Assignment On Cost of

Capital Math Solution

July 12, 2012
বিভাগ Accounting
 0

 Cost of Capital Math solution

By (M. Shajahan Mina)
 

Exercise # 01:
Calculate the explicit costs of debt for each of the following situations, assuming
(a) tax rate of 40 percent, (b) coupon rate of interest on debentures is 14 percent,
(c) par value of the debenture is Tk 3000 each.

(A)   If debentures are sold at par and floatation costs are 2 percent;

(B)    If debentures are sold at premium of 10 percent and floatation costs are 3
percent;

(C)    If debentures are sold at discount of 5 percent and floatation costs are 3
percent.

Solution    Given

Tax rate (T) = 0.40

Face value of debenture (FV) = 3000

Net sale value of debenture (NSV) = 3000 – 3000 ´ 0.02 = 2940

Interest on debenture (I) = 3000 ´ 0.14 = 420

Number of year or Maturity period (N) = 1 year

Requirement: Cost of debt (K ) = ?
d

(A) Debenture sold at par:

K  = =
d

= 10.51% [Ans.]

(B) Debenture sold at 10% premium:

NSV = (3000 ´ 1.10) – (3000 ´ 1.10) ´ 0.03 = 3201

K  = =
d

= 1.64% [Ans.]

(C) Debenture sold at 5% discount:

NSV = (3000 ´ 0.95) – (3000 ´ 0.95) ´ 0.03 = 2764.5

K  = =
d
= 16.91% [Ans.]

Exercise # 02
The following are the information of a company:
Book value Market value Specific cost
Type of capital (Tk) (Tk) (%)

300000 380000 7%

200000 220000 8%

DebtPreference shareEquity 600000 600000 14%

share

Retained earnings 200000 500000 11.2%

      1300000        1700000

Determine the weighted average cost of capital using (A) Book value weights
and, (B) Market value weights. How are they different? Can you think of a
situation where the weighted average cost of capital would be the same using
either of the weights?

Solution (A)    Weighted Averaged Cost of Capital (WACC)

 
 Book Specific
value Capital cost Weighted
Type of capital (Tk) ratio (Tk) Average

(3) = S(2) (5)

(1) (2) (2) (4) =(3) ´ (4)

300000 0.23 0.07 0.0161

200000 0.15 0.08 0.0120

DebtPreference
shareEquity share
600000 0.46 0.14 0.0644
Retained
earnings 200000 0.16 0.112 0.0179

SWA
1300000
= 0.1104

So the book value weight is SWACC = 0.1104 = 11.04%   [Ans.]

            (B)          Weighted Averaged Cost of Capital (WACC)

Market Specific
value Capital cost Weighted
Type of capital (Tk) ratio (Tk) Average

(3) = S(2) (5)

(1) (2) (2) (4) =(3) ´ (4)
 380000 0.22 0.07 0.0154

220000 0.13 0.08 0.0104

DebtPreference
shareEquity share
600000 0.35 0.14 0.0490
Retained
earnings 500000 0.30 0.112 0.0336

SWA
1700000
= 0.1084

So the market value weight is SWACC = 0.1084 = 10.84%   [Ans.]

Comment: Higher market value creates higher cost of capital. When the book
value and the market value have the same totals, then the weighted average cost
of capital would be the same using either of the weights.
 

Exercise # 03
A company has on its books the following amounts and specific costs of each
type of capital:
Book value Market value Specific cost
Type of capital (Tk) (Tk) (%)

DebtPreference shareEquity
share 300000 380000 7%

Retained earnings
200000 220000 8%

600000 600000 14%

 200000 500000 11.2%

      1300000        1700000

Determine the weighted average cost of capital using (A) Book value weights
and, (B) Market value weights. How are they different? Can you think of a
situation where the weighted average cost of capital would be the same using
either of the weights?

Solution (A)    Weighted Averaged Cost of Capital (WACC)

Book Specific
value Capital cost Weighted
Type of capital (Tk) ratio (Tk) Average

(3) = S(2) (5)

(1) (2) (2) (4) =(3) ´ (4)

300000 0.23 0.07 0.0161

200000 0.15 0.08 0.0120

DebtPreference
shareEquity share
600000 0.46 0.14 0.0644
Retained
earnings 200000 0.16 0.112 0.0179
 SWA
1300000
= 0.1104

So the book value weight is SWACC = 0.1104 = 11.04%   [Ans.]

            (B)          Weighted Averaged Cost of Capital (WACC)

Market Specific
value Capital cost Weighted
Type of capital (Tk) ratio (Tk) Average

(3) = S(2) (5)

(1) (2) (2) (4) =(3) ´ (4)

380000 0.22 0.07 0.0154

220000 0.13 0.08 0.0104

DebtPreference
shareEquity share
600000 0.35 0.14 0.0490
Retained
earnings 500000 0.30 0.112 0.0336

SWA
1700000
= 0.1084

So the market value weight is SWACC = 0.1084 = 10.84%   [Ans.]

Comment: Higher market value creates higher cost of capital. When the book
value and the market value have the same totals, then the weighted average cost
of capital would be the same using either of the weights.
 

Exercise # 04
XYZ Company has debentures outstanding with 5 years left before maturity. The
debentures are currently selling for Tk 90 (the face value is Tk 100). The
debentures are to be redeemed at 5 percent premium. The interest is paid
annually at a rate of 12 percent. The firm tax rate is 40 percent. Calculate the
cost of debenture.

Solution    Given

Tax rate (T) = 0.40

Face value of debenture (FV) = 100

Redeemed value (RV) = 100 + 100 ´ 0.05 = 105

Net sale value of debenture (NSV) = 90

Interest on debenture (I) = 100 ´ 0.12 = 12

Number of year or Maturity period (N) = 5 years