1. A company decides to sell a new issue of 7 year 15% bonds of Rs. 100 each at par.

If the
company realizes the full face value Rs. 100 of the bond and will pay Rs. 100 at maturity. What
will be the cost of debt? If the Corporate Tax Rate is 40%, what would be the After Tax Cost of
Debt?

INT
kd  i 
B0
INT = 0.15*100 = Rs. 15

B0 = 100

Kd = 15/100 = 0.15*100 = 15%

OR
n INTt Bn
B0   t

t 1 (1  k )
d (1  kd ) n
100 = 15*(PVIFA) 15%, 7 yrs + 100(PVIF) 15%, 7 yrs

With Trial and error also we get same 15% as result.

2. Assume in the above example if the bond is sold below par at discount at Rs. 94 each. What
would be the Cost of Capital?

INT = 0.15*100 = Rs. 15

Bn = 100

B0 = 94
n INTt Bn
B0   t

t 1 (1  k )
d (1  kd ) n
94 = 15*(PVIFA) 15%, 7 yrs + 100(PVIF) 15%, 7 yrs

With Trial and error, we get

PV Required = 94

PV @ 16% = 95.97

PV @ 17% = 92.13

Interpolation

Kd = Lower Range + (HR-LR) ((HV-RV) / (HV-LV))

= 16+ (17-16)* 1.94 (1.97/3.84) = 16.5%

• Short Cut Method

 kd = 15 + ((100-94) / 7 ) / (100+94)/2

= 16.4%

Kd after Tax = 16.4 (1 – 0.35 ) = 10.73%

Note that the Short Cut Method gives approximate answer.

3. A 7 year, Rs. 100 debenture of a firm sold at Rs. 97.75. The rate of interest is 15% per year, and
bond will be redeemed at 5% premium on maturity. The firm’s tax rate is 35%. Compute the
after – tax cost of debenture.

INT = 0.15*100 = Rs. 15

Bn = 105

B0 = 97.75
n INTt Bn
B0   t

t 1 (1  k )
d (1  kd ) n
97.75 = 15*(PVIFA) kd%, 7 yrs + 105(PVIF) kd%, 7 yrs

With Trial and error, we get

PV Required = 105

PV @ 16% = 97.75

Kd after Tax = 16 (1 – 0.35 ) = 10.4%

4. A company issues 10% irredeemable preference share. Face value is Rs. 100 but the issue price
is Rs. 95. What will be the cost of preference share? What is the cost if issue price is Rs. 105?

If Issue Price is Rs. 95:

PDIV
kp 
P0
Kp = 10 / 95 = 0.1053 * 100 = 10.53%

If Issue Price is Rs. 105:

Kp = 10 / 105 = 0.0952 * 100 = 9.52%

5. Suppose that the current market price of a company’s share is Rs. 90 and the expected dividend
per share next year is Rs. 4.50. If the dividends are expected to grow at a constant rate of 8 per
cent. What would be the cost of Equity for the firm?
DIV1
ke  g
P0

DIV1 = Rs. 4.50

Ke = 4.50 / 90 + 0.08 = 0.05 + 0.08 = 0.13 = 13%.

6. Assume that a company’s share is currently selling for Rs. 134. Current dividends, DIV are Rs.
3.50 per share and are expected to grow at 15 per cent over the next 6 years and then at a rate
of 8 per cent forever. What would be the company’s cost of equity?
n
DIV0 (1  g s )t DIVn  1 1
P0   t
 
t=1 (1  ke ) ke  g n (1  ke )n

DIV0= 3.50

DIV1= 4.03

DIV2= 4.63

DIV3= 5.33

DIV4= 6.13

DIV5= 7.05

DIV6= 8.11

DIV7= 8.7588

P0 = 134

G1 = 0.15

G2 = 0.08
 Trial and Error Method = 0.12 * 100 = 12%

7. The share of a company is currently selling for Rs. 100. It wants to finance its capital
expenditures of Rs.100 million either by retaining earnings or selling new shares. If the company
sells new shares, the issue price will be Rs.95. The dividend per share next year, DIV1, is Rs. 4.75
and it is expected to grow at 6 per cent. Calculate (i) the cost of internal equity (retained
earnings) and (ii) the cost of external equity (new issue of shares).
DIV1
ke  g
P0

Cost of Internal Equity (Retained Earnings):

Ke = 4.75 / 100 + 0.06 = 0.0475 + 0.06 = 0.1075 = 10.75%

Cost of External Equity (New Selling / Issues of Shares):

Ke = 4.75 / 95 + 0.06 = 0.05 + 0.06 = 0.11 = 11%

It is obvious that the cost of external equity is greater than the cost of internal equity because of
the underpricing (cost of external equity = 11 per cent > cost of internal equity = 10.75 per cent).

8. A firm is currently earning Rs. 100,000 and its share is selling at a market price of RS. 80. The
firm has 10,000 shares outstanding and has no debt. The earnings of the firm are expected to
remain stable, and it has a payout ratio of 100 per cent. What is the cost of equity? If the firm’s
payout ratio is assumed to be 60 per cent and that it earns 15 per cent rate of return on its
investment opportunities, then, what would be the firm’s cost of equity?

Zero Growth Model

DIV1 EPS1
ke   (since g  0)
P0 P0

EPS= 100000 / 10000 = Rs. 10

Ke = 10/ 80 = 0.125 = 12.5%

If the firm’s payout ratio is assumed to be 60 per cent and that it earns 15 per cent rate of return
on its investment opportunities.

Dividend per share = Rs. 10*0.6 = Rs.6

Retention Ratio = 0.40

If firm has 15 per cent rate of return on its investment opportunities than

g = br

g = 0.40 * 015 = 0.06 Growth

Ke = 10 / 80 + 0.06 = 0.075 + 0.06 = 13.5%