Cost of Capital

The Riley company has Rs. 200 million in total net assets at the end of 19X0. It plans
to increase is production machinery in 19X1 by Rs. 50 million. Bond Financing, at
an 11 percent rate, will sell at par. Preferred will have an 11.5 percent dividend
payment and will be sold at a par value of Rs. 100. Common stock currently sells for
Rs. 50 per share and can be sold to net Rs. 45 after flotation costs. There is Rs. 10
millions of internal funding available from retained earnings. Over the past few
years, dividend yield has been 6 percentages and the firm’s growth rate is 8 Percent.
The tax rate is 40 percentages. The capital structure shown below is considered
optimal.

Debt:
4% coupon bonds Rs. 40,000,000
7% coupon bonds 40,000,000 Rs. 80,000,000

Preferred stock 20,000,000

Common stock(Rs. 10 par) Rs.40,000,000

Retained Earning 60,000,000

Equity 100,000,000

Total
Rs. 200,000,000

(a) How much of the Rs. 50 million must be financed by equity capital if the
present capital structure is to be maintained?
(b) How much of the equity funding must come from the sale if new common
stock?
(c) Calculate the component cost of: New debt, New preferred stock, Retained
earnings and New equity.
(d) What is Riley’s average cost of equity fir 19X1?
(e) What would be Riley’s WACC if only retained earnings were used to finance
additional growth that is, if only Rs.20 million were raised?
(f) What is the WACC when Rs. 50 million is raised?
(g) What is the WACC on the Rs.30 million raised over the Rs 20 million?

1. (a) XYZ limited has sales of Rs 200,000, net income of Rs. 15,000, and the following
balance sheet:
Cash Rs. 10,000 Account payable Rs. 30,000
Receivables 50,000 Other current labilities 20,000
Inventories 150,000 Long-term debt 50,000
Net fixed assets 90,000 Common equity 200,000

Total assets Rs. 300,000 Total labilities and Rs. 300,000

equity

The company’s new owner thinks that inventories are excessive and can be lowered to the
point where the current ratio is equal to the industry average , 2.5 times, without affecting
either sales or net income. If inventories are soldoff and not replaced so as to reduce the
current ratio to 2.5 times, if the funds generated are used to reduce common equity (stock can
be re-purchsed at book value), and if no other changes occur,by how much will (i) the debt
ratio change? (ii) the ROE change?