INTERMEDIATE – Financial Management

Chapter: Cost of Capital

Paper: Financial Management Marks: 33

SPC Receipt No: Test ID: 01634

Time Allowed: 1 Hour 15 Mins

Question No. 1 to Question No. 3 are Compulsory. Write any one between Question No.4 and
Question No.5

Question 1:

The capital structure of RV Limited as on 31st March, 20X8 as per its balance sheet is as follows:

Particular Amount
Equity shares of Rs. 10 each 25,00,000
10% Preference shares of Rs. 100 each 5,00,000
Retained earnings 5,00,000
13% debentures of Rs. 100 each 20,00,000
The market price of equity shares is Rs. 50 per share. Expected dividend on equity shares is Rs. 3 per
share. The dividend per share is expected to grow at the rate of 8%. Preference shares are redeemable
after eight years and the current market price is Rs. 80 per share. Debenture are redeemable after five
years and are currently selling at Rs. 90 per debenture. The tax rate applicable to the company is 35%.
CALCULATE weighted average cost of capital using:

(i) Book value proportions

(ii) Market value proportions Marks 10

Solution:
Question 2:

Capital structure of D Ltd. as on 315 March, 2023 is given below:

Particular Amount
Equity share capital (` 10 each) 30,00,000
8% Preference share capital (`100 each) 10,00,00
12% Debentures (`100 each) 10,00,000

- Current market price of equity share is ` 80 per share. The company has paid dividend of ` 14.07 per
share. Seven years ago, it paid dividend of ` 10 per share. Expected dividend is ` 16 per share.
- 8% Preference shares are redeemable at 6% premium after five years. Current market price per
preference share is ` 104.
- 12% debentures are redeemable at 20% premium after 10 years. Flotation cost is ` 5 per debenture.
- The company is in 40% tax bracket.
- In order to finance an expansion plan, the company intends to borrow 15% Long-term loan of `
30,00,000 from bank. This financial decision is expected to increase dividend on equity share from
`16 per share to ` 18 per share. However, the market price of equity share is expected to decline from
`80 to ` 72 per share, because investors' required rate of return is based on current market conditions.

Required :

(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book value
weights. Marks 10

Solution:
 Alternate Solution of the Above Question:
(Considering the Value of Preference Share Capital is 1,00,000)
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value
weights.

Capital Amount Weights Cost WACC

Equity Share Capital 30,00,000.00 0.732 25% 18.30
Prefrence Share
Capital 1,00,000.00 0.024 8% 0.192
Debentures 10,00,000.00 0.244 9.02% 2.20

Total 41,00,000.00 1.000 20.692

(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book
value weights.

Cost of Long Term Debt 15% (1-.04)=

= 9%
Revised Ke = 18 + .05 = 30%
72
Capital Amount Weights Cost WACC

Equity Share Capital 30,00,000.00 0.423 30% 12.690

Preference Share Capital 1,00,000.00 0.014 8% 0.112

Debentures 10,00,000.00 0.141 9.02% 1.270

Long Term Debt 30,00,000.00 0.422 9.00% 3.798

 Total 71,00,000.00 1.000 17.872

Question 3:

Alpha Ltd. has furnished the following information : -

- Earning Per Share (EPS) Rs. 4

- Dividend payout ratio 25%

- Market price per share Rs. 50

- Rate of tax 30%

- Growth rate of dividend 10%

The company wants to raise additional capital of Rs. 10 lakhs including debt of Rs. 4 lakhs. The cost of debt
(before tax) is 10% up to Rs. 2 lakhs and 15% beyond that. Compute the after tax cost of equity and debt
and also weighted average cost of capital. Marks 5

Solution:
Question 4:

Marks 8

Solution:
Question 5:

A Company wants to raise additional finance of 5 crore in the next year. The company expects to retain
1 crore earning next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3: 1.
(ii) The additional issue of equity shares will result in price per share being fixed at 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first 75 lakh and 12% for
the next 50 lakh.
(iv) The net expected dividend on equity shares is 2.00 per share. The dividend is expected to
grow at the rate of 5%.
(v) Income tax rate is 25%.

You are required:

(a) To determine the amount of equity and debt for raising additional finance.

(b) To determine the post-tax average cost of additional debt.

(c) To determine the cost of retained earnings and cost of equity.

(d) To compute the overall weighted average cost of additional finance after tax.

Marks 8

Solution:
c) Ke = (D1/P0)+G (2/25)+5%
13%
d)
Capital Amount Weights Cost WACC

Equity (Including retained earnings) 3,75,00,000.00 0.750 13.00% 9.750

Debt 1,25,00,000.00 0.250 8.10% 2.025

WACC 5,00,00,000.00 1.000 11.775