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Project Appraisal -Cost of Capital - Exercises

1. Benzone Petroleum Corporation (BPC) has 3 major divisions: Oil refining,

mining and petrochemicals. It has identified proxy companies in these lines of
business which are listed and whose shares are actively traded. Neither BPC
nor any of the proxy companies employ debt in their capital structures. The
betas of three divisions have been estimated as:
Refining 1.16
Mining 1.64
Petrochemicals 0.70
The expected return on the market index is 13% in the foreseeable future and
91 days treasury bills are currently yielding 7%. The divisions are evaluating a
number of projects which have the following expected returns:
Project Division Expected Return(%)
1 Mining 18
2 Petrochemicals 12
3 Petrochemicals 10
4 Refining 26
5 Refining 13
6 Mining 21
7 Petrochemicals 14
8 Mining 16

a. Which projects should be accepted and which rejected?

b. If BPC as well as the proxy companies had a debt to total ratio of 40% and intend
financing each of the projects with 40% debt out of a debenture issue with a 6%
post-tax cost, would your answer change? how?

2. The cost of specific sources of capital for Bharat Nigam Limited (BNL) are:
rE = 16%, rP = 14%, rD = 12%
The market value proportions of equity, preference, and debt are:
wE = 0.60, wP = 0.05, wE = 0.35
The tax rate for BNL is 30%
What is WACC of BNL ?

3. Ramesh Engineering is currently at its target debt-equity ratio of 4:5. It is evaluating

a proposal to expand capacity which is expected to cost
Rs. 4.5 million and generate after –tax cash flows of Rs. 1 million per year
for the next 10 years. Two financing options are being looked at:
 Issue of equity stock. The required return on the company’s new equity is
18%. The issuance cost will be 10%.
 Issue of debentures carrying a yield of 12%. The issuance cost will be
(a) What is the NPV of the expansion project?
(b) After considering the floatation costs, whether the project is worthwhile?
4. Shiva Chemicals Limited wishes to use equity, preference, and debt capital in the
following proportions:
Equity : 0.40
Debt : 0.60

Data for calculating the Weighted Marginal Cost of Capital (WMCC)

Schedule for Shiva Chemicals

Source of Capital Target Proportion Range of New Financing

(Rs. in million )
Equity 40% 0-30 18.00
30 and above 20.00

Debt 60% 0 –50 10.00

50 and above 11.00
(a) At what amounts of new capital will there be breaks in the
marginal cost of capital schedule?
(b) What will be the marginal cost of capital in the interval
between each of the breaks?

5. Mahindra Hitec Ltd. has the following capital structure based on market value.
Sr. No. Particulars Amount in Rs.
1. Equity Capital 100,00,000
(80,000 shares of Rs. 10 face value)
2. 15% Preference Capital 6,21,000
(6,000 shares of Rs. 100 par value)
3. 14% Debentures 9,70,000
(Face value of Rs. 1,000)
4. 16% Term Loan 8,00,000

Dividend expected for the next year is Rs.3.50 and expected to grow at the
Rate of 12%. It is presently selling at Rs. 125.
Preference shares are redeemable after 5 years at a premium of 5% and debentures
are redeemable after 10 years at face value. They are presently selling at Rs. 103.50
and Rs. 970 respectively.
The applicable tax rate for the company is 40%.
Calculate the WACC using market value as weights.

6. Diversified Ltd. is evaluating a granite project for which it proposes to use a debt-
equity ratio of 1.5:1. The pre-tax cost of debt is 15% and the tax rate is expected to be
30%. The risk-free rate is 12% and the expected return on the market portfolio is
There are three firms, A,B and C engaged in granite manufacturing. Their tax tare is
40%.Their equity betas and debt-equity ratios are as follows:
Equity beta D/E ratio
A 1.20 2.1
B 1.10 1.8
C 1.05 1.3
Calculate the weighted average cost of capital. (required rate of return)