COURSE TITLE : CORPORATE FINANCE

REFERENCE BOOK BY : CA AKANKSHA NAIR

PROGRAMME & TRIMESTER : BACHELORS IN BUSINESS MANAGEMENT & MARKETING:

FIRST YEAR (AY : 2023 - 2024), TRIMESTER III

TABLE OF CONTENTS
Sr. No Topics Page No.
1. Introduction 2
2. Sources of Finance 10
3. Time Value of Money 27
4. Capital Budgeting 33
5. Capital Structure 43
6. Cost of Capital 50

Note :

This Book is a ready reckoner for Formula’s, Formats, Definitions, Concepts & Tables. The book will be
supplemented with worksheet for practice, after every chapter is completed. The book intends to simplify
your learning experience. Please do not copy or use the given material in any manner inappropriate.
 CHAPTER 1
SCOPE OF CORPORATE FINANCE

STAGES OF DECISION MAKING

PROCUREMENT OF FUNDS

[DISCUSSED IN NEXT CHAPTER IN DETAIL]

EFFECTIVE UTILISATION OF FUNDS

FINANCE FUNCTIONS / FINANCE DECISIONS
IMPORTANCE OF CORPORATE FINANCE
OBJECTIVES OF CORPORATE FINANCE

A. PROFIT MAXIMISATION
B. WEALTH / VALUE MAXIMISATION
ROLE OF FINANCE EXECUTIVE
 CHAPTER 2
TYPES OF FINANCING
LONG TERM SOURCES
(b) Depositary Receipts
 CHAPTER 3
TIME VALUE OF MONEY

KEY TAKEAWAYS

• The time value of money is a financial principle that states the value of a rupee today is worth more than
the value of a rupee in the future.
• This philosophy holds true because money today can be invested and potentially grow into a larger amount
in the future.
• The present value of a future cash flow is calculated by dividing the future cash flow by a discount factor
that incorporates the amount of time that will pass and expected interest rates.
• The future value of a sum of money today is calculated by multiplying the amount of cash by a function of
the expected rate of return over the expected time.
• The time value of money is used to make strategic, long-term financial decisions such as whether to invest
in a project or which cash flow sequence is most favourable.

Reasons why a Rupee tomorrow is worth less than a Rupee today

– Preference for current consumption

– Inflation

– Uncertainty

– Opportunity cost

Applications of TVM

– Capital Budgeting

– Working Capital Management

– Valuation

– Mergers & Acquisition

– Accounting

– Investment Planning

– Retirement Planning

– Loans

Simple Interest

1. Mr. Rahul has deposited Rs. 100,000 in a savings bank account at 6 per cent simple interest for 2 years.
Calculate the Maturity value using simple interest

Answer: After 2 years he will get:

1,00,000 + (100,000x6/100x2 years) = 1,12,000

Compound Interest

2. Mr. Rahul has deposited Rs. 100,000 in a savings bank account at 6 per cent compound interest for 2 years.
Calculate the Maturity value using compound interest.

Answer:

Option 1:

At end of year 1: = 1,00,000 + 6,000 = 1,06,000

Reinvesting 1,06,000 for year 2

At end of Year 2: = 1,06,000 + (1,06,000*6/100)

= 1,06,000 + 6,360 = 1,12,360

Option 1:

Maturity = 1,00,000*(1+0.06)2 = 1,12,360

Techniques of Conversion:
1. Compounding

FV = PV*(1+r)n
OR
FV = PV X CF
Where,
FV = Amount or future value after ‘n’ years

PV = Principal or cash flow today

r = Nominal Interest rate per annum

n = Number of years for which compounding is done

2. Discounting

PV = FV / (1 + r)n
[1/(1 + r)n] = the
OR
discounting factor
PV = FV * 1/ (1 + r)n

PV = FV x DF

Where:

PV = present value (today's value),

FV = future value (a value or cash flow sometime in the future),

r = interest rate per period, and

n = number of compounding periods

Time Value of Money

FV = PV x CF (compounding factor)

PV = FV x DF (discounting factor)
FUTURE VALUE

3. Ms. Laurel has invested Rs. 10,000 in a Bank certificate of deposit for 2 years at 8% interest. How much will
she receive on maturity?

Answer:

FV = PV x (1+r)n

FV = 10000 x (1+0.08)2

4. Mr. Aryan deposits Rs. 100,000 with a bank which pays 10 percent interest compounded annually, for 3 years.
How much amount he would get at maturity?

Answer:

Ans: FV = PV x (1+r)n

FV = 1,00,000 x (1+0.10)3

FV = 1,00,000 x 1.331 = Rs. 1,33,100.

Multiple compounding in one year

If Interest is received for more than once in a year then the effective maturity value is calculated as follows:

FV = PV* (1 + r / m)n *m

Where,

m = no. of times of compounding in a year

r = rate of interest per annum

n = No. of years

n*m = Total number of compounding in all for the given period

Example: How much will be in an account at the end of five years the amount deposited today is Rs 20,000 and
interest is 8% per year, compounded semi-annually?

FV = PV* (1 + r / m)n *m

FV = 20000 x (1 + 0.08/2) 5 *2

FV = 29,605.
 PRESENT VALUE

PV of a future cash flow is the amount of current cash that is EQUIVALENT value to the decision maker.

5. Find the PV of Rs. 10,000 receivable after 6 years, if the rate of interest is 10 per cent. Assume compounding
of Interest.

Answer: PV = FV x DFr,n [also, DF = 1 / (1+r)n]

PV = 10,000 x [1 / (1+0.1)6]

PV = 10,000 x 0.5645

PV = 5,645

6. Find the present value of Rs. 50,000 to be received at the end of four years at 12 per cent interest
compounded

Answer:

FV = PV x (1+r)n

50,000 = PV x (1+0.12)4

PV = 50,000 / 1.5735

PV = 31,776 (approx.)

Present value of an uneven series of payments

7. Find the PV of the following cash flows streams. The discount rate is 10 per cent.

Year cash flow

1 1000

2 4000

3 4000

4 4000

5 3000

Answer:

Year Payment PVF PV of Individual payments

1 1000 x 0.9091 909.10

2 4000 x 0.8264 3305.60

3 4000 x 0.7513 3005.20

4 4000 x 0.6830 2732.00

5 3000 x 0.6209 1862.70

PV = sum = 11814.60
 8. Mr. Shah has invested Rs. 50,000 on Xerox machine on 1.1.2012. He estimates net cash income from Xerox
machine in next five years as under. Calculate the PV of all future cash flows

Year Estimated Inflows

2012 12000

2013 15000

2014 18000

2015 25000

2016 30000

Answer:

Year Estimated Inflows PVF @ 10% PV of Inflows

2012 12000 x 0.9091 = 10909

2013 15000 x 0.8264 = 12396

2014 18000 x 0.7513 = 13523

2015 25000 x 0.6830 = 17075

2016 30000 x 0.6209 = 18627

PV = sum = 72530
 CHAPTER 4
CAPITAL BUDGETING

 Capital budgeting decisions pertain to purchase of fixed / long-term assets which are used in the operation of
the organization and yield a return keeping in mind the goal of wealth maximization

 In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve
current outflow of cash but are likely to produce benefits (inflow of cash) over a period.

 Capital Expenditure is an outlay of funds that is expected to produce benefits over a period exceeding one
year (concept learnt in F.A.)

Importance of Capital Budgeting decisions

 Such decisions affect the profitability of an organization.

 A capital budgeting decision has its effect over a long-time span.

 Capital expenditure decisions once made are not easily reversible without much financial loss to the
organization.

 Such decisions involve a huge cost and so there is a need for thoughtful, wise, and correct investment
decisions.

Types of Capital Budgeting decisions

 Accept – Reject decisions – Under this, if the project is accepted, the firm would invest in it; if the proposal is
rejected, the firm does not invest in it.

 Mutually Exclusive Project decisions – Under this, the projects compete with other projects in such a way
that the acceptance of one will exclude the acceptance of the other projects.

Cash Flows

Cash Inflows: -
Sales x

(-) Expenses (x)

PBD&T x
(-) Depreciation (x)
PBT x
(-) Tax (x)
PAT x
(+) Depreciation x
Cash Inflows X

(i.e. PATBD)
Evaluation/Investment appraisal techniques

A. Pay Back Method/Payback period (PBP)

 This method answers the question – How many years will it take for the cash benefits to pay off the original
cost of investment?

 Accept-Reject rule:

If PBP < Standard PBP (of similar projects) = > Accept

If PBP > Standard PBP (of similar projects) = > Reject

 There can be two different situations while using the pay back period.

a. Even / Uniform cash flows

1. An investment of Rs. 40,000 in a machine is expected to produce constant cash flows of Rs. 8,000 for 10
years.

Answer:

40000 / 8000 = 5 years is PBP, it would take 5 years to recover the investment

2. An investment of Rs. 50,00,000 in a pension plan is expected to produce constant cash flows of Rs.
500,000 annually for the next 20 years. Calculate the payback period.

Answer:

50,00,000 / 500,000 = 10 years.

b. Uneven / non-uniform cash flows

In such cases, payback is calculated by a process of cumulating cash inflows till they equate the original outlay.

Payback period = Year before full recovery + Proportionate amount period

3. Suppose an initial cost of a project is Rs. 50000

Annual inflows after tax before depreciation
Year Amount
1 10000
2 15000 Find PB
3 20000
4 25000

Answer:

Solution:
Year Amount Cumulative
1 10000 10000
2 15000 25000
3 20000 45000
4 25000 70000

The initial cost is Rs. 50000 which will be recovered

between year 3 and 4. Therefore the PB period
will be 3 years + a fraction of the 4th year.
Rs. 45000 will be recovered by Year 3 and balance
Rs. 5000 will be recovered in the 4th year whose
annual cash flow is Rs25000 (for 12 m).
Therefore the fraction in the 4th year needed to reach
the cost of 5000 = > we say: (5000/25000*12)
PB = 3 years + 2.4 months
B. Accounting/Average Rate of Return
Average Rate of Return – It is also known as accounting rate of return. It is based on accounting information
rather than cash flows.

Accept – Reject rule

ARR > Required rate of return ACCEPT
ARR < Required rate of return REJECT

4. The purchase price of a computer is Rs. 24000. Salvage value is Rs. 4000. Working capital is Rs. 6000.
Economic life is 5 years. Depreciation is to be provided on SLM. Average profits are Rs. 40000. Required
rate of return is 15%. State whether the project is acceptable by computing ARR.

Answer:

Average Investment = 6000 + 4000 + ½*(24000-4000) = Rs. 20000

ARR = 40000 / 20000 = 200%

The ARR > Required RoR (15%), therefore, ACCEPT the project

5. Zee Ltd. provides the following information:

Purchase price – Rs. 160,000

Installation charges –Rs. 40,000
Salvage value –Rs. 80,000
Economic life – 4 years
Working capital required –Rs. 20,000
Annual earning before deprecation and tax –Rs. 130000
Rate of tax – 30%
Calculate ARR if deprecation is charged using Straight Line method

Answer:

ARR = Annual average earnings after tax / Average investment

Average Investment
= 20000+ 80000+ ½*[200000 – 80000] = 160,000
ARR = Annual Avg. earnings / Average Investment
ARR = 70000 / 160000 * 100 = 43.75%

Year Annual Earnings Depn PBT Tax PAT

before Depn n Tax
1 130000 30000 100000 30000 70000
2 130000 30000 100000 30000 70000
3 130000 30000 100000 30000 70000
4 130000 30000 100000 30000 70000
Total 280000
Average 70000
 C. Discounted Cash Flow / Time Adjusted Techniques

These techniques take into consideration the time value of money while evaluating the costs and benefits of a
project.

All these methods require cash flows to be discounted at a certain rate. This rate is known as the cost of capital
(K) or (r)

a. Net Present Value method

NPV may be described as-

the sum of the present value of cash inflows each year

Less: the sum of present values of cash outflows

Accept – Reject Rule

If NPV > Zero (i.e. positive) ACCEPT

If NPV < Zero (i.e. negative) REJECT

If NPV = Zero INDIFFERENT (can be still accepted)

Cash flows are equal/Uniform

6. Initial investment Rs. 200,000, Net cash inflow Rs. 60,000 per year, Life 6 years. Cost of capital 8%, No
Scrap value, Calculate NPV.

Solution:

When cash flows are equal, we can use Present Value concept

PV of cash inflow = 60,000 x DF (year1,2,3,4,5,6) = 2,77,800

Less: cash outflow = 200,000

NPV = 77, 800

Since NPV is positive, the proposal should be accepted.

Cash flows are Uneven

7. Given the following data calculate NPV. Initial investment 60000. Life 5 years. Cost of capital 10%.
Year AdjustedInflows
1 14000
2 16000
3 18000
4 20000
5 25000

Answer:

Year Inflows PV @ 10% PV

1 14000 0.909 12726
2 16000 0.826 13216
3 18000 0.751 13518
4 20000 0.683 13660
5 25000 0.621 15525
68645
NPV = 68645 - 60000 = 8645, ACCEPT
 D. Internal Rate of Return method

The IRR is the discount rate which Equates the aggregate present value of net cash inflows with the aggregate
present value of cash outflows of a project.

In other words, at this rate the NPV of a project will be equal to Zero.

That is PV of Cash Inflows = PV of Cash Outflows

Accept – Reject Rule – It requires comparison of the IRR with the required rate of return or cut-off rate.

If IRR > cut-off rate - ACCEPT

If IRR < cut-off rate - REJECT

The required rate of return is known, whereas IRR is found by trial-and-error method.

8. A project costs Rs. 16,000 and is expected to generate cash inflows of Rs. 8000 and Rs. 7000 and Rs. 6000
at the end of each year for next 3 years. Calculate IRR.

Answer:

As a first step, we try a 20 per cent discount rate.

NPV = -16000 + Rs. 8000 (PVF1,0.20) + Rs. 7000 (PVF2,0.20) + Rs. 6000 (PVF3, 0.20).

= - 16000 + Rs. 8000*0.8333 + Rs. 7000*0.694 +6000*0.579

= -16000 + 14996 = - 1004.

A negative NPV indicates that the project`s true rate of return is lower than 20%. Lets try 16%. At 16% the projects
NPV is

NPV = -16000 + Rs. 8000 (PVF1,0.16) + Rs. 7000 (PVF2,0.16) + Rs. 6000 (PVF3, 0.16)

= - 16000 + Rs. 8000*0.0.862 + Rs. 7000*0.743 +6000*0.641

= -16000 + 15943 = - 57.

Since the projects NPV is still negative at 16% a rate lower than 16% should be tried. When we select 15% as the
trial rate, the projects NPV is + 200.

NPV = -16000 + Rs. 8000 (PVF1,0.15) + Rs. 7000 (PVF2,0.15) + Rs. 6000 (PVF3, 0.15)

= - 16000 + Rs. 8000*870 + Rs. 7000*0.756 +6000*0.658

= -16000 + 16200 = +200

Hence the Internal rate of return lies between 15 % and 16%.

We can find out a close approximation of the rate of return by the method of linear interpolation as follows:

IRR = lower rate + (higher rate– lower rate) x NPV of lower rate

(Lower rate NPV – Higher rate NPV)

= 0.15 + {(0.16-0.15) * 200} / [200 – (-57)]} = 15.78%

The IRR rule states that if the (IRR) on a project is greater than the minimum required rate of return – the cost of
capital – then the decision would generally be to go ahead with it.

Conversely, if the IRR on a project or investment is lower than the cost of capital, then the best course of action may
be to reject it.
E. Profitability Index Method

It is also known as Benefit-Cost ratio. It can be defined as the ratio obtained by dividing the present value of cash
inflows by the present value of cash outflows.

Accept – Reject Rule

If PI > 1 - ACCEPT

If PI < 1 – REJECT

9. A project of 20 years life requires an original investment of Rs. 100,000. The other relevant information is
given below: Average annual earnings before depreciation and tax Rs.20,000 Annual tax rate 50%

Calculate:

A) Payback period

B) Average rate of return

C) Rate of return on original Investment

Answer:

Annual earnings 20000

Less: depreciation 5000

EAD&BT 15000

Less: tax @ 50% (assume) 7500

EAT 7500

Add: depreciation 5000

EAT BD (Cash Flow) 12500

Payback period = 100,000 / 12500 = 8 years

ARR= [Average Annual Earnings (after tax) ÷ Avg. Investments] x 100

= 7500 / {100,000/2} *100 = 15% (avg. invt = Original invt/2)

ROR on original invt = 7500/ 100,000 * 100 = 7.5%

F. Discounted payback period

Under this method cash flows involved in a project are discounted back to present value terms.

Then the cash flows are compared with the original investment to find the payback period.

This method allows for timing of the cash flows but it does not consider the cash flows after the payback period.

10. DCF limited is implementing a project with an initial capital outlay of Rs. 8000. Its cash inflows are as
under:

Year Cash flow

1 6000
2 2000
3 1000
4 5000
The expected rate of return is 12%.
Calculate Discounted Payback.

Answer:
Year Cash inflow Disc Fac P.V. Cumulative
12%
1 6000 0.893 5358 5358
2 2000 0.797 1594 6952
3 1000 0.712 712 7664
4 5000 0.636 3180 10844
10844
Discounted PB is 3 years and 1.27 months
Investment is Rs. 8000
 CHAPTER 5
CAPITAL STRUCTURE

INTRODUCTION

• The objective of a firm should be directed towards the maximization of the firm‘s value.

• The proportion of funds contributed by different sources is termed as “Capital Structure”. The decision about
the proportion and type of financing with the aim of wealth maximization is the Financing decision.

• Thus, managers aim to identify the optimal capital structure.

• Value of firm (EV) = EBIT

• Overall cost of capital / weighted average cost of capital

• Capital structure will decide the weight of the debt & equity and ultimately the overall cost of the capital as
well as value of the firm

Capital Structure Decision

CAPITAL STRUCTURE PLANNING AND POLICY

• The capital structure should be planned generally, keeping in view the interests of the equity shareholders
and the financial requirements of a company.

• While developing an appropriate capital structure for its company, the financial manager should interalia aim
at maximizing the long-term market price per share.
 SOURCES

Debt: The essence of debt is that you promise to repay. If you fail to make those payments, you lose control of your
business.

• Fixed Claim

• Tax Deductible

• High Priority in Financial Trouble

• Fixed Maturity

• No Management Control

Equity: Funds contributed by owners with no promise of repayment.

• Residual Claim

• Not Tax Deductible

• Lowest Priority In Financial Trouble

• Infinite

• Management Control

FACTORS AFFECTING CAPITAL STRUCTURE

• Company Profile: Size, Nature

• Amount of finance & period

• Purpose of finance

• Cash Flow amount & consistency

• Availability of funds

• Assets: Tangible & Intangible

• Interest Coverage Ratio & Debt Service Coverage Ratio

• Expected Return

• Expected Growth rate

• Cost of financing

• Tax rate

• Business Risk & Financial Risk

• Control

• Issue Costs

• Regulatory framework

• Loan Covenants

• Stock price level

EVALUATION OF CAPITAL STRUCTURE

• EBIT-EPS Analysis (also MPS)

• Indifference point

• Financial Break-Even points

• Financial Ratios (DSCR & ISCR)

• WACC

• Leverage

EBIT-EPS Analysis

• The EBIT-EPS analysis is a first step in deciding about a firm‘s capital structure.

• It suffers from certain limitations and does not provide unambiguous guide in determining the level of debt
in practice.

• The major short comings of the EPS as a financing-decision criterion are:

a) It is based on arbitrary accounting assumptions and does not reflect the economic profits.

b) It does not consider the time value of money.

c) It ignores the variability about the expected value of EPS, and hence, ignores risk.

d) Designing an appropriate capital structure is concerned with choosing a capital structure that can provide the
highest wealth, i.e., the highest MPS (Market Price Per Share). This, in turn, is dependent upon EPS.

Indifference point

• Finance managers often evaluate financing plans based on how the plan affects earnings per share, or EPS.
Financing plans produce different levels of EPS at different levels of earnings before interest and taxes, or
EBIT. The EBIT-EPS indifference point is the EBIT level at which the earnings per share is equal under two
different financing plans.

• The indifference level of EBIT is one at which the EPS remains same irrespective of the debt equity
mix. While designing a capital structure, a firm may evaluate the effect of different financial plans on the
level of EPS, for a given level of EBIT.

• Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same for two
alternative financial plans. The indifferent point can be defined as "the level of EBIT beyond which the
benefits of financial leverage begin to operate with respect to Earnings Per share (EPS)".

Indifference point

Where,
X = Equivalency Point or Point of Indifference
I1= Interest under alternative financial plan 1.
I2 = Interest under alternative financial plan 2.
T = Tax Rate
PD1 = Preference Dividend in alternative financial plan 1.
PD2= Preference Dividend in alternative financial plan 2.
N1= Number of equity shares under alternative financial plan 1.
N2 = Number of equity shares under alternative financial plan 2.
The point of indifference can also be determined by preparing the EBIT chart or range of earnings chart. This chart
shows the expected earnings per share (EPS) at various levels of earnings before interest and tax (EBIT) which may be
plotted on a graph and straight line representing the EPS at various levels of EBIT may be drawn. The point where this
line intersects is known as point of indifference or break-even point.

Financial Break Even point

• In case the EBIT level of a firm is just sufficient to cover the fixed financial charges then such level of EBIT is
known as financial break-even level.

• The financial break-even level of EBIT may be calculated as follows:

• If the firm has employed debt only (and no preference shares), the financial break-even EBIT level is

• Financial break-even EBIT = Interest Charge

• If the firm has employed debt as well as preference share capital, then its financial break-even EBIT will be
determined not only by the interest charge but also by the fixed preference dividend. It may be noted that
the preference dividend is payable only out of profit after tax, whereas the financial break-even level is
before tax. The financial break-even level in such a case may be determined as follows:

Financial break-even EBIT =

Debt Service coverage Ratio

• Benchmark to measure the cash-producing ability of entity to cover debt payments

• DSCR= Cash operating Profit (EBITDA)

Principal & Interest paid

• A DSCR below one indicates inability to repay debt.

• Widely used by banks

Interest Service coverage Ratio

• Tool for financial institutions

• ISCR less than one suggests the inability to serve its interest on debts

• It explains the ability to earn operating profit to meet interest payment of the loan

ISCR = Net operating Income (EBIT)

Interest paid

• Sometimes, it is also calculated as

ISCR = Cash operating Profit (EBITDA)

Interest paid

It explains the ability of cash profits to meet interest payment of the loan.

Questions

1. (i) Calculate the level of EBIT at which the EPS is indifferent among the following alternatives:
Equity share capital of Rs. 6 lakhs and 12% debentures of Rs. 4 lakhs;
Or
Equity share capital of Rs. 4 lakhs, 14% preference share capital of Rs. 2 lakhs and 12% debentures of Rs. 4 lakhs
Assume tax rate is 35% and equity share face value is Rs. 10 per share.
(ii) Also Calculate Financial Break Even Point.
Answer:
2. A new project is under consideration in Zip Ltd. which requires a capital investment of Rs 4.50 Cr. Interest on
term loan is 12% and corporate tax rate is 50%. If the debt-equity ratio insisted by the financing agencies is
2:1, Calculate the point of indifference for the project. Assume shares of Rs. 10 each. Also calculate Financial
BEP.
Answer:
3. Paramount Ltd wants to raise Rs. 100 lakhs for a diversification project which would give EBIT of Rs.22 lakhs
p.a. Cost of debt is 15% for amounts up to and including 40 lakhs; 16% for additional amounts up to and
including Rs. 50 lakhs and 18% for additional amounts above 50 lakhs. The equity shares (face value of Rs. 10
each) currently has market price of Rs. 40 each. The market price will fall to Rs, 32 each if debts exceeding
Rs. 50 lakhs are raised. Tax rate is 50%. With the use of EPS decide which alternative is better. The following
are the different alternatives:

Option Equity Debt

I 50% 50%
II 60% 40%
III 40% 60%
Answer:
 4. Govinda Enterprises Ltd. Has 10,00,000 shares of Rs 10 each with market price of Rs 50 per share. It has also
issued bonds for Rs 4 Crores @12% p.a. It is considering an expansion plan and needs to mobilize Rs 5 Crores.
The alternatives being considered are:
(i) Issue Equity at Rs 40 per share.
(ii) Issue Bonds at 10% p.a.
(iii) Issue Preference Shares @12% p.a.
(iv) Finance 50% with Equity at Rs 40 per share and 50% with bonds @ 10% p.a.
The Company is in the tax bracket of 35%.
If the company is hopeful of generating an EBIT of Rs 2.5 Crores after expansion, which method of financing is the
best from the shareholder’s view point?
What more information is required if the market price of the share is the criterion for decision making?

Answer:
 CHAPTER 6
COST OF CAPITAL

• Cost of capital represents the return a company needs to achieve in order to justify the cost of a capital
project, such as purchasing new equipment or constructing a new building.
• Cost of capital encompasses the cost of both equity and debt, weighted according to the company's
preferred or existing capital structure. This is known as the weighted average cost of capital (WACC).
• A company's investment decisions for new projects should always generate a return that exceeds the firm's
cost of the capital used to finance the project. Otherwise, the project will not generate a return for
investors.
 1. Calculate the Cost of Equity Capital in the following cases:
(i) A company is expected to disburse a dividend of Rs.30 on each equity shares of Rs.10 each. The
current market price of shares is Rs.80. Calculate the cost of Equity capital as per dividend yield
method.
(ii) A company has its equity shares of Rs.10 each quoted in a stock exchange has market price of
Rs.56. A constant expected annual growth rate of 6% and a dividend of Rs.3.60 per share was paid for
the current year. Calculate cost of capital.

Answer:
2. Suppose you estimate that eBay’s stock has a beta of 1.45. for UPS beta is 0.79. If the risk-free
interest rate is 3% and you estimate the market’s expected return to be 8%, calculate the equity cost of
capital for eBay and UPS. Which company has a higher cost of equity capital?
Answer:

3. Valence Industries wants to know its cost of equity. Its chief financial officer (CFO) believes the
risk-free rate is 5 percent, equity risk premium is 7 percent, and Valence’s equity beta is 1.5. What
is Valence’s cost of equity using the CAPM approach?

Answer:
 4. Here are stock market and Treasury bill returns (in %) between Year 1 and Year 5:

Year Index Return T-Bill Return

1 1.31 3.9

2 37.43 5.6

3 23.07 5.21

4 33.36 5.26

5 28.58 4.86

What is the average risk premium?

Answer:
 5. Berta ltd, issues 11% irredeemable preference shares of the face value of Rs. 100 each. Floatation
costs are estimated at 5% of the expected sale price. What is the Cost of Preference Shares, if
preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount?
Answer:
 6. Delta ltd has Rs. 100 preference share redeemable at a premium of 10% with 15 years’ maturity.
The coupon rate is 12%. Floatation cost is 5%. Sale price is Rs. 95 (net). Calculate the cost of
preference shares.

Answer:
 7. Max ltd has 10% perpetual debt of Rs. 1,00,000. The tax rate is 35%. Determine the cost of capital
(before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10% discount, and (iii) 10%
premium
Answer:
 8. Calculate the explicit cost of debt (after tax) for Annie Lenox limited in each of the following
situations:
➢ Debentures are sold at par and floatation costs are 5%
➢ Debentures are sold at premium of 10% and floatation costs are 5% of issue price
➢ Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is 10 years and tax rate is
35%

Answer:
 9. Star Cements ltd has given you the following capital structure, Calculate WACC based on book
values and market values. Cost of capital is net of tax.

Sources Market Book Cost

Values Values (%)
(Rs Cr) (Rs Cr)
Equity 80 120 18
Preference 30 20 15
Debentures 40 40 14
Answer:
 10. Alpha limited is considering raising of funds of about Rs. 100 lakhs by one of the two alternative
methods viz., 14% institutional term loan and 13% non-convertible debentures. The term loan option
would attract no major incidental cost. The debentures would have to be issued at a discount of 2.5%
and would involve a cost of issue of Rs. 1 lakh. You are to advise the company as to the better option
based on the effective cost of capital in each case. Assume a tax rate of 50%.
Answer: