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Financial Management

Q 1. X company has the following capital structure at 31 March, 2009, which is


considered to be optimum:
+14% Debentures – 3,00,000
+11% Debentures – 1,00,000
+Equity (1,00,000) – 16,00,000
Total: 20, 00, 000

The company’s share has a current market price for Rs. 23.60/share. The expected
dividend per share for next year is 50% of the 2003 EPS. Following are the earnings per
share figure of the company during the preceding 10 years. (The past trends are
expected to continue)

EPS Rs. EPS Rs.

2005 1.00 1999 1.61


2006 1.10 2000 2.00
2007 1.21 2001 1.95
2008 1.33 2002 2.15
2009 1.46 2003 2.36

The company can issue 16% new debentures. The company’s debentures are currently
selling at Rs. 96. The new preference issue can be sold at a net price of Rs. 9.20, paying
a dividend of Rs. 1.1/share. The company’s marginal tax is 50%.

Questions:

I. Calculate the after tax cost (i) of new debt, (ii) of new preference capital & (iii) of
ordinary equity, assuming new equity comes from retained earnings.
II. Find the marginal cost of capital, again assuming no new ordinary shares are sold.
(WACC=MACC)
III. How much can be spent for capital investment before new ordinary shares must
be sold? Assume that retained earnings available for next year’s investment are
50% of 2003 earnings.
IV. What is the marginal cost of capital (cost of funds raised in excess of the amount
calculated in Q II), if the firm can sell new ordinary shares to net Rs. 20/share?
The cost of debt & of preference capital is constant.

Solutions:

I. (i) Cost of debt = 16/96 = 0.16


After tax rate = Kd(1-d) = 0.16(1-0.5) = 0.16X0.5 = 0.80 or 8%
(ii) Cost of preference share = 1.1/9.20 = 11/92 = 0.12
After tax cost = 11/92 X ½ = 11/184 = 0.059%
(iii) Cost of ordinary equity = Dividend/Po + g = 1.18/23.60 + 0.10 = .05+.10 =
0.15
Cost Weight Product WACC
Debentures: 3,00,000 0.15 0.08 0.0120
II
Preference share: 1,00,000 0.05 0.12 0.0060
Equity share: 16,00,000 0.80 0.15 0.120
Total 0.138

Since there is no change in capital structure, marginal cost will be same as that to
WACC.

III. Retained earnings = no. of equity shares X 50% of EPS Rs. 2.36 = 1,00,000 X
1.18
= Rs. 1,18,000
Investment before equity= retained earnings / % equity= 1,18,000 / 50% = Rs.
1,47,500

IV. For spending any amount over Rs. 1,47,500, new equity shares will have to be
issued.
Cost of equity = 1.18/20 + 0.10 = 0.059 + 0.10 = 0.159

MACC or WACC:

% Specific Cost Product

Debentures: 0.15 0.08 0.0120


Preference share: 0.05 0.12 0.0060
Equity share: 0.80 0.159 0.1272
Total 0.1452

Q 2. A firm is thinking of raising funds by the issuance of equity capital. The current
market price of the firm’s share is Rs. 150. The firm is expected to pay dividend of
Rs 3.55 next year. The firm paid dividend in past years as follows:

Year Dividend Year Dividend


2003 2.00 2006 2.60
2004 2.20 2007 2.93
2005 2.42 2008 3.22
The firm can sell shares for Rs. 140 per share. In addition, the floatation cost per
share is Rs. 10. Calculate cost of new issue.

Solution: Current market price – Rs. 150


Rate of growth – 10%
Next year dividend – 3.55
Current Market Price – Rs. 140
Ke = 3.55/140 + 0.10 = 0.125
After floatation cost = 3.55/ 140-10 + 10% = 3.55/130 + .10 = .027+10 =
.127

Q 3. A company is considering distributing additional Rs 80000 as dividend to it’s


ordinary shareholders. The shareholders are expected to earn 18% on their
investment. They are in 30% tax & incur brokerage of 3% on the reinvestment of
dividends received. The firm can earn 12% on the retained earnings. Should the co.
distribute or retain Rs. 80000 ?

Solution: Shareholder’s expected rate of return= 18%


Brokerage= 3%
Income tax rate = 30%
Return after brokerage= 1- 0.03 = 0.97
Return after income tax= 18% of 0.97(1-.30)= .97 X .7 X .18 / 0.1222
Firm’s rate of return = 12%
Therefore, since investor’s rate of return is lower than the company’s return. So,
dividend should be distributed.