Cost of Capital for CA CAP-II, by CA Narahari Aryal CHAPTER 3: COST OF CAPITAL MEANING OF COST OF CAPITAL ¥ Its the cost of long term source of funds (i.e. cost of funds used for financing a business.) Y Investors provide long-term funds (i.e., Equity shares, Preference Shares, Retained earnings, Debentures etc.) to a company and they expect a return (in the form of interest, preference dividend and equity dividend) from that investment. In order to satisfy the investor's expectations the company should be able to earn enough revenue Thus, to the company, the cost of capital is the minimum rate of return that the company must earn on its investments to fulfill the expectations of the investors. ¥ Therefore, a Cost of Capital has two meanings: a) The rate of Return (%) that investors expect to be paid for putting the funds into the company. b) The minimum rate of return (3) that a company should make from its own investment, Y To check whether the company is able to earn minimum rate, cost of capital is used as the discounting factor in investment appraisals. Y The firm’s cost of capital can be determined by working out weighted average costs of raising different sources of capital. Therefore, computation of overall cost of capital involves two steps: a) Computation of cost of capital for specific source of funds , and b) Computation of overall cost of capital. IMPORTANCE OF COST OF CAPITAL The cost of capital is an essential tool in each one. Cost of capital is important and helpful for following purposes: Y Maximization of the Value of the Firm: To maximize value of the firm, a firm tries to minimize the average cost of capital. There should be ‘optimum mix of debt and equity in the capital structure so that the business does not to bear undue financial risk. Y Capital Budgeting Decisions: Cost of capital is important for a firm in taking capital budgeting decisions. Generally cost of capital is the discount rate used in evaluating the desirability of the investment project. Y Decisions Regarding Leasing: Estimation of cost of capital is necessary in taking leasing decisions of business concern Management of Working Capital: In management of working capital the cost of capital may be used to calculate the cost of carrying investment in receivables and to evaluate alternative policies regarding receivables. It is also used in inventory management, ¥ Dividend Decisions: Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm should be formulated according to the nature of the firm— whether itis a growth firm, normal firm or declining firm. However, the nature of the firm is determined by comparing the internal rate of return (r) and the cost of capital (ke) i.e., r>ke, r= ke, or r< ke which indicate growth firm, normal firm and decline firm, respectively.Cost of Capital for CA CAP-II, by CA Narahari Aryal Y Determination of Capital Structure Cost of capital influences the capital structure of a firm. In designing optimum capital structure thet is the proportion of debt and equity, due importance is given to the overall or weighted average cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimized. Valuation of Business: ‘When valuing a business, the cost of capital is the discount rate that we use to. discount back the cash flows to the firm (i.., cash flows before debt cash flows) to arrive at value today DETERMINATION OF THE COST OF CAPITAL The cost of capital can either be explicit or implicit. The cash outflow of an entity towards the utilization of capital which is clear and obvious is termed as explicit cost of capital. These outflows may be interest payment to debenture holders or repayment of principal amount to loan providers or payment of dividend to shareholders etc. On the other hand implicit cost of capital is the cost which is actually not a cash outflow but it is an opportunity loss of foregoing a better investment opportunity by choosing an alternative option. The comparison between them can be explained as under: Explicit cost of capital Rate of return that an entity pays to procure external finance. It is the discount rate that equates PV of cash inflows , which are incremental to the taking of financing opportunity, with the PV of its incremental cash outflows Itis a direct payment made to lenders of finance such as interest on debt funds, dividend on shares. Implicit cost of capital Rate of return associated with the best investment opportunity for the firm and its shareholders (i.e. opportunity cost) that will be foregone if the project presently under consideration is accepted by the firm. Those costs which are incurred when the funds are used, COST OF DEBT Y The capital structure of a firm normally includes the debt capital. (Debt is money borrowed that must be repaid with interest). Debt may be in the form of debentures, bonds, term loans from financial institutions and banks etc. The amount of interest payable for issuing debenture is considered to be the cost of debenture or debt capital (Kd) Y However interest paid on debt capital can be claimed as a business expense in taxation and therefore it saves taxes. Hence cost of debt is the effective rate (net of tax) a company pays on its debt capital. Y Debt may be either perpetual/irredeemable or redeemable. In case of Irredeemable debt, the company never repays principal component and its cost is simply the discount rate which makes PV of future interest payments (net of tax saving) equal to the initial principal borrowed. In case of redeemable debt, cost of debt will be the discount rate which makes PV of future interest payments and PV of redeemable value, equal to the initial principal borrowed. The bonds or debentures can be issued or redeemed at par, (face valve}, discount (below face value) and premium (more than the face value). While calculating cost of debt, actual amount realized (i.e. Net Proceeds) should be considered instead of face value. ¥ Computation:Cost of Capital for CA CAP-II, by CA Narahari Aryal, Interest (1-Tax Rate) Cost of Irredeemable Debt(kd} x100 Net Proceeds (NP) Note-1: in case of existing debt, cost of debt is calculated by considering market price of debentures/bonds. Note-2: If debts are issued at par without any floatation cost, then cost of debt can alternatively be calculated as follows: Cost of debt (kd) = Interest rate (1-Tax Rate) Interest (1-Tax Rate) +{ Redeemable Value-Net Proceeds)/Life of debt (698 9 redeemable = AA@$ $i Debt (Kd) (Redeemable Value +Net Proceeds)/2 Note-1: It should be noted that this formula does not consider time value of money and hence it provides approximate cost of debt. However, in examination, it can be used as a cost of debt. Note-2: If Redeemable value is equal to Net proceeds, then life of debt becomes irrelevant. Note-3: Cost of Convertible Debentures/Bonds: The calculation of cost of convertible debentures is very much similar to the redeemable debentures. While determining the redeemable value of debentures, it is assumed that all the debenture holders will choose the option which has the higher value and accordingly itis considered to calculate cost of debt. Basic Debt Related Term: Y Face Value/Par Value: Itis the value stated on the face of the bond/debenture. Unless otherwise stated, bond/debenture is assumed to be issued at face value/par value. The face value/par value may be 100 or 1,000 depending upon the question. ¥ Redemption value: The value which the bond/debenture holder will get on maturity is called redemption value. If no information about redeemable value is given, the bond/debenture is always assumed to be redeemed at par value Y Coupon Rate: Rate stated on the face of the instrument (bonds/debentures). Amount of interest is always calculated on the basis of face value by using coupon rate, Y- Floatation cost: Cost incurred while issuing securities. Y Basis Point: Basis point is the smallest unit in a measure of interest which is one hundredth of a percentage point. Thus, one basis point is 0.01% & 100 basis point is 196.Cost of Capital for CA CAP-II, by CA Narahari Aryal COST OF PREFERENCE SHARES v Preference shares are those shares which have the prior right on a) Payment of dividend and b) Refund of capital in case of liquidation of company. Dividend Rate: The rate of dividend payable on preference share is predetermined. Therefore, preference shares are called fixed cost capital. On the basis of dividend rate and face value of share, the amount of dividend is determined as below: a) Dividend per share (DPS) = Face value X Dividend rate b) Total Dividend = Face value X Dividend rate X No. of preference share. The computation of cost of preference shares is similar to computation of cost of debt. However, Preference dividend is an appropriation of profit after taxes. Therefore, there is no need to make any adjustment for taxes while determining the cost of preference shares (Kp). The preference shares are classified into two categories viz Redeemable and Irredeemable. Computation: Preference Dividend x100 Cost of Irredeemable Preference shares (Kp) Net Proceeds (NP) Note-1: In case of existing preference shares, cost of preference shares is calculated by considering market price of preference shares. Note-2: If shares are issued at par without any floatation cost, then cost of preference share will be equal to rate of preference dividend. Pref. Dividend +{ Redeemable Value-Net Proceeds)/Life of pref. Shares Cost of redeemable Preference shares (Kp) (Redeemable Value +Net Proceeds)/2 Note-1: It should be noted that this formula does not consider time value of money and hence it provides approximate cost of debt. However, in examination, it can be used as a cost of debt. Note-2: If RV is equal to Net proceeds, then life of preference shares become irrelevant. Note-3: When a company is required to pay certain percentage of dividend as dividend distribution tax to Government than for the company, the total committed payment will be dividend plus dividend tax. Therefore, while calculating cost of preference share capital, the dividend tax on preference dividend should be added to preference dividend. COST OF EQUITY SHARES v Equity shares are the main source of finance of a firm. It is the permanent source of capital and not required to pay except in liquidation. Equity share holders (collectively) are the owners of the firm and are ultimate risk bearers. Since equity share holders have residual claim in incomes and ultimate risk bearer, they expect more return from the company. The equity share holders’ required rate of return is a cost from the company's perspective, Based on investor's behavior, cost of equity can be calculated by using following approachesDividend > v Cost of Capital for CA CAP-II, by CA Narahari Aryal, -e Approach/Dividend Yield Approach: Itis also known as dividend valuation approach. ‘As per this approach, the cost of equity is the rate which equates the future dividends to the current market price. This approach applies to those companies which pay constant dividend year after year without any growth in dividends. Capital appreciation is ignored, Computation: Dividend Per Share(DPS) Cost of equity (Ke) = —@$____—- x 100 Market Price Per Share (Po) or Net Proceeds Per Share (NP) Dividend Growth Approach/Dividend Price Ratio plus Growth Approach: a ‘As per this approach, dividend per share will not remain constant rather it increases year after year at a constant rate. The cost of equity is the sum of next year’s dividend yield plus the growth rate in dividends. > Computation: Cost of equity (Ks) +8 Poor NP Where, D1 = Expected Dividend or Dividend at the end of year 1 = DO (1+g) = constant growth rate in dividends and earnings PO = Market price per share and NP = Net Proceeds Note: The growth rate (g) can be calculated by using the following formula: Dn = 00 (148)" or Growth rate (g) = b(Retention Ratio) x r(return on investment) Where, Dn is dividend in nth year, 00 is dividend at time 0, n is the number of year. Note: When a company is required to pay certain percentage of dividend as dividend distribution tax to Government than for the company, the total committed payment will be dividend plus dividend tax. Therefore, while calculating cost of equity, the dividend tax should be added to equity dividend. Earnings Price Approach/Earning Yield Approach: = oi ¥ It similar to dividend price approach ‘As per this approach, investors expect certain amount of earnings from the company whether it is distributed or not. Cost of equity is the discount rate that equates PV of future earnings with the current market value of shares. It applies to those companies which have stable income, Computation: Expected Earnings Per Share at the end of year 1 (EPS) Cost of equity (Ke) = —_______ x 100 Market Price Per Share (Ps) or Net Proceeds Per Share (NP)Cost of Capital for CA CAP-II, by CA Narahari Aryal Earnings Growth Approach: v ¥ Similar to dividend growth approach. It seeks to nullify the effect of changes in dividend policy, AAs per this approach, earnings do not remain constant and the price of equity shares is also directly influenced by the growth rate in earnings. Computation: & Cost of equity (Ky) = +8 Poor NP Where, Di = Expected Earnings or Earnings at the end of year 1 G = constant growth rate in dividends and earnings Po= Market price per share NP = Net Proceeds Capital Asset Pricing Approach (CAPM): v CAPM model describes the risk ~ return trade-off for securities. It assumes that return should be in accordance with the risk involved in investment, AAs per this approach, investors in equity shares expect a return more than the risk free rate of return (Rf) a5 a compensation for taking extra risk. The amount of risk premium depends upon the riskiness of the security. Computation: Cost of Equity (Ke) = RF+ B (Beta Security) x (Rm — Rf) Where, Rm = Return on market portfolio. (Rm ~ Rf) = Market Risk Premium. Bx (Rm — Rf) = Risk premium in security Note: Beta of the security can be calculated as follows Cov.(Rs, Rm) osx s,m or, Bs= om om Where, Cov.(Rs, Rm) = covariance between security with market 15m = correlation coefficient of security with market os ‘andard deviation of security ‘om = standard deviation of market, and o? m = variance market Realized Yield Approach: According to this approach, the average rate of return realized in the past few years is historically regarded as ‘expected return’ in the future. It computes cost of equity based on the past records of dividends actually realized by the equity shareholders. The equity shareholders continue to expect the same rate of return and the reinvestment opportunity cost of the shareholders is same as the realized yield.Cost of Capital for CA CAP-II, by CA Narahari Aryal, Ke = Discount rate at which amount invested in the shares by the shareholders equals to the present value of return actually realized by the investors Example: Mr. Aryal had purchased a share of Alpha Limited for Rs 1,000. He received dividend for a period of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for Rs 1,128, You are required to compute the cost of equity as per realised yield approach. Solution: We know that as per the realised yield approach, cost of equity is equal to the realised rate of return Therefore, it is important to compute the internal rate of return by trial and error method. This realised rate of return is the discount rate which equates the present value of the dividends received in the past five years plus the present value of sale price of Rs 1,128 to the purchase price of Rs1, 000. The discount rate which equalizes these two is 12 percent approximately. Let us look at the table given for a better understanding: Year idend (Rs) | Sale Proceeds (Rs) | Discount Factor @12% _| Present Values (Rs) a 100 - 0.893 89.3 2 100 0.797 79.7 3 100 i 0.712 7.2 4 100 > 0.636 63.6 5 100 1128 0.567 696.276 100.076 We find that the purchase price of Alpha limited’s share was Rs 1,000 and the present value of the past five years of dividends plus the present value of the sale price at the discount rate of 12 per cent is Rs 1,000.076. Therefore, the realised rate of return may be taken as 12 percent. This 12 percent is the cost of equity. COST OF RETAINED EARNINGS Y Retained earnings refer to undistributed profits of a firm. Out of the total earnings, firms generally distribute only part of them in the form of dividends and the rest will be retained within the firms. Y Cost of Retained earnings is normally considered equal to cost of equity capital. Y Its considered as the opportunity cost of foregone dividends from alternative investment to the existing equity share holders. Y Therefore, it is considered equal to cost of equity since equity shareholders have the same expectations on earnings retained by the firm. Y However, while calculating cost of retained ean 18s, market price of share shall be considered instead of net proceeds as flotation cost need not be considered. WEIGHTED AVERAGE (OR) OVERALL COST OF CAPITAL (WACC) Y It is the weighted average costs of all sources of funds. Therefore, WAC = Sum of (cost of individual component x proportion of capital, i.e. weights) v Assignment of weights may be based on book value or market values of capital structure. Assigning book value weights assumes that new financing is in the same proportion as per current capital mix. Itis the only alternative when market values are not available.Cost of Capital for CA CAP-II, by CA Narahari Aryal Y Ifthe weights of different components of capital are calculated on the basis of current market value of such component, itis called market value weights. For this, market value of each component shall be computed first. However, market value of equity shares may be taken to represent combined ‘market value of equity shares and retained earnings because retained earnings are treated as part of equity and market value of equity shares is based on availability of retained earnings. When new project is financed from the pool of funds then the appraisal of the project can be carried ‘out on the basis of WACC. Therefore, it can be considered as a minimum desired rate of return and can be used as a discounting factor for a new project. Y The steps to calculate WACC is as follows: Step 1: Calculate the total capital from all the sources. (Le. Long term debt capital + Pref. Share Capital + Equity Share Capital + Retained Earnings) Step 2: Calculate the proportion (or %) of each source of capital to the total capital. For example, proportion of equity share capital will be equal to, Equity Share Capital Total Capital (as calculated in Step 1 above) Step 3: Multiply the proportion as calculated in Step 2 above with the respective cost of capital. (Le. Ke x Proportion (%) of equity share capital (for example) calculated in Step 2 above) Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the WACC MARGINAL COAT OF CAPITAL (MCC. it is the cost of capital for raising additional rupee of capital (ie. new funds) ¥ Its the WACC of new capital using the marginal weights. Y The marginal funds shall be raised in target capital structure (ie. the desired ratio of raising addi Y In order to compute WAC of marginal funds, the existing capital structure and its cost is irrelevant (unless otherwise stated). Therefore, MCC is calculated by using marginal weights. Y When a firm raises funds in proportional manner and the component's cost remains unchanged, nal funds) there will be no difference between average cost of capital (of the total funds) and the marginal cost of capital. The component costs may remain constant up to certain level of funds raised and then start increasing with amount of funds raised. For example, the cost of debt may remain 7% (after tax) till Rs 10 lakhs of debt is raised, between Rs 10 lakhs and Rs 15 lakhs, the cost may be 8% and so on. Similarly, if the firm has to use the external equity when the retained profits are not sufficient, the cost of equity will be higher because of the floatation costs. When the components cost start rising, the average cost of capital will rise and the ‘marginal cost of capital will however, rise at a faster rate. Y Hence, while calculating Marginal Cost of Capital, we need to compute level of capital up to which cost of new capital remain same (called breaking point) and above that level cost of funds increases, Itcan be calculated as- Limit of low cost fund for specific source Breaking Point = Weight of that specific sourceCost of Capital for CA CAP-II, by CA Narahari Aryal PROBLEMS: Question No 1: Suppose the amount of loan is Rs 500,000 Interest Rate up to Rs 3 Lakhs= 10% p.a Interest Rate above Rs 3 Lakhs= 12% p.a IF tax Rate is 40% find cost of Debt. Solution: 1) Computation of amount of interest: First Rs 300,000: 300,000 x 10% = 30,000 Second Rs 200,000 200,000 x 12% = 24,000 Total interest 54,000 2) Total Loan = 500,000 3) Cost of Debt (Kd) = Interest (1~ Tax rate) / Net Proceeds = 54,000 X 0.6 /500,000 = 6.48% Alternative Solution: 1) Cost of Debt for first Rs 3 Lakhs = 10% X 0.6 = 6% 2) Cost of Debt for balance Rs 2 Lakhs = 12% X 0.6 = 7.2% 3) Cost of Debt for Total Debt = Sum of (Weight X Cost) = 0.6 x6% + 0.4.x 7.2% = 6.48% Question No 2: (PE-Il, May-06) ‘A company issues Rs 10, 00000 12% debentures of Rs 100 each. The debentures are redeemable after the expiry of 7 years. Tax rate applicable to the company is 35%. Calculate the cost of debt after tax if debentures are issued at: (a) Par {b) 10% Discount (c) 10% Premium (d) If brokerage is 2%, what is Cost of Debt if issued at par? Solution: Cost of debt can be calculated on total basis or per debenture basis Interest (1-Tax Rate) + (RV-NP)/Life of debt Cost of redeemable Debt (Kd) = —_—_§ — $$$ (RV+NP}/2 1) Cost of Debt (Kd) if issued at Par: = [12 X 0.65 + (100 - 100) /7]/ (100 + 100)/2 = 7.8 % 2) Cost of Debt (kd) if issued at 10% Discount: = [12 X 0.65 + (100 ~ 90) /7]/ (100 + 90)/2 = 9.71% 3) Cost of Debt (Kad) i 5 = [12K 0.65 + (100-110) /7]/ (100 + 110)/2 = 6.07% 4) Cost of Debt (Kd) if brokerage is 2% and issued at Par: = [12 X 0.65 + (100-98) /7]/ (100 + 98)/2 = 8.17%Cost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 3: Compute after tax cost of debt from the following information: No of debentures issued = 100000 _Face value per debenture =Rs 100 Coupon rate = 1200 basis point Issue price per debenture = Rs 110 Flotation cost = 2% of issue price Corporate tax rate =35% Solution: 100 basis point = 19%. Hence 1200 basis point = 12%. Cost of Debt (Kd) Interest (1- Tax Rate) / Net Proceeds = (12 x0.65)/(110- 2.2) = 7.24% Question No 4: You are given the following information: Particulars Alta Btd Cit FV per debenture Rs 100 Rs 100 Rs 100 Coupon Rate p.a 14% 15% 20% Market Price per debenture Rs 140 Rs 75 Rs 125 Tax Rate 30% 40% 20% Find cost of debt Solution: Cost of Debt (Kd) = Interest (1- Tax Rate) / Market Price of debenture For Company A: 14 x 0.7)/140 For Company B: = (15 x 0.6)/75 = 12% For Company C: Question No 5: You are given the following information: Particulars Altd Bltd FV per preference share Rs 100 Rs 100 Dividend Rate p.a 15% 12% ‘Market Price per Share Rs 125 Rs 75 Calculate percentage cost of preference share. Solution: Cost of Preference Share (Kp) = Pref. Div./ Market Price of debenture For Company A: = 15/125 = 12% For Company 8: 2/75 = 16% Question No 6: M Ltd. issued Rs 100 lakhs 10% preference shares of Rs 100 each redeemable at par after 5 years. Calculate cost of preference shares in each of the following cases: a) If preference shares are issued at par. b) [Fit is issued at 10% premium with a flotation cost of 5% of issue price. ©) Ifitis issued at 5% discount, Solution: Pref. Dividend + (RV-NP)/Life of Pref. Shares Cost of redeemable Pref. Shares (Kp)=_—§ —————_ (aveNnP)/2 10Cost of Capital for CA CAP-II, by CA Narahari Aryal 1) Cost of Pref. Shares (Kp) if issued at Par: = [10 + (100 ~ 100) /5)/ (100 + 100)/2 = 10% 2). Cost of Pref. Shares (Kp) if issued at 10% Premium with 5% flotation cost: = [10 + (100 - 104.5) /5]/ (100 + 104.5)/2 = 10.6 % 3) Cost of Pref. Shares (Kp) if issued at 5% Discount: = [10 + (100 - 95) /5]/ (100 + 95)/2 = 11.28 % Question No 7: Calculate Cost of Capital in each of the following cases: a) 10-year 14% Preference shares of Rs 100, redeemable at premium of 5% and flotation costs 5%. Dividend tax is 10%. b) An equity share selling at Rs.50 and paying a dividend of Rs.6 per share, which is expected to continue indefinitely, ©) The above equity share if dividends are expected to grow at the rate of 5%. Solutic in: a) Cost of Preference Share(Kp): Pref. Dividend (1 + Div tax) + (RV-NP)/Life of Pref. Shares Cost of redeemable Pref. Shares (Kp) =| (RV+NP)/2 = [15.4 + (105 - 95) /10]/ (105 + 95)/2= 16.40 % b) Cost of Equity Share(Ke): Dividend per Share (DPS) 6 Cost of equity (Ke) = —— =12% Market Price per Share (Po) 50 €) Cost of Equity Share(ke): Dividend year 1 (D1) 6x1.05 Cost of equity (Ke) = § +g = +005 = 17.6% Market Price per Share (Po) 50 Question No 8: The Shares of NS Ltd. are selling at Rs 20 per share. The company had paid Rs 2 dividend per share last year. The estimated growth rate of the company is approximately 5% p.a. a) Determine the cost of equity capital of the co. b) If cost of capital is 15.5%, determine the estimated market price of the equity share if the anticipated growth rate of the company 1) Rises to 8% and 2) Falls to 3% aCost of Capital for CA CAP-II, by CA Narahari Aryal Solution: a) Cost of Equity Share(Ke): Dividend year 1 (D1) Cost of equity (Ke) = +8 Market Price per Share (Po) b) Market Price of Equity Share if growth rate is 8%: 2x 1.05 +005 = 15.5% 20 Dividend year 1 (01) 2x1.08 Market Price per Share (Po) = = —— =ns288 Cost of equity (Ke) ~ growth rate (e) 15.5% - 8% ©) Market Price of Equity Share if growth rate is 3%: Dividend year 1 (01) 2x1.03 Market Price per Share (P9)=], ———————- =|. ————._ = rs 16.48 Cost of equity (Ke) ~ growth rate (e) 15.5% - 3% Question No 9: You are given the following information Particulars Altd Bitd Cltd Ditd Last Dividend (Da) 5 3 2 a ‘Annal Growth Rate (g) a6 8% 6% 5% Cost Of Equity (K.) 12% 14% 10% 13% Find Current Price of Share (Pc) (Ans: Rs 65, 54, 53, 52.5) Solution: Market Price of Equity Share is calculated by using the formula below: Dividend year 1 (01) Market Price per Share (P9) =, Cost of equity (Ke) ~ growth rate (g) For A Ltd: = (5x 1,04)/ (12% - 4%) For B Ltd: = (3x 1.08)/ (14% - 8%) = Rs $4 For C Ltd: = (2x 1.06)/ (10% - 6%) For D Ltd: = (4x 1.05)/ (13% - 55) = Rs 52.50 Question No 10: You are given the following information. Particulars Altd Bitd cid | td Last Dividend (Da) 2 3 4 | 5 Annual Growth Rate (2) 5% 4% 1% | 8% Current Price (Po) 30 52 7 | 60 a). Find cost of existing equity & cost of retained earnings (Ans: 12%, 10%, 11%, 17%) 2Cost of Capital for CA CAP-II, by CA Narahari Aryal b) Find cost of new equity & cost of retained earnings if new shares are allotted at Rs 25, Rs 40, Rs 100 and Rs 54 respectively for A, B, C & D Ltd. (Ans: 13.4%, 11.8%, 11.28%, 18%) Solution: a) Cost of equity and cost of retained earnings: Cost of Equity Share (Ke) can be calculated as: Dividend year 1 (D1) Cost of equity (Ke) +8 Market Price per Share (Po) For A Ltd: = (2x 1.05)/ 30 + 0.05 = 12% For B Ltd: = (3x 1.04)/ 52 + 0.04 = 10% For C Ltd: = (4x 1.07)/ 107 + 0.07 = 11% For D Ltd: = (5x 1.08)/ 60 + 0.08= 17% Since there is no flotation cost, cost of retained earnings (Kre) will also remain same as cost of equity. b) Cost of new equit Cost of new equity Share (Ke) can be calculated as: Dividend year 1 (D1) Cost of equity (ke)= +g Net Proceeds (NP) For A Ltd: = (2x 1.05)/ 25 + 0.05 = 13.4% For B Ltd: = (3x 1.04)/ 40 + 0.04 = 11.8% For C Ltd: = (4x 1.07)/ 100 + 0.07 = 11.28% For D Ltd: = (Sx 1.08)/ 54 + 0.08= 18% Cost of retained earnings (Kre) will remain same as earlier cost of equity since Kre is not based on Net proceeds. Question No 11: Determine Ke from the following information Current Market Price (Ps) = Rs 150, Flotation Cost per share =Rs 3 and Dividend paid in past few years are: Year 1 2 3 4 5 6 Dividend 5 5.25 551 5.79 6.08 6.38 Assume dividend grows constantly. The expected dividend on new shares at the end of current year is Rs 6.70 Solution: From the information given, dividend is growing year by year. Hence, first of all we need to compute growth rate in dividends as follows: if year 1 dividend is considered is DO, Year 6 dividend is DS Now, DS = DO (1 + g)* [DS can be considered as a Future Value and DO can be considered Present Value) Now, by using FVIF table, Future Value = Present Value x FVIF gn BCost of Capital for CA CAP-II, by CA Narahari Aryal Or, 6.38 =5 x PVIF g, 5 years Or, FVIF g, S years = 1.276 From the FVIF table, the factor 1.276 located at 59. Hence g= 5% Cost of new equity Share (Ke) can be calculated as: Dividend year 1 (D1) Cost of equity (Ke) = _|§ ————————__ +g =[6.7/147] +0.05 = 9.56% Net Proceeds (NP) Question No 12: NS Ltd issued equity shares having a FV of Rs 10 at 10% premium, incurring 5% of issue price as a cost of issue. The expected rate of dividend is 20% a) What is cost of equity (Ke? b) What is cost of retained earnings (Ks) if MPS is Rs 15? a) Cost of equi Dividend per share Cost of equity (Ke)= | = 2/10.45= 19.14% Net Proceeds (NP) b) Cost of retained earnings: Dividend per share Cost of equity (Kre) = Market Price per Share (Po) Question No 13: The Beta (B) of NS Ltd is 1.2. The company maintains 5% growth in dividends and earnings. The last dividend (Do) was Rs 2.4. Return of Government treasury securities (Rr) Is 10%. The Return from market (Rn) is 14%. The current price per share (Po) is Rs 28 and current earnings per share (EPS) is Rs 3.9, Calculate Ke based on a) Dividend Price Method b) Dividend Growth Method ©) Asper CAPM. d) Earning Price Method Solution: a) Cost of equity by using dividend price method: Dividend per share Cost of equity (Ke)= $= 2.4/28= 8.57% Market Price per Share (Po) b) Cost of equity by using Dividend Growth Method Dividend year 1 (01) Cost of equity (Ke)= § ——————__#g_ = [(2.4x 1.05)/28] + 0.05 = 14% Market Price per Share (Po) Cost of equity by using CAPM: Ko Rr+ B (Rm Ri) = 10% + 1.2 (14%- 10%) = 14.8% 4d) Cost of equity by using Earning Price Method: Earnings per share Cost of equity (Ke)= © =3,9/28= 13.93% Market Price per Share (Pa) 4Cost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 14: (Important for concept) Calculate WACC by using (i) Book Value Weights and (ii) Market Value Weights Sources Book Value (Rs) Market Value (Rs) Equity Share Capital ‘45000 ‘90000 Retained Earnings 15000 - Preference Share Capital 10000 10000 Debt @ 5% 30000 30000 The after tax cost of various sources are: Ke =14%, Ka =13%, K,= 10% and Kz =5% Solution: i) Computation of WACC by using Book Value weights: Source of Fund Specific cost [Book Value | Weight | Wt X Specific Cost Equity Share Capital 14% ‘45000 0.45 6.30 Retained Earnings 13% 15000 05 195 Preference Share Capital 10% 10000 0.10 1.00 Debt @ 5% 5% 30000 0.30 150 Total 100,000, 1.00 | WACC= 10.75% ii) Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight Equity Share Capital 14% 67500 05192 Retained Earnings 13% 22500 0.1731 Preference Share Capital 10% 10000 0.0769 Debt @ 5% 3% 30000 (0.2308 1.1540 Total 130,000 2.00 | WACC=11.4421% Note: Market value of equity share is apportioned on the basis of book value weights between equity shares and retained earnings n of WACC by using Market Value weights: Specific cost | Market Value Wt X Specific Cost Equity Share Capital 14% ‘90000 9.6922 Retained Earnings 13% = = - Preference Share Capital 10% 10000 0.0769 0.7690 Debt @ 5% 3% 30000 (0.2308 1.1540 Total 130,000 3.00 | WACC=11.6152% Note: Market value of equity shares may be taken to represent combined market value of equity shares and retained earnings because retained earnings are treated as part of equity and market value of equity shares is based on availability of retained earnings, 15Cost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 15: (CAP-II, Dec-11, 7 Marks) ‘Three companies A, B & C is in the same type of business and hence have similar operating risks. However, the capital structure of each of them is different and the following are the details: A B c Equity Share Capital Rs.400,000 Rs 250,000 —_Rs500, 000 (Face value Rs 10 per share) Market Value per Share Rs 15 20 2 Dividend per share Rs 2.70 4 2.88 Debentures Rs NIL 100,000 250,000 (F ace value per debenture Rs 100) Market value per debenture : 125 80 Interest Rate - 10% 38% Assume that the current levels of dividends are generally expected to continue indefinitely and the income tax rate at 50%. required compute the weighted average cost of capital of each company. rn: 1) Computation of specific cost of capital: Companies Formula A B c Cost of Equity | DPS/Po 27/AS = 18% 4/20 = 20% 2.88/12 = 24% Cost of Debt | 1(I-t)/ Po - (0x05/125=4% | (8x05)/80=5% 2) Computation of WACC using Market Value weights: Company A: Source of Fund Specific cost | Market Value | Weight | Wt X Specific Cost Equity Share Capital 18% 600,000 1 18 Debt = = Total ‘600,000 1.00 WACC= 18% Company B: Source of Fund Specific cost | Market Value | Weight | Wt Specific Cost Equity Share Capital 20% 500,000 0.80 16 Debt 4% 125,000 0.20 08 Total 625,000 1.00 | WACC=16.8% Company C: Source of Fund Specific cost | Market Value | Weight | Wt X Specific Cost Equity Share Capital 24% 600,000 7s 18.00 Debt 5% 200,000 0.25 1.25 Total 800,000 1.00 | WACC=19.25% Question No 16: (CAP-II, June-13, 7.5 Marks) Ciron Limited has the following capital structure: 9% Debentures Rs. 275,000 11% Preference Shares Rs. 225,000 Equity Shares (face value Rs. 10 per share) Rs. 500,000 Rs. 1,000,000 16Cost of Capital for CA CAP-II, by CA Narahari Aryal, Additional information: a) Rs. 100 (Sale Price) per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market price per debenture is Rs. 105, b) Rs, 100 (Sale Price) 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. 4) Corporate income-tax rate is 35%. Requires Calculate Weighted Average Cost of Capital (WAC) using market value weights. Solution: 1) Computation of specific cost of capital: Formula Specific Cost Cost of Debt (1-7) + [RV-NP)/Life of debt 9x 0.65 + (100-98)/10 2s its (Rv+NP)/2 (100 + 98)/2 Cost of pref. shares PD #(RV-NP)/Life of Pref. shares | 11 + (100-97)/10 | = =11.47% (RV+NP)/2 (100 + 97)/2 Cost of Equity D1 = 2/20 + 0.05 = 15% eee eee a Np. Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight | Wt Specific Cost Equity Share Capital 15% 1200,000_| 0.6947 110.4205 Preference Share Capital 11.47% 238,500 | 0.1381 15840 Debt 6.11% 288,750 | 0.1672 1.0216 Total 1727,250_[ 1.00 | WACC=13.03% Question No17: Pacific Utilities company has present structure (which the company feels is optimal) of 50% long term debt, 10% preferred stock and 40% common equity. The company has 25 million outstanding common stocks. For the coming year the company has determined that its optimal capital budget (Rs 125 mi can be externally financed with 70 million of 10% first mortgage bonds sold at par and Rs 14 million of preferred stock costing the company 11%. ion) The remained of the capital budget will be financed with retained earnings. The company's common stock is presently selling at Rs 25 a share and next year's common dividend (D1) is expected to be Rs 2 a share. The company's past annual growth rate in dividends has been 6%, However, a company's tax rate is 40%. Assuming ‘g' will be maintained, calculate WACC for proposed capital budget. vCost of Capital for CA CAP-II, by CA Narahari Aryal, Solution: Computation of WACC by using Book Value weights: Source of Fund ‘Specific cost Book Value | Weight | WtX Specific Cost. Retained earnings (2/25) + 0.06 = 14% aim 0.328 4592 Preference Share Capital 11% 74M 112 1232 Debt @ 5% 10x06 = 6% 7oM 056 3.36 Total 125 1.00 | WACC=9.184% Question No 18: (PE II, May-07), (CAP-II, Dec-15) The following information is available for your perusal: Present book value of a firm's capital structure is (Rs.) Debentures of Rs. 100 each 800,000 Preference shares of Rs. 100 each 200,000 Equity shares of Rs. 10 each 1,000,000 2,000,000 All these securities are traded in the capital markets at recent prices of: Debentures: Rs. 110, Preference shares: Rs. 120 and Equity shares: Rs. 22. Anticipated external financing opportunities are as follows: i) Rs. 100 per debenture redeemable at par: 20 years maturity, 8% coupon rate, 4% floatation costs, sale price Rs. 100. ii) Rs. 100 preference share redeemable at par: 15 years maturity, 10% dividend rate, 5% floatation costs, sale price Rs. 100 iil) Equity shares: Rs. 2 per share floatation costs, sale price Rs. 22. In addition, the dividend expected on the equity share at the end of the year is Rs. 2 per share; the anticipated growth rate in dividends is 5% and the firm has the practice of paying all its earnings in the form of dividend. The corporate te ax rate is 50%. Required: Determine the weighted average cost of capital of the firm using: a) Book value weights and b) Market value weights. Solution: Computation of specific cost of capital: Formula ‘Specific Cost | Cost of Debt (1-1) + (RV-NP)/Life of debt 8x0.5 + (100-96)/20 (RV+NP)/2 (100 + 96)/2 Cost of pref. shares PD H(RV-NP)/Life of Pref. shares | 10 + (100-95)/15 kp = ———__—___——_ | - __—-._ = 10.60% (RV+NP)/2 (100 +95)/2 Cost of Equity Dr = 2/20 + 0.05 = 15% 7 NP 18Cost of Capital for CA CAP-II, by CA Narahari Aryal Computation of WACC by using Book Value weights: Source of Fund Specific cost [Book Value | Weight | WtX Specific Cost Equity Share Capital 15% 100,000 0.50 7.50 Preference Share Capital 10.60% 200,000 0.10 1.06 Debt 4.23% 800,000 0.40 169 Total 200,000 | 1.00 | WACC=10.25% ‘Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight | WtX Specific Cost Equity Share Capital 15% 220,000 | 0.6627 9.9405 Preference Share Capital 10.60% 240,000 | 0.0723 0.7664 Debt 4.23% 880,000 | 0.2650 1.1210 Total 3320,000 | 1.00 | WACC=11.83% Question No 19: (CAP-II, June-09, 4 X 2.5 = 10 Marks) You are the financial analyst of a FMCG company based in Hetauda. The company wished to raise additional finance of Rs. 30 million to meet its investment plans. It has Rs. 6.3 million in the form of retained earnings available for investment purpose. Following further details are also available: a) Debt-equity mix to be maintained at 30:70. b) Cost of debt: Up to Rs. 6 million, 12% (before tax); Beyond Rs. 6 million 15% (before tax) )_ Earnings per shares: Rs. 80 and Dividend payout is 50 percent of earnings 4) Expected growth rate of dividends, 20 percent e) Current market price per share, Rs. 660 & Tax rate is 30 percent On the basis of information given above, you are required to determine/compute the following: a) Pattern of raising the additional finance, assuming the company intends to maintain the existing debt equity mix, b) Post tax average cost of additional debts, €). Cost of retained earnings and cost of equity, d) Overall weighted average after tax cost of additional finance. Solu a). Pattern of raising additional funds: 1) Required Fund: 30 milion 2), Debt: Equity Ratio is 30:70. 3) Hence Amount of Debt = 30x0.3 =9 Million (6 million @ 12% and 3 million @15%) 4) Amount of Equity = 30x0.7 = 21 Million. Out of 21 million, retained earnings is 6.3 million. Hence amount of fresh issue of equity share will be 21 ~ 6.3 = 14.7 Million b) Post tax average cost of additional debt: Cost of Debt: (kd) = Interest (1- Tax Rate) / Net Proceeds = (1.17 Mx0.7)/9M 10% ©) Cost of equity and cost of retained earnings: nd year 1 (D1) Cost of equity (Ke) = +g = _ [40/660] + 0.2 = 26.06% Market Price per Share (Po) {Since there is no flotation cost, cost of retained earnings is also equal to cost of equity) 19Cost of Capital for CA CAP-II, by CA Narahari Aryal, d) Computation of WACC by using Book Value weights: Source of Fund Specific cost | Book Value | Weight | WtX Specific Cost Equity shareholders fund 26.06% 9 Million 0.70 18.242 Debt 9.10% 21 Million 0.30 2.73 Total 30Million | 1.00 | WACC=20.972% ‘Question No 20: (Final, Nov-99, 10 Marks, ICAI) The following is the capital structure of Simons Company Ltd. as on 31-12-2010 Rs Equity Shares: 10,000 shares of Rs 100 each 1000,000 10% Preference Shares of Rs 100 each 400,000 12% Debentures {600,000 2000,000 The market price of company's share (Po} is Rs 110 and it is expected that a dividend (D,) of Rs 10 per share would be declared for the year 2010. The dividend growth rate is 6%. If the co. is in 50% Tax bracket, compute the WACC Assuming that in order to finance an expansion plan, the Co. intends to borrow a fund of Rs 10 Lakhs being 14% rate of interest, what will be Company's revised WACC? This financing decision is expected to increase dividend from Rs 10 to Rs 12 per share. However, the market price of equity share is expected to decline from Rs 110 to Rs 105 per share. Solution: Existing Position: Computation of specific cost of capital Source of fund Formula Cost of Equity (01/48 (20/110 }40.06 = 15.09% Cost of Pref. shares 10% Cost of Debt Interest Rate (1-t) =12x05= 6% Computation of WAC: Source of Fund Specific cost Book Value | Weight | WtX Specific Cost Equity Share Capital 15.09% 000,000 Os 7545 Pref. shares [ 10% 400,000 02 20 Debt 6% 600,000 03 18 Total 200,000 | 1.00 | WACc=11.345% Pr ‘oposed Position: Computation of specific cost of capital: Source of fund Formula Cost of Equity (01/P:) +8 (12/105 }+0.06 = 17.43% Cost of Pref. shares 10% Cost of Debt (old) Interest Rate (1-t) 2x 0.5 = 656 Cost of Debt (New) Interest Rate (1-t) 20Cost of Capital for CA CAP-II, by CA Narahari Aryal, Computation of WACC: Source of Fund Specific cost Book Value | Weight | WtX Specific Cost Equity Share Capital 17.43% 100,000 | 0.3333 5.81 Pref. shares 10% 400,000 | 0.1333 1.33 Debt (old) 6% 600,000 02 1.20 Debt (New) 7% 100,000 | 0.3334 2.33 Total 3000,000 1.00 | WACC=10.67% Question No 21 :{ PE Il, May-03) JKL Ltd, has the following book-value capital structure as on March 31, 2003. Rs Equity Share Capital (200,000 Shares) 400,000 11.5% Preference Shares 100,000 10% Debentures 000,000 000,000 The equity share of the company sells for Rs 20. It is expected that the company will pay next year a dividend of Rs 2 per share, which is expected to grow at 5% p.a. forever. Assume a 35% tax rate. Required: a) Compute WACC of the Co. based on the existing capital structure. b) Compute the new WACC, if the Co. raises an additional Rs 20 lakhs debt by issuing 12% debentures. This would result in increasing the expected equity dividend to Rs 2.40 and leave the growth rate unchanged, but the price of equity share will fall to Rs 16 per share (Ans: 1.375% & 12.66%) Question No 22: (CAP-II, June-14, 14343=7 Marks) The Servex Company has the following capital structure on 30" June 1998: Rs. 2, 00,000 Ordinary shares 40, 00,000 10% Preference shares 10, 00,000 14% Debenture 30,,00,000 80, 00,000 The share of the company sells for Rs. 20 per share. It is expected that the company will pay a dividend of Rs, 2 per share next year which will grow at 7 percent forever. Assume a 50 % tax rate. Require a) Compute a weighted average cost of capital based on the existing capital structure. b) Compute the new weighted average cost of capital if the company raises an additional Rs. 2 million debt by issuing 15 percent debentures. This would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged, but the price of share will fall to Rs. 15 per share. ©) Compute the cost of capital, if in ii) above growth rate increases to 10 percent. Question No 23: (CAP-IL, July-15, 3+3=6 Marks) XYZ Ltd, has the following capital structure: 4,000 Equity shares of Rs. 100 each Rs. 400,000 10% Preference shares Rs. 100,000 11% Debentures Rs. 500,000 The current market price of the share of XYZ Ltd. is Rs. 102. The company expected to declare a dividend of Rs. 10 at the end of the current year, with an expected growth rate of 10%. The tax rate is 25%, 2Cost of Capital for CA CAP-II, by CA Narahari Aryal, Required: a) Find out the cost of equity capital and the WACC. b) Assuming that the company can raise Rs. 300,000 12% Debentures, find out the new cost of equity and WACC if dividend rate is increased from 10% to 12%, growth rate is reduced from 10% to 8%, and market price of the share is reduced to Rs. 98. Question No 24: The ABC Ltd. Company is planning a $ 100 million expansion of its chain of discount services stations to several neighboring states. This expansion will be financed in part with debt issued with a coupon interest rate of 15%. The bonds have a 10 years maturity and $ 1000 face value, and they will be sold to net ABC Ltd. $990 after issue costs. ABC Ltd's marginal tax rate is 40% Preferred Stock will cost ABC Ltd. 14% after taxes. The Common Stock pays a dividend of $2 per shares {ie.D0). The current market price per Share is $ 15 and new shares can be sold to net $ 14 per share. Di The Co. expects to have $ 20 million of retained earnings available to finance the expansion. The target capital structure is as follows:- Debt: 20% Preferred Stock: 5% B Common stock: 75% Calculate the WACC for evaluating this expansion program. idends are expected to increase at an annual rate of 5% for the foreseeable future. Solution: Computation of specific cost of capital: Formula Specific Cost ] Cost of Debt (1-1) + (RV-NP)/Life of debt 150 x 0.6 + (1000-990)/10 Ss - £8.15 (RV+NP)/2 (1000 + 990)/2 Cost of pref. 14% shares Cost of Equity o1 = (2x1.05)/14 + 0.05 = 20% Ke= ———_—— + NP Cost of Retained D1 = (2x1.05)/15 + 0.05 = 19% earnings Ke= ——_._ +8 Po. Computation of WACC by using given weights: Source of Fund Specific cost Value _| Weight Equity Share Capital 20% 55M oss Retained earnings 19% 20M 0.20 Preference Share Capital 14% 5M 0.05 Debt 9.15% 20M 0.20 Total 100M 1.00 | WACC=17.33% 2Cost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 25: MM Co. Ltd. has the following book value capital structure: Equity Capital (10 Lakhs Shares Rs 10 each) Pref. Share Capital 13% (15,000 Shares Rs 100 per share) Retained Earnings Debentures 14% (75,000 debentures, Rs 100 per debenture) Term loans 14% Rs 100 Lakhs Rs 15 Lakhs Rs 150 Lakhs Rs 75 Lakhs Rs 60 Lakhs Rs 400 lakhs The next expected dividend per share is Rs 1.75. The dividend per share is expected to grow at the rate of 896, The market price per equity share is Rs 25. Preference shares redeemable after 8 years are currently selling at Rs 80 per share. Debentures redeemable after 5 years are selling at Rs 75 per debentures. Applicable corporate income tax rate is 60%. Calculate the average cost of capital by using:- a) Book Value Proportions. b) Market Value Proportions Solution: Computation of specific cost of capital: Formula Specific Cost ] Cost of Debenture T(H-T) + (RV-Po/Life of debt 14x 0.4 + (100-75)/5 (Rv+ Po)/2 (100 + 75/2 Cost of Term Loan | Interest Rate (1-Tax) 14 x0.4=5.6% Cost of pref. shares PD +{RV- Po)/Life of Pref. shares 13 + (100-80)/8 (RV+ Po)/2 (100 + 80)/2 Cost of Equity and DL = 11.75/25) + 0.08 = 15% Cosette | Kandke= “ earnings Po. ‘Computation of WACC by using Book Value weights: Source of Fund Specific cost | Book Value | Weight | WtX Specific Cost Equity Share Capital 15% 100 lakhs | 0.25 3.75 Retained earnings 15% 150 lakhs | 0.375 5.625 Preference Share Capital 17.22% a5 Lakhs | 0.0375 0.65 Debentures 12.11% 75lakhs | 0.1875 227 Term Loan 5.6% 60 Lakhs ous Total 400 takhs | 1.00 Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight | WtX Specific Cost Equity Share Capital 15% 250lakhs | 0.66 9.50 Retained earnings : : : : Preference Share Capital 17.20% 2 Lakhs 0.03 052 Debentures 12.11% 56.25 Lakhs | 0.15 1.82 Term Loan 5.6% 60 Lakhs 0.16 0.90 Total 378.25 Lakhs | 1.00 | WACC=13.14% Note: Market value of equity represents combined market value of equity shares and retained earnings. 2BCost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 26: Determine the cost of capital of NRS Limited using Book Value and Market Value weights from the following information: Sources Equity Shares Retained Earnings Preference Shares Debentures Additional information: Book Value 120, 00,000 30, 00,000 9, 00,000 36, 00,000 Market Value 2,00, 00,000 10, 40,000 33, 75,000 1. Equity: Equity Shares are quoted at Rs 130 per share and a new issue after floatation costs is priced at Rs 120 is fully subscribed. 2. Dividend: During the past S years, dividends have steadily increased from Rs 10.60 to Rs 14.19 per share. Dividend at the end of the current year is expected to be Rs 15 per share Preference Shares: 15% Preference Shares with face value of Rs 100 would realize Rs 105 per share Debentures: The Company proposes to issue 11-year 15% debentures but the yield on debentures of similar maturity and risk class is 16%; floatation cost is Rs 2 per debenture. 5. Tax: Corporate Tax Rate is 35%, Ignore di Solution: Computation of specific cost of capital Formula ‘Specific Cost Cost of Debenture (1-7) + (RV-Po)/Life of debt 15x 0.65 + (100-91.75)/11 Kd= ———— = 105% (V+ Poy/2 (100+ 91.75)/2 Cost of pref. shares Kp= PD/Po 15/105 = 14.29% Cost of Equity DL = (15/120) + 0.06 = 18.5% Keand Kre= +8 NP Cost of retained DL = (15/130) + 0.06 = 17.54% earnings Keand ky +e Po. ‘Computation of WACC by using Book Value weights: Source of Fund Specificcost | Book Value | Weight | WtX Specific Cost Equity Share Capital 18.5% 120 lakhs | 0.6154 11.385 Retained earnings 17.54% BO lakhs | 0.1538 2.6976 Preference Share Capital 14.29% Slakhs | 0.0462 0.6602 Debentures 10.95% Bélakhs | 0.1846 20214 Total 195 lakhs | 1.00 | WACC=16.76% ‘Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight | Wt Specific Cost Equity Share Capital 18.5% 160 lakhs | 0.655 i212 Retained earnings 17.54% 40lakhs | 0.164 2.88 Preference Share Capital 14.29% 10.40 Lakhs | 0.043 O61 Debentures 10.95% 33.75 lakhs | 0.138 151 Total 244.15 Lakhs | 1.00 | WACC=17.12% 24Cost of Capital for CA CAP-II, by CA Narahari Aryal, Note: Market value of equity has been apportioned in the ratio of book value of equity shares and retained earnings. Working Note: 1) Computation of Market Value of Debentures: Current Yield = Interest /Current Price Or, 0.16 = 15/Current Price Therefore, Current Price = 15/0.16 = Rs 93.75 2) Computation of growth rate (g) Do= 10.60 and Ds = 14.19 Or, FV = PVX FVIF g, 5 years Or, FVIF g, 5 years = 14.19/10.60 Or, FVIF g, 5 years = 1.338. The factor 1.338 in FVIF table is located at 6%. Hence, g= 6% Question No 27: The R &G Company has following capital structure at 31” March 2004, which is considered to be optimum: Rs 13% Debentures 360,000 11% Preference Share Capital 120,000 Equity Share Capital (200,000 Shares) 1920,000 The Company's Share has a current market price of Rs 27.75 per Share. The expected dividend per share in next year is 50% of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue. Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 EPS(Rs)1.00 112 1.254 1.405 1574 1.762 1.974 2.211 2.476 2.773 The Company can issue 14% new debenture. The company's debenture is currently selling at Rs 98. The new preference issue can be sold at a net price of Rs 9.80, paying a dividend of Rs 1.20 per share. The company's marginal tax rate is 50%. Calculate the after tax cost (a) Of new debts and new preference share capital {b) Of ordinary equity, assuming new equity comes from retained earnings. (©) Calculate the marginal cost of capital (Assume book value weight is maintained) {d) How much can be spent for capital investment before new ordinary share must be sold? Assuming that retained earnings available for next year's investment are 50% of 2004 earnings, {e) What will be the marginal cost of capital (cost of fund raised in excess of the amount calculated in part (c) if the company can sell new ordinary shares to net Rs 20 per Share? The cost of debt and of preference capital is constant. (Assume book value weight is maintained) Solution: Computation of specific cost of capital: Formula Specific Cost Cost of Debenture | Kd= Interest (1-T) /NP = (14x 0.5)/98 = 7.14% Cost of pref. shares Kp = PD/ NP 12/98 = 12.24% Cost of retained D = (1.3865/27.75) + 0.12 = 17% earnings ——-+s Po 25Cost of Capital for CA CAP-II, by CA Narahari Aryal, Computation of growth rate (g) f= Land & = 2.773 Or, FV = PVX FVIF g, 9 years Or, FVIF g, 9 years = 2.773/1 Or, FVIF g, years =2.773, The factor 2.773in FVIF table is located at 12%. Hence, Computation of WMCC as per Book Value weights: Source of Fund Specific cost | Book Value | Weight Retained earnings 17% 19.2lakhs 08 Preference Share Capital 12.24% 1.2 Lakhs 0.05 Debentures 7.14% 3.6 Lakhs 0.15 Total 24 Lakhs 1.00 Capital investment before new ordinary share is sold: 1) The target capital structure is 80% equity, 5% preference shares and 15% debentures. Hence every rupee is financed as per the above ratio. 2). Ifthe retained earnings is 50% of 2004 earnings, it will be Rs 2.773 x 200,000 x 50% = Rs 277,300 3) Since weight of equity is 80%, total capital investment will be, 277300/ 0.8 = Rs 346,625 (The meaning is that if total fund required is 346,625, amount of equity fund is 277300, which is financed from retained earnings, amount of debt is Rs $1993.75 and amount of preference shares is Rs 17331.25) Cost of fund raised in excess of the amount of Rs 346625: Cost of fresh equity (Ke): = (D1/NP) +g = (1.3865/20) + 0.12 = 18.93% Since limit of retained earnings (1* breaking point is already exhausted on Rs 346,625, the cost will be increased if the fund is raised above Rs 346,625 as follows: Source of Fund Specific cost__| Book Value _| Weight | WtX Specific Cost Equity shares 18.93% 19.2lakhs 0.8 15.14 Preference Share Capital 12.24% 1.2 Lakhs (0.05 0.612 Debentures 7.14% 3.6 Lakhs 0.15 L071 Total 24 Lakhs 1.00 | WACC=16.82% Question No 28: You are given the following information: EBIT= Rs 200,000 Interest at 10%= Rs 20,000 Cost of Equity=12% Ignore Tax Find Overall cost of Capital. (Ans: 1.76%) Question No 2: Gamma Ltd has in issue 5, 00,000 Rs 1 ordinary shares whose current ex-dividend price is Rs 1.5 per share. The co. has just paid a dividend of 27 paisa per share and dividends are expected to continue at this level in the future. Ifthe co. has no debt capital, what is the WACC? (Ans: 18%) 26Cost of Capital for CA CAP-II, by CA Narahari Aryal, ‘Question No 30: Sachin enterprises Ltd. provides the following extracts from its accounts as at 31-03 2010. Rs Capital and Reserves 15,000,000 Debt, IDBI Loan (12%) 10,000,000 ACD Loan (13.5%) 25,000,000 Capital Employed 150,000,000 Profit before Tax 18,000,000 Provision for Tax 450,000 Profit After-tax 13,500,000 ‘The Risk Free Rate of Return in the economy is 10% and the premium expected from business in general is 5%. The beta of Sachin Enterprises Ltd. Shares is currently 1.28 Required: Work out the WACC in percentage terms (accurate to two decimal places) If beta is reduced to 1.18 in future what will be the impact on the WACC? (Ans: 11.79% & 11.63%) Question No 31: Excel Industries Ltd. has assets of Rs 160,000 which have been financed with Rs 52,000 of debt and Rs 90,000 of equity and General Reserve of Rs 18,000. The firm's total profits after interest and taxes for the year ended 31* March, 2008, were Rs 13,500. It pays 8% interest on borrowed funds and is in the 50% tax bracket. It has 900 equity shares of Rs 100 each selling at 2 market of Rs 120 per Share. What is the WACC? Use book value weights. (Ans: 9.74%) Question No 32: ‘ABC Ltd. has the following book valve capital structure: Equity share Capital (150 million shares, Rs 10 par) Rs 1500 million Reserve & Surplus Rs 2250 million 10.5% preference Share capital (1 million Shares Rs 100 par) Rs 100 million 9.5% debentures (1.5 million debentures, Rs 1000 par) Rs 1500 million 8.5% term loan from financial institutions Rs 500 million The debentures of ABC Ltd. are redeemable after three years and are quoting at Rs 981.05 per debenture. The applicable income tax rate for the company is 35%. The current market price per equity share is Rs 60. The prevailing default risk free interest rate on 10 year GON treasury bonds is 5.5%. The average market risk premium is 8%. The beta of the company is 1.1875. The preferred stock of the company is redeemable after 5 years is currently selling at Rs 98.15 per preference share. Require i. Calculate WACC of the Co, using market value weights ji, Define the marginal cost of capital schedule for the firm if it raises Rs 750 million for a new project. The firm plans to have a target debt to value ratio of 20%. The beta of new project is 1.4375. The debt capital will be raised through term loans. It will carry interest rate of 9.5% for the 1° 100 million and 10% for the next Rs 50 million 2Cost of Capital for CA CAP-II, by CA Narahari Aryal, Solution: (i)_ Computation of WACC (Market Value Weights) Sources Amount (Rs. in Million) | Weight(a) | __Costib) __| (a) X(b) ESH(150 Mi eeome eee 9,000.00 0.813 | 15.00%(WwN 4) | 12.195% 1500/3750) 110.5% PSC (1 Mio @ Rs. 98.15) 98.15 (0.009 | 10.972%{WN3) | 0.099% 19.5% Debentures (1.5 Mio @ 4 ie 1471575 0.133 | 6.872%(WN1) | 0.914% 8.5% Term Loans 500.00 0.045 | 5.525%(WN2) | 0.249% Total 11,068.725 ‘WACC 1B.A57% Working Notes: 1. Calculation of Cost of Debentures (Kd) Interest (1-Tax) + (RV-NP)/N 95(1-0.35) + (1000 - 981.05)/3 Ka = ——___ - ——_________ 687% (Rvenry/2 (2000+981.05)/ 2. Calculation of cost of Term Loan (Kd) Kd = Interest (1-Tax Rate] = 8.5% (1-35%) = 5.525% 3. Calculation of Cost of Preference share Dividend + (RV-NP)/N 10.50+ (100-98.15)/5 Cost of Preference Share (K;) (RVeNP)/2 (100 + 98.15)/2 4. Computation of Cost of Equity (Ke) As per Capital asset pricing model, Ke = Rf + B(Rm-Rf) = 5.50% + 8% X 1.1875 = 15.00% Since, there is no floatation cost, Ke = Kre = 15.00% (li) Pattern of raising additional finance: > Additional fund is Rs 750 Million. Since Debt to Value ratio is 20%, 150 Million should be raised through Debt and 600 Million is raised through Equity Debt up to 100 Million is financed @9.5%, Post tax cost being 6.175% and 50 Million additional dent is financed @ 10%, Post tax cost is 6.5%. Equity fund is raised @ 17% (5.5 + 1.4375x8) Marginal Cost for first break point up to Rs 500 Million(Limit of low cost debt) will be as follows: 6.175% x 0.2.4 17% x 0.8 = 14.835%, > Marginal cost for fund more than 500 Million will be as 6.5% x0.2 + 17% x 0.8 = 14.9% Cost of capital for total 750 Million = 14.86%, (14.835% x 0.66667 + 14.9% x 0.33333) v = ie Question No 33: NS Ltd has the following book value capital structure: Equity Capital (in shares of Rs 10 each, fully paid up- at par) Rs 15 Crores, 11% Preference Capital (in shares of Rs 100 each fully paid up at par) Rs 1 Crores. Retained earnings Rs 20 Crores 13.5% Debentures (of Rs 100 each) Rs 10 Crores, 15% Term Loans Rs 12.5 Crores 28Cost of Capital for CA CAP-II, by CA Narahari Aryal, The next expected dividend on equity shares per share is Rs 3.60; the dividend per share is expected to grow at the rate of 7%. The market price per share is Rs 40. Preference stock, redeemable after 10 years, is currently selling at Rs 75 per share. Debentures, redeemable after six years, are selling at Rs 80 per debenture. The income tax rate for the company is 40% Rei Calculate the WACC using (a) Book value Weights; and (b) market value proportions b. Define the Weighted Marginal cost of capital schedule for the company, if it raises Rs 10 Crores next year given the following information: 1. The amount will be raised by equity and debt in equal proportions; 2. The company expects to retain Rs 1.5 Crores earnings next year, 3. The additional issue of equity shares will result in the net price per share being fixed at Rs 32,(Assume g will be maintained) 4, The debt capital raised by way of term loans will cost 15% for the first Rs 2.5 Crores and 16% for the next Rs 2.5 Crores. Solution: Computation of specific cost of capital: Formula ‘Specific Cost | Cost of Debenture T(1-T) + (RV-Pol/Life of debt 13.5x 0.6 + (100-80//6 k= ———________ ——\ -12.% (RV+ Po)/2 (200 + 80)/2 Cost of pref. shares PD +(RV- Pol/life of Pref. shares | 11 +(100-75)/10 (RV+ Po)/2. (200 + 75)/2 Cost of Equity DL = (8.6/40) + 0.07 = 16% NP Cost of termloan_| Kn = Interest Rate (1-Tax) 15x0.6= 9% | Computation of WACC by using Book Value weigh Source of Fund Specific cost [Book Value | Weight | Wt X Specific Cost Equity Share Capital 16% 15 Crore 0.26 416 Retained earnings 16% 20 Crore 0.34 5.44 Preference Share Capital 15.43% | 1Crore 0.02 0.31 Debentures 12.7% | 10 Crore 017 246 Term toan 9% 12.5 Crore o2t 1.89 Total 585 Crores | 1.00 | WACC=13.96% Computation of WACC by using Market Value weights: Source of Fund Specific cost | Market Value | Weight | Wt X Specific Cost Equity Share Capital 16% 60Crore | 0.7385 11.816 Retained earnings : = a Preference Share Capital 15.43% | 0.75 Crore 0.0092 0.142 Debentures 12.7% | &Crore 0.0985 1.251 Term Loan 9% 12.5 Crore 0.1538 1384 Total 81.25 Crores | 1.00 | WACC=14.59% 29Cost of Capital for CA CAP-II, by CA Narahari Aryal, Computation of new specific cost of capital for WMC: Since equity and debt is raised in equal proportions, the proposed budget of Rs 10 Crores will be financed as Rs 5 Crores from debt and Rs 5 Crores from equity. Out of 5 Crores debt 2.5 Crores is raised at 15% and balance of Rs 2.5 Crores is raised at 16%. Similarly, Out of 5 Crores of equity, 1.5 Crores is available form retained earnings and balance of Rs 3.5 Crores is raised by issuing fresh equity shares Formula Specific Cost ] Cost of Equity DL 3.6/32) + 0.07 = 18.25% Kee +8 : | Cost of Retained Di = (8.6/40) + 0.07 = 16% earnings Ke= +8 Po Cost of term loan_| Kn = Interest Amount (1-Tax)/NP (0.775x0.6 /5 = 9.3% | Computation of WMCC of proposed capital budget of Rs 10 Crores: Source of Fund Specific cost | Target Value | Weight | Wt Specific Cost Equity Share Capital 18.25% 35 Crore | 0.35 6.3875 Retained earnings 16% 15Crores | 0.15 2.4000 Term Loan 9.3% 5 Crore 05 4.6500 Total 10 Crores | 1.00 | WACC=13.4375% Question No 34: (On January 1% 2005 the total market value of the Powell Company was Rs 60 million. During the year, the ‘company plans to raise and invest Rs 30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt, Debt Rs 30,000,000 ‘Common Equity Rs 30,000,000 Total Capital Rs 60,000,000 New bonds will have an 89% coupon rate, and they will be sold at par. Common stock, currently selling at Rs 30 a share, can be sold to net the company Rs 27 a share. Stock holders required rate of return is estimated to be 12%, consisting of dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is Rs 1.20, so Rs 1.2/30=4%). Retained earnings for the year are estimated to be Rs 3 million. The marginal corporate tax rate is 40% 1, To maintain the present capital structure, how much of the new investment must be financed by common equity? How much of the needed new common equity funds must be generated internally? Calculate the cost of each of the common equity components. ‘At what level of capital expenditures will the firm's WACC increase? Calculate the firm's WAC using: (i) The cost of retained earnings (first breaking point) and (ii) The cost of new equity (second breaking point). (ii) WACC of additional funds Rs 30 milion. 30Cost of Capital for CA CAP-II, by CA Narahari Aryal, Solution: 1) Amount financed from new equity will be 15 Million because present capital structure is maintained. {L.e. 50% of 30 Million) 2), Since available retained earnings is only Rs 3 Million, only 3 Million is financed from retained earnings and balance of Rs 12 Million will be financed from fresh equity shares. 3) Cost of Fresh equity and cost of retained earnings is calculated as follows: Cost of retained earnings (Kre) = D1/PO + g = (1.2/30) + 0.08 = 12% Cost of Fresh Equity (Ke) = D1/NP + g = (1.2/27) +0.08 = 12.44% 4) Level of capital expenditure, from where WACC increase is 1* break point which will be 6 Million (Amount of retained earnings/ financing proportion = 3Miilion/0.5) 5) WMCC for first breaking point= Kd Wd + KeWe = 4.8% x 0.5 + 12% x0.5 = 8.4% 6) WMCC for second breaking point= Kd Wd + KeWe = 4.8% x 0.5 + 12.44% x 0. rate of bond is 8% and 40% tax rate, cost of debt will be 8% x 0.6 =4.8%) 7) WACC of additional fund of Rs 30 Million: 8.4 x 6/30 + 8.62 x24/30 = 8.576% (WMCC for first 6 Million 1s 8.4% and WMCC for balance 24 Million is 8.62 %.) = 8.62% (Since coupon Question No 35: AA firm wishes to raise funds up to Rs 10, 00,000 and finds that its WMCC depends upon the amount of funds raised. The firm has set pattern of financing that is 75% shareholders’ funds and 25% debt. The shareholders’ funds may be taken as consisting of retained earnings and capital. The following specific pre-tax cost of capital for each source has been estimated at different levels of financing from that source. Source ‘Amount Shareholders! funds up to Rs 150,000 150,000 -600,000 600,000 -900,000 Bonds up to Rs 100,000 100,000 -200,000 12% 200,000 -300,000 16% Find out the WMCC at different breaking points given that (i) The tax rate applicable to the firm is 50%, and (ii) The retained earnings of Rs 150,000 will be provided by the current earnings at specific cost of capital of 12%, (iii) Additional needed shareholders’ funds will have to be raised by the issue of share capital. Solution: Step-1: Calculation of break point: Source of Funds | Amount Break Point Specific Cost 150,000 200,000 12% Equity (0.75) 600,000 ‘800,000 14% 300,000 120,000 17% 100,000 400,000 5% Debt (0.25) 200,000 ‘800,000 6% 300,000 120,000 8% 31Cost of Capital for CA CAP-II, by CA Narahari Aryal ‘Step-2: Computation of WMCC: Range of Funds Source Weight Specific Cost__| WMCC Up to Rs 200,000 Equity 0.75 12% Debt 0.25 5% 10.25% Rs 200,001 to Equity 0.75 14% Rs 400,000 Debt 0.25 5% 11.75% Rs 400,001 to Equity 0.75 14% Rs 800,000 Debt 0.25 6% 12% Rs 800,001 to Equity 0.75 17% Rs 120,000 Debt 0.25 8% 14.75% Question No 36: (CAP-II, June-11, 8 +7 = 15 Marks) Following book value capital structure is available in respect of POR Ltd {(Rs. in millions) Equity capital (in shares of Rs. 100 each, fully paid-up at par) 150 11% Preference Capital (in shares of Rs. 100 each, fully paid-up at par) 10 Retained Earnings 200 13.5% Debentures (of Rs. 100 each) 100 15% Term Loan 125 The next excepted dividend per share on equity shares is Rs. 36 and the dividend per share is expected to grow at the rate of 7%. The market price per shares is RS. 400. Preference stock, redeemable after 10 years, is currently selling at Rs. 75 per share. Debentures, redeemable after 6 years, are selling at Rs. 80 per debenture. The income tax rate for the co. is 25%. You are required to: 1) Calculate the weighted average cost of capital using market value proportion and. 2) Determine the weighted marginal cost of capital for the company, if it raises Rs. 100 million next year, given the following information: > The amount will be raised by equity and debt in equal proportions. The company expects to retain Rs. 15 million earning next year. ‘Additional equity issue will result in the net price per share being fixed at Rs. 320. > The debt capital raised by way of term loan will cost 15% for the first Rs. 25 million and 16% for the next Rs. 25 million. (This question is similar to Question no 33. For checking solution, refer suggested) Question No 37: (CAP-II, June-12, 8 Marks) ‘A company wishes to find out its weighted marginal cost of capital (WMCC) based on target capital structure proportions. The company presented the following data to you to assist the company in determining its WMC. Source Proportion Range Cost Equity share capital 50% Up to Rs. 300,000 13% s.300,000 - Rs. 750,000 13.30% Rs. 750,000 and above 15.50% Preference shares 10% Up to Rs. 100,000 9.33% Rs, 100,000 and above 10.60% Long term debt 40% Up to Rs. 400,000 5.68% Rs. 400,000- Rs. 800,000 6.50% Rs. 800,000 and above 7.10% Required: Determine the WMCC for the company. 32Cost of Capital for CA CAP-II, by CA Narahari Aryal, Solution: Computation of Breaking Points: 1) Exhaustion of 13% Equity share capita: = Amount of 13% Equity share capital = 3,,00,000 Rs. 6, 00,000 Weight of Equity 0.50 2) Exhaustion of 9.33% Preference share capital = Amount of 9.33% Preference share capital 1,00,000 = Rs. 10, 00,000 Weight of Preference share capital 0.10 3) Exhaustion of 5.68% Long Term Debt = Amount of 5.68% Long Term Debt = 4,00,000 = Rs. 10, 00,000. ‘Weight of Long Term Debt 0.40 4) Exhaustion of 13.30% Equity share capital: = Amount of 13.30% Equity share capital =1,50,000 = Rs. 15, 00,000 Weight of Equity 050 5) Exhaustion of 6.50% Long Term Debt = Amount of 6.50% Long Term Debt = —8, 00,000 Rs. 20, 00,000 Weight of Long Term Debt 0.40 Computation of WMCC (1 Breaking Points, i.e. For Rs. 6,00,000) Sources ‘Amount | Weight(a) | Cost(b) | (a) x (b) Equity share capital 300,000 | 0.50 13% | 6.50% Preference share capital | _ 60,000 O10 | 9.33% | 0.93% Long Term Debt 240,000 | 040 | 5.68% | 2.27% Total {600,000 wcc 9.71% Computation of WMCC (2" Breaking Points, .e. 10,00,000,WMCC for balance amount of Rs. 4,00,000) Sources ‘Amount | Weight(a) | Cost(b) | (a) X (b) Equity share capital 200,000 | 0.50 | 13.30% | 6.65% Preference share capital | _ 40,000 0.10 | 9.33% | 0.93% Long Term Debt 160,000 | 0.40 | 5.68% | 2.27% Total 400,000 wc 9.86% Computation of WMCC (3 Breaking Points, i.e. 15,00,000.WMCC for balance amount of Rs. 5,00,000) Sources Amount | Weight(a) | Cost(b) | (a) X (b) Equity share capital 250,000 | 0.50 | 13.30% | 6.65% Preference share capital | 50,000 0.10 | 10.66% | 1.07% Long Term Debt 200,000 | 040 | 6.50% | 2.60% Total 500,000 wecc 10.32% Computation of WMCC (4" Breaking Points, i. 20,00,000.WMCC for balance amount of Rs. 5,00,000) Sources ‘Amount | Weight(a) | Cost(b) | (a) x (b) Equity share capital 250,000 | 0.50 | 15.50% | 7.75% Preference share capital | 50,000 0.10 | 10.66% | 1.07% Long Term Debt 200,000 | 0.40 | 650% | 2.60% Total 500,000 wecc 11.42% 33Cost of Capital for CA CAP-II, by CA Narahari Aryal, Question No 38: ((CAP-II, June-19, 5 Marks) ZED Ltd is presently financed entirely by equity shares. The current market value is Rs 600,000. A dividend Cf Rs 120,000 has just been paid. All earnings are paid as dividends. This level of dividends is expected to be paid indefinitely. The Co. is thinking of investing in a new project involving a outlay of Rs 500,000 now and is expected to generate net cash receipts of Rs 105,000 p.a. indefinitely. The project would be financed by issuing Rs 500,000 debentures at the market interest rate of 18%. Ignoring tax consideration 1. Calculate the value of equity shares and the gain made by the equity share holders if the cost of equity rises to 21.6%, 2. Prove that WACC is not affected by gearing. (Ans: Value of equity shares= Rs 625,000) ‘Question No 39: (CAP-II, Dec-13, 8 Marks) ‘The present capital structure of the Shree Ram Mills Ltd. is as follows: Rs. in millions Equity shares (face value Rs. 10) 240 Reserves 360 11% Preference shares (face value Rs. 10) 120 12% Debentures (face value Rs. 100) 120 14% Term loans 360 Total 1,200 Following additional information is available: The company's equity beta 1.06 Yield on long term treasury bonds 10% Stock market risk premium 6% Current ex-dividend equity share price Rs. 15 Current ex-dividend preference share price Rs, 12 Current ex-interest debenture market value Rs, 102.50 Debentures are redeemable after 3 years and interest is paid annually. Corporate tax rate is 40% Required: Ignore floatation costs and calculate the company's weighted average market value cost of capital. Question No 40: (CAP-II, Dec-18, 5 Marks) One of your client has seen many references to the cost of capital in the proposal for landing from banks and has asked you to give him some guidance on what would be an appropriate figure for his organization- NRS Limited. The following information is available for NRS Limited. Existing Capital Structure Rs Issued Ordinary shares (120,000) 120,00,000 Retained Earnings 40,00,000 6% Preference Shares (20,000) 20,00,000 9% Debentures repayable in 2076 (Par Value Rs 1000) {60,00,000 9% debentures was issued in 2075 at par. Its current price is Rs 920. A similar issue if made now would require being at Rs 900. 34Cost of Capital for CA CAP-II, by CA Narahari Aryal, Preference shares have a par value of Rs 100 and were originally issued at Rs 92 per share. Its current price is Rs 43. A similar issue if made now would require to be at Rs 40 per share. The market price of an ordinary share is Rs 700. Rs 6 million in dividends was paid this year which represented 75% of earnings. Earnings are expected to grow at an annual rate of 5%. If ordinary shares are issued now, cost incurred would represent Rs 50 per share and a reduction below market value of Rs 25 per share would also be made. Corporate tax rate is 25% Require: WACC of NRS Ltd. ‘Question No 41: (CAP-II, Dec-19, 10 Marks) The Rocket Ltd. has target capital structure of 60% equity and 40% debt. The schedule of financing cost for the Rocket is shown in the table below: New Debt Amount (Rs}) | After tax Cost of Debt _| New Equity Amount (Rs.) | Cost of Equity 0-1,000,000 5% 0-1,000,000 9% 1,000,001-2,000,000 6% 1,000,001-3,000,000 10% 2,000,001-3,000,000 | 7% 3,000,001- 5,000,000 | 11% 3,000,001- 4,000,000 8% 5,000,001- 8,000,000 12% 4,000,001- 5,000,000 | 9% I [ Required: {i) Calculate the break point for The Rocket Ltd. (ii) Calculate Weighted Average Cost of Capital (WAC) for alternate level of financing. Solution: Working for Break Point Break Point Working Size of Investment/Capital (Rs.) Debt > 1,000,000 1,000,000 + 0.40 > 2,500,000 Debt > 2,000,000 2,000,000 + 0.40 > 5,000,000 Debt > 3,000,000 3,000,000 + 0.40 > 7,500,000 Debt > 4,000,000 4,000,000 + 0.40 > 10,000,000 Debt > 5,000,000 5,000,000 + 0.40 > 12,500,000 Equity > 1,000,000 1,000,000 + 0.60 > 1,666,667 Equity > 3,000,000 3,000,000 = 0.60 > 5,000,000 Equity > 5,000,000 5,000,000 + 0.60 > 8,333,333 Equity > 8,000,000 8,000,000 + 0.60 > 13,333,333 Co. will have a break point each time a component cost changes, for a total of eight break points; Break Point _| Size of Investment/Capital (Rs.) _| Reason for Change in Cost of Capital > 1,666,667 | Equity > 2,500,000 | Debt > 5,000,000 | Debt as well as Equity > 7,500,000 | Debt > 8,333,333 | Equity > 10,000,000 | Debt > 12,500,000 | Debt > 13,333,333 | Equity 35Cost of Capital for CA CAP-II, by CA Narahari Aryal, WACC for Alternative level of Financing investment/Capital (Rs.) | Equity | Costof | Debt | Costof WACC 60% Equity | 40% Debt Up to 1,666,667 60% % 40% 5% 7.40% 1,666,668 - 2,500,000 60% 10% 40% 3% 8.00% 2,500,001 - 5,000,000 60% 10% 40% 6% 8.40% 5,000,001 - 7,500,000 60% 1% 40% % 9.40% 7,500,001 - 8,333,333 60% 11% 40% 8% 9.80% 8,333,334 - 10,000,000 60% 12% 40% a% | __10.40% 10,000,001 - 12,500,000 | 60% 12% 40% 9% | __ 10.80% 12,500,000- 13,333,333 | 60% 12% 40% = = Question No 42, Tinau Trading Co is planning to raise funds for an expansion of existing business activities and in preparation for this the company has decided to calculate its weighted average cost of capital. Tinau Trading Co has the following capital structure: INRs. (millions) Equity Ordinary shares 200 Reserves 10 210 Non-current liabilities Loan notes 200 Total 410 ‘The ordinary shares of Tinau Co have a nominal value of NRs. 50 per share and are currently trading on the stock market on an ex dividend basis at 58.5 per share. Tinau Trading Co has an equity beta of 1-15, ‘The loan notes have @ nominal value of 1,000 and are currently trading on the stock market on an ex interest basis at 1,035 per loan note. The interest on the loan notes is 6% per year before tax and they will be redeemed in six years’ time at a 6% premium to their nominal value. The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinau Trading Co pays corporation tax at an annual rate of 25% per year. Require Calculate the market value weighted average cost of capital and the book value weighted average cost of capitalof Tinau Trading Co, and comment briefly on any difference between the two values. Solution: 1) Cost of Equity (Ke) as per CAPM= 4 + (1:15x6)= 109% 2). Cost of debt of loan notes ‘After-tax annual interest payment = 60 x 0-75 = 45 per loan note. Year ‘Amount(Rs) | 5%discount | PV A% discount | PV 0 (1035) 1.0000 (1035) 41,0000 (1035) 16 450 5.076 228.4 5.242 235.9 6 1060 0-746 7908 0-790 837.4 (15.8) 38.3 Therefore, Kd = 4+ [(1 x 38.3) /(38.3 + 15.8]] = +0-7 = 4-7% per year 36Cost of Capital for CA CAP-II, by CA Narahari Aryal Market values of equity and debt: Number of ordinary shares = 200m/50 = 4 million shares Market value of ordinary shares = 4m x 58.5 = 234 million Market value of loan notes= 200m x 1035/1000 = 207 million 34 +207 = 441 million Total market valu Market value WACC: Ko = {(10-9 x 234) + (4-7 x 207)) /441 = 8% Book value WACC: Ko = ((10:9 x 210) + (4-7 x 200)}/410= 2289+ 940 = 7.88% Market values of financial securities reflect current market conditions and current required rates of return. Market values should therefore always be used in calculating the weighted average cost of capital (WACC) when they are available. If book values are used, the WACC is likely to be understated, since the nominal values of ordinary shares are much less than their market values. The contribution of the cost of equity is reduced if book values are used, leading to a lower WACC, as evidenced by the book value WACC (7.88%) and the market value WACC (8%) of Tinau Trading Co. 37