Cost of Capital Class Worksheet
PROBLEMS
1. The Ess Kay Refrigerator Company is deciding to issue 2,000,000 of Rs 1,000, 14 per cent 7-year debentures. The
debentures will have to be sold at a discount rate of 3 per cent. Further, the firm will pay an underwriting fee of 3
per cent of the face value. Assume a 35% tax rate.
Calculate the after-tax cost of the issue. What would be the after-tax cost if the debenture were sold at a premium
of Rs 30?
2. A company issues new debentures of Rs 2 million, at par; the net proceeds being Rs 1.8 million. It has a 13.5 per
cent rate of interest and 7 year maturity. The company’s tax rate is 52 per cent. What is the cost of debenture
issue? What will be the cost in 4 years if the market value of debentures at that time is Rs 2.2 million?
3. A company has 100,000 shares of Rs 100 at par of preference shares outstanding at 9.75 per cent dividend rate.
The current market price of the preference share is Rs 80. What is its cost?
4. A firm has 8,000,000 ordinary shares outstanding. The current market price is Rs 25 and the book value is Rs 18
per share. The firm’s earnings per share is Rs 3.60 and dividend per share is Rs 1.44. How much is the growth rate
assuming that the past performance will continue? Calculate the cost of equity capital.
5. A company has 5,000,000 ordinary shares outstanding. The market price of the share is Rs 96 while the book
value is Rs 65. The firm’s earnings and dividends per share are Rs 10 and Rs 7 respectively. The company wants
to issue 1,000,000 shares with a net proceeds of Rs 80 per share. What is the cost of capital of the new issue?
6. A company has paid a dividend of Rs 3 per share for last 20 years and it is expected to continue so in the future.
The company’s share had sold for Rs 33 twenty years ago, and its market price is also Rs 33. What is the cost of
the share?
7. A firm is thinking of raising funds by the issuance of equity capital. The current market price of the firm’s share is
Rs 150. The firm is expected to pay a dividend of Rs 3.55 next year. The firm has paid dividend in past years as
follows:
Year
Dividend per Share (Rs)
2003
2004
2005
2006
2007
2008
2.00
2.20
2.42
2.66
2.93
3.22
The firm can sell shares for Rs 140 each only. In addition, the flotation cost per share is Rs 10. Calculate the cost
of new issue.
8. A company is considering the possibility of raising Rs 100 million by issuing debt, preference capital, and equity
and retaining earnings. The book values and the market values of the issues are as follows:
(Rs in millions)
Book Value
Market Value
Ordinary shares
30
60
Reserves
10
—
Preference shares
20
24
Debt
40
36
100
120
The following costs are expected to be associated with the above-mentioned issues of capital. (Assume a 35 per
cent tax rate.)
(i) The firm can sell a 20-year Rs 1,000 face value debenture with a 16 per cent rate of interest. An underwriting
fee of 2 per cent of the market price would be incurred to issue the debentures.
(ii) The 11 per cent Rs 100 face value preference issue fetch Rs 120 per share. However, the firm will have to pay
Rs 7.25 per preference share as underwriting commission.
(iii) The firm’s ordinary share is currently selling for Rs 150. It is expected that the firm will pay a dividend of Rs
12 per share at the end of the next year, which is expected to grow at a rate of 7 per cent. The new ordinary
shares can be sold at a price of Rs 145. The firm should also incur Rs 5 per share flotation cost.
Compute the weighted average cost of capital using (i) book value weights (ii) market value weights.
9. A company has the following long-term capital outstanding as on 31 March 2008: (a) 10 per cent debentures with
a face value of Rs 500,000. The debentures were issued in 2003 and are due on 31 March 2010. The current
market price of a debenture is Rs 950. (b) Preference shares with a face value of Rs 400,000. The annual dividend
is Rs 6 per share. The preference shares are currently selling at Rs 60 per share. (c) Sixty thousand ordinary shares
of Rs 10 par value. The share is currently selling at Rs 50 per share. The dividends per share for the past several
years are as follow:
Year
Rs
Year
Rs
2003
2.00
2000
2.80
2004
2.16
2001
3.08
2005
2.37
2002
3.38
2006
2.60
2003
3.70
Assuming a tax rate of 35 per cent, compute the firm’s weighted average cost of capital.
10. A company is considering distributing additional Rs 80,000 as dividends to its ordinary shareholders. The
shareholders are expected to earn 18 per cent on their investment. They are in 30 per cent tax and incur an average
brokerage fee of 3 per cent on the reinvestment of dividends received. The firm can earn a return of 12 per cent on
the retained earnings. Should the company distribute or retain Rs 80,000?
11. The Keshari Engineering Ltd has the following capital structure, considered to be optimum, on 31 June 2008.
Rs in million
14% Debt
10% Preference
Ordinary equity
93.75
31.25
375.00
Total
500.00
The company has 15 million shares outstanding. The share is selling for Rs 25 per share and the expected dividend
per share is Rs 1.50, which is expected to grow at 10 per cent.
The company is contemplating to raise additional funds of Rs 100 million to finance expansion. It can sell new
preference shares at a price of Rs 23, less flotation cost of Rs 3 per share. It is expected that a dividend of Rs 2 per
share will be paid on preference. The new debt can be issued at 10 per cent rate of interest. The firm pays taxes at
rate of 35 per cent and intends to maintain its capital structure.
You are required (i) to calculate the after-tax cost (a) of new debt, (b) of new preference capital, and (c) of
ordinary equity, assuming new equity comes only from retained earnings which is just sufficient for the purpose,
(ii) to calculate the marginal cost of capital, assuming no new shares are sold, (iii) to compute the maximum
amount which can be spent for capital investments before new ordinary shares can be sold, if the retained earnings
are Rs 700,000, and (iv) to compute the marginal cost of capital if the firm spends in excess of the amount
computed in (iii). The firm can sell ordinary shares at a net price of Rs 22 per share.
12. The following is the capital structure of X Ltd as on 31 December 2008.
Rs in million
Equity capital (paid up)
563.50
Reserves and surplus
485.66
10% Irredeemable Preference shares
10% Redeemable Preference shares
15% Term loans
56.00
28.18
377.71
Total
1,511.05
The share of the company is currently selling for Rs 36. The expected dividend next year is Rs 3.60 per share
anticipated to be growing at 8 per cent indefinitely. The redeemable preference shares were issued on 1 January
2003 with twelve-year maturity period. A similar issue today will be at Rs 93. The market price of 10%
irredeemable preference share is Rs 81.81. The company had raised the term loan from IDBI in 2003. A similar
loan will cost 10% today.
Assume an average tax rate of 35 per cent. Calculate the weights average cost of capital for the company using
book-value weights.
13. The following capital structure is extracted from Delta Ltd’s balance sheet as on 31 March 2008:
(Rs ’000)
Equity (Rs 25 par)
66,412
Reserves
65,258
Preference (Rs 100 par)
3,000
Debentures
30,000
Long-term loans
5,360
170,030
The earnings per share of the company over the period 2004–2008 are:
Year
Rs
Year
Rs
2004
2.24
1994
4.40
2005
3.00
1995
5.15
2006
4.21
1996
5.05
2007
3.96
1997
6.00
2008
4.80
1998
6.80
The equity share of the company is selling for Rs 50 and preference for Rs 77.50. The preference dividend rate
and interest rate on debenture respectively are 10 per cent and 13 per cent. The long-term loans are raised at an
interest rate of 14 per cent from the financial institution. The equity dividend is Rs 4 per share.
Calculate the weighted average cost of capital for Delta Ltd, making necessary assumptions.
14. A company has the following capital structure at the end of 31 March 2008:
(Rs in million)
Share Capital
Reserve
Long-term loans
6,808
34,857
538,220
The company’s EPS, DPS, average market price and ROE for last seven years are given below:
Year
EPS
DPS
AMP
ROE
2002
2003
2004
2005
2006
2007
21.55
22.14
26.40
20.16
20.40
23.09
5.28
5.76
5.76
6.53
7.68
11.53
143.04
187.52
312.32
587.52
366.72
416.64
20.9
18.6
11.7
11.0
9.5
10.3
2008
22.00
7.68
355.20
8.4
Note: EPS, DPS and AMP adjusted for bonus issues.
You are required to calculate: (a) growth rate g, using alternative methods; (b) cost of equity, using dividend –
growth model, and (c) weighted average cost of capital, using (i) book-value weights and (ii) market-value
weights. Assume that the interest rate on debt is 11 per cent and the corporate income tax rate is 35 per cent.
15. Eskayef Limited manufactures human and veterinary pharmaceuticals, bulk drugs, skin care products, and
vaterinary feed supplements and markets bio-analytical and diagnostic instruments. On 31 March 2003, the
company has a paid-up share capital of Rs 75 million and reserves of Rs 325.90 million. It does not employ longterm debt. The following are other financial highlights on the company during 2003–2008:
Year
EPS (Rs)
DPS (Rs)
Book
Value (Rs)
Market
Value
2003
6.21
2.00
26.03
100.00
2004
10.91
2.50
34.44
205.00
2005
11.57
2.50
43.52
209.38
2006
11.47
2.70
37.98
164.00
2007
10.44
3.00
45.42
138.88
2008
11.23
3.20
53.45
155.00
Note: (1) Years 2003, 2004 and 2005 closed on 30 November while years 2006, 2007 and 2008 on 31 March. (2)
Market value is the averages of high and low share prices.
You are required to calculate (a) ROE, (b) dividend payout, (c) retention ratio, (d) growth rate, (e) dividend yield,
(f) earnings yield and (g) cost of equity.