Solution Manual

Chapter 11
Cost of Capital
Question 1: Refer to the book for the question.

Solution 1:

Where,

ke = Cost of equity

D1 = Dividend one year from now

P0 = Current market price of share

g = Growth rate of dividend

= 0.15 or 15%

= 0.140 or 14%

= 0.1421 or 14.21%

(c) Dividend at the end of one year = Rs 20 * 1.2 = Rs 24

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 = 0.248 or 24.8%

(d) The cost of equity may be found as,

= 0.06 + 0.1

= 0.16 = 16%

(e) we can use the formula given below:

where,

kd = Cost of debt
INT = Interest rate on bonds
T = Tax rate
Pn = Debenture redemption value
P0 = Debenture issue price
n = Number of years

= 6.4%

Question 2: Refer to the book for the question.

Solution 2:

The present WACC and the proposed WACC of the firm may be ascertained as follows:

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= 0.18 or 18%

It is assumed that equity shares, preference shares and debentures are traded at par.

Existing New**
Particulars
Weight COC Weight * COC Weight COC Weight * COC

Equity Share Capital 18% 10.80 18% 7.20%

Preference Share
10% 1.00 10% 0.67%
Capital

9% Debentures 9% 2.70 9% 1.80%

10% Loan (New) -- -- 6% 1.99%

TOTAL 14.50% WACC 11.66%

** See working notes below regarding new weights and COC of new debt.

So, the new WACC of the company will be 11.66% that is lesser than the existing WACC which is14.50%.

Working Notes

(a) The new weights of different sources are calculated as follows:

(b) Cost of Loan

Rate of Interest * (1 t)

= 10 * (1 0.40) %

= 6%

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Question 3: Refer to the book for the question.

Solution 3:

In this case, cost of capital can be calculated as the internal rate of return of dividends and the sale
proceeds as follows:

The dividend received by an investor on an average is Rs 30 (20 + 25 + 35 + 40 / 4) and profit is Rs 200

(700 500) for 4 years on an average Rs 50 per year. The total annual return in Rs 50 + Rs 30 = Rs 80
which is about 16% on the initial investment of Rs 500. So, we can start with 16% by trial and error
procedure to find out IRR.

At 16%, NPV = Rs [20 * (0.862) + 25 * (0.743) + 35 * (0.641) + 40 * (0.552) + 700 * (0.552) 500]

= Rs (17.24 + 18.58 + 22.44 + 22.08 + 386.40 500)

= Rs (466.74 500)

= Rs ( ) 33.26

As NPV is negative @ 16%, 15% may be considered as discount rate,

At 15%, NPV = Rs [20 * (0.870) + 25 * (0.756) + 35 * (0.658) + 40 * (0.572) + 700 * (0.572) 500]

= Rs (17.4 + 18.9 + 23.03 + 22.88 + 400.4 500)

= Rs ( ) 17.39

As NPV is still negative @ 15%, 14% may be considered as discount rate.

At 14%, NPV = Rs [20 * (0.877) + 25 * (0.769) + 35 * (0.675) + 40 * (0.592) + 700 * (0.592) 500]

= Rs (17.54 + 19.23 + 23.63 + 23.68 + 414.4 500)

= Rs (498.48 500])

= Rs ( ) 1.52

As NPV is still negative @ 14%, 13% may be considered as discount rate

At 13% NPV = Rs [20 * (0.885) + 25 * (0.783) + 35 * (0.693) + 40 * (0.613) + 700 * (0.613) 500]

= Rs (17.7 + 19.58 + 24.26 + 24.52 + 429.1 500)

= Rs (515.16 500)

= Rs 15.16

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NPV is positive Rs 15.16 at discount rate of 13% and negative Rs 1.52 at 14%, so by interpolation,

= 13 + 0.909

= 13.909%

Question 4: Refer to the book for the question.

Solution 4:
(Rs)
Return available to Equity shareholders:
Earnings before Interest and taxes (EBIT) 6,00,000
Less: Interest (12% of Rs 12 lakh) 1,44,000
Profit before tax 4,56,000
Less tax @ 40% 1,82,400
Profit for Shareholders 2,73,600
Less: Preference Dividend (10% of Rs 4 lakh) 40,000
Earnings for Equity Shareholders 2,33,600

Market value of Equity Shares (1,00,000 * 5) 5,00,000

Market value of preference shares (40,000 * 9) Rs 3,60,000
ke = (Earnings ÷ Market Value) = (2,33,600 ÷ 5,00,000) 46.72%
kp = (40,000 ÷ 3,60,000) 11.11%
kd = [0.12 (1 0.4)] 7.2%

WACC can be calculated as follows:

Particulars Amount Weight COC W * COC

(Rs)
Equity Shares 5,00,000 0.243 0.467 0.113
Preference Shares 3,60,000 0.175 0.111 0.019
12% Debentures 12,00,000 0.582 0.072 0.042
TOTAL 20,60,000 1.000 WACC 0.174

So, WACC is 17.4%

Question 5: Refer to the book for the question.

Solution 5:

Current Market Price, P0 = Rs 100

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Recent Dividend Paid, D0 = Rs 15

Growth Rate g = 12%

Therefore next dividend, D1 = Rs 15 * (1 + 0.12)

= Rs 16.8

= 0.288 or 28.8%

Cost of equity capital of company is 28.8%.

Question 6: Refer to the book for the question.

Solution 6:

Option (a) Effective cost of 12% long term loan:

In this case, company has to pay 12% interest and there is no other cost involved. Thus interest after tax
shield due to tax @ 40% comes to 7.2%.

Option (b) Effective cost of 10% Debentures:

Annual Interest ‘I’ = Rs 10

Net Proceed,

P0 = 100 crore Rs 3 Crore (3% discount) Rs 0.5 crore (Cost of issue)

= Rs 96.5 crore

= 0.622 = 6.22%

Option (b) is better as effective cost of capital (6.22%) is less as compared to option (a) with effective cost
of capital of 7.2%.

Question 7: Refer to the book for the question.

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Solution 7:

Calculation of weighted average cost of capital (WACC).

Particulars Amount (Rs in crore) Weight COC W * COC

Equity Capital 40 0.4 0.15 0.06
Reserves and Surplus 20 0.2 0.15 0.03
Debt 30 0.3 0.08 0.024
Preference Capital 10 0.1 0.11 0.011
Total 100 1.0 WACC 0.125

So, WACC is 12.5%

Question 8: Refer to the book for the question.

Solution 8:

For the situation given

P0 = Rs (100 5 1) = Rs 94

I = 12 * (1 0.4) = 7.20%

Putting the values in Bond Value Equation

94 = 7.20 (PVAFr, n) + 100 (PVFr, n)

Right hand side value should be equal to Rs 94.

This can be calculated by trial and error procedure

At kd = 8% = Rs 7.20 * (6.710) + Rs 100 * (0.463)

= Rs (48.31 + 46.3)

= Rs 94.61

At kd = 9%

= Rs [7.2 * (6.418) + 100 * (0.422)]

= Rs (46.21 + 42.2)

= Rs 88.41

Cost of capital can be found by interpolation as follows,

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 = 8 + 0.098

= 8.098% or 8.1%

The value of kd can also be calculated by following short cut (approximate) method as given below:

where,

Pn = Redemption value of Debenture

kd = After tax cost of Debt

I = Interest rate

t = Tax Rate

N = Life of Debentures

Po = Debenture Issue Value

So,

= 8.04%

Question 9: Refer to the book for the question.

Solution 9:

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I. WACC based on Book Value Weights:

Amount Book Value

Particulars COC W * COC
(Rs in crore) (Rs in crore)
Equity Capital 100 0.4 0.12 0.048
Preference Capital 25 0.1 0.09 0.009
Retained Earnings 50 0.2 0.12 0.024
Debt 75 0.3 0.05 0.015
TOTAL 250 1.0 WACC = 0.096

So, WACC based on Book values weights is 9.6%.It can also be calculated as follows,

Book Value
Particular COC Book Value * COC
(Rs in crores)
Equity Capital 100 0.12 12.00
Preference Capital 25 0.09 2.25
Retained Earnings 50 0.12 6.00
Debt 75 0.05 3.75
TOTAL 250 24.00

II. WACC based on Market Value Weights:

Particular Amount ** Weight COC Weight * COC

Equity Capital 133.33 0.45 0.12 0.054
Preference Capital 25.00 0.084 0.09 0.008
Retained Earnings 66.67 0.225 0.12 0.027
Debt 71.25 0.241 0.05 0.12
TOTAL 296.25 WACC = 0.101

So, WACC based on market value weights is 10.1%. It can also be calculated as follows

Particular Market Amount COC Market Value * COC

Equity Capital 133.33 0.12 16
Preference Capital 25.00 0.09 2.25
Retained Earnings 66.67 0.12 8.00
Debt 71.25 0.05 3.56
TOTAL 296.25 29.81

** See working notes below.

Working Notes:

Calculation of Market Value

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Total Market Value of Equity = 10 crores * 20 = 200 crores

Out of 200 crores, equity share capital proportion to retained earning is 2:1.

Total Market Value of Preference share capital is 25 crores

Total Market Value of Debt is (75 * 95%) = 71.25 crores.

Question 10: Refer to the book for the question.

Solution 10:

Specific Costs of Capital:

I = 3.6 (Interest on debenture at 12% rate of interest)

t = 0.4 (Tax rate)

Pn = 31.5 (Redemption value at 5% premium)

Po = 29.4 (Issue price at 2% floatation)

N = 10 years (Maturity period of debenture)

= 7.78%

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(iv) Cost of borrowing = 10 * (1 0.4)

= 6%

Amount
Particulars Weights COC Weighted * COC
(Rs in lakh)
Equity 50 + 16 = 66 66 ÷ 151 = 0.4371 0.1653 0.07225
Preference Shares 15 15 ÷ 151 = 0.0993 0.1530 0.01519
Debentures 30 30 ÷ 151 = 0.1987 0.0778 0.01546
Borrowings 40 40 ÷ 151 = 0.2649 0.06 0.01589
TOTAL 151 1.0000 WACC 0.1189979

WACC = 0.11879

= 11.879%

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