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Cost of Capital
K = r0 + b + f
where
K = Cost of capital,
r0 = return at zero risk level,
b = Premium for business risk;
f = Premium for financial risk.
C1 Cn Cn
Io = (1+K) + (1+K)2 + (1+K)n
where
Io = Net amount of funds received by the firm at
time zero
C = Cash Outflow in the period concerned
n = Duration or number of years for which the
funds are provided
K = Explicit cost of capital.
1. Traditional Approach
(i) The total market value of the firm and its cost of
capital are independent of its capital structure. The
total market value of the firm can be computed by
capitalizing the expected stream of operating
earnings at discount rate considered appropriate for
its risk class.
(ii) The cut-off rate for investment purposes is
completely independent of the way in which
investment is financed.
Problems in determination
5. Problem of weights
The assignment of weights to each type of funds is a
complex issue. The finance manager has to make a
choice between the risk value of each source of funds
and the market value of each source of funds. The
results would be different in each case.
Cost of Debt
Kd = (l-T)R
Solution:
Cost of debentures can be calculated according to the
following formula:
Kd = I (1-T)
NP
where
Kd = Cost of debt after tax.
I = Annual interest payment.
NP = Net proceeds of loans or debentures.
T = Tax rate.
= 1 x .45
10 = .045 or 4.5%
= 1 x .45
9 = .05 or 5%
I + (P - NP)/n
Kd(before tax) = (N + NP)/2
where
I = Annual interest payment,
P = Par value of debentures,
NP = Net proceeds of debentures,
n = Number of years to maturity.
Solution
I + (P - NP)/n
Kd (before tax) = (P + NP)/2
10,000 + (1,00,000 - 98,000) / 10
= (1,00,000 + 98,000)72
10,000+200
= 99,000 =.103 or 10.30%.
Dp
Kp = NP
Solution
(i) When preference shares are issued at 10%
premium:
Dp 10,000 X 100
Kp = NP = 1,10,000 =9.09%
Solution:
Dp + (P - NP)/n
Kd (before tax) = (P + NP)/2
10,200
= 99,000 = 10.30%.
Solution:
The cost of new equity can be determined according to
the following formula:
D
Ke = NP
where
Ke = Cost of equity capital;
D = Dividend per equity share;
NP = Net proceeds of an equity share,
2
Ke = 10.45 = 0.19 or 19%
2
Ke = 15 =0.133 or 13.3%.
Solution
D + g
Ke = MP
4.50 + .07
= 90
= 0.5+ .07 = .12 or 12%.
14.10 + 6%
= 147
= 9.6% + 6% = 15.6%.
33
Ke = E
NP
where
Ke = Cost of equity capital;
D = Earning per share;
NP = Net proceeds of an equity share,
Solution
E 10
Ke = NP = 90 = 0.11 or 11%.
Solution
36
Rs.
Dividends payable to the shareholders 50,000
Less: Income tax @ 30% 15,000
After tax dividends 35,000
Less: Brokerage cost @ 2% 700
Net amount available for investment 34,300
3,430 X 100
Rs. 50,000 = 6.86%.
Solution
(a) COMPUTATON OF WEIGHTED AVERAGE
COST OF CAPITAL
(BOOK VALUE WEIGHTS)
Source (i) Amount Proporti After Weighted
(Rs.) (2) on (3) tax Cost (Rs.)
(4) (5) = (3) x
(4)
Equity 45,000 .45 14% 6.30%
Share Capital
Retained Earnings 15,000 .15 13% 1.95%
Preference Share
Capital 10,000 .10 10% 1.00%
Debentures 30,000 .30 5% 1 .50%
Weighted average cost of capital (K0) 10.75%
48
Solution
From the facts given in the question, the following
balance sheet may be drawn:
50
BALANCE SHEET
Liabilities Rs. Assets Rs.
900 Equity shares of 90,000 Total 1,60,000
Rs. 100 each Assets
Reserves 18,000
8% Borrowed funds 52,000 _______
1,60,000 1,60,000
Calculation of earnings per share:
1. Earnings after interest and tax
available for equity share holders Rs. 13,500
2. Number of equity shares outstanding
of Rs. 100 each Rs. 900
3. Earning per share (EPS) (1) / (2) Rs. 15
_____EPS__________ X 100
ke = Present market price of the share
Rs. 15 X 100
ke = Rs.120 = 12.5%.
Solution
The relationship among cost of capital, dividend, price
and expected growth rate is given by the formula:
53
Re.l X 100 + 5%
Company's cost of equity capital = Rs. 20
= 10%
Dividend
(b) Market price = Cost of Equity -Growth Rate %
Re 1
Company's cost of equity capital = 10% - 6%
Re. 1
= 4% = Rs. 25