FINANCIAL MANAGEMENT Solutions to Numerical Problems

Rajiv Srivastava - Dr. Anil Misra Chapter 13

13-1: Cost of Perpetual Debt

Permanent Debt Limited keeps a fixed amount of debt in its books. It pays coupon of 15%. Its debt
sells at par in the market. What is the cost of debt if the firm pays 35% tax?
What is the cost of debt it sells a) at 5% premium b) at 5% discount to the face value?

Solution:
Cost of perpetual debt:
Coupon rate 15.00% Face value Rs 100.00
Coupon Payment Rs 15.00 Tax 35.00%
Current market price Rs 100.00

Cost of perpetual debt = Coupon x (1 - T)/Market Price

= 15 x (1 - 0.35)/100 = 9.75%
Market price at 5% premium to the face valu Rs.105.00
Cost of debt = 15 x (1 - 0.35)/105 = 9.29%

Market price at 5% discount to the face value = Rs 95.00

Cost of debt = 15 x (1 - 0.35)/95 = 10.26%

13-2: Cost of Redeemable Debt

Dhatu Nigam Limited has decided to issue debentures with the face value of Rs 100 with coupon
of 12% payable annually. The tenure of the debentures is 8 years when it would be redeemed at a
premium of 5% to the face value. The floatation cost is placed at 5% of the issue price. The firm
pays 40% tax. What is the cost of debt if the firm is able to market its debenture a) at par b) at a
price of Rs 110 c) at a price of Rs 90?

Solution:
Cost of redeemable debt;
Coupon 12.00% Face Value Rs 100.00
Price Rs 100.00 Redemption Rs 105.00
Floatation cost 5.00% Tax rate 40%

Cash flows of Debenture Figures in Rs

Year Price Floatation Interest Tax Saved RV Cash flow
0 100.00 -5.00 95.00
1 -12.00 4.80 -7.20
2 -12.00 4.80 -7.20
3 -12.00 4.80 -7.20
4 -12.00 4.80 -7.20
5 -12.00 4.80 -7.20
6 -12.00 4.80 -7.20
7 -12.00 4.80 -7.20
8 -12.00 4.80 -105.00 -112.20
Cost of redeemable debt 8.55%
= IRR of the cash flow of debenture

We may compute the cash flow of the debenture with different issue price and its IRR to
find the cost of debt.
For market price of Rs 110 we get IRR of 6.94%
For market price of Rs 90 we get IRR of 10.39%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

13-3: Cost of Perpetual Preference Capital

ABC Limited has issued 14% preference shares of Rs 100 each. The current price of the preference
shares is Rs 100 What is the cost of preference capital for ABC limited?
What would be the cost of preference capital if the price of preference shares is changed to a) Rs
90 and b) Rs 120?

Solution:
Cost of perpetual preference capital:
Dividend rate 14.00% Face value Rs 100.00
Dividend Rs 14.00
Current market price Rs 100.00
Cost of perpetual preferential capital = Dividend/Market Price
Cost = 14/100 = 14.00%

Market Price = Rs 90.00

Cost = 14/90 = 15.56%

Market Price = Rs 120.00

Cost = 14/120 = 11.67%

13-4: Cost of Redeemable Preference Capital

ABC Limited has issued 12% preference shares redeemable at the end of 7 years at premium of
10% with the face value of Rs 100 but issued at Rs 105 with floatation cost of 5%. What is the cost of
preference capital issued by ABC Limited?

Solution::
Cost of redeemable preference capital is governed by the cash flows.
Dividend 12.00% Face Value Rs 100.00
Price Rs 105.00 Redemption Rs 110.00
Floatation 5%
Cash flows of preference share Figures in Rs
Year Price Flotation Dividend RV Cash flow
0 105.00 -5.25 99.75
1 -12.00 -12.00
2 -12.00 -12.00
3 -12.00 -12.00
4 -12.00 -12.00
5 -12.00 -12.00
6 -12.00 -12.00
7 -12.00 -110.00 -122.00
Cost of preference capital = IRR of the cash flows = 13.02%

13-5: Cost of Debt, Different Repayment Schedules

A debenture of Rs 100 is issued with 5 years to maturity that carries an annual coupon of 15%. The
debenture is issued at Rs 100 only. The firm pays tax of 35%.
Find the cost of debt under following:
I) when repayment is made at the end of 5th year
ii) when repayment is made in equal installments of Rs 20 each at the end of each year.
iii) when repayment is made in equated annual installments.

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

Solution::
Under all circumstances the cost of debenture is determined by its cash flows.
Given Coupon Rate 15% Periodicity Annual
Face Value Rs 100.00 Redemption value Rs 100.00
Coupon payment Rs 15.00 Time to maturity 5
Issue Price Rs 100.00 Tax rate 35%

i) Cost with bullet repayment

Cash flows of the Debenture Figures in Rs

Year 0 1 2 3 4 5
Issue Price 100.00
Interest( Net of tax) -9.75 -9.75 -9.75 -9.75 -9.75
Redemption -100.00
Cash Flow 100.00 -9.75 -9.75 -9.75 -9.75 -109.75
Cost of debt = IRR of the cash flows of debenture = 9.75%

ii) Cost with annual equal repayment

Annual redemption Rs 20.00
Cash flows of the Debenture Figures in Rs
Year 0 1 2 3 4 5
Issue Price 100.00
Redemption -20.00 -20.00 -20.00 -20.00 -20.00
Principal Outstanding 100.00 80.00 60.00 40.00 20.00 0.00
Interest( Net of tax) -9.75 -7.80 -5.85 -3.90 -1.95
Cash Flow 100.00 -29.75 -27.80 -25.85 -23.90 -21.95
Cost of debt = IRR of the cash flows of debenture = 9.75%

iii) Cost with annual equal repayment

Annuity for 5 years
Discount rate 15%
Present value of annuity at 15.00% for 5 years = PVIFA(15.00%,5) = 3.3522
Principal Amount = Rs 100.00
Equated Annual Installment = 100/PVIFA(15.00%,5) = Rs 29.83
Schedule of interest and Principal Figures in Rs
Year 0 1 2 3 4 5
Opening O/s 100.00 100.00 85.17 68.11 48.50 25.94
Installment 29.83 29.83 29.83 29.83 29.83
Interest 15.00 12.78 10.22 7.27 3.89
Principal repaid 14.83 17.06 19.61 22.56 25.94
Ending O/s 85.17 68.11 48.50 25.94 0.00

Cash flows of the Debenture Figures in Rs

Year 0 1 2 3 4 5
Issue price 100.00
Interest -15.00 -12.78 -10.22 -7.27 -3.89
Principal -14.83 -17.06 -19.61 -22.56 -25.94
Tax saved 5.25 4.47 3.58 2.55 1.36
Cash flows 100.00 -24.58 -25.36 -26.26 -27.29 -28.47
Cost of debt = IRR of the cash flows of debenture = 9.75%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

13-6: Cost of Debt with Floatation

Find the cost of debt for all the three options of repayment for the Problem 13-5 with floatation
cost of 5%.

Solution:
Again the cost of debenture is given by its cash flows.
Coupon Rate 15% Periodicity Annual
Face Value Rs 100.00 Redemption value Rs 100.00
Coupon payment Rs 15.00 Time to maturity 5
Issue Price Rs 100.00 Tax rate 35%
Floatation Cost 5%
i) Cost with bullet repayment
Cash flows of the Debenture Figures in Rs
Year 0 1 2 3 4 5
Issue Price 100.00
Floatation cost -5.00
Interest -9.75 -9.75 -9.75 -9.75 -9.75
Redemption -100.00
Cash Flow 95.00 -9.75 -9.75 -9.75 -9.75 -109.75
Cost of debt = IRR of the cash flows of debenture = 11.11%

ii) Cost with annual equal repayment Annual redemption Rs 20.00

Cash flows of the Debenture Figures in Rs
Year 0 1 2 3 4 5
Issue Price 100.00
Floatation cost -5.00
Redemption -20.00 -20.00 -20.00 -20.00 -20.00
Principal Outstanding 100.00 80.00 60.00 40.00 20.00 0.00
Interest -9.75 -7.80 -5.85 -3.90 -1.95
Cash Flow 95 -29.75 -27.8 -25.85 -23.9 -21.95
Cost of debt = IRR of the cash flows of debenture = 11.90%

iii) Cost with annual equal repayment

Annuity for 5 years Discount rate 15%
Present value of annuity at 15.00% for 5 years = PVIFA(15.00%,5) = 3.3522
Principal Amount = Rs 100.00
Equated Annual Installment = 100/PVIFA(15.00%,5) = Rs 29.83
Schedule of interest and Principal Figures in Rs
Year 0 1 2 3 4 5
Opening O/s 100.00 100.00 85.17 68.11 48.50 25.94
Installment 29.83 29.83 29.83 29.83 29.83
Interest 15.00 12.78 10.22 7.27 3.89
Principal repaid 14.83 17.06 19.61 22.56 25.94
Ending O/s 85.17 68.11 48.50 25.94 0.00
Cash flows of the Debenture
Issue price 100.00
Floatation coat -5.00
Interest -15.00 -12.78 -10.22 -7.27 -3.89
Principal -14.83 -17.06 -19.61 -22.56 -25.94
Tax saved 5.25 4.47 3.58 2.55 1.36
Cash flows 95.00 -24.58 -25.36 -26.26 -27.29 -28.47
Cost of debt = IRR of the cash flows of debenture = 11.73%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

13-7: Cost of Debt and Market Price

Find the cost of debt when new debenture is issued at a price of a) Rs 90 and b) Rs 110.
The details of the debenture are as below:
Coupon Rate 15% Periodicity Annual
Face Value Rs.100.00 Redemption value Rs.100.00
Coupon payment Rs.15.00 Time to maturity 5
Tax rate 35%
Solution:
Coupon Rate 15% Redemption value Rs 100.00
Face Value Rs 100.00 Time to maturity, years 5
Coupon payment Rs 15.00 Tax rate 35%
a) Issue Price Rs 90.00
Cash flows of the Debenture Figures in Rs
Year 0 1 2 3 4 5
Issue Price 90.00
Interest( Net of tax) -9.75 -9.75 -9.75 -9.75 -9.75
Redemption -100.00
Cash Flow 90.00 -9.75 -9.75 -9.75 -9.75 -109.75
Cost of debt = IRR of the cash flows of debenture = 12.56%

b) Issue Price Rs 110.00

Cash flows of the Debenture Figures in Rs
Year 0 1 2 3 4 5
Issue Price 110.00
Interest( Net of tax) -9.75 -9.75 -9.75 -9.75 -9.75
Redemption -100.00
Cash Flow 110.00 -9.75 -9.75 -9.75 -9.75 -109.75
Cost of debt = IRR of the cash flows of debenture = 7.29%

13-8: Cost of Equity and Dividend:

The current market price of shares of Syntex Garments is Rs 300 with expected earnings level of Rs
30. Find out the cost of equity when the proposed dividend per share is
i) Rs 12 ii) Rs 15 and iii) Rs 18.
What conclusion do you draw from the results of I), ii, and iii)?

Solution:
i) Expected Dividend per Share, D1 Rs 12.00
Expected Earnings per Share, E1 Rs 30.00
Retained earnings 18.00
Current Market Price, P0 Rs 300.00
Growth, g = Retained earnings/Price = 18/300 = 6.00%
Cost of equity, re = E1/P0 = D1/P0 + (E1 - D1)/P0 = D1/P0 + g
= 12/300 + 0.06
= 0.04 + 0.06 = 10.00%

ii) Expected Dividend per Share, D1 Rs 15.00

Retained earnings Rs 15.00
Growth, g = Retained earnings/Price = 15/300 = 5.00%
Cost of equity, re = D1/P0 + g
= 15/300 + 0.05
= 0.05 + 0.05 = 10.00%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

iii) Expected Dividend per Share, D1 Rs 18.00

Retained earnings Rs 12.00
Growth, g = Retained earnings/Price = 12/300 = 4.00%
Cost of equity, re = D1/P0 + g
= 18/300 + 0.04
= 0.06 + 0.04 = 10.00%

The cost of equity remains same irrespective of the dividend policy. The amount of present
dividend lost is gained exactly by the growth rate and vice versa.

13-9: Cost of Equity: DDM

ABC Ltd. has expected earnings at Rs 30 per share of which it expects to distribute Rs 15 as
dividend. The market price of its share is Rs 300.
Find the following:
i) Current cost of equity
ii) Cost of new equity if the firm issues fresh shares at current market price but with floatation cost
of 5%.
iii) Cost of existing equity if s dividend tax of 155 is imposed on the distributed earnings when a)
current level of dividend amount is maintained b) when dividend to the shareholders is reduced
by the extent of dividend tax.
iv) Cost of equity with dividend tax and floatation cost.

Solution:
Expected Earnings per Share, E1 Rs 30.00
Expected Dividend per Share, D1 Rs 15.00
Current Market Price, P0 Rs 300.00

i) Cost of equity, re = E1/P0 = D1/P0 + (E1 - D1)/P0

= D1/P0 + g
= 15/300 + 15/300
= 0.05 + 0.05 = 10.00%

ii) With floatation cost, f as % of market price

Floatation cost, f 5.00%
Effective price realisation P 0' = P0 (1 - f ) Rs 285.00
Cost of equity, re = E1/P0' = D1/P0' + (E1 - D1)/P0'
= 15/285 + 15/285
= 5.26% + 5.26% = 10.53%

iii) With dividend tax, t

a) When dividend net of tax to shareholders maintained at same level:
Such policy would reduce the retained earnings reducing the growth.
Dividend tax, t 15.00%
Dividend, D 1 Rs 15.00
Amount of tax Rs 2.25
Retained earnings Rs 12.75
Growth, g = Retained Earnings/Price = 4.25%

Cost of equity = 0.05 + 0.0425 = 9.25%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

b) When dividend gross of tax to shareholders is maintained at the same level:

Such policy would keep the level of retained earnings and growth same but the amount
of dividend to the shareholders would reduce by the extent of dividend tax.

Dividend, D 1 net of tax = Rs 12.75

Cost of equity = D1/P0 + g
= 12.75/300 + 15/300
= 0.0425 + 0.05 = 9.25%

The cost of equity remains indifferent to the policy of distribution confirming the principle
that cost of equity depends upon the earnings level only and not the way how are they
appropriated.

iv) With floatation cost and dividend tax

Cost of equity = D1/P0' + (E1 - D1)/P0'
= 12.75/285 + 15/285
= 4.47% + 5.26% = 9.74%

13-10: Cost of Equity Capital with CAPM

Apex Retails Limited has its shares quoted in the market for last several years. Its beta is estimated
to be 1.20. The yield on T - Bills is 5% and market return is expected to be 15%. Find the cost of
equity for Apex Retail Limited.

Solution:
Risk free rate of return, rf 5.00%
Market Returns, rm 15.00%
Beta of the stock, β 1.20
Risk Premium, r m - rf 10.00%
Cost of equity as per CAPM, re = rf + β (rm - rf)
re = 0.05 + 1.2(0.15 - 0.05)
= 17.00%

13-11: Cost of Equity, Capital Appreciation and Dividend Yield

Metal Forge Limited has been growing at 20%. It had paid dividend of Rs 4.00 per share last year.
The current growth is expected to last for another 5 years and thereafter it would be normal growth
of the industry at 8%. Find out the following:
i) The current price of the share.
ii) The price of the share after 1, 2, 3, 4, and 5 years.
iii) The capital appreciation and the dividend yield for each of the 5 years.
iv) Confirm that the cost of equity remains at 14% for each of the year.

Solution:
i) Current Price, P0
Present Dividend Rs 4.00
Dividend Growth 20%
Expected return 14%

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

Year Dividend, Rs Present Value, Rs

1 4.80 4.211
2 5.76 4.432
3 6.91 4.665
4 8.29 4.911
5 9.95 5.169
Sum of present value of dividend Rs 23.39

Steady state growth after 5 years = 8%

At 5th year the price of the share would be given by DDM.
P5 = D6/(r - g)
P5 = D5 (1+g)/(r - g)
P5 = 9.95 x (1 + 0.08)/(0.14 - 0.08) = Rs 179.16
P0 = Discounted value of P5 + Discounted value of dividend from Year 1 - 5
P0 = 93.05 + 23.39
P0 = Rs 116.44

ii), iii) Price at year 1, P1 would be governed by following:

and iv)
P0 (1 + r) = D1 + P1
P1 = P0 (1 + r) - D1
The price, capital appreciation and dividend yield for 5 years are as below:

Year Dividend Price, Capital Appreciation, Dividend Total

Rs Rs % Yield, % Return, %
0 4.00 116.44
1 4.80 127.94 9.88% 4.12% 14.00%
2 5.76 140.09 9.50% 4.50% 14.00%
3 6.91 152.79 9.07% 4.93% 14.00%
4 8.29 165.89 8.57% 5.43% 14.00%
5 9.95 179.16 8.00% 6.00% 14.00%

13-12: Determining Optimal Capital Structure

A financial analyst of the a large corporation has prepared the following profile of cost of debt
and equity for different levels of debt on the basis of his survey for his organisation.

Debt, % Cost of debt, % Cost of equity, %

0.00% 14.00%
10.00% 10.00% 15.00%
20.00% 11.50% 15.00%
40.00% 12.00% 15.50%
50.00% 12.50% 16.00%
60.00% 14.00% 18.00%
70.00% 15.00% 20.00%

Assuming that the survey has given reliable results find out what is the optimal debt ratio for the
firm and what would be the cost of capital for the optimal? Also plot the cost of capital for
different levels of debt.

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

Solution:
For the given level of debt and equity the weighted average cost of capital for the firm is
computed below:
Debt, % Cost of debt, % Cost of equity, % WACC
0.00% 0.00% 14.00% 14.00%
10.00% 10.00% 15.00% 14.50%
20.00% 11.50% 15.00% 14.30%
40.00% 12.00% 15.50% 14.10%
50.00% 12.50% 16.00% 14.25%
60.00% 14.00% 18.00% 15.60%
70.00% 15.00% 20.00% 16.50%

Cost of Capital Debt Equity WACC

24%
Cost of Capital, %

22%
20%
18%
16%
14%
12%
10%
8%
0.00% 10.00% 20.00% 40.00% 50.00% 60.00% 70.00%
Level of Debt %

As is evident from the table and the graph above the least cost of capital (WACC) is
14.10% at debt level of 40%. Therefore, the optimal debt equity ratio is 2:3.

13-13: WACC - Book Value, Market Value and Specific Sources

Anand Industries has three sources of capital - the equity shares, preference shares and straight
debt, costing 18%, 15% and 7% respectively.
The proportions of different kinds of capital as reflected in the balance sheet and as per the
market values are as under:
Proportions
Capital Book value Market value
Equity 50% 70%
Preference 20% 15%
Debt 30% 15%
Find out the WACC based on a) book values b) market values.
Anand Industries wishes to raise the capital for an expansion programme with equity, preference
and debt at 15%, 35% and 50%. What would be the cost of capital for the expansion programme?

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

Solution: Following is given

Proportions of value
Source of funds Cost Book Market Specific
Equity 18.00% 50% 70% 15%
Preference Shares 15.00% 20% 15% 35%
Debt 7.00% 30% 15% 50%

Book Value Market Value Specific

Cost, % Weight, % Cost, % Weight, % Cost, % Weight, % Cost, %
Equity 18% 50% 9.00% 70% 12.60% 15% 2.70%
Preference 15% 20% 3.00% 15% 2.25% 35% 5.25%
Shares
Debt 7% 30% 2.10% 15% 1.05% 50% 3.50%
WACC 14.10% 15.90% 11.45%

13-14: Cost of Capital - Book Value Weights and Market Value Weights
Megha Steel Limited has capital employed of Rs 100 crore whose market value is Rs 150 crore as
shown below:
Rs Crore Book Values Market values
Equity shares 30 130
Retained Earnings 45
Preference shares 7 6
Debentures 18 14
100 150
The firm paid dividend of Rs 20 last year which have been growing at 8%. It also pays income tax
at 35%.
Following further information is available in respect of various sources of capital:
Equity shares: Fresh shares can be issued at a price of Rs 220 with floatation cost of 4%.
Debentures: Fresh debentures can be issued with following features:
Coupon Rate 12% Periodicity Annual
Face Value Rs 100.00 Redemption value Rs 100.00
Coupon payment Rs 12.00 Time to maturity 15 years
Issue Price Rs 95.00 Floatation cost 1.50%

Preference Shares: New preference shares can be issued as follows:

Dividend 15% Floatation Cost 2.00%
Face Value Rs 100.00 Issue Price Rs 110.00
Find cost of specific sources of capital
Find WACC based on a) book values and b) market values.

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FINANCIAL MANAGEMENT Solutions to Numerical Problems
Rajiv Srivastava - Dr. Anil Misra Chapter 13

Solution: Features of Debentures

Coupon Rate 12% Periodicity Annual
Face Value Rs 100.00 Redemption value Rs 100.00
Coupon payment Rs 12.00 Time to maturity 15 years
Issue Price Rs 95.00 Tax rate 35%
Floatation Cost 1.50%
Cost of debt
Cash flows of Debenture Figures in Rs
Year Price Flotation Interest Tax Saved RV Cash flow
0 95.00 -1.43 93.58
1 -12.00 4.20 -7.80
2 -12.00 4.20 -7.80
3 -12.00 4.20 -7.80
4 -12.00 4.20 -7.80
5 -12.00 4.20 -7.80
6 -12.00 4.20 -7.80
7 -12.00 4.20 -7.80
8 -12.00 4.20 -7.80
9 -12.00 4.20 -7.80
10 -12.00 4.20 -7.80
11 -12.00 4.20 -7.80
12 -12.00 4.20 -7.80
13 -12.00 4.20 -7.80
14 -12.00 4.20 -7.80
15 -12.00 4.20 -100.00 -107.80
Cost of redeemable debt = IRR of the cash flow of debenture = 8.58%
Cost of Preference Shares
Dividend,, % 15% Issue Price Rs 110.00
Face Value Rs 100.00 Floatation Cost 2.00%
Dividend Amount Rs 15.00
Cost of Preference capital = Dividend/Issue price net of costs
= 13.36%
Cost of Equity Shares
Issue Price Rs 220.00 Dividend proposed Rs 21.60
Floatation Cost 4% Growth rate of dividend 8%
Cost of new equity = D1/P0(1-f) + g
= 21.6/ 220(1 - 0.04) + 0.08 = 17.43%
Cost of retained earnings = D1/P0 + g
= 21.6/ 220 + 0.08 = 17.82%
WACC
Book Values Market Values
Source Cost Value Weight Cost Value Weight Cost
Equity 17.43% 30 30.00% 5.23% 130 86.67% 15.10%
shares
Retained 17.82% 45 45.00% 8.02% 0 0.00% 0.00%
Earnings
Preference 13.36% 7 7.00% 0.94% 6 4.00% 0.53%
shares
Debt 8.58% 18 18.00% 1.54% 14 9.33% 0.80%
WACC 100 15.73% 150 16.44%

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