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Cost of Capital Solved Problems

# Cost of Capital Solved Problems

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10/06/2014

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FINANCIAL MANAGEMENT

Solved Problems
Rushi Ahuja1
SOLVED PROBLEMS – COST OF CAPITAL
Problem 1
Calculate the cost of capital in the following cases:i)

X Ltd. issues 12% Debentures of face value Rs. 100 each and realizes Rs. 95 per Debenture.The Debentures are redeemable after 10 years at a premium of 10%.ii)

Y. Ltd. issues 14% preference shares of face value Rs. 100 each Rs. 92 per share. The sharesare repayable after 12 years at par.Note: Both companies are paying income tax at 50%.
Solution
(i)

Cost of Debt
[Int + (RV – SV) / N] (1 – t)
d
(RV + SV) / 2Int = Annual interest to be paid i.e. Rs. 12t = Company’s effective tax rate i.e. 50% or 0.50RV = Redemption value per Debenture i.e. Rs. 110N = Number of years to maturity = 10 yearsSV = issue price per debenture minus floatation cost i.e. Rs. 95[12 + (110 – 95) / 10] (1 – .5)
d
=(110 + 95) / 2[12 + 2.5](0.5) 7.25= = = 7.43%97.50 97.50
(ii)

Cost of preference capital
D + (RV – SV) / N
p
(RV + SV) / 2Where,D = Dividend on Preference share i.e. Rs. 14SV = Issue Price per share minus floatation cost Rs. 92N = No. of years for redemption i.e. 12 yearsRV = Net price payable on redemption Rs. 100

FINANCIAL MANAGEMENT

Solved Problems
Rushi Ahuja 2
14 (100 – 92) / 12
p
=(110 + 95) / 214 + .67=95= 15.28%
Problem 2
a)

A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share of Rs. 10 each. Find out the cost of preference share capital when it is issued at (i) 10% premium, and(ii) 10% discount.b)

A company has 10% redeemable preference share which are redeemable at 6the end of 10
th
yearfrom the date of issue. The underwriting expenses are expected to 2%. Find out the effective cost of preference share capital.c)

The entire share capital of a company consist of 1,00,000 equity share of Rs. 100 each. Its currentearnings are Rs. 10,00,000 p.a. The company wants to raise additional funds of Rs. 25,00,000 byissuing new shares. The flotation cost is expected to be 10% of the face value. Find out the cost of equity capital given that the earnings are expected to remain same for coming years.
Solution
(a)

Cost of 10% preference share capital
(i)

When share of Rs. 10 is issued at 10% premiumK
p
= D / P
0
= 10 / 11 x 100= 9.09%(ii)

When share of Rs. 10 is issued at 10% discount
p
= PD / P
0
= 10 / 9 x 100= 11.11%(b)

The cost of preference share (face value = Rs. 100) may be found as follows:D + (RV – SV) / N
p
=(RV+ SV) / 2

FINANCIAL MANAGEMENT

Solved Problems
Rushi Ahuja 3
In this case D = 10RV = 100SV = 100 2 = Rs. 9810 + (100 – 98) / 10
p
=(100 + 98) / 2= 10.3%(c)

In this case, the net proceeds on issue of equity shares are Rs. 100 – 10 = Rs. 90 and earnings pershare is Rs. 10.Cost of new equity is:
e
= D
1
/ p
0
= 10 / 90 11.%
Problem 3
A company is considering raising of funds of about Rs. 100 lakhs by one of two alternative method,viz., 14% institutional term loan or 13% non-convertible debentures. The term loan option would attractno major incidental cost. The debentures would have to be issued at a discount of 2.5% and wouldinvolve cost of issue of Rs. 1,00,000.Advise the company as to the better option based on the effective cost of capital in each case. Assume atax rate of 50%.
Solution
Effective cost of 14% loan: In this case, there is no other cost involved and the company has to payinterest at 14%. This interest after tax shield @ 50% comes to 7% only.Effective cost of 13% NCD : In this case,Annual Interest, I = Rs. 13SV = 100 2.50 1.00= 96.5013 (1 – 5)
d
=96.50%= 6.74%The effective cost of capital is lesser in case of 13% NCD.