# Subject: Financial Management

Topic: Cost of Capital By: Questionscastle Academic Team Document Code: CA/IPCC/FM/00014
Q 1. (a) A company issues `10,00,00,000 16% debentures of `100 each. The company is in 35% tax bracket. You are required to calculate the cost of debt after tax, if debentures are issued at (i) par, (ii) 10% discount and (iii) 10% premium. (b) If brokerage is paid at 2% what will be the cost of debentures if issue at par. Q 2. (A) (i) A company issues `10,00,000 12% debentures of `10,00,000 12% debentures of `100 each. The debentures are redeemable after the expiry of fixed period of 7 years. The company is in 35% tax bracket. Required: Calculate the cost of debt after tax, if debentures are issued at (a) Par, (b) 10% discount and (c) 10% premium. (b) X Ltd. Issues 12% debentures of face value `100 each and realize `95 per debenture. The debentures are redeemable after 10 years at a premium of 10%. Calculate the cost of capital presuming tax rate is 50%. Q 3. Y Ltd. issues preference shares of face value `100 each carrying 14% dividend and realizes `92 per share. The shares are repayable after 20 years at par. Q 4. XYZ & Co. has 20,000 equity shares of `10 each fully paid. The current market price per share is `20. Earnings available to the shareholders at the end of the period under consideration are `60,000. Calculate cost of equity share capital using earnings/price ratio. Q 5. The current price of an equity share of `10 is `20. The next expected dividend per share is 20%. The dividends are expected to grow at a rate of 5%. Calculate the cost of equity based on dividend growth model. Q 6. From the under mentioned facts determine the cost of equity shares of company X. (i). Current market price of a share `150. (ii). Cost of floatation per share on new shares `3 (iii). Dividend paid on the outstanding shares over the last five years. Year Dividend per share 1 `10.50 2 `11.02 3 `11.58 4 `12.16 5 `12.76 6 `13.40 (iv). Assume a fixed dividend payout ratio. (v). Expected dividend on the new shares at the end of current year is expected to be `14.10 per share. Q 7. On Jan 1st, 2006, Canon Copy Machines one of the favorites of the stock market, was priced at `300 per share. This price was based on an expected dividend at the end of the year `3 per share and an expected annual growth rate in the dividends of 20% in the future. By Jan 2007, economic Questionscastle.com Page 1

indicators have turned down, and investors have revised their estimates for future growth rate of dividend down to 15%. What should be the price of the firm’s common stock in Jan 2007? Assume the following: a. A constant growth valuation model is a reasonable representation of the way the market values CMM. b. The firm does not change the risk complexion of its assets nor its financial leverage. c. The expected dividend at the end of year 2007 is `3.45 per share. Q 8. A company has issued equity share capital having a face value of `10 at a premium of 10%, incurring 5% of issue price as cost of issue. The expected rate of dividend is 20%. (i) What is the cost of capital? (ii) What is the cost of retained earnings if the market value of equity share is `15.. Q 9. Unlever Ltd. is an equity based firm with project undertaken viz. Project A, B and C with Rf 8%, Rm 12%. Project Beta Weight A 1.3 0.5 B 1.0 0.3 C 0.8 0.2 Compute cost of capital. Q 10.The following information is available relating to a risk free return, Rf and market rate, Rm of a security during the last 6 years. Year Rf Rm 1 0.06 0.14 2 0.05 0.10 3 0.07 0.14 4 0.08 0.17 5 0.09 0.12 6 0.07 0.11 On the basis of above information find out Ke on the basis of the CAPM given that the β is 0.863. Q 11.The beta coefficient of Computech Ltd. is 1.2. The company has been maintaining 5% rate of growth in dividends and earnings. The last dividend paid was `2.40 per share. Return on Govt. securities is 10%. Return on Market Folio is 14%. The current market price of one share of computech ltd. is `28. The earnings per share is `3.90. Calculate the cost of equity capital based on: (i) Dividend Yield Method, (ii) Dividend growth method, (iii) Capital Asset Pricing method and (iv) Earnings price model. Q 12.The capital structure of a company consists of equity shares of `50 lakh; 10% pref. shares of `10 lakh; and 12% debentures of `30 lakh. The cost of equity capital of the company is 14.7% and income tax rate is 30%. Calculate Weighted Average Cost of Capital. Q 13.The Tata Company has two divisions: Health Food & Specialty Metals. Each division employ debt up to 30% and pref. capital equal to 10% of its total requirements, with equity capital used for the remainder. The current borrowing rate is 15% and companies tax rate is 40%. Presently pref. shares can be sold carrying 13% dividends at par. Tata wishes to establish a minimum return standard for each division based on the risk of that division. This standard then would serve as the transfer price of the capital to the division. The company has thought about of using capital asset pricing model in this regard. It has identified two samples of companies having similar capital structure to that of tata, with betas of 0.902 for health foods and 1.30 for specialty metals. The risk free rate presently is 12% and the expected return in the market folio is 17%. Using the

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CAPM approach, what weighted average required returns on investment would you recommend for these two divisions. Q 14.The following is the capital structure of Simmons Ltd. as on 31st Dec 1998. Equity shares: 10000 shares of `100 each. 10,00,000 10% Pref. Shares of `100 each 4,00,000 12% Debentures 6,00,000 20,00,000 The market price of companies equity share is `110 and it is expected that a dividend of `10 per share would be declared for the year 1998. The dividend growth rate is 6%. (i). If the company is in the 35% tax bracket, find weighted average cost of capital. (ii). Assuming that in order to finance an expansion plan, the company needs to borrow a fud of `10 lakh bearing 14% rate of interest, What would be the companies revised weighted average cost of capital? This finance decision is expected to grow dividends from `10 to `12 per share. However the market price of equity share is expected to decline from `110 to `105 per share. Q 15.A company is currently paying a dividend of `2.00 per share. The dividend is expected to grow at 15% p.a. for three years, that at 10% for the next three years, after which it is expected to grow at 5% rate forever. What is the present value of share if the capitalization rate is 9%? Q 16.The capital structure of Hindustan Traders Ltd. as on 31.3.2004 is as follows: Equity Capital: 100 Lakh equity shares of `10 each `10 crores. Reserves `2.00 crores 14% debentures of `100 each `3.00 crores For the year ended 31.3.2004 the company is to pay dividend at 20%. As the company is a market leader with a good future, dividend is likely to grow by 5% each year. The equity shares are now traded at `80 per share on the stock exchange. Tax rate is 50% Required: a. The current weighted cost of capital. b. The company has plans to raise the further `5 crore by way of long term loan at 16% interest. When this takes place the market rate of equity shares is expected to fall at `50 per share. What will be the new average weighted cost of capital? Q 17.X Ltd. is proposing to sell a 5 year bond of `5000 at 8% p.a. The bond amount will be amortized equally during its life time. What is the bond’s present value for the investor if he expects a minimum rate of return of 6%? Q 18.The following items have been extracted from the liabilities side of balance sheet of XYZ company as at 31st Dec 2006. Paid up capital 400000 equity shares of `10 each `40,00,000 Reserves and surplus `60,00,000 Loans: 15% Non convertible debentures `20,00,000 14% Institutional Loans `60,00,000 Other information about the company as relevant is given below: Year Ended Dividend Earnings Average market price 31st Dec per share per share per share 2006 4.00 7.50 50.00 2005 3.00 6.00 40.00 Questionscastle.com Page 3

2004 4.00 4.50 30.00 You are required to calculate the weighted average cost of capital, using book values as weights and Earnings/Price ratio as the basis of cost of equity. Assume tax rate is 40%. Q 19.Calculate economic value added with the help of the following information of Hypothetical Ltd. Financial Leverage 1.4 times Capital Structure Equity capital is `170 lakhs Reserves and surplus `130 lakhs 10% debentures of `400 lakhs Cost of equity 17.5% Income tax rate 30%. Q 20.Pacific utilities company has present capital structure (which the company feels is optimal) of 50% long term debt, 10% preferred stock, and 40% common equity. The company have 25 million common stock. For the coming year the company has determined that its optimal capital budget (`125 million) can be externally financed work with `70 million of 10% first mortgage bonds sold at par and `14 million of preferred stock costing the company 11%. The remained of the capital budget will be financed with retained earnings. The company’s common stock is presently selling at `25 per share, and next year’s common dividend is expected to be `2 a share. The company’s past annual growth rate in dividends has been 6%. Tax rate 40%. Calculate cost of capital for proposed capital budget. Q 21.On Jan 1st, 2005 the total market value of Powell company was `60 million. During the year the company plans to raise and invest `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 `30,000,000 Common equity `30,000,000 Total Capital `60,000,000 New bonds will have an 8% coupon rate, and they will be sold at par. Common stock currently selling at `30 a share, can be sold to net the company `27 a share. Stockholders required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is `1.20, so `1.20/30=4%). Retained earnings for the year are estimated to be `3 million. The marginal corporate tax rate is 40%. a. To maintain the present capital structure, how much of the new investment must be financed by common equity? b. Calculate the cost of each of the common equity component. c. At what level of capital expenditures will the firm’s WACC increase? d. Calculate the firm’s WACC using (i) the cost of retained earnings (first breaking point) and (ii) the cost of new equity (second breaking point. (iii) WACC of additional funds `30 million. Q 22.(i) EBIT = 2,00,000 (ii) Int. at 10% `20,000 (iii) Cost of equity = 12% and (iv) Ignore tax. Find overall cost of capital.

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