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MBA 2

nd
Semester
Amity Global Business School
Kavitha Menon
1
Introduction
Every company needs funds for:
Working capital for current business operations
Long term investments launching new product,
improvisation of existing product, aggressive
positioning & marketing of product, expansion,
restructuring, acquisition, modernization, contingency
requirements & replacement of long-term assets from
time to time.
2
Introduction
Hence, they should know:
How much funds they require,
From where will they procure the required funds, &
At what cost the funds will be available & procured.
3
Introduction
Small
amounts
Short
maturity
period
Cost is,
therefore
less
Also less
risky
Short
term
funds
Large
amounts
Large
maturity
period
Cost is high
Greater
uncertainty
& risk
Long
term
funds
4
Introduction
As cost of long term funds is high, companies need to
manage such funds & try to control the cost & risk
involved with it.
Inefficient management of such funds can lead to high
cost of capital for the company, which in turn
decreases the profits thereby depleting the value 0f the
company.
5
Concept of cost of capital
6
Investor
Or
lender
Company
or
borrower
Return on lent
money
Cost of borrowed
money
=
Company pays cost to investors
for lending their money
Lends money at an expected
return
Cost Of Capital
The rate that must be earned on the funds or capital
employed by the company.
The minimum rate of return that a firm must earn on
its investments for the market value of the common
stock of the firm to remain unchanged
It is also referred to as a hurdle rate because this is
the minimum acceptable rate of return.
It is the compensation expected by the investors from
the company for the time & risk taken up by them.
7
Cost Of Capital
Any investment which does not cover the firms cost
of funds will reduce shareholder wealth (e.g. if you
borrowed money at 10% to make an investment
which earned 7%, it would reduce your wealth)
Hence if


where r = rate of return
k = cost of capital

8
Value Maximization r > k
Leads to
Meaning
When we say a firm has a cost of capital of, for
example, 12%, we are saying:
The firm can only have a positive NPV on a project if
return exceeds 12%
The firm must earn 12% just to compensate investors for
the use of their capital in a project
The use of capital in a project must earn 12% or more

9
Required Rate of Return
Vs
Cost of Capital
Required rate of return :
is from the investors point of view
Cost of capital :
is the same return from the firms point of view
Appropriate discount rate:
is the same rate yet again to be used in the present
value calculations
10
Significance
Evaluating Capital budgeting decision

Designing a firms optimal capital structure such
that value of the firm is maximum & cost of capital
is minimum

Appraising the financial performance of top
management by comparing the profit & the cost of
capital (r>k)

11
General economic conditions
Demand for and supply of capital within the economy and the
level of expected inflation
Market conditions:
As the marketability of a security increases, investors required
rates of return decrease, lowering the companys cost of capital.
Amount of financing:
Requests for larger amounts of capital increase the firms cost of
capital.
A firms operating and financing decisions
Business Risk- The risk to the firm of being unable to cover the
fixed operating costs.
Financial Risk- The risk of being unable to cover required
financial obligations like interest & preference dividends.
12
Factors determining the cost of capital
Components of cost of capital
Three components of cost of capital, k
The riskless cost of the particular type of financing, r
j
The business risk premium, b
The financing risk premium, f

Or
k = r
j
+ b + f



13
Sources of funds
Common stock (Equity Shares)
Preferred stock (Preference Shares)
Bonds & debentures (debt)
Retained earnings (profit the company makes but does
not give to the shareholders in the form of dividends)

14
Specific Cost
Since different sources of funds have different risks,
investors require different rates of return on various
securities, thereby causing different cost of capital to the
firm.
Risk with equity capital > risk with preference capital> risk
with debt
In case of companies
Cost of equity > cost of preference shares > cost of debt
In case of investors
Return of equity > return of preference shares > return of debt
15
Specific Cost
Example:
Cost of debt
Cost of preference shares
Cost of equity capital
Cost of retained earnings
16
Weighted Average Cost of Capital (WACC)
When the specific costs are combined to arrive at the
overall cost of capital.
Also called composite cost of capital, combined cost of
capital or just cost of capital.
17
Computation of Cost of Capital
Steps:
1. Computation of cost of specific sources of a capital,
viz., debt, preference capital, equity and retained
earnings, and
2. Computation of weighted average cost of capital
18
19
Flotation Costs
When a company sells securities to the public, it must
use the services of an investment banker
The investment banker provides a number of services
for the firm, including:
Setting the price of the issue, and
Selling the issue to the public
The cost of these services are referred to as floatation
costs, and they must be accounted for in the WACC
Generally, we do this by reducing the proceeds from the
issue by the amount of the flotation costs, and
recalculating the cost of capital
20
21
Cost of Debt
Includes :
Term loans from banks & financial institutions
Debentures
Bonds
Debt may be perpetual or redeemable debt.
Also, it may be issued at par, at premium or
discount.
22
Cost of Debt
Regarding Cost of Debt, k
d
:
Equals the current interest cost or coupon rate
to borrow new funds
Current interest rates are determined from the
going rate in the financial markets
Before tax cost of debt is the rate of return
required by the lenders
23
Tax Adjustment
The interest paid on debt is tax deductible
The higher the interest charges, lower would be the
amount of tax payable by the firm.
As a result, the after-tax cost of debt to the firm will be
substantially lower than the investors required rate of
return.
After-tax-cost of debt = k
d
= k
i
(1-t)
Where t is the corporate tax rate & k
i
is before tax
cost of debt
Loss making firms will not have after tax cost of debt.
When calculating WACC, after-tax-cost of debt is to be
used
24
Formula for cost of perpetual debt
1. Before tax cost of debt 2. After tax cost of debt




where,
k
i
- before tax cost of debt
k
d
after tax cost of debt
P
0
- net proceeds of the debt
I - the amount of interest
t tax rate
25
0
P
I
k
i
=
) 1 ( t k k
i d
=
Net proceeds from the issue (P
0
)

Where
P
0
= Net proceeds from the issue
FV = Face Value of Debt
P
m
= Premium
D = Discount
F = Floatation Costs (i.e. cost of raising funds including
underwriting, brokerage & issue expenses
26
F FV P =
0
F P FV P
m
+ =
0
F D FV P =
0
Issued at par
Issued at a
premium
Issued at a
discount
Exercise
Y Ltd issued Rs. 2,00,000, 9% debentures at a premium of
10%. The costs of flotation are 2% of issue price .The tax
rate is 50%. Compute the after tax cost of debt.







Net proceeds = 200,000 + 20,000 2% * 220,000 = 215,600
27
) 1 (
0
t
P
I
k
d
=
) 50 . 1 (
600 , 215
000 , 200 * % 9
=
d
k
% 17 . 4 =
d
k
Exercise
A company has a 10% perpetual debt of Rs. 100,000.
The tax rate is 35%.
Determine the cost of capital (before & after tax)
assuming the debt is issued at
(i) par
(ii) 10% premium
(iii) 10% discount.
Assume floatation costs at 1% of face value
28
Formula for cost of redeemable debt
The debt repayable after a certain period is known as
redeemable debt





where,
I - the amount of interest
RV Redeemable value
P
o
net proceeds from the sale
n term of the debt in years
t tax rate
29
) (
2
1
) (
1
0
0
P RV
P RV
n
I
k
i
+
+
=
) (
2
1
) (
1
) 1 (
0
0
P RV
P RV
n
t I
k
d
+
+
=
Exercise
A company issued Rs. 1,00,000 10% redeemable
debentures at a discount of 5%. The cost of flotation
amount to Rs. 3,000. The debentures are redeemable
after 5 years. Compute before tax and after tax cost
of debt. The tax rate is 50%.
30
Exercise
ABC Ltd. issues 15% debentures of face value of Rs. 100
each, redeemable at the end of 7 years, the debentures
are issued at a discount of 5% and the floatation cost is
estimated to be 1%.
Find out the cost of capital of debentures given that
the firm has 50% tax rate.
31
32
Cost of Preference Capital
It is the dividend expected by the preference shareholders.
In case of preference capital, payment of dividends is not
legally binding
Preference dividend is not tax deductible, unlike interest
payments on debt, as its an appropriation of earnings
They are paid out after corporate tax has been paid. No
adjustment is required for taxes while computing k
p
Since interest is tax deductible & preference dividend is not,
the cost of preference capital is substantially higher
than the after tax cost of debt
Preference capital can be redeemable or irredeemable.
33
Formula for Cost of Irredeemable
Preference Shares
If Preference shares are perpetual,


Where
k
p
cost of preference capital
P
0
net proceeds
D
p
annual preference dividend
D
t
Dividend distribution tax
34
0
) 1 (
P
D D
k
t p
p
+
=
Exercise
A company issued 10,000, 10% preference share of Rs.
10 each, Cost of issue is Rs. 2 per share.
Calculate cost of capital, if these shares are issued (a)
at par , (b) at 10% premium, and (c) at 5% discount.
35
Exercise
A company issued 100,000, 8% irredeemable
preference shares of Rs. 500 each. Issue expenses are
2% of face value. Assuming 10% dividend tax payable
by the company, compute the cost of preference capital
if the shares are issued:
(i) at par
(ii) at 10% discount
(iii) at 10% premium
36
Formula for Cost of Redeemable
Preference Shares
where,
D
p
- the amount of preference dividend
RV Redeemable Value
P
0
net proceeds from the sale
n term of the preference share in years
37
) (
2
1
) (
1
0
0
P RV
P RV
n
D
k
p
p
+
+
=
Exercise
A company issues 1,00,000 10% preference share of Rs.
10 each. Calculate the cost of preference capital if it is
redeemable after 10 years.
a) At par b) at 5% premium
38
Exercise
Calculate cost of preference capital
(a) A company issued 12% preference shares of Rs. 500
each, at Rs. 450 redeemable after 5 years at par. The
cost of flotation is expected to be 5% of issue price.
(b) A company issued 12% preference shares of Rs. 500
each, at Rs. 550 redeemable after 5 years at par. The
cost of flotation is expected to be 5% of issue price.
(c) A company issued 12% preference shares of Rs. 500
each, at Rs. 450 redeemable after 5 years at Rs. 520.
The cost of flotation is expected to be 5% of issue
price.

39
Exercise
ABC Ltd. issues 15% preference shares of the face value
of Rs. 100 at
Par
Premium of 10%
Discount of 5%
Find the cost of capital of preference share if
The preference shares are irredeemable, and
If the preference shares are redeemable after 10 years at a
premium of 10%.
Floatation cost of 4% of issue price.
40
41
Cost of Equity Capital
Minimum rate of return that a firm must earn on the
equity-financed portion of an investment project in
order to leave unchanged the market price of the shares
Equity capital can be raised:
internally by retained earnings
or
the firm can distribute dividends & raise capital by new
issue of equity shares
In both the cases the shareholders are providing funds
to the firms to finance their capital expenditures
Equity shareholders required rate of return would be
same
42
Example
A firm accepts an investment project involving an outlay
of Rs. 1000 which is to financed by equity & debt in the
ratio of 75:25. The project will earn Rs. 110 every year.
Required rate of return on equity is 12% and cost of debt
is 8%.





If the project earns less than Rs. 110, it would give a
return less than that required by investors leading to
decline in market price of shares.
This rate is the cost of equity
43
Rs.
Total Return
Less: Interest on debt 25% * 1000 * 8%
110
20
Amount available to equity shareholders 90
Rate of return on equity = Rs. 90/750 * 100 = 12%
Is equity capital free of cost?
It is often said the equity shares have no cost of
capital no fixed rate of dividend, no commitment to
pay such dividend (sole discretion of the BoD), such
shareholders are the last claimants on the profits of
the company.
But equity capital has a cost - involves opportunity
cost; ordinary shareholders provide funds to the firm
in expectation of dividends and capital gains
44
Difficulties in determining equity
investors rate of return
Two difficulties involved:
Difficult to estimate dividend payments
Depends upon company policy & strategic decisions
Cannot be estimated correctly & they grow over time
Difficult to estimate capital gains
Depends upon market conditions & investors
perceptions, which are difficult to forecast.re expected
to grow
45
Approaches to calculate
cost of equity
To overcome the difficulties, two widely
used approaches are used :
1. Dividend Approach
2. Capital Asset Pricing Model (CAPM)
Approach
46
Dividend Approach
Based on the dividend valuation model which assumes
that the value of a share (current market price of a
share) equals the present value of all future dividends
that it is expected to provide over an indefinite period.
47
Dividend Growth Model
Dividends are expected to grow at a constant rate
of g

g
P
D
k
e
+ =
0
1
48
Where,
k
e
= cost of equity
P
0
= Net proceeds per share/current market
price

D
1
= Expected dividend per share = D
0
(1+g)
g= expected growth in dividends
Net Proceeds in case of new
equity issue
Current market price in case
of existing
Can be written as follows:



These equations are based on the following assumptions:
Market price of the share is a function of expected
dividends
The Dividend is positive
The dividends grow at a constant rate
The dividend payout ratio i.e. (1 b) is constant, b
being retention ratio
Also called as GORDONs model
g k
D
P
e
o

=
1
49
Dividend Growth Model
Cost of Retained Earnings
A firms internal equity consist of its retained earnings.
The opportunity cost of the retained earnings is the
rate of return foregone by equity shareholders.
The shareholders generally expect dividend and capital
gain from their investment.
The required rate of return of shareholders can be
determined from the dividend valuation model
50
If the firm had distributed earnings to shareholders,
they could have invested it in the shares of the firm or
in the shares of other firms of similar risk at the
market price (P
0
) to earn a rate of return equal to k
e
Thus the firm should earn a return on retained funds
equal to k
e
to ensure growth of dividends & share
prices.
If a return less than k
e
is earned on retained earnings,
the market price of the firms share will fall.
51
Explanation
Exercise - 1
ABC Ltd plans to issue 1,00,000 new equity share of Rs.
10 each at par. The flotation costs are expected to be
5% of the share price. The company will pay a dividend
of Rs. 1 per share and the growth rate in dividend is
expected to be 5%. Compute the cost of new issue
share.
52
Exercise - 2
SQL Ltd. has just declared & paid a dividend at the
rate of 15% on the equity share of Rs. 100 each. The
expected future growth rate in dividends is 12%.
Calculate the cost of capital of equity shares given that
the present market value of the share is Rs. 168.
53
Exercise - 3
Epsilon Co.s last annual dividend was Rs. 4 per share
and both earnings & dividends are expected to grow at
a constant rate of 8%. The share now sells for Rs. 50
per share. Calculate the cost of retained earnings
using Gordons growth model
54
Exercise - 4
Investors require a 12% rate of return on equity shares
of Co. Y. What would be the market price of the shares
if the previous dividend was Rs. 2 and investors expect
dividends to grow at a constant rate of
(a) 4%
(b) 0%
(c) -4%
(d) 11%
(e) 12%
(f) 14%
55
Exercise - 5
A mining companys iron ore reserves are being
depleted, and its cost of recovering a declining quantity
of iron ore are rising every year. As a consequence, the
companys earnings & dividends are declining @ 8% per
year. If the previous years dividend was Rs. 10 and the
required rate of return is 15%, what would be the
current price of the equity share of the company?
56
Exercise - 6
The share of SQL Ltd. is presently traded at Rs. 50 and
the company is expected to pay dividends of Rs. 4 per
share with a growth rate expected at 8% p.a.
It plans to raise fresh equity capital. The merchant
banker has suggested that an under-pricing of Re 1 is
necessary in pricing the new issue besides involving a
cost of 50 paisa per share on miscellaneous expenses.
Find out the cost of existing equity shares as well as the
new equity given that the dividend rate and the growth
rate are not expected to change
57
Exercise - 7
The share of a company is currently selling at Rs. 100.
It wants to finance its capital expenditure of Rs. 100
million either by retaining earnings or selling new
shares. If the company sells new shares, the issue price
will be Rs. 95. The dividend per share next year is Rs.
4.75 and it is expected to grow at 6%.
Calculate -
(i) cost of internal equity (retained earnings)
(ii) cost of external equity (new issue of shares)

58
Estimating future growth in dividends
Growth in dividend can be extremely volatile &
sensitive depending upon the market, economic &
company factors.
It is expected future growth impossible to calculate it
accurately
Methods to estimate g
Past growth in dividends
Current retained earnings
59
Past growth in dividends
Example:
Dividends paid by the company during the last few
5 years are: Rs. 18, Rs. 17, Rs. 20. Rs. 24 and Rs. 25.
For accurate results, use TVoM formula
PV
n
= FV
n
* P VIF
(g,n)
Using the formula
P VIF
(g,n)
= 18 /25 = 0.72
Looking into the PVIF table




60
Period 8% 9%
5 0.735 .708
Past growth in dividends
Solve using the above formula:



g = 8.56%

61
(


+ =
PVIF HigherRate PVIF LowerRate
Q PVIF LowerRate
LowerRate g
(

+ =
708 . 0 735 . 0
72 . 0 735 . 0
% 8 g
Growth in earnings arises because a company increases
its investments and obtains a greater earnings.
Higher growth can be obtained through greater
retained earnings and investments in more profitable
assets
Thus, g = r * b
Where
r = rate of return obtained on new investment
b = retention ratio i.e. proportion of earnings retained
62
Current Retained Earnings
Example
The latest earnings and dividends of a company are Rs.
37 and Rs. 16 respectively. The expected rate of return
on new investment is 18%. Calculate expected growth
rate.
b = (37-16)/37 = 0.57
g = r * b
= 0.18 * 0.57
= 10.26%

63
Exercise - 8
An ordinary share of a company, which does not
engage in external financing, is selling for Rs. 50. The
earnings per share is Rs. 7.50 of which 60% is paid as
dividends. The company reinvests retained earnings at
a rate of 10%. Calculate cost of equity capital
64
Exercise - 9
Determine the cost of equity shares of company X:
i. Current market price of a share Rs. 150
ii. Cost of flotation per share on new shares Rs. 3
iii. Dividend paid on the outstanding shares over the past 6
years:





iv. Assume a fixed dividend payout ratio
v. Expected dividend on new shares at the end of the
current year is 14.10 per share
65
Year Dividend (Rs.)
1
2
3
4
5
6
10.50
11.02
11.58
12.16
12.76
13.40
Exercise - 10
XYZ Ltd. is attempting to evaluate the costs of internal &
external equity. The companys share is currently being
sold at Rs. 62.50 per share. The company expects to pay Rs.
5.42 per share at the end of the year. The dividends for the
past 5 years are given below:





The company expects to net Rs. 57.50 per share after
flotation costs. Calculate (a) growth rate of dividend (b)
flotation cost (%) (c)cost of internal equity (d) cost of
external equity
66
Year Dividend (Rs.)
2009
2008
2007
2006
2005
5.17
4.92
4.68
4.46
4.25
Dividend Distribution Tax
In India, as per the income tax act, a company is liable
to pay dividend distribution tax on the dividend
declared by it. The shareholders do not have to pay
any tax.
Then



Where, D
t
is the dividend distribution tax.
67
g
P
D D
k
t
e
+
+
=
0
1
) 1 (
68
Weighted Average Cost of Capital (WACC)
Also called Composite cost of capital or Overall cost of
capital
It is the rate of return that must be earned by the firm
in order to satisfy the requirements of the different
investors.
69
Steps in calculating WACC
70
Calculate the
cost of specific
sources of funds
Multiply the
cost of each
source by its
proportion in
the capital
structure
Add the
weighted
component
costs to get the
WACC.
WACC Vs Simple Average CC
WACC gives consideration to the proportion of various
sources of funds in the capital structure in a company,
which simple average does not.
71
Why WACC ?
Overall cost of capital is of utmost importance as this
rate is to be considered while deciding the optimal
financing mix for the firm and is to be used as the
discount rate or cut-off rate while evaluating the
capital budgeting proposals.
This overall CoC is calculated using WACC
72
Formula for k
o
WACC = Cost of Equity * Proportion of equity in the
financing mix (+) Cost of Debt * Proportion of debt in
the financing mix (+) Cost of preference capital *
Proportion of preference capital in the financing mix





73
w
e
w
d
w
p
Formula for k
o




Where
k
e
= Cost of equity
w
e
= Proportion of equity in the financing mix
k
d
= Cost of debt

w
d
= Proportion of debt in the financing mix

k
p
= Cost of preference capital
w
d
= Proportion of preference capital in the financing mix

74
p p d d e e
w k w k w k WACC * * * + + =
Which weights to use?
The question is which weights to use
Should we use the values given in the balance sheet,
which reflects the historical values of the amounts of
funds raised from various sources?
OR
Should we use the market values of the various claims?
75
Weights used -
Historical or existing weights
1. Book Value
2. Market Value
76
Book -Value Weights
Weights based on the actual or existing proportions of
different sources in the overall capital structure.
Readily available from published records of the firm
balance sheet which lists the long-term debts, equity &
preference capitals
The book value debtequity ratios are analysed by
investors to evaluate the risk of the firms in
practice
77
Book-value Weights (contd)
Source Total book value % of total
Long term debt Rs. 400,000 40%
Preference capital Rs. 100,000 10%
Equity capital Rs. 500,000 50%
Grand Totals Rs. 10,00,000 100%
78
The following table shows the calculation of the
book-value weights for Cost of Capital:
Market-value Weights
The problem with book-value weights is that the book
values are historical, not current values
The market recalculates the values of each type of
capital on a continuous basis. Therefore, market
values are more appropriate
Calculation of market-value weights is very similar to
the calculation of the book-value weights
The main difference is that we need to first calculate
the total market value (price * quantity) of each type
of capital
Market Value of Retained Earnings
Can be indirectly estimated.
Since retained earnings are treated as equity capital for
the purpose of calculation of specific cost of capital,
the market value of the ordinary shares may be taken
to represent the combined market value of equity
shares & retained earnings.
Separate market values of retained earnings & ordinary
shares allocated based on ratio of their book
values
80
Calculating the Market-value weights
Source Price per
unit
Units Total market
value
% of
total
Long term
debt
Rs. 905 400 362,000 31.15%
Preference
capital
Rs. 100 1000 100,000 8.61%
Equity capital Rs. 70 10,000 700,000 60.24%
Grand Totals Rs. 11,62,000 100%
81
The following table shows the current market prices:
Example
Sources of Finance Amount (Rs.) Cost (%)
Equity Share Capital 450,000 18
Reserves & surplus 150,000 18
Preference Capital 100,000 11
Debentures 300,000 8
82
Lohia Chemicals Ltd. has the following book value capital
structure as on 31
st
march 2010 and the expected after tax costs
of carious sources of finance:
Calculate WACC
Solution
Source Amount
(1)
Proportion
(2)
After-
tax cost
(3)
Weighted
cost
(4)=(2)*(3)
Equity Share
Capital
450,000 0.45 0.18 0.081
Reserves &
surplus
150,000 0.15 0.18 0.027
Preference
Capital
100,000 0.10 0.11 0.011
Debentures 300,000 0.30 0.08 0.024
Total 10,00,000 0.143
83
WACC = 0.143 = 14.3%
Alternative Solution
Source Amount
(1)
After-tax cost
(2)
Total cost
(3)=(1)*(2)
Equity Share
Capital
450,000 0.18 81000
Reserves & surplus 150,000 0.18 27000
Preference Capital 100,000 0.11 11000
Debentures 300,000 0.08 24000
Total 10,00,000 143000
84
WACC = (143000/1000000 ) * 100
= 14.3%
85
A firms after-tax cost of capital of the specific sources
is as follows
Cost of debt 8%
Cost of preference capital (inclu. DDT) 14%
Cost of equity funds 17%
The following is the capital structure:
Source Amount (Rs. )
Debt 300,000
Preference Capital 200,000
Equity Capital 500,000
Total 10,00,000
86
Calculate the weighted average cost of capital, k
o
, using
book-value weights
87
A company has on its books the following amounts &
specific costs of each type of capital
TYPE OF CAPITAL BOOK VALUE MARKET
VALUE
SPECIFIC
COSTS
Debt 400,000 380,000 5
Preference 100,000 110,000 8
Equity 600,000 15
Retained Earnings 200,000 12,00,000 13
13,00,000 16,90,000
88
Determine the weighted average cost of capital using (a)
book value weights (b) market value weights.
How are they different?
When will the WACC be the same , using either of the
weights
Exercise - 3
A firm finances all its investments by 40% debt & 60%
equity. The estimated required rate of return on equity
is 20% after taxes and that of debt is 8% after taxes.
The firm is considering an investment proposal
costing Rs. 40,000 with an expected return that will
last forever. What amount must the proposal yield per
year so that the market price of the share does not
changes? Show calculations to prove your point.
89
90
In considering the most desirable capital structure for a
company, the following estimates of the cost of debt
capital (after tax) have been made at various levels of
debt-equity mix:






You are required to find out the weighted average cost of
capital of the firm for different proportions of debt:
91
Debt as % of total
capital employed
Cost of debt (%) Cost of equity (%)
0
10
20
30
40
50
60
7.0
7.0
7.0
7.5
8.0
8.5
9.5
15
15
15.5
16
17
19
20
92
The following balances appear in the balance sheet of
Nagaraj Alloys Ltd.:




The company is expected to earn an EBIT of Rs. 900,000 p.a.
and the tax rate is 40%. The current market prices of equity
& preference shares are Rs. 12.50 and Rs. 8 respectively.
However, the debentures are being traded at par.
Calculate WACC, based on book value & market value
weights, given the retained earnings & dividends are valued
equally by shareholders.
93
Equity share capital of Rs. 5 each Rs. 800,000
10% preference share of Rs. 10 each Rs. 500,000
Reserves & surplus Rs. 600,000
12% debentures of Rs. 100 each Rs. 10,00,000
94
A limited company has the following capital structure :





The market price of the companys equity share is Rs. 20. It is expected
that the 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
presumes at 50%. Compute the following:
a) A weighted average cost of capital based on the existing capital
structure
b) The new WACC if the company raises additional Rs. 20,00,000 debt by
issuing 10% debentures. This would result in increasing the expected
dividend to Rs. 3 and leave the growth rate unchanged but the prices of
share will fall to Rs. 15 per share.
c) The cost of equity capital if in (b) above, the growth rate increases to
10%
95
Equity Share Capital (200,000 shares)
6% preference share capital
8% debentures
Rs. 40,00,000
Rs. 10,00,000
Rs. 30,00,000
Rs. 80,00,000
96
The capital structure of MNP Ltd. is as under:




Additional information:
Rs. 100 per debenture redeemable at par has 2% floatation cost and 10
years of maturity. The market price per debenture is Rs. 105.
Rs. 100 per preference share redeemable at par has 3% floatation cost
and 10 years of maturity. The market price per preference share is Rs.
106.
Equity share has Rs. 4 floatation cost and market price per share of
Rs. 24. The next year expected dividend is Rs. 2 per share with annual
growth of 5%. The firm has a practice of paying all earnings in the
form of dividends.
Corporate Income-tax rate is 35%.
Required : Calculate Weighted Average Cost of Capital (WACC) using
market value weights.

97
9% Debenture
11% Preference shares
Equity shares (face value : Rs. 10 per share)
Rs. 2,75,000
Rs. 2,25,000
Rs. 5,00,000
Rs. 10,00,000
98
A company wishes to determine the optimal capital
structure from the following information. Determine
the optimum capital structure from the viewpoint of
minimizing the cost of capital.

99
Financing
Plan
Debt
Amount
Equity
Amount
After tax
cost of
debt (%)
Cost of
equity
(%)
A
B
C
D
800,000
600,000
500,000
200,000
200,000
400,000
500,000
800,000
14
13
12
11
20
18
16
18