Chapter B3 – Cost of Capital 1

CHAPTER

B3

SUGGESTED ANSWERS
RECENT EXAM QUESTIONS

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A company issues:
• 15% convertible debentures of ` 100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk - free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of
` 12.76 per share. Five year ago, it paid dividend of ` 10 per share. Flotation cost is 5% of issue amount.
• 5% preference shares of ` 100 each at premium of 10%. These shares are redeemable after 10 years
at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.
(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate cost of preference shares.
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.03, t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05, t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA 0.03, t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA 0.05, t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIF i, 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIF i, 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIF i, 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828
Ans.

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