 – ` 2,77,300 shall be financed by

issuing 14% Debenture and 12% preference shares in the ratio of 3 : 1

respectively.

iv. If the company spends more than ` 3,46,625 as calculated in part (iii) above, it

will have to issue new shares at ` 20 per share.

The cost of new issue of equity shares will be:

Calculation of marginal cost of capital (assuming the existing capital structure

will be maintained):

Source of Capital Weights

(a) Cost (%)

(b)

WACC (%)

(a)(b)

14% Debenture 0.15 7.14 1.071

12% Preference shares 0.05 12.24 0.612

Equity shares 0.80 18.93 15.144


Question 5

i. Beta of snowflakes Computers

= 1.10 2/8 + 1.502/8 + 21/8 + 13/8 = 1.275

Beta coefficient is a measure of volatility of securities return relative to the

returns of a broad based market portfolio. Hence beta measures volatility

of snowflakes Computers stock return against broad based market

portfolio. In this case we are considering four business groups in computer

segment and not a broad based market portfolio , therefore beta calculations

will not be the same.

ii. Cost of equity

= rf + av mkt risk premium β

= 7.5% + 1.275 8.5% = 18.34%

Main frame KE = 7.5% + 1.10 8.5% = 16.85%

Personal KE = 7.5% + 1.5 8.5% = 20.25%

Computers

Software KE = 7.5% + 2 8.5% = 24.5%

Printers KE = 7.5% + 1 8.5% = 16%

Advise: To value printer division, the use of 16% KE is recommended.

Question 6

i. Cost of Equity Share Capital (Ke)

ii. Cost of Debt (Kd)

Interest on first ` 2,00,000 @ 10% = `20,000

Interest on next ` 2,00,000 @ 15% = ` 30,000

iii. Weighted Average Cost of Capital (WACC)

Source of capital Amount (`) Weights Cost of

Capital (%) WACC (%)

Equity shares 6,00,000 0.60 12.20 7.32

Debt 4,00,000 0.40 8.75 3.50

Total 10,00,000 1.00 10.82

Alternatively Cost of Equity Share Capital (Ke) can be calculated as

Accordingly

Weighted Average Cost of Capital (WACC)

Source of

capital

Amount

(`)

Weights Cost of

Capital (%)

WACC

(%)

Equity shares 6,00,000 0.60 12.00 7.20

Debt 4,00,000 0.40 8.75 3.50

Total 10,00,000 1.00 10.70

Question 7

From the given data, funds expected to be available to the company

= Rs.25 lakh + 30= Rs.55 lakh.

While the amount of funds expected to be used by the company = Rs.75 lakh

So, the amount of external funds required = 75 – 55 = Rs.20 lakh

Question 8

The required rate of return from that stock is

ke = Rf + (Rm – Rf) = 6 + 1.50 ´ (12 – 6)= 15 percent

The growth rate of dividend is 5%

So, the price of the share can be calculated as:

1e

net

DK g

P

D1 = 2 + 5% = 2.1

net

2.115% 5%

P

Therefore Pnet = 21

Question 9

a. Determination of the amount of equity and debt for raising additional

finance:

Pattern of raising additional finance

Equity 3/4 of ` 5 Crore = ` 3.75 Crore

Debt 1/4 of ` 5 Crore = ` 1.25 Crore

The capital structure after raising additional finance:

Particulars (` In crore)

Shareholders’ Funds

EquityCapital (3.75 –1.00) 2.75

Retained earnings 1.00

Debt (Interest at 10% p.a.) 0.75

(Interest at12%p.a.) (1.25-0.75) 0.50

Total Funds 5.00

b. Determination of post-tax average cost of additional debt

Kd= I (1 – t)

Where,

I = Interest Rate

t = Corporate tax-rate

On ` 75,00,000 = 10% (1 – 0.25) = 7.5% or 0.075

On ` 50,00,000 = 12% (1 – 0.25) = 9% or 0.09

Average Cost of Debt

c. Determination of cost of retained earnings and cost of equity (Applying

Dividend growth model):

Where,

Ke = Cost of equity

D1 = DO (1+ g)

D0 = Dividend paid (i.e = ` 2)

g = Growth rate

P0 = Current market price per share

Then

Cost of retained earnings equals to cost of Equity i.e. 13.4%

d. Computation of overall weighted average after tax cost of additional finance

Particular (`) Weights Cost of funds

Weighted Cost (%)

Equity (including retained earnings)

3,75,00,000 3/4 13.4% 10.05

Debt 1,25,00,000 1/4 8.1% 2.025

WACC 5,00,00,000 12.075

financial management - ssei...table (fvif) suggests that `1 compounds to `1.338 in 5 years at the...

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