{"id":16398,"date":"2023-03-16T10:43:52","date_gmt":"2023-03-16T05:13:52","guid":{"rendered":"https:\/\/gstguntur.com\/?p=16398"},"modified":"2023-03-16T10:45:10","modified_gmt":"2023-03-16T05:15:10","slug":"cost-of-capital-ca-inter-fm-study-material","status":"publish","type":"post","link":"https:\/\/gstguntur.com\/cost-of-capital-ca-inter-fm-study-material\/","title":{"rendered":"Cost of Capital \u2013 CA Inter FM Study Material"},"content":{"rendered":"

Cost of Capital \u2013 CA Inter FM Study Material<\/a> is designed strictly as per the latest syllabus and exam pattern.<\/p>\n

Cost of Capital \u2013 CA Inter FM Study Material<\/h2>\n

Theory Questions<\/strong><\/p>\n

Question 1.
\nExplain the significance of cost of capital. (4 Marks Nov. 2019)
\nAnswer:
\nThe cost of capital is one of the most important component to take financial decisions. The correct calculation of cost of capital helps in the following decision making:
\n(1) Evaluation of investment options:
\nPresent value of all future benefit is calculated by discounting them with the relevant cost of capital. Different investment options have different cost of capital so we have to calculate cost of capital related to every project and then present value of future benefits related to these projects.<\/p>\n

(2) Financing Decision:
\nFinance managers obtains funds from various sources with consideration of cost, risk and control. Finance manager can easily compare cost of different sources and select source with lowest cost.<\/p>\n

(3) Designing of optimum credit policy:
\nIn modern world firm has to sell its products or services on credit. For evaluation of credit period cost of capital is used, benefit though credit should be higher than cost of funds blocked in credit.<\/p>\n

\"Cost<\/p>\n

Question 2.
\nDistinguish between Unsystematic Risk & Systematic Risk. (2 Marla Nov. 2020)
\nAnswer:
\nUnsystematic Risk :
\nRisk which is associated with performance of company is known as company specific risk or unsystematic risk. This risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable risk.<\/p>\n

Systematic Risk:
\nRisk which is associated with macro-economic or market under which a firm is doing business is known as unsystematic risk. This risk cannot be eliminated by the diversification of the securities portfolio, it is also known as non-diversifiable risk. The examples are Center and State government policies, inflation, GDP, per capita income, interest rate etc. This risks are assessed in terms of beta coefficient (b or (3) and calculated through regression equation between return of a security and the return on a market portfolio.<\/p>\n

\"Cost<\/p>\n

Practical Problems<\/strong><\/p>\n

Cost Of Debt<\/strong><\/p>\n

Question 1.
\nA company issues 25,000,14% debentures of \u20b9 1,000 each. The debentures are redeemable after the expiry period 5 years. Tax rate applicable to the company is 35%.<\/p>\n

Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost. (5 Marks Nov. 2015)
\nAnswer:
\nKd<\/sub> = \\(\\frac{\\mathrm{I}(1-\\mathrm{t})+\\left(\\frac{\\mathrm{RV}-\\mathrm{NP}}{\\mathrm{n}}\\right)}{\\frac{\\mathrm{RV}+\\mathrm{NP}}{2}}\\) \u00d7 100
\n= \\(\\frac{140(1-0.35)+\\left(\\frac{1000-930}{5}\\right)}{\\frac{1000+930}{2}}\\) \u00d7 100
\nNet Proceeds = 1,000 – 5% Discount – 2% Flotation cost = 930
\nNote: Flotation cost has been calculated on the basis of face value (i.e. 2% of \u20b9 1,000 or \u20b9 950 whichever is higher).<\/p>\n

Question 2.
\nTT Ltd. issued 20,000,10% Convertible debentures of \u20b9 100 each with a maturity period of 5 years. At maturity the debenture holders will have the option to convert the debentures into equity shares of the company in the ratio of 1 : 5 (5 shares for each debenture). The current market price of the equity shares is \u20b9 20 each and historically the growth rate of the shares are 4% per annum. Assuming tax rate is 25%.<\/p>\n

Compute the cost of 10% debentures using Approximation Method and Internal Rate of Return Method.
\nPV Factor are as under:<\/p>\n\n\n\n\n\n
Year<\/td>\n1<\/td>\n2<\/td>\n3<\/td>\n4<\/td>\n5<\/td>\n<\/tr>\n
PV Factor @ 10%<\/td>\n0.909<\/td>\n0.826<\/td>\n0.751<\/td>\n0.683<\/td>\n0.621<\/td>\n<\/tr>\n
PV Factor (S’ 15%<\/td>\n0.870<\/td>\n0.756<\/td>\n0.658<\/td>\n0.572<\/td>\n0.497<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

Answer:
\n(a) Calculation of Cost of Convertible debenture using Approximation Method:
\nKd<\/sub> = \\(\\frac{\\mathrm{I}(1-t)+\\frac{\\mathrm{CV}-\\mathrm{NP}}{\\mathrm{n}}}{\\frac{\\mathrm{CV}+\\mathrm{NP}}{2}}\\) \u00d7 100
\n= \\(\\frac{10(1-0.25)+\\frac{121.67-100}{5}}{\\frac{121.67+100}{2}}\\) \u00d7 100 = 10.68%<\/p>\n

\"Cost<\/p>\n

(b) Calculation of Cost of Convertible debenture using IRR Method Calculation of NPV at two discount rates:<\/p>\n\n\n\n\n\n\n\n\n
Year<\/td>\nCash Flow<\/td>\nPresent Value<\/td>\nPresent Value<\/td>\n<\/tr>\n
10%<\/td>\nDCF<\/td>\n15%<\/td>\nDCF<\/td>\n<\/tr>\n
0<\/td>\n(100)<\/td>\n1.000<\/td>\n(100)<\/td>\n1.000<\/td>\n(100)<\/td>\n<\/tr>\n
1 – 5<\/td>\n7.50<\/td>\n3.790<\/td>\n28.43<\/td>\n3.353<\/td>\n25.15<\/td>\n<\/tr>\n
5<\/td>\n121.67<\/td>\n0.621<\/td>\n75.56<\/td>\n0.497<\/td>\n60.47<\/td>\n<\/tr>\n
NPV<\/td>\n<\/td>\n<\/td>\n+3.99<\/td>\n<\/td>\n-14.38<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

IRR\/Kd<\/sub> = LR + \\(\\frac{\\mathrm{NPV}_{\\mathrm{L}}}{\\mathrm{NPV}_{\\mathrm{L}}-\\mathrm{NPV}_{\\mathrm{H}}}\\) \u00d7 (H – L)
\n= 10% + \\(\\frac{3.99}{3.99-(-14.38)}\\) \u00d7 (15% – 10%)
\n= 11.09%
\nDetermination of Convertible value:
\nHigher of
\n(i) The cash value of debentures = \u20b9 100
\n(ii) Value of equity shares = 5 shares \u00d7 \u20b9 20 (1 + 0.04)5<\/sup>
\n= 5 shares \u00d7 \u20b9 24.333 = \u20b9 121.67
\n\u20b9 121.67 will be taken as redemption value as it is higher than the cash option and attractive to the investors.<\/p>\n

\"Cost<\/p>\n

Cost of Preference Share Capital<\/strong><\/p>\n

Question 3.
\nA company issued 40,000,12% Redeemable Preference Shares of \u20b9 100 each at a premium of \u20b9 5 each, redeemable after 10 year at a premium of 110 each. The flotation cost of each share is \u20b9 2.
\nYou are required to calculate cost of preference share capital ignoring dividend tax. (5 Marks May 2013)
\nAnswer:
\nK\u03c1<\/sub> = \\(\\frac{\\mathrm{PD}+\\left(\\frac{\\mathrm{RV}-\\mathrm{NP}}{\\mathrm{n}}\\right)}{\\frac{\\mathrm{RV}+\\mathrm{NP}}{2}}\\) \u00d7 100
\n= \\(\\frac{12+\\left(\\frac{110-103}{10}\\right)}{\\frac{110+103}{2}}\\) \u00d7 100
\n= 11.92%<\/p>\n

Cost of Equity<\/strong><\/p>\n

Question 4.
\nJC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of \u20b9 20 and proposes to pay 60% dividend at the current year end with a P\/E ratio 6.25, it wants to offer the issue at market price. The flotation cost is expected to be 4% of the issue price.
\nYou are required to determine rate of return for equity share (cost of equity) before the issue and after the issue. (5 Marks May 2018)
\nAnswer:
\nMarket price of share (MPS\/P0<\/sub>) = EPS \u00d7 PE = \u20b9 20 \u00d7 6.25 = \u20b9 25
\nNet proceeds = 125 – 4% = \u20b9 120
\nReturn on Equity (ROE) = 1\/PE = 1\/6.25 = 16%
\nGrowth rate = r \u00d7 b = 1696 \u00d7 40% = 6.40%
\nKe<\/sub> (before issue) = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{60 \\% \\text { of } 20}{125}\\) + 6.40% = 16%<\/p>\n

Ke<\/sub> (after issue) = \\(\\frac{\\mathrm{D}_1}{\\mathrm{NP}}\\) + g = \\(\\frac{60 \\% \\text { of } 20}{120}\\) + 6.40% = 16.40%<\/p>\n

\"Cost<\/p>\n

Question 5.
\nABC Company\u2019s equity share is quoted in the market at \u20b9 25 per share currently. The company pays a dividend of \u20b9 2 per share and the investor\u2019s market expects a growth rate of 6% per year.
\nYou are required to:
\n(i) Calculate the company\u2019s cost of equity capital.
\n(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share.
\n(iii) If the company issues 10% debentures of face value of \u20b9 100 each mid realises \u20b9 96 per debenture while the debentures are redeemable after 12 years at a premium of 12%, what will be the cost of debenture? Assume Tax Rate to be 50%. (5 Marks Nov. 2016)
\nAnswer:
\n(i)
\n\"Cost
\nNote: Thc cost of equity can be calculated with taking the effect of growth on dividend (i.e. D1<\/sub> = 2.12).<\/p>\n

(ii) P0<\/sub> = \\(\\frac{D_1}{\\mathrm{Ke}-\\mathrm{g}}\\) = \\(\\frac{2}{14 \\%-8 \\%}\\) = \u20b9 33.33<\/p>\n

(iii) Kd<\/sub> = \\(\\frac{\\mathrm{I}(1-\\mathrm{t})+\\left(\\frac{\\mathrm{RV}-\\mathrm{NP}}{\\mathrm{n}}\\right)}{\\frac{\\mathrm{RV}+\\mathrm{NP}}{2}}\\) \u00d7 100
\n= \\(\\frac{10(1-0.50)+\\left(\\frac{112-96}{12}\\right)}{\\frac{112+96}{2}}\\) \u00d7 100
\n= 6.089%<\/p>\n

\"Cost<\/p>\n

Weighted Average Cost of Capital<\/strong><\/p>\n

Question 6.
\nBeeta Ltd. has furnished the following information:
\nEarning per share (EPS) : \u20b9 4.00
\nDividend payout ratio : 25%
\nMarket price per share : \u20b9 40.00
\nRate of tax : 30%
\nGrowth rate of dividend : 8%
\nThe company wants to raise additional capital of \u20b9 10 lakhs including debt of \u20b9 4 lakhs. The cost of debt (before tax) is 10% upto \u20b9 2 lakhs and 15% beyond that.
\nCompute the after tax cost equity and debt and the weighted average cost of capital. (4 Marks Nov. 2011)
\nAnswer:
\nK0<\/sub> = Ke<\/sub> We<\/sub> + Kd1<\/sub> Wd1<\/sub> + Kd2<\/sub> Wd2<\/sub>
\n= 10.7% \u00d7 \\(\\frac{6}{10}\\) + 7% \u00d7 \\(\\frac{2}{10}\\) + 10.50% \u00d7 \\(\\frac{2}{10}\\) = 9.92%
\nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{4.00 \\times 25 \\% \\times 108 \\%}{40}\\) + 0.08 = 10.70%
\nKd1<\/sub> = I (1 – t) = 10% (1 – 0.30) = 7%
\nKd2<\/sub> = I (1 – t) = 15% (1 – 0.30) = 10.50%
\nAssumption: DPS \u20b9 1.00 is treated at D0<\/sub>.<\/p>\n

Question 7.
\nThe following details are provided by GPS Limited:
\nEquity Share capital : \u20b9 65,00,000
\n12% Preference Share Capital : \u20b9 12,00,000
\n15% Redeemable Debentures : \u20b9 20,00,000
\n10% Convertible Debentures : \u20b9 8,00,000
\nThe cost of equity capital for the company is 16.30% and Income Tax Rate for the company is 30%.
\nYou are required to calculate the Weighted Average Cost of Capital (WACC) of the company. (5 Marks May 2014)
\nAnswer:
\nWACC = Ke<\/sub> We<\/sub> + Kp<\/sub> Wp<\/sub> + Krd<\/sub> Wrd<\/sub> + Kcd<\/sub> Wcd<\/sub>
\nWorking Notes:
\n(i) Calculation of cost of Preference Share capital (Kp<\/sub>) :
\nKp<\/sub> = Rate of Preference Dividend = 12%<\/p>\n

(ii) Calculation of cost of Redeemable Debentures (Krd<\/sub>):
\nKrd<\/sub> = I (1 – t) = 15% (1 – 0.30) = 10.50%<\/p>\n

(iii) Calculation of cost Convertible Debentures (Kcd<\/sub>):
\nKcd<\/sub> = I (1 – t) = 10% (1 – 0.30) = 7%<\/p>\n

\"Cost<\/p>\n

Question 8.
\nA Ltd. wishes to raise additional finance of \u20b9 30 lakhs for meeting its investment plans. The company has \u20b9 6,00,000 in the form of retained earnings available for investment purposes. The following are the further details:
\nDebt equity ratio : 30:70
\nCost of debt:
\nUpto \u20b9 3,00,000 : 11% (before tax) and
\nBeyond \u20b9 3,00,000 : 14% (before tax)
\nEarning per share : \u20b9 15 per share
\nDividend payout : 70% of earnings
\nExpected growth rate : 10%
\nCurrent market price : \u20b9 90 per share
\nCompany\u2019s tax rate : 30%
\nShareholder’s personal tax rate : 20%<\/p>\n

You are required to:
\n1. Calculate the post tax average cost of additional debt.
\n2. Calculate the cost of retained earnings and cost of equity.
\n3. Calculate the overall weighted average (after tax) cost of additional (8 Marks May 2015)
\nAnswer:
\nTotal capital required is \u20b9 30 lakhs. With a debt-equity ratio of 30 : 70. It means \u20b9 9 lakhs is to be raised through debt and \u20b9 21 lakhs through equity. Out of \u20b9 21 lakhs, \u20b9 6 lakhs are available in the form of retained earnings hence \u20b9 15 lakhs will have to raise by issuing equity shares.<\/p>\n

1. Post tax average cost of additional debt:
\nKd1<\/sub> = I (1 – t) = 11% (1 – 0.30) = 7.70%
\nKd2<\/sub> = I (1 – t) = 14% (1 – 0.30) = 9.80%
\nAverage Kd<\/sub> = Kd1<\/sub>Wd1<\/sub> + Kd2<\/sub>Wd2<\/sub> = 7.7% \u00d7 \\(\\frac{3}{9}\\) + 9.8% \u00d7 \\(\\frac{6}{9}\\) = 9.10%<\/p>\n

2. Cost of retained earning & cost of equity:
\nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{10.50+10 \\%}{90}\\) + 0.10 = 22.83%
\nKr<\/sub> = Ke<\/sub> (1 – PT) = 22.83% (1 – .20) = 18.27%
\nD0<\/sub> = \u20b9 15 \u00d7 70% = \u20b9 10.50<\/p>\n

3. Overall cost of additional finance:
\nK0<\/sub> = Ke<\/sub> We<\/sub> + Kr<\/sub> Wr<\/sub> + Kd<\/sub> Wd<\/sub>
\n= 22.83% \u00d7 \\(\\frac{15}{30}\\) + 18.27% \u00d7 \\(\\frac{6}{30}\\) + 9.10% \u00d7 \\(\\frac{9}{30}\\)
\n= 17.80%
\nAssumption: DPS \u20b9 10.50 is treated at D0<\/sub>.<\/p>\n

\"Cost<\/p>\n

Question 9.
\nThe X Company has following capital structure at 31st March, 20015, which is considered to be optimum:
\n14% debenture : \u20b9 3,00,000
\n11% preference share capital : \u20b9 1,00,000
\nEquity share capital (1,00,000 shares) : \u20b9 16,00,000
\nThe company\u2019s share has a current market price of \u20b9 23.60 per share. The expected dividend per share in next year is 50 per cent of the 2015 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:
\n\"Cost
\nThe company issued new debentures carrying 16% rate of interest and the current market price of debenture is \u20b9 96. Preference shares \u20b9 9.20 (with dividend of \u20b9 1.1 per share) were also issued. The company is in 50% tax bracket.<\/p>\n

(i) Calculate the after tax cost of (a) New Debts, (b) New Preference Share, and (c) New Equity Share (assuming new equity from retained earnings).
\n(ii) Calculate the marginal cost of capital when no new share was issued.
\n(iii) How much can be spent for capital investment before new ordinary shares must be sold? Assuming that retained earnings for next year\u2019s investment are 50% of 2015.
\n(iv) What will be marginal cost of capital when the fund exceeds the amount calculated in (iii), assuming new equity is issued at \u20b9 20 per share? (8 Marks May 2016)
\nAnswer:
\nAssumption: The present capital structure is optimum. Hence, it will be followed in future.
\nExisting Capital Structure Analysis<\/p>\n\n\n\n\n\n\n\n
Name of source<\/td>\nAmount(\u20b9)<\/td>\nProportion<\/td>\n<\/tr>\n
14% debentures<\/td>\n3,00,000<\/td>\n0.15<\/td>\n<\/tr>\n
11% Preference<\/td>\n1,00,000<\/td>\n0.05<\/td>\n<\/tr>\n
Equity share capital<\/td>\n16,00,000<\/td>\n0.80<\/td>\n<\/tr>\n
Total<\/td>\n20,00,000<\/td>\n1.00<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

(i) (a) After tax cost of new debt
\n\"Cost<\/p>\n

(ii) MCC(K0<\/sub>) when no new equity share was issued:
\nKd<\/sub>Wd<\/sub> + Kp<\/sub> Wp<\/sub> + Kr<\/sub> Wr<\/sub> = 8.33% \u00d7 .15 + 11.96% \u00d7 .05 + 15% \u00d7 .80 = 13.85%<\/p>\n

(iii) The company can pay the following amount before issue of new shares:
\nEquity (retained earnings in this case) = 80% of the total capital
\nTherefore, investment before new issue = \\(\\frac{1,18,000}{80 \\%}\\) = \u20b9 1,47,500
\nRetained earnings = \u20b9 2.36 \u00d7 50% \u00d7 1,00,000 = \u20b9 1,18,000<\/p>\n

(iv) MCC (K0<\/sub>) when funds exceeds \u20b9 1,47,500
\nKd<\/sub>Wd<\/sub> + Kp<\/sub>Wp<\/sub> + Ke<\/sub>We<\/sub> = 8.33% \u00d7 .15 + 11.96% \u00d7 .05 + 15.90% \u00d7 .80 = 14.57%
\nIf the company pay more than \u20b9 1,47,500, it will have to issue new shares. The cost of new issue of ordinary share is:
\nKe<\/sub> = \\(\\frac{D_1}{P_0(\\text { new })}\\) + g = \\(\\frac{1.18}{20}\\) + 20 = 15.90%
\nWN: Calculation of growth:
\nGrowth from year 2006 to 2007 = (1.10 – 1.00) \u00f7 1.00 = 10%
\n[Same rate of growth is found in future years]<\/p>\n

\"Cost<\/p>\n

Question 10.
\nFollowing is the capital structure of RBT Ltd. As on 31st March, 2016:<\/p>\n\n\n\n\n
Sources of Fund<\/td>\nBook Value<\/td>\nMarket Value<\/td>\n<\/tr>\n
Equity Share of \u20b9 10 each<\/p>\n

Retained Earnings<\/p>\n

11% Preference Share of \u20b9 100 each<\/p>\n

14% Debentures of \u20b9 100 each<\/td>\n

\u20b9 50,00,000<\/p>\n

\u20b9 13,00,000<\/p>\n

\u20b9 7,00,000<\/p>\n

\u20b9 30,00,000<\/td>\n

\u20b9 1,05,00,000<\/p>\n

Nil<\/p>\n

\u20b9 9,00,000<\/p>\n

\u20b9 36,00,000<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

Market price of equity shares is \u20b9 40 per share and it is expected that a dividend of \u20b9 4 per share would be declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate applicable to the company is 40% and shareholder\u2019s personal income tax rate is 20%.<\/p>\n

You are required to calculate:
\n(i) Cost of capital for each source of capital,
\n(ii) Weighted average cost of capital on the basis of book value weights,
\n(iii) Weighted average cost of capital on the basis of market value weights. (8 Marks Nov. 2016)
\nAnswer:
\n(i) Calculation of cost of capital for each source of capital:
\nKe<\/sub> = \\(\\frac{D_1}{P_0(\\text { new })}\\) + g = \\(\\frac{4}{40}\\) + 0.08 = 18%
\nKr<\/sub> = Ke<\/sub> (1 – PT) = 18%(1 – 0.20) = 14.40%
\nKd<\/sub> = I (1 – t) = 14% (1 – 0.40) = 8.40%
\nKp<\/sub> = Rate of PD = 11%<\/p>\n

(ii) Calculation of WAC.C (K0<\/sub>) using book value proportions<\/p>\n\n\n\n\n\n\n\n\n
Name of Source<\/td>\nAmount<\/td>\nProportion<\/td>\nK<\/td>\nK0<\/sub><\/td>\n<\/tr>\n
Equity Share Capital<\/td>\n50,00,000<\/td>\n0.50<\/td>\n18%<\/td>\n9.00%<\/td>\n<\/tr>\n
Retained Earnings<\/td>\n13,00,000<\/td>\n0.13<\/td>\n14.40%<\/td>\n1.87%<\/td>\n<\/tr>\n
Preference Share Capital<\/td>\n7,00,000<\/td>\n0.07<\/td>\n11%<\/td>\n0.77%<\/td>\n<\/tr>\n
Debentures<\/td>\n30,00,000<\/td>\n0.30<\/td>\n8.40%<\/td>\n2.52%<\/td>\n<\/tr>\n
Total<\/td>\n1,00,00,000<\/td>\n1.00<\/td>\nWACC<\/td>\n14.16%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

(iii) Calculation of WACC(K0<\/sub>) using market value proportions<\/p>\n\n\n\n\n\n\n\n\n
Name of Source<\/td>\nAmount<\/td>\nProportion<\/td>\nK<\/td>\nK0<\/sub><\/td>\n<\/tr>\n
Equity Share Capital<\/td>\n83,33,333<\/td>\n0.555<\/td>\n18%<\/td>\n9.99%<\/td>\n<\/tr>\n
Retained Earnings<\/td>\n21,66,667<\/td>\n0.145<\/td>\n14.40%<\/td>\n2.09%<\/td>\n<\/tr>\n
Preference Share Capital<\/td>\n9,00,000<\/td>\n0.060<\/td>\n11%<\/td>\n0.66%<\/td>\n<\/tr>\n
Debentures<\/td>\n36,00,000<\/td>\n0.240<\/td>\n8.40%<\/td>\n2.02%<\/td>\n<\/tr>\n
Total<\/td>\n1,50,00,000<\/td>\n1.000<\/td>\nWACC<\/td>\n14.76%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

Market value of Equity Share Capital = \u20b9 1,05,00,000 \u00d7 50\/63 = \u20b9 83,33,333
\nMarket value of Retained Earnings = \u20b9 1,05,00,000 \u00d7 13\/63 = \u20b9 21,66,667
\n\u2018Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.<\/p>\n

\"Cost<\/p>\n

Question 11.
\nAlpha Ltd. has furnished the following information:
\nEarning per share (EPS) : \u20b9 4.00
\nDividend payout ratio : 25%
\nMarket price per share : \u20b9 50
\nRate of tax : 30%
\nGrowth rate of dividend : 10%
\nThe company wants to raise additional capital of \u20b9 10 lakhs including debt of \u20b9 4 lakhs. The cost of debt (before tax) is 10% upto \u20b9 2 lakhs and 15% beyond that.
\nCompute the after tax cost equity and debt and the weighted average cost of capital. (5 Marks May 2019)
\nAnswer:
\nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{4.00 \\times 25 \\% \\times 110 \\%}{50}\\) + 0.10 = 12.20%
\nKd1<\/sub> = I (1 – t) = 10% (1 – 0.30) = 7%
\nKd2<\/sub> = I (1 – t) = 15% (1 – 0.30) = 10.50%
\nK0<\/sub> = Ke<\/sub> We<\/sub> + Kd1<\/sub> Wd1<\/sub> + Kd2<\/sub> Wd2<\/sub>
\n= 12.20% \u00d7 \\(\\frac{6}{10}\\) + 7% \u00d7 \\(\\frac{2}{10}\\) + 10.50% \u00d7 \\(\\frac{2}{10}\\) = 10.82%<\/p>\n

\"Cost<\/p>\n

Question 12.
\nA company wants to raise additional finance of \u20b9 5 crores in next year. The company expected to retain \u20b9 1 crore in next year. Further details are as follows:
\n(i) The amount will be raised by equity and debt in the ratio of 3 : 1.
\n(ii) The additional issue of equity shares will result in price per share being fixed at \u20b9 25.
\n(iii) The debt capital raised by way of term loan will cost 10% for the first \u20b9 75 lakhs and 12 % for the next \u20b9 50 lakhs.
\n(iv) The net expected dividend on equity shares is \u20b9 2.00 per share. The dividend is expected to grow at the rate of 5%.
\n(v) Income tax rate of 25%.<\/p>\n

You are required:
\n(a) To determine the amount of equity and debt for raising additional finance.
\n(b) To determine the post tax average cost of additional debt.
\n(c) To determine the cost of retained earning and cost of equity.
\n(d) To compute the overall weighted average cost of additional finance after tax. (10 Marks Nov, 2019)
\nAnswer:
\n(a) Total capital required is \u20b9 5 crores. With a debt-equity ratio of 1:3. It means \u20b9 1.25 crores is to be raised through debt and \u20b9 3.75 crores through equity. Out of \u20b9 3.75 crores, \u20b9 1 crore are available in the form of retained earnings hence \u20b9 2.75 crore will have to raise by issuing equity shares.<\/p>\n

(b) Post tax average cost of additional debt:
\nKd1<\/sub> = I (1 – t) = 10% (1 – 0.25) = 7.5%
\nKd2<\/sub> = I (1 – t) = 12% (1 -0.25) = 9%
\nAverage Kd<\/sub> = Kd2<\/sub> Wd2<\/sub> + Kd2<\/sub> Wd2<\/sub>
\n= 7.5% \u00d7 \\(\\frac{75}{125}\\) + 9% \u00d7 \\(\\frac{50}{125}\\) = 8.10%<\/p>\n

(c) Cost of retained earning & cost of equity:
\nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{2}{25}\\) + 0.05 = 13%
\nKr<\/sub> = Ke<\/sub> = 13%<\/p>\n

(d) Overall cost of additional finance:
\nK0<\/sub> = Ke<\/sub> We<\/sub> + Kr<\/sub> Wr<\/sub> + Kd<\/sub> Wd<\/sub>
\n= 13% \u00d7 \\(\\frac{275}{500}\\) + 13% \u00d7 \\(\\frac{100}{500}\\) + 8.10% \u00d7 \\(\\frac{125}{500}\\) = 11.78%<\/p>\n

\"Cost<\/p>\n

Question 13.
\nThe capital structure of PQR Ltd. is as follows:
\n10% Debentures : \u20b9 3,00,000
\n12% Preference shares : \u20b9 2,50,000
\nEquity shares (face value \u20b9 10 per share) : \u20b9 5,00,000
\nAdditional information:<\/p>\n

    \n
  1. \u20b9 100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market price per debenture is \u20b9 110.<\/li>\n
  2. \u20b9 100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The market price per preference share is \u20b9 108.<\/li>\n
  3. Equity share has \u20b9 4 floatation cost and market price per share of \u20b9 25. The next year expected dividend is \u20b9 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.<\/li>\n
  4. \u00a0Corporate Income tax rate is 30%.<\/li>\n<\/ol>\n

    Required:
    \nCalculate Weighted Average Cost of Capital (WACC) using market value weights. (10 Marks Jan. 2021)
    \nAnswer:
    \nCalculation of Weighted Average Cost of Capital by Using Market Value Weight<\/p>\n\n\n\n\n\n\n\n
    Particular<\/td>\nMarket value<\/td>\nWeight<\/td>\nCost<\/td>\nWeighted cost<\/td>\n<\/tr>\n
    10% Debenture<\/td>\n3,30,000<\/td>\n0.178<\/td>\n7.27%<\/td>\n1.294%<\/td>\n<\/tr>\n
    12% Preference share<\/td>\n2,70,000<\/td>\n0.146<\/td>\n12.49%<\/td>\n1.823%<\/td>\n<\/tr>\n
    Equity Share Capital<\/td>\n12,50,000<\/td>\n0.676<\/td>\n14.52%<\/td>\n9.816%<\/td>\n<\/tr>\n
    Total<\/td>\n18,50,000<\/td>\n1.000<\/td>\nWACC<\/td>\n12.933%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

    Working notes:
    \n1. Calculation of specific cost of various sources of funds:
    \n\"Cost<\/p>\n

    2. Calculation of market value of various sources of funds:
    \nDebentures = 3,00,000 \u00d7 110\/100 = 3,30,000
    \nPreference shares = 2,50,000 \u00d7 108\/100 = 2,70,000
    \nEquity shares = 5,00,000 \u00d7 25\/10 = 12,50,000<\/p>\n

    \"Cost<\/p>\n

    Important Questions<\/strong><\/p>\n

    Question 1.
    \nA company issued 10,000,15% Convertible debentures of \u20b9 100 each with a maturity period of 5 years. At maturity the debenture holders will have the option to convert the debentures into equity shares of the company in the ratio of 1 : 10 (10 shares for each debenture). The current market price of the equity shares is \u20b9 12 each and historically the growth rate of the shares are 5% per annum.
    \nCompute the cost of debentures assuming 35% tax rate.
    \nAnswer:
    \nDetermination of Redemption value:
    \nHigher of
    \n(i) The cash value of debentures = \u20b9 100
    \n(ii) Value of equity shares = 10 shares \u00d7 \u20b9 12(1 + 0.05)5<\/sup>
    \n= 10 shares \u00d7 15.312 = \u20b9 153.12
    \n\u20b9 153.12 will be taken as redemption value as it is higher than the cash option and attractive to the investors.
    \nCalculation of Cost of Convertible debenture:
    \nAlternative 1: Using approximation method:
    \nKd<\/sub> = \\(\\frac{\\mathrm{I}(1-\\mathrm{t})+\\left(\\frac{\\mathrm{RV}-\\mathrm{NP}}{\\mathrm{n}}\\right)}{\\frac{\\mathrm{RV}+\\mathrm{NP}}{2}}\\) \u00d7 100 = \\(\\frac{15(1-0.35)+\\frac{153.12-100}{5}}{\\frac{153.12+100}{2}}\\) \u00d7 100 = 16.09%<\/p>\n

    Alternative 2: Using present value method:
    \nCalculation of NPV at two discount rates:
    \n\"Cost<\/p>\n

    \"Cost<\/p>\n

    Question 2.
    \nRBML is proposing to sell a 5-year bond of \u20b9 5,000 at 8 percent rate of interest per annum. The bond amount will be amortised equally over its life.
    \nWhat is the bond\u2019s present value for an investor if he expects a minimum rate of return of 6 percent?
    \nAnswer:
    \nThe amount of interest will go on declining as the outstanding amount of bond will be reducing due to amortisation. The amount of interest for five years will be:
    \nFirst year : \u20b9 5,000 \u00d7 0.08 = \u20b9 400
    \nSecond year : \u20b9 (5,000 – \u20b9 1,000) \u00d7 0.08 = \u20b9 320
    \nThird year : \u20b9 (4,000 – \u20b9 1,000) \u00d7 0.08 = \u20b9 240
    \nFourth year : \u20b9 (3,000 – \u20b9 1,000) \u00d7 0.08 = \u20b9 160; and
    \nFifth year : \u20b9 (2,000 – \u20b9 1,000) \u00d7 0.08 = \u20b9 80.<\/p>\n

    The outstanding amount of bond will be zero at the end of fifth year. Since RBML will have to return \u20b9 1,000 every year, the outflows every year will consist of interest payment and repayment of principal:
    \nFirst year : \u20b9 1,000 + \u20b9 400 = \u20b9 1,400
    \nSecond year : \u20b9 l1,000 + \u20b9 320 = \u20b9 1,320
    \nThird year : \u20b9 1,000 + \u20b9 240 = \u20b9 1,240
    \nFourth year : \u20b9 1,000 + \u20b9 160 = \u20b9 1,160; and
    \nFifth year : \u20b9 1,000 + \u20b9 80 = \u20b9 1,080.
    \nThe above cash flows of all five years will be discounted with the cost of capital. Here the expected rate i.e. 6% will be used. Value of the bond is calculated as follows:
    \nVB<\/sub> = \\(\\frac{1,400}{(1.06)^1}+\\frac{1,320}{(1.06)^2}+\\frac{1,240}{(1.06)^3}+\\frac{1,160}{(1.06)^4}+\\frac{1,080}{(1.06)^5}\\)
    \n= \u20b9 1,320.75 + \u20b9 1,174.80 + \u20b9 1,041.14 + \u20b9 918.88 + \u20b9 807.05 = \u20b9 5,262.62<\/p>\n

    \"Cost<\/p>\n

    Question 3.
    \nMr. Mehra had purchased a share of Alpha Limited for \u20b9 1,000. He received dividend for a period of five years at the rate of 10 per cent. At the end of the fifth year, he sold the share of Alpha Limited for \u20b9 1,128.
    \nYou are required to compute the cost of equity as per realised yield approach.
    \nAnswer:
    \nCalculation of IRR\/Ke<\/sub>
    \nKe<\/sub> = LR + \\(\\frac{\\mathrm{NPV}_{\\mathrm{L}}}{\\mathrm{NPV}_{\\mathrm{L}}-\\mathrm{NPV}_{\\mathrm{H}}}\\) \u00d7 (H – L) = 11% + \\(\\frac{38.50}{38.50-(-35.80)}\\) \u00d7 (13% – 11%) = 12.04%
    \nCalculation of NPV at two discount rates:
    \n\"Cost<\/p>\n

    Question 4.
    \nCalculate the cost of equity from the following data using realized yield approach:
    \n\"Cost
    \nAnswer:
    \nIn this questions we will first calculate yield for last 4 years and then calculate it geometric mean as follows:
    \n\"Cost
    \nGeometric mean:
    \nKe<\/sub> = [(1 + Y1<\/sub>) \u00d7 (1 + Y2<\/sub>) \u00d7 (1 + Yn<\/sub>)]1\/n<\/sup> – 1
    \nKe<\/sub> = [1.1944 \u00d7 1.2821 \u00d7 1.0609 \u00d7 1.0772]1\/4<\/sup> – 1 = 0.15 or 15%<\/p>\n

    \"Cost<\/p>\n

    Question 5.
    \nThe following is the capital structure of Simons Company Ltd. as on 31.12.1998:
    \n\"Cost
    \nThe market price of the company\u2019s share is \u20b9 110 and it is expected that a dividend of \u20b9 10 per share would be declared for the year 1998. The dividend growth rate is 6%.
    \n(i) If the company is in the 50% tax bracket, compute the WACC.
    \n(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of \u20b9 10,00,000 bearing 14% rate of interest, What will be the company\u2019s revised weighted average cost of Capital? This financing decision is expected to increase dividends from \u20b9 10 to \u20b9 12 per share. However, the market price of equity share is expected to decline from \u20b9 110 to \u20b9 105 per share.
    \nAnswer:
    \nIn this questions we will first calculate yield for last 4 years and then calculate it geometric mean as follows:
    \nWACC(K0<\/sub>) = Ke<\/sub> We<\/sub> + Kp<\/sub> Wp<\/sub> + Kd<\/sub> Wd<\/sub>
    \n= 15.09% \u00d7 \\(\\frac{10}{20}\\) + 10% \u00d7 \\(\\frac{4}{20}\\) + 6% \u00d7 \\(\\frac{6}{20}\\) = 11.35%
    \nKe<\/sub> = \\(\\frac{D_1}{P_0}\\) + g = \\(\\frac{10}{110}\\) + 0.6 = 15.09%
    \nKp<\/sub> = Rate of preferential dividend [FV = NP] = 10%
    \nKd<\/sub> = I (1 – t) = 12% (1 – 0.50) = 6%<\/p>\n

    (ii) Calculation of Revised WACC
    \nRevised WACC (K0<\/sub>)
    \n= Ke<\/sub> We<\/sub> + Kp<\/sub> Wp<\/sub> + Kd<\/sub> Wd<\/sub> + KTL<\/sub> WTL<\/sub>
    \n= 17.43% \u00d7 \\(\\frac{10}{30}\\) + 10% \u00d7 \\(\\frac{4}{30}\\) + 6% \u00d7 \\(\\frac{6}{30}\\) + 7% \u00d7 \\(\\frac{10}{30}\\) = 10.68%
    \nRevised Ke<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{12}{105}\\) + .06 = 17.43%
    \nKTL<\/sub> = I (1 – t) = 14%(1 – 0.50) = 7%<\/p>\n

    \"Cost<\/p>\n

    Question 6.
    \nXYZ Ltd. has the following book value capital structure:
    \nEquity Share Capital (\u20b9 10 each, fully paid up at par)\u00a0 :\u00a0 \u20b9 15 crores
    \n11% Preference Share Capital (\u20b9 100 each, fully paid up at par)\u00a0 :\u00a0 \u20b9 1 crores
    \nRetained Earnings : \u20b9 20 crores
    \n13.5% Debentures (of \u20b9 100 each) : \u20b9 1o crores
    \n15% Terms Loans : \u20b9 12.5 crores
    \nThe next expected dividend on equity shares per share is \u20b9 3.60; the dividend per share Is expected to grow at the rate of 7%. The market price per share is \u20b9 40. Preference stock, redeemable after 10 years, is currently selling at \u20b9 75 per share. Debentures, redeemable after six years, are selling at \u20b9 80 per debenture. The income – tax rate for the company is 40%.<\/p>\n

    Required:
    \n(i) Calculate the weighted average cost of capital (K0<\/sub>) using:
    \na. Book value proportions; and
    \nb. Market value proportions.
    \n(ii) Define the weighted marginal cost of capital schedule for the company, if it raises \u20b9 10 crores next year, given the following information:
    \na. The amount will be raised by equity and debt in equal proportions;
    \nb. The company expects to retain \u20b9 1.5 crores earnings next year;
    \nc. The additional Issue of equity shares will result In the net price per share being fixed at \u20b9 32;
    \nd. The debt capital raised by way of term loans will cost 15% for the first \u20b9 2.5 crores and 16% for the next \u20b9 2.5 crores.
    \nAnswer:
    \n(i) Calculation of WACC(K0<\/sub>)
    \n(a) By Using Book Value Proportions
    \n\"Cost
    \n*Kc<\/sub> & Kr<\/sub> are same, so calculated together.<\/p>\n

    (ii) Weighted Marginal Cost of Capital Schedule and Marginal WACC:
    \nMarginal Cost of Capital Schedule:
    \nFinance through Equity:
    \nRetained earnings = \u20b9 1.5 crores
    \nNew issue = \u20b9 3.5 crores
    \nFinance through Debt:
    \n15% Debt = \u20b9 2.5 crores
    \n16% Debt = \u20b9 2.5 crores
    \nMarginal Cost of Capital
    \n\"Cost<\/p>\n

    Working Notes:
    \nCalculation of existing Ke<\/sub>, Kr<\/sub>, Kd<\/sub>, Kp<\/sub> and KTL<\/sub>:
    \n\"Cost
    \nKTL<\/sub> = I (1 – t) = 15% (1 – 0.40) = 9%
    \nCalculation of revised Ke<\/sub>, Kr<\/sub>, Kd1<\/sub> and Kd2<\/sub>
    \nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{3.60}{32}\\) + 0.07 = 18.25%
    \nKr<\/sub> = Ke<\/sub> (existing) = 16%
    \nKd1<\/sub> = I (1 – t) = 15% (1 – 0.40) = 9%
    \nKd2<\/sub> = I (1 – t) = 16% (1 – 0.40) = 9.60%<\/p>\n

    \"Cost<\/p>\n

    Question 7.
    \nCalculate the WACC using the following data by using:
    \n(a) Book value weights
    \n(b) Market value weights
    \nThe capital structure of the company is as under:
    \nDebentures (\u20b9 100 per debenture)\u00a0 :\u00a0 \u20b9 5,00,000
    \nPreference shares (\u20b9100 per share)\u00a0 :\u00a0 \u20b9 5,00,000
    \nEquity shares (\u20b910 per share)\u00a0 :\u00a0 \u20b9 10,00,000
    \nThe market prices of these securities are:
    \nDebentures\u00a0 :\u00a0 \u20b9 105 per debenture
    \nPreference shares\u00a0 :\u00a0 \u20b9 110 per share
    \nEquity shares\u00a0 :\u00a0 \u20b9 24 each
    \nAdditional information:<\/p>\n

      \n
    1. \u20b9100 per debenture redeemable at par, 10% coupon rate, 4% floatation cost, 10 years of maturity. The market price per debenture is \u20b9 105.<\/li>\n
    2. \u20b9 100 per preference share redeemable at par, 5% coupon rate, 2% floatatlon cost, 10 years of maturity.<\/li>\n
    3. Equity share has \u20b9 4 floatation cost and market price per share of \u20b9 24, The next year expected dividend is \u20b9 1 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends. Corporate Income-tax rate is 50%.<\/li>\n<\/ol>\n

      Answer:
      \n(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
      \n\"Cost<\/p>\n

      (b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
      \n\"Cost<\/p>\n

      \"Cost<\/p>\n

      Question 8.
      \nABC Ltd. wishes to raise additional finance of \u20b9 20 lakhs for meeting its Investment purpose. The company has \u20b9 4,00,000 in the form of retained earnings available for Investment purposes. The following are the further details:
      \nDebt equity ratio : 25 : 75
      \nCost of debt:
      \nUpto \u20b9 2,00000 : 10% (before tax) and
      \nBeyond \u20b9 200000 : 13% (before tax)
      \nEarning per share : \u20b9 12 per share
      \nDividend payout : 50% of earnings
      \nExpected growth rate : 10%
      \nCurrent market price : \u20b9 60 per share
      \nCompany\u2019s tax rate : 30%
      \nShareholder\u2019s personal tax rate : 20%.<\/p>\n

      Required:
      \n(i) Calculate the post tax average cost of additional debt.
      \n(ii) Calculate the cost of retained earnings and cost of equity.
      \n(iii) Calculate the overall weighted average (after tax) cost of additional
      \nAnswer:
      \nTotal capital required is \u20b9 20 lakhs. With a debt-equity ratio of 1 : 3. It means \u20b9 5 lakhs is to be raised through debt and \u20b9 15 lakhs through equity. Out of \u20b9 15 lakhs, \u20b9 4 lakhs are available in the form of retained earnings hence \u20b9 11 lakhs will have to raise by issuing equity shares.<\/p>\n

      (i) Post tax average cost of additional debt:
      \nKd1<\/sub> = I (1 – t) = 10% (1 – 0.30) = 7%
      \nKd2<\/sub> = I(1 – t) = 13%(1 0.30) = 9.10%
      \nAverage Kd<\/sub> = Kd1<\/sub> Wd1<\/sub>+ Kd2<\/sub> Wd2<\/sub>
      \n= 7% \u00d7 \\(\\frac{2}{5}\\) + 9.10% \u00d7 \\(\\frac{3}{5}\\) = 8.26%<\/p>\n

      (ii) Cost of retained earning & cost of equity:
      \nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0}\\) + g = \\(\\frac{6+10 \\%}{60}\\) + 0.10 = 21%
      \nKr<\/sub> = Ke<\/sub>(1 – PT) = 21% (1 – .20) = 16.80%
      \nD0<\/sub> = \u20b9 12 \u00d7 5096 = \u20b9 6<\/p>\n

      (iii) Overall cost of additional finance:
      \nK0<\/sub> = Ke<\/sub> We<\/sub> + Kr<\/sub> Wr<\/sub> + Kd<\/sub> wd<\/sub>
      \n= 21% \u00d7 \\(\\frac{11}{20}\\)+ 16.80% \u00d7 \\(\\frac{4}{20}\\) + 8.26% \u00d7 \\(\\frac{5}{20}\\) = 16.98%
      \nAssumption: DPS is treated at D0<\/sub>.<\/p>\n

      \"Cost<\/p>\n

      Question 9.
      \nThe R & G Company has following capital structure at 31st March, 2004, which is considered to be optimum:
      \n13% debenture\u00a0 :\u00a0 \u20b9 3,60,000
      \n11% preference share capital\u00a0 :\u00a0 \u20b9 1,20,000
      \nEquity share capital (2,00,000 shares)\u00a0 : \u20b9 9,20,000
      \nThe company’s share has a current market price of \u20b9 27.75 per share. The expected dividend per share in next year is 50 per cent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:
      \n\"Cost
      \nThe company can issue 14 per cent new debenture. The company\u2019s debenture is currently selling at \u20b9 98. The new preference issue can be sold at a net price of \u20b9 9.80, paying a dividend of \u20b9 1.20 per share. The company\u2019s marginal tax rate is 50%.<\/p>\n

      (i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity, assuming new equity comes from retained earnings.
      \n(ii) Calculate the marginal cost of capital.
      \n(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that retained earning available for next year’s investment are 50% of 2004 earnings.
      \n(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part (iii)] if the company can sell new ordi-nary shares to net \u20b9 20 per share? The cost of debt and of preference capital is constant.
      \nAnswer:
      \nAssumption. The present capital structure is optimum. Hence, it will be followed in future.
      \nExisting Capital Structure Analysis<\/p>\n\n\n\n\n\n\n\n
      Name of source<\/td>\nAmount(\u20b9)<\/td>\nProportion<\/td>\n<\/tr>\n
      13% debentures<\/td>\n3,60,000<\/td>\n0.15<\/td>\n<\/tr>\n
      11% Preference<\/td>\n1,20,000<\/td>\n0.05<\/td>\n<\/tr>\n
      Equity share capital<\/td>\n19,20,000<\/td>\n0.80<\/td>\n<\/tr>\n
      Total<\/td>\n24,00,000<\/td>\n1.00<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

      (i) (a) After tax cost of new debt
      \nKd<\/sub> = \\(\\frac{\\mathrm{I}(1-\\mathrm{t})}{\\mathrm{NP}}\\) \u00d7 100 = \\(\\frac{14(1-.50)}{98}\\) \u00d7 100 = 7.143%
      \nAfter tax cost of new preference shares
      \nKp<\/sub> = \\(\\frac{\\text { PD }}{\\mathrm{NP}}\\) \u00d7 100 = \\(\\frac{1.20}{9.80}\\) \u00d7 100 = 12.25%<\/p>\n

      (b) Cost of new equity (comes from retained earnings)
      \nKe<\/sub> = \\(\\frac{D_1}{P_0 \\text { (old) }}\\) + g = \\(\\frac{1.3865}{27.75}\\) + 0.12 = 17%
      \n(ii) MCC(K0<\/sub>) = Kd<\/sub> Wd<\/sub> + Kp<\/sub> Wp<\/sub> + Ke<\/sub> We<\/sub>
      \n= 7.143% \u00d7 .15 + 12.245% \u00d7 .05 +17% \u00d7 .80 = 15.28%<\/p>\n

      The company can pay the following amount without selling the new shares:
      \nEquity (retained earnings in this case) = 80% of the total capital
      \nTherefore, investment before new issue = \\(\\frac{2,77,300}{80 \\%}\\) = \u20b9 3,46,625
      \nRetained earnings = \u20b9 1.3865 \u00d7 2,00,000 = \u20b9 2,77,300<\/p>\n

      (iv) MCC(K0<\/sub>) = Kd<\/sub> Wd<\/sub> + Kp<\/sub> Wp<\/sub> + Ke<\/sub> We<\/sub>
      \n= 7.143% \u00d7 . 15 + 12.245% \u00d7 .05 + 18.93% \u00d7 .80 = 16.83%
      \nIf the company pay more than \u20b9 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
      \nKe<\/sub> = \\(\\frac{\\mathrm{D}_1}{\\mathrm{P}_0(\\text { new })}\\) + g = \\(\\frac{1.3865}{20}\\) + 0.12 = 18.93%<\/p>\n

      \"Cost<\/p>\n

      Question 10.
      \nDetermine the cost of capital of Best Luck Limited using the book value (BV) and market value (MV) weights from the following information:<\/p>\n\n\n\n\n\n\n\n
      Sources of Fund<\/td>\nBook Value<\/td>\nMarket Value<\/td>\n<\/tr>\n
      Equity Shares<\/td>\n\u20b9 1,20,00,000<\/td>\n\u20b9 2,00,00,000<\/td>\n<\/tr>\n
      Retained Earnings<\/td>\n\u20b9 30,00,000<\/td>\nNil<\/td>\n<\/tr>\n
      Preference Shares<\/td>\n\u20b9 36,00,000<\/td>\n\u20b9 33,75,000<\/td>\n<\/tr>\n
      Debentures<\/td>\n\u20b9 9,00,000<\/td>\n\u20b9 10,40,000<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

      Additional Information:<\/p>\n

        \n
      1. Equity: Equity shares are quoted at \u20b9 130 per share and a new issue priced at \u20b9 125 per share will be fully subscribed; floatation costs will be \u20b9 5 per share.<\/li>\n
      2. Dividend: During the previous 5 years, dividends have steadily increased from \u20b9 10.60 to \u20b9 14.19 per share. Dividend at the end of the current year is expected to be \u20b9 15 per share.<\/li>\n
      3. Preference Shares: 15% Preference shares with face value of \u20b9 100 would realise \u20b9 105 per share.<\/li>\n
      4. Debentures: The company proposes to issue 11 year 15% debentures but the yield on debentures of similar maturity and risk class is 16%; floatation cost is 2%.<\/li>\n
      5. Tax: Corporate tax rate is 35%. Ignore dividend tax.<\/li>\n<\/ol>\n

        Answer:
        \n(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
        \n\"Cost<\/p>\n

        (b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
        \n\"Cost
        \nMV of Debenture = \\(\\frac{\\text { Interest }}{\\text { Market rate of Interest }}\\) = \\(\\frac{15 \\% \\text { of } 100}{16 \\%}\\) \u00d7 100 = \u20b9 93.75
        \nNP of Debenture = MV of Debenture – Floatation Cost
        \n= \u20b9 93.75 – \u20b9 2 (2% of \u20b9 100) = \u20b9 91.75<\/p>\n

        \"Cost<\/p>\n

        Note: Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures at discount.
        \nMarket value of Equity Shares = \u20b9 2,00,00,000 \u00d7 120\/150 = \u20b9 1,60,00,000
        \nMarket value of Retained Earnings = \u20b9 2,00,00,000 \u00d7 30\/150 = \u20b9 40,00,000
        \nMarket Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.<\/p>\n","protected":false},"excerpt":{"rendered":"

        Cost of Capital \u2013 CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern. Cost of Capital \u2013 CA Inter FM Study Material Theory Questions Question 1. Explain the significance of cost of capital. (4 Marks Nov. 2019) Answer: The cost of capital is one of the most important …<\/p>\n

        Cost of Capital \u2013 CA Inter FM Study Material<\/span> Read More »<\/a><\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"spay_email":"","footnotes":""},"categories":[167],"tags":[],"jetpack_featured_media_url":"","_links":{"self":[{"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/posts\/16398"}],"collection":[{"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/comments?post=16398"}],"version-history":[{"count":1,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/posts\/16398\/revisions"}],"predecessor-version":[{"id":16570,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/posts\/16398\/revisions\/16570"}],"wp:attachment":[{"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/media?parent=16398"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/categories?post=16398"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/gstguntur.com\/wp-json\/wp\/v2\/tags?post=16398"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}