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Pillai Institute of Management Studies and

Research (PIMSR),
New Panvel

Master of Management Studies (MMS)

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MMS – Semester-II
Subject : Financial Management

Lesson-3 : Cost of Capital


(theory and problems)
Lecture date : 15.1.2018

by
Prof. K.G.S. MANI

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Lecture date : 15.1.2018
Lesson – 3 : Cost of Capital

(1) Cost of Capital :


(i) Concept : The term cost of capital refers to the minimum rate of
return a firm must earn on its investment so that the market value
of the company’s equity shares does not fall. This is in principle
with the overall firm’s objective of wealth maximisation.

(ii) Definition of Cost of Capital :


(a) “Cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditures”.
(b) “Cost of capital is the rate of return that a firm must earn on
its project / investments to maintain its market value and attract
funds.

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(c) Definition of Weighted Average Cost of Capital (WACC) :
Weighted Average Cost of Capital (WACC) is defined as “the
average cost of company’s capital (equity capital, debts
(debentures and Long term Loans from banks) weighted according
to the proportion of each element bears to the total of capital
funds. Weights are usually based on market valuations, current
yields and cost after tax.

Simple WACC = (Cost of equity x percentage of equity amount)


(+) (Cost of debt (net of tax) x Percentage of debt amount)

WACC = Cost x Weight

(Note : Weighted Average Cost of Capital (WACC) is also known


as Overall Cost of Capital (denoted by ko) or Capitalisation Rate).

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(iii) Computation of Cost of Capital :
Computation of overall cost of capital of a firm involves the following :
(i) Computation of cost of each specific source of finance (known as
specific cost for equity shares, preference shares, debt, retained
earnings) ,
(ii) Computation of weighted average cost of capital (WACC) (also
known as over all cost of capital (ko) or Capitalisation Rate.

(iv) Concept of Weighted Average Cost of Capital :


A company’s cost of capital is the weighted average cost of various
sources of financial used by it viz. equity shares, preference shares
and debt.
Example :
Suppose that a company uses equity shares, preference shares and
debt in the following proportions : 50, 10 and 40. If the component
costs of equity, preference and debt are 16%, 12% and 8%
respectively, the weighted average cost of capital (WACC) is as
follows :

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Weighted Average Cost of Capital (WACC) =
= (Proportion of Equity shares) x (Cost of Equity) (+)
(Proportion of preference shares) x (Cost of Preference) (+)
(Proportion of debt) x (Cost of debt) =
= (0.5)(16) + (0.10)(12) + (0.4)(8) = 12.4%

(v) Elements of Cost of Capital :

(i) Cost of equity (ke) is more than cost of debt (kd).


(ii) Cost of debt (kd) is fixed rate and interest on debt is tax deductible
(cost of debt = kd (1 - t) (explanation in next slide)
(iii) Hence, proper mix of debt-equity should be achieved.
(iv) If equity component increases in capital structure, total cost of
capital (ko) increases.
(v) Higher the debt, higher the “capital gearing” of the company.
(vi) Higher debt component in capital structure to earn more dividend
for equity shareholder is known as “Trading on Equity”).
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(vi) Concept of Cost of Debt :
The interest paid on the debt instrument (debenture, bonds, long
term loans from banks) are ‘tax deductible’. In other words, the
amount of interest paid is debited to the Profit and Loss Account
and the tax is paid on the net earnings (after debiting interest).
The actual interest paid by the company is higher (by the tax
amount) than actual cost of the debt. Hence, the tax allowed
should be deducted from the cost of debt so as to arrive at the
real cost of debt. The formula is as under :
Cost of Debt (kd) = kd (1 – tax)
Example : Interest rate = 15%, Corporate tax rate = 30% calculate
cost of debt (kd).
kd = 15 (1 – 30/100) = 15 – (15 x 450/ 100) =
15 – 4.50 = 10.50%
As interest is tax deductible, the real cost of debt is 10.50% and
not 15% (Note : Students should adjust interest rate for tax while
calculating the cost of debt (kd). If Corporate Tax is not given in
the problem, interest rate should be taken as it is).
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(vii) Concept: Cost of equity(ke) is costlier than cost of debt(kd)
(i) An increase in the debt component (debentures) in the capital
structure will increase the required rate of return of equity since the
interest rate is fixed for debentures and higher amount of
distributable profit is available for equity shareholders.
Example : PAT = Rs 50,00,000, Interest on debentures = Rs
5,00,000 p.a. Amount available for dividend payment to equity
share holders (No. 1,00,000) is Rs 45,00,000, EPS = Rs 45.
(a) Assume debenture amount increased and interest per annum is
Rs 10,00,000 and now EPS is Rs 40 (40,00,000 / 1,00,000).
(b) Assume Equity shares increased to 2,00,000 Nos. and debenture
amount remains unchanged. Now Interest on debenture is Rs
5,00,000, and EPS = (50,00,000 - 5,00,000) / 2,00,000 =Rs 22.50
(c) Assume debentures also increased and interest payment is Rs
10,00,000 and equity increased to 2,00,000 shares. Now
EPS = (50,00,000 – 10,00,000) / 2,00,000 shares = Rs 20
Note : compare (a), (b), and (c ) to understand the concept as above.

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(2) Risk in Cost of Capital :
This includes cost of equity (ke), cost of preference shares (kp),
cost of debt (kd) and cost of retained earnings (kr)
(i) Cost of debt (kd) : Risk is lower than other sources of funds and
interest (cost) is lower than any other source of funds.
(ii) Cost of Preference Shares (kp) : Risk is higher than debt but
lower than equity share capital. Return (dividend) is higher than
debt but lower than equity share capital.
(iii) Cost of Equity Shares (ke) : Risk is higher than any other source
of funds. Return (dividend) is higher than any other source of
funds.
(iv) Cost of Retained Earning (kr) : This is opportunity cost, i.e. Return
which may be earned if the funds are invested in Money Market.
Overall Cost of Capital (ko) = ke + kd + kp + kr
ko is also known as ‘weighted average cost of capital’ (WACC).

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(3) Weighted Average Cost of Capital (WACC)
Concept of WACC :
Cost of capital is referred to as composite cost of capital in
financial decision making. Weighted average cost of capital is the
average cost of various sources of financing. It is also known as
overall cost of capital or average cost of capital. Weighted average
cost of capital is calculated after deciding specific cost of capital by
putting weight to each specific cost. The following steps are
involved in the calculation of weighted average cost.
i) Calculate cost of specific sources of funds individually.
ii) Multiply the cost of each source by its proportion in the capital
structure.
iii) Add weighted costs of all sources of funds to get the weighted
cost of capital. Cost of capital should be always calculated on the
‘after tax basis’ (net of tax) in the financial decision making.

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Concept of Weighted Average Cost of Capital (contd.) :
A company’s cost of capital is the weighted average cost of various
sources of financial used by it viz. equity shares, preference shares and
debt. (example)
(i) Cost of Equity (ke) = Percentage of dividend paid by the Company on
equity shares.
(ii) Cost of Debt (kd) = Percentage of interest paid on the debt instrument
(Debentures, Bonds, Long Term Loans of Banks).
(iii) Cost of Preference Share holders (kp) = Percentage of dividend
paid by the company on Preference Shares.
(iv) Cost of Retained Earnings (kr) = Percentage of return earned by the
company on its investments or earnings foregone by the Company on its
Retained Earnings.
Example : Suppose that a company uses equity shares, preference
shares and debt in the following proportions : 50, 10 and 40. If the
component costs of equity, preference and debt are 16%, 12% and 8%
respectively, the weighted average cost of capital (WACC) is as follows :

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Weighted Average Cost of Capital (WACC) =
= (Proportion of Equity shares) (Cost of Equity) +
(Proportion of preference shares) (Cost of Preference) +
(Proportion of debt) (Cost of debt)
= (0.5)(16) + (0.10)(12) + (0.4)(8) = 12.4%
Computation of weighted average cost of capital requires the following
elements :
Assignment of weights : Weights are to be assigned to each source.
Weights can be either (i) Book Value Weight, (ii) Market Value
Weight.
Two types of cost of capital : (see the problems in following slides)
(i) Specific Cost of Capital
(ii) Weighted Average Cost of Capital
Note : (a) Wherever percentage is used, the multiplier 100 should be
applied. (b) Weighted Average Cost of Capital (WACC) and Overal
Cost of Capital (Ko), both are the same.

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(4) Importance of Cost of Capital (CoC) :
The determination of the firm’s overall cost of capital is important
on account of following factors :
(i) Cost of capital (CoC) helps the managers in determining the
optimal capital structure of the company (firm).
(ii) CoC serves as the basis for evaluating the financial performance
of top management and the company.
(iii) CoC also helps in formulating dividend policy and working capital
policy.
(iv) CoC provides the basis for financial appraisal of new capital
expenditure proposals.
(v) CoC plays a crucial role in the following areas of financial
management :
(a) Capital structure decisions : An optimal capital is that structure at
which the value of the company (firm) is maximum and cost of
capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.

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(b) Evaluation of financial performance : Cost of capital is used to
evaluate the financial performance of the company. The actual
profitability is compared to the expected and actual cost of capital
of funds. If the profit is greater than the cost of capital, the
performance is satisfactory.
(c) Capital budgeting decisions : The cost of capital is used for
discounting the cash inflows and cash outflows under Net Present
Value (NPV) method for investment proposal. So it is very useful
in capital budgeting decisions.
(d) Other financial decisions : Cost of capital is also useful in making
such other financial decisions as dividend policy, capitalisation of
profits (issue of bonus shares), and making the Rights Issue of
Equity Shares.

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(5) Cost of Capital Formulae :
(i) Cost of Equity (ke)= (Dividend paid / Market Price of Share) x 100
(ii) Cost of Debt(kd) = (Interest ( 1 – tax) / Market Price) x 100
(iii) Cost of Equity Capital (ke) =
= (Dividend paid / Market Price per share) x 100 (+) Growth Rate
(iv) Market Price of Equity Share (MP) =
= Dividend paid /(Cost of Equity % - Growth Rate %)
(v) Cost of Equity Capital (ke) =
ke = [D1 / P0(1 – f)] + g
Explanation :
Ke = Cost of Equity Capital
D1 = Expected Dividend (in future)
P0 (zero) = Sale price (Issue price)
f = Floating cost (this includes issue expenses, discount if any)
G = Growth Rate in Dividend

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(vi) Cost of Debt (kd) =
kd = [(I + (RV – SV)/N ) x (1 – t) / (RV + SV)/2
Explanation :
Kd = Cost of Debt (Debentures, Bank Long Term Loans)
I = Rate of Interest
RV = Redeemable Value of Debentures (debts) at the time of maturity
SV = Net Sale Proceeds from the issue of Debentures (after reducing
Discount and floatation expenses or issue expenses)
N = Term of Maturity period of Debentures
T = Corporate Tax Rate

(Note : In the Cost of Capital calculation for Debts, only Long Term
Loans are considered and Short Term Loans or Bank Borrowings
should not be considered)

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Weighted Average Cost of Capital (WACC)

Problem - 1

Following is the Capital Structure of ABC Ltd. calculate Weighted


Average Cost of Capital (WACC)

Sources of Finance Amount(Rs) Proportion (%) Cost (%)

Debt 15,00,000 25 5

Preference Shres 12,00,000 20 10


Equity Shares 18,00,000 30 12
Rtained Earnings 15,00,000 25 11
Total 60,00,000 100

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Solution to Problem-1

Calculation of Weeighted Average Cost of Capital


Sources Proportion (%) Cost (%) (X) Weighted
(W) Cost =
Proportion X
Cost (WX)

Debt 25 5 1.25
Preference Shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
Weighted Average Cost 9.60
of Capital (WACC)

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Problem - 2 :
Assume a company in which the cost of debt capital is 4% and the
cost of equity capital is 15% in which 40% of total capital is debt and
60% is equity. Calculate the cost of capital.

Solution to problem-2 :

(Note : In Weighted Average Cost of Capital (WACC),


proportion of each element of capital to total capital
structure is known as Weight).

Calculation of Cost of Capital :


Sources Proportion (%) Cost (%) Total Cost (%)
(Weight)
Debt 40 4 1.60
Equity Shares 60 15 9.00
WACC 100 10.6

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Problem-3
From the following capital structure of
KBC Limited, you are required to
calculate the (i) Specific Cost of Capital
and (ii) Overall Cost of Capital (ko) (WACC).
Source Book Value (Rs) After tax cost(%)
Equity share capital (Rs10) 45,000 14%
Retained Earnings 15,000 9%
Pref. Share Capital 10,000 10%
Debentures 30,000 13%

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Solution-3 :
(i) Specific Cost method :
Source Amount (Rs) Proportion(%) Cost (%) Specific cost
(%)
Equity shares 45,000 45 14 6.30
Retained earnings 15,000 15 9 1.35
Pref. Shares 10,000 10 10 1.00
Debentures 30,000 30 13 3.90
1,00,000 100 12.55
WACC = 6.30 + 1.35+ 1.00 + 3.90 = 12.55%

(ii) Weighted Average Cost method :


Source Amount (Rs) Cost (%) Total Cost (Rs)
Equity Shares 45,000 14 6,300
Retained earnings 15,000 9 1,350
Pref. Shares 10,000 10 1,000
Debentures 30,000 13 3,900
1,00,000 12,550
WACC = (12,550 / 1,00,000) x 100 = 12.55%

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Problem-4 :
A company has on its books the following amounts and specific costs of
each type of capital.
Type of capital Book value Rs Market Value Rs Specific cost (%)
Debt 4,00,000 3,80,000 5
Preference shares 1,00,000 1,10,000 8
Equity shares 6,00,000 12,00,000 13
Retained earnings 2,00,000 0 9
13,00,000 16,90,000
Determine the weightd average cost of capital using :
(i) Book Value weights, (ii) Market Value weights.

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Solution – 4 :
Type of capital Book value Rs Specific cost % Proportion % Cost (WACC)
(%)
Debt 4,00,000 5 30.77 1.54
Pref. share capital 1,00,000 8 7.69 0.62
Equity share capital 6,00,000 13 46.15 6.00
Retained Earnings 2,00,000 9 15.30 1.38
WACC (%) 13,00,000 9.54

Market Value Cost (WACC)


Type of capital Rs Specific cost % Proportion % (%)
Debt 3,80,000 5 22.49 1.12
Pref. share capital 1,10,000 8 6.50 0.52
Equity shre capital 12,00,000 13 71.00 9.23
Retained Earnings 0 9 0 0
WACC (%) 10.87

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Problem - 5
Three companies A, B, C Ltd are in the same type of business and hence have
similar operating risks. However, the capital structure of each of them is
different and the following are the details :
Particulars A B C
Equity share capital (Rs) 4,00,000 2,50,000 5,00,000
(Face Value Rs 10 each)
Market value per share Rs 15 20 12
Dividend per share 2.7 4 2.88
Debentures (Face value Rs 0 1,00,000 2,50,000
100)
Interest Rate 0 10% 8%
M.V. per debenture 0 125 80
Assume that the current levels of dividens are generally expected to continue
indefinitely and the income-tax rate at 50%
You are required to compute weighted average cost of capital of each company

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Solution – 5 :
Cost of Equity shares :
Formula (Ke) : (Dividend / Market value) x 100

Company A = (2.70 /15) x 100 = 18%

Company B = (4 / 20) x 100 = 20%

Company C = (2.88 / 12) x 100 = 24%

Cost of Debt :
Formula (Kd) : (Interest (1-tax) / Market Value ) x 100

Company A = No debentures

Company B = 10(1- 0.50) / 125 x 100 = 4%

Company C = 8(1 - 0.50) / 80 x 100 = 5%

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Name of Company Equity Rs Equity % Debt Rs Debt %
A (40,000 x 15) 6,00,000 100 0 0
B (25,000 x 20) 5,00,000 80 1,25,000 20
C (50,000 x 12) 6,00,000 75 2,00,000 25

WACC (at Market Values of Debt and Equity)


= (Cost of Equity x % of Equity) + (Cost of Debt x % of Debt)

Company A = (18% x 1.00) = 18%


Company B = (20% x 0.80) + (4% x 0.20) = 16.8%
Company C = (24% x 0.75) + (5% x 0.25) = 19.25%

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Problem-6 : (home work) (Problem on concepts)
XYZ Company Ltd has capital structure consisting of Equity Shares
(40%) and Debentures. Total Capital fund is Rs 100 lakhs. Face value
of equity share is Rs 10 and interest paid on debentures is Rs 6,00,000.
The company earned a net profit (PAT) of Rs 20 lakhs. The Company
has decided to distribute 50% of profit as dividend. Corporate tax is
30%. Calculate (i) Cost of Equity (ke), (ii) Cost of Debt (kd) and
(iii) Weighted Average Cost of Capital (ko) of the company.

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Problem- 7 : (Home work)
MSN Company has on its books the following amounts and specific
costs of each type of capital : (amount in Rupees)
Type of capital Book Value Market Value Specific Cost (%)
Debt 4,00,000 3,80,000 5%
Preference Shares 1,00,000 1,10,000 8%
Equity Shares 6,00,000 12,00,000 13%
Retained Earnings 2,00,000 0 9%
13,00,000 16,90,000

Determine the Weighted Average Cost of Capital (WACC) using :


(i) Book Value weights
(ii) Market Value weights

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Solution - 7 :
Type of capital Book Value Specific Cost Proportion (%) Cost (%)
(Rs) (%)
Debt 4,00,000 5 30.77 1.54
Preference Capital 1,00,000 8 7.69 0.62
Equity Capital 6,00,000 13 46.15 6.00
Retained Earnings 2,00,000 9 15.30 1.38
13,00,000 9.54
WACC = 9.54 %

Type of Capital Market Value Specuific cost Proportion (%) Cost (%)
(Rs) (%)
Debt 3,80,000 5 22.49 1.12
Preference Cappital 1,10,000 8 6.50 0.52
Equity Capital 12,00,000 13 71.00 9.23
Retained Earnings 0 9 0 0
16,90,000 10.87
WACC = 10.87%

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Problem-8 (home work) :
From the following capital structure of PSN Co. Ltd, you are
required to calculate overall cost of capital (WACC) using :
(i) Book Value weights
(ii) Market Value weights (Amount in Rs)
Source Book Value Market Value
Equity share capital (FV Rs 10) 45,000 90,000
Retained Earnings 15,000 0
Preference Share Capital 10,000 30,000
The after-tax cost of different sources is as follows :
Equity Share Capital 14%
Retained Earnings 13%
Preference Shre Capital 10%
Debentures 5%

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Solution-8 : (Amount in
Rs)
Calculation of Weighted Average Cost of Capital (Book Value)
Source Amount (Rs) Cost (%) Total Cost Rs
Equity Share Capital 45,000 14 6,300
Retained Earnings 15,000 13 1,950
Pref. Share Capital 10,000 10 1,000
Debentures 30,000 5 1,500
1,00,000 10,750
WACC = (10,750 / 1,00,000) x 100 = 10.75%

Calculation of Weighted Average Cost of Capital (Market Value)


Source Amount(Rs) Cost (%) Total Cost Rs
Equity
Equity Share Capital 90,000 14 12,600
Retained Earnings 0 13 0
Pref. Share Capital 10,000 10 1,000
Debentures 30,000 5 1,500
1,30,000 15,100
WACC = (15,100 / 1,30,000) x 100 = 11.62%

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Problem-9 Z:
(home work) :
GTN Co. Ltd has various alternative of capital mix and
cost thereof as under :
Debt as % of Cost of Debt Cost of Equity
Total Capital (kd) (%) (ke) (%)
0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 5.5 13
50 6 13.5
60 6 14
70 7 14.5
80 7 15
90 7.5 15
100 7.5 15
A Company has cost of debt at 6%(after tax) and cost
of Equity is 14%. The Debt Equity proportion is 3%.
(i) Suggest optimum debt equuity mix at minimum cost.
(ii) Calculate Weighted Average Cost of Capital (WACC).

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Solution-9
GTN Company Limited
Calculation of Composite Cost of Capital
Debt as % of Cost of Debt Cost of Equity Composite Cost of Capital
Total Capital

0 5 12 (5 x 0) + (12 x 1) = 12.00
10 5 12 (5 x 0.10) + (12 x 0.90) = 11.30
20 5 12.5 (5 x 0.20) + (12.5 x 0.80) = 11.0
30 5.5 13 (5.5 x 30) + (13 x 0.70) = 10.75
40 5.5 13 (5.5 x 0.40) + 13 x 0.60) = 10.0
50 6 13.5 (6 x 0.50) + (13.5 x 0.50) = 9.75
60 6 14 (6 x 0.60) + (14 x 0.40) = 9.20
70 7 14.5 (7 x 0.70) + (14.5 x 0.30) = 9.25
80 7 15 (7 x 0.80) + (15 x 0.20) = 8.65
90 7.5 15 (7.50 x 0.90) + (15 x 0.10) = 8.25
100 7.5 15 (7.50 x 1.00) + (15 x 0) = 7.50

Optimum Debt Equity Mix for the company is 100% Debt only and
0% Equity capital
Total Capital employed is 100%
Composite cost of capital will be least at 7.50% when the entire amount
is only debt. Hence 100% debt is preferred.

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Calculation of Weighted Average of Cost of Capital (WACC) :
Source Cost of Debt Weights (for Weighted Cost WACC (%)
(after tax) capital)
Debt 0.06 0.03 0.0018 0.18
Equity 0.14 0.97 0.1358 13.58
Total 1.00 0.1376 13.76

Weighted Average Cost of Capital (WACC) = 13.76%

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Problem-10 : (home work)
Masanto Co. Ltd share is quoted in the market at Rs 20 currently. The
Company paid a dividend of Rs 2 per share and the investor expect
a growth rate of 5% in divdend per year.
Calculate the following :
(i) Company's equity cost of capital (ke).
(ii) If the anticipatd growth rate is 8%. What would be the indicated
Market Price of the share of the company ?
(iii) If the company's cost of capital is 12% and the anticipated
growth rate is 5%, and dividend payment is maintained at Rs 2 per share,
what would be the indicated market price of the share ?

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Solution-10 :
Masanto Company Limited :
Formula :
(i) Cost of Equity Capital =
[(Dividend paid / Market Price ) x 100] + Growth Rate % =
[(Rs 2 / Rs 20 x 100)] + 5% = 10% + 5% = 15%
Therefore, Cost of Equity Capital = 15%

(ii) Market Price of Equity Share =


Dividend paid / (Cost of Equity Capital - Growth Rate %) =
2 / (15% - 8%) = 2 x 100 / 7 = Rs 28.57

(iii) Market Price of Equity Share =


(Same formula as (ii) above)
2 / (12% - 5%) = 2 x 10 / 7 = Rs 28.57

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Problem - 11 :
(home work)
Samanto Company Limited has the following capital structure :
Equity Shares : Rs 60 lakhs
12% Pref. Shares : Rs 10 lakhs
14% Debentures : Rs 30 lakhs
The Market Price of Company's share is Rs 20. It is expected
that the company will pay next year a dividend of Rs 2 per share
which will grow at 8% for ever. Corporate tax rate is 40%.
You are required to :
(i) Calculate the Weighted Average Cost of Capital based on
the existing capital structure.
(ii) Compute the new weighted average cost of capital, if the
company raises an additional Rs 20 lakhs debt by issuing
15% debentures.
This would result in increasing the expected dividend to
Rs 3 per share and leave the growth rate unchanged
but the market price of share will fall to Rs 16 per share.

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Solution-11 :
Samanto Company Limited.
Cost of Equity Capital (ke) (formula) =
[(Dividend paid / Market Price) x 100)] (+) Growth rate %
[ (2 / 20 ) x 100) + 8% = 18% = 0.18

Cost of Debt (kd) (formula) =


kd ( 1 - tax) = 14% ( 1 - 0.40 ) = 14% x 0.60 = 8.40% = 0.084

Weighted Average Cost of Capital on the existing capital structure:


Source Amount (Rs) Cost (after Weights Weighted WACC (%)
tax) Cost
Equity Share Capital 60,00,000 0.18 0.60 0.1080 10.80
12% Pref. Shares 10,00,000 0.12 0.10 0.0120 1.20
14% Debentures 30,00,000 0.084 0.30 0.0252 2.52
1,00,00,000 14.52
Weighted Average Cost of Capital (WACC) = 14.52%

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New Weighted Average Cost of Capital :
Cost of Capital (ke)= (formula as above)
( 3 / 16) x 100 (+) 8% = 26.75% = 0.2675

Cost of Debentures (kd) = kd ( 1 - tax) =


14 ( 1 - 0.40) = 14 x 0.60 = 8.40 % = 0.084

15 ( 1 - 0.40) = 15 x 0.60 = 9.00% = 0.090

Calculation of new Weighted Average Cost of Capital


Source Amount Cost (after Weights Weighted WACC (%)
tax) Cost
Equity Shares 60,00,000 0.2675 0.5 0.13375 13.375
12% Pref. Shares 10,00,000 0.12 0.083 0.00996 0.996
14% Debentures 30,00,000 0.084 0.25 0.021 2.100
15% Debentures 20,00,000 0.09 0.167 0.01503 1.503
1,20,00,000 17.974
New Weighted Average Cost of Capital (WACC) = 17.974% = 17.97%

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Problem-12 : (home work)
SRN Ltd has the following Capital Structure :
Equity : 2,00,000 shares = Rs 40.00 lakhs
6% Preference shares : 1,00,000 shares = Rs 10 lakhs
8% Debentures : 3,00,000 Nos. = Rs 30 lakhs
It proposed to borrow Rs 20.00 lakhs with interest at 10% p.a.
The dividend on equity will increase from Rs 2 to Rs 3.
You are required to ascertain the change in the Weighted
Average Cost of Capital (WACC) consequent to
proposed long term loan from bank.

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Solution - 12 : (home work)
Working Notes :
(i) Equity shares : Amount Rs 40,00,000
No. of equity shares = 2,00,000 shares
Dividend paid per share = Rs 2
Total Dividend amount = 2,00,000 x 2 = Rs 4,00,000
Dividend (ke)(%) = (4,00,000 / 40,00,000) x 100 = 10%
Proportion (Weight) = 40 / 80 = 0.50 = 50%
Weighted Cost = cost x weight = 10% x 0.50 = 5%

Dividend increased from Rs 2 to Rs 3


Dividend paid per share Rs 3
No. of equity shares = 2,00,000 Nos.
Total Dividend paid = 2,00,000 x = Rs 6,00,000
Dividend (ke)(%) = (6,00,000/ 40,00,000) x 100 = 15%

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(ii) Preference Shares :
Dividend paid = 6% x Rs 10,00,000 = Rs 60,000
Proportion (wiehgt) = (10 lakhs / 80 lakhs) x 100 = 12.5%
Proportion of Pref. shares = 12.5% = 0.125
Weighted Cost = 6 x 0.125 = 0.75

(iii) Debentures :
Interest paid = 8% x 30 lakhs = Rs 2,40,000
Proportion (weight) in capital structure =
(30 / 80) x 100 = 37.5% = 0.375
Weighted cost = 8 x 0.375 = 3.00

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SRN Company Limited
Calculation of Weighted Average Cost of Capital (WACC) (for old capital structure)
(see working notes before solving problem)
Sources of capital Cost (amount) Cost (%) Weight (%) Weighted
Rs Cost (%)
Equity shares (dividend paid) 4,00,000 10 50.0 5.00
10% Pref. Shares (dividend) 60,000 6 12.5 0.75
8% Debentures 2,40,000 8 37.5 3.00
100 8.75

Weighted Average Cost of Capital (WACC) = 8.75%

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Calculation of WACC for proposed Capital Structure (for new capital structure)
Sources of Capital Amount (Rs in Proportion Cost (%) WACC (%)
lakhs) (weight %)
Equity shares 40 40 15 6.00
6% Pref. Shares 10 10 6 0.60
8% Debentures 30 30 8 2.40
10% New Long Term Loan 20 20 10 2.00
100 11.00

Weighted Average Cost of Capital for new capital structure : 11.00 %


WACC for old capital structure : 8.75% (as above)
Increase in WACC : 2.25%
Ans : There will be an increase in WACC by 2.25%

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THANK YOU

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