Prof.

Prapti Paul

Cost of capital is the minimum required rate of return, a project must earn in order to cover the cost of raising funds being used by the firm in financing of the proposal. Minimum rate of return that a firm must earn in order to satisfy the expectations of its investors is called the cost of capital of the firm. In other words, the cost of capital is the rate of return a firm must earn in order to attract the supplier of funds to make available the funds to the firm. If a firms actual rate of return exceeds its cost of capital and if this return is earned without increasing the risk of the firm, then the wealth maximization goal is achieved. Cost of capital when used as a discount rate in capital budgeting helps accepting only those proposals whose rate of return is more than the cost of capital of the firm and hence results in increasing the value of the firm.

Cost of capital has a useful role to play in deciding the financial plan or capital structure of the firm. In order to maximize the value of the firm, the cost of all the different sources of funds must be minimized.
2

1.

Risk free interest rate: is the interest rate on the risk free and default
free securities. E.g. securities issued by GOI.

2.

Business risk: risk associated with the firms promise to pay interest and
dividends to its investors. Business risk is related to the response of the firms Earnings Before Interest and Taxes, EBIT to a change in sales revenue. Every project has its effect on the business risk of the firm. If a firm accepts a proposal which is more risky than the average present risk, the investor will probably raise the cost of funds so as to be compensated for the increased risk.

3.

Financial risk: the particular composition and mixing of different sources

of finance, known as the capital structure can affect the return available to the investors. The financial risk is defined as the likelihood that the firm would not be able to meet its fixed financial charges. It is related to the response in firms earnings per share to a variation in EBIT. Higher the proposition of fixed cost securities in the overall capital structure greater would be the financial risk.
3

4.

The investor may also like to add a premium with reference to other factors. One such factor is the liquidity or marketability of the investment. Higher the liquidity available with an investment, lower would be the premium demanded by the investor. If an investment is not easily marketable, then the investors may add a premium for this also and consequently demand a higher rate of return. In the view of the above, the cost of capital maybe defined as: k = If + b+ f where k = cost of capital of different sources

If = risk free interest rate

b = business risk premium f = financial risk premium

Risk-return relationships of various securities

4

The explicit cost of capital of a particular source may be defined in terms of the interest or divided that the firm has to pay to the suppliers of the funds. There is an explicit flow of cash payable by the firm to the supplier of funds. E.g. the firm has to pay interest on capital, dividend at fixed rate on preference share capital and also some expected dividend on equity shares. These payments refer to the explicit cost of capital.

There is one source of funds which does not involve any payment or flow, i.e. the retained earnings of the firm. The profits earned by the firm but not distributed among the equity shareholders are ploughed back and reinvested within the firm. Had these profits been distributed to equity shareholders, they could have invested these funds elsewhere and would have earned some return.
This return foregone by the investors when the profits are ploughed back. Therefore, the firm has an implicit cost of these retained earnings and this implicit cost is the opportunity cost of investors. Thus, the implicit cost of retained earnings is the return which could have been earned by the investor, had the profit been distributed to them. Except the retained earnings, all other sources of funds have explicit cost of capital.
5

The measurement of cost of capital refers to the process of determining the cost of funds to the firm. Once this cost has been determined, it is in the light of this cost of capital that the capital budgeting proposal will be evaluated. Underlying assumptions: Business risk of the firm is unaffected by the proposal being evaluated at the cost of capital. The implication of this assumption is that every firm has a particular level of business risk as determined by the present composition of its assets. If a new proposal is also accepted then this business risk level is not going to be changed, or in other words the new proposal accepted by the firm is assumed to possess the same level of risk as those already held. Financial risk of the firm is assumed to remain unchanged, whether a proposal is accepted or not.

a)

b)

Taxes and Cost of Capital: cost of capital which is used to discount cash flows (after tax) should also be after tax only. Specific and Overall cost of Capital: at a particular point of time the firm might have raised funds from various sources i.e. short term as well as long term. Conceptually, the cost of capital as a measure represents the combined cost of total funds being used by the firms. However the short term sources of funds are kept outside the calculation of cost of capital as these short term sources e.g. bank credit, trade credit, bill etc are generally considered to be temporary in nature and are subject to repayment in the short run. Therefore the cost of capital of a firm is calculated as the combined cost of long term sources of funds. All these long term sources have their own specific costs. The combined cost of capital depends upon these specific costs. The combined cost of capital is known as the overall cost of capital of the firm, while the specific costs are known as specific cost of capital of a particular source. The long term sources of funds can be broadly classified into: (i) long term debt and loans, (ii) preference share capital (iii) equity share capital, and (iv) retained earnings. The firm has a specific cost of capital for each of these sources and on the basis of these specific cost of capital, the overall cost of capital an be determined.
7

The cost of capital for debt may be defined as the returns expected by the potential investors of debt securities of the firm. Following information is required to calculate cost of debt: Net proceeds from the issue: refers to the net cash inflow at the time of issue of debt. B0 = FV + Pm - D F where B0 = net proceeds FV= face value of debt Pm= premium charged on the issue of debt D = discount allowed at the time of issue of debt F = floatation cost i.e. the cost of raising funds (including underwriting, brokerage and issue expenses). E.g.: a debenture having a face value of Rs.100 is issued at a discount of 5% and total issue of expenses are estimated at 5%, the net proceeds i.e. B 0 = Rs.100 Rs.5 Rs.5= Rs.90. incase the debenture is issued at a premium of 10%, then B0 = Rs.110 Rs.5.50 = Rs.104.50 (floatation cost has been calculated at the face value or the issue price whichever is higher).

a)

b)

Periodic payments of interest: the interest amount is assumed to be payable annually. Also interest on debt is always payable on the face value irrespective of the issue price. E.g. if the company issued 15% debentures, then the annual interest charge is Rs.15, irrespective of the fact whether the net proceeds, B0 , was Rs.100 or more or less. Maturity payment : the principal amount of the debt instrument or loan will be payable by the firm on the maturity date. This may be paid together with the interest for the last year. On the basis of the above information, cost of capital of perpetual debt (i.e. debt availed by the firm on a regular basis) may be ascertained as follows: COST OF CAPITAL OF PERPETUAL DEBT: i.e. debt availed by the firm on a regular basis: ki = I B0

c)

where ki = cost of capital of debt (before tax) I = annual interest payable B0 = net proceeds
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Tax adjustment: as the interest on debt is tax deductible, the firm gets a saving in its tax liability. Thus, the effective cost of debt is lower than the interest paid to the debt investors. The amount of tax savings and the effective cost of debt depend on the tax rate. The real cost of debt is determined only after considering this tax shield as follows: kd = ki (1-t)

where kd = cost of capital of debt (after tax) ki = cost of capital of debt (before tax) t = tax rate Note: tax benefit of interest deductibility is available only if the firm is a profit making one. For a loss making firm or for a no- tax paying firm, this adjustment is not required and in such case kd= ki.

Cost of capital of Redeemable Debt: Ii (i-t) + COPi + COPn

i=1

(1+kd) (1+kd) (1+kd)

where, I = annual interest payment ; kd = after tax cost of capital of debt B0 = net proceeds; COPi = regular cash outflow on account COPn = cash outflow on account of repayment at maturity
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1.

ABC Ltd. Issues 15% debentures of face value of Rs.100 each, redeemable at the end of 7 years. The debentures are issued at a discount of 5% and the floatation cost is estimated to be 1%. Find out the cost of capital of debentures given that the firm has 50% tax rate. ABC ltd. Issues 15% debentures of face value of Rs.1000 each at a floatation cost of Rs.100 per debenture. Find out the cost of capital of the debentures which is to be redeemed in 5 annual installments of Rs.200 each starting from the end of year1. the tax rate may be taken at 50%.

2.

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The fixed rate of dividend on preference shares is the starting point for calculation of cost of capital of preference share capital As the preference shares may either be redeemable or irredeemable, the cost of capital may also be ascertained accordingly: Cost of capital of Redeemable preference shares: if the preference shares are redeemable at the end of a specific period, then the cost of capital of preference shares can be calculated using the following equation: P0 = PDi + (1+kp)
i

Pn (1+kp)
n

Where P0 = net proceeds on issue of preference shares PD = Annual preference dividend at a fixed rate of dividend Pn = amount payable at the time of redemption kp = cost of preference share capital n = redemption period of preference shares
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Cost of capital of Irredeemable Preference shares: the dividend at the fixed rate will be payable to the preference shareholders perpetually. kp = PD P0 where PD = annual preference dividend P0 = net proceeds on issue of preference shares kp = cost of capital of preference shares.

3. ABC Ltd. Issues 15% preference shares of the face value of Rs.100 each at a floatation cost of 4%. Find out the cost of capital of preference shares if (i) the preference shares are irredeemable, and (ii) if the preference shares are redeemable after 10 years at a premium of 10%.

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Zero- growth Dividends ke = D1 P0 where, ke = cost of equity share capital D1 = expected dividend at the end of year 1 P0 = current market price of the share

Constant growth in dividends: Dn = D0 (1+g) P0 = D0 (1+g) ke g = D1 ke g k e = D1 + g

P0

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4. ABC Ltd. Has just declared and paid a dividend at the rate 15% on the equity shares of Rs.100 each. The expected future growth rate in dividends is 12%. Find out the cost of capital of equity shares given that the present market value of the shares is Rs.168. Varying growth rate in dividends:
5 10 i=1

P0 = D0(1+g1) + D5(1+g2) + D10(1+g3) (1+ke)

i=6

(1+ke)

i=11

(1+ke)

where P0 ke

= value of equity share = required rate of return for equity shareholders

g1,g2,and g3 = different growth rates for different periods, and

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A firm may face a situation where it needs to raise funds by issue of fresh equity in order to finance the new projects. If so, what is the return that must be earned on these funds raised to make the project worth while??The existing equity share capital expect the firm to pay a stream of dividends and this stream of dividends is earned from the existing assets. The new equity capital will also likewise expect to receive the same quantum of returns. For the new shares to obtain the same stream as on the existing shares, the new funds obtained from the issue of fresh capital must be utilized to produce a return high enough to provide a dividend stream whose present value is just equal to the net proceeds of the fresh issue. The minimum rate of return which the new shares expect in order to prevent a decline in the market price of the existing shares, is the cost of fresh equity

The firm should sell the new shares at the current market price of the existing equity shares. However in practice, the net proceeds to the firm will be reduced by the floatation cost, underwriting expenses , advertisements, issue expenses, brokerage and above all a discount off the current price to the potential investor to induce them to subscribe all the shares offered . Thus the net proceeds will be reduced below the market price for (i) the floatation cost and (ii) offer price being below the current market price. kn = D1 + g NP where NP = net proceeds from the fresh issue kn = cost of new equity

The share of ABC Ltd. Is presently traded at Rs.50 and the company is expected to pay dividends of Rs.4 per share with a growth rate expected at 8% p.a. It plans to raise fresh equity share capital. The merchant banker has suggested that an under pricing of Rs.1 is necessary in pricing anew issue besides involving the cost of 50paisa per share on miscellaneous expenses. Find out the cost of existing equity share as well as the new equity share capital given that the dividend rate and growth rate are not expected to change.

As the retained earnings increase the shareholders equity in the same way as the issue of new equity share capital would do, the retained earnings are often considered as subscription to additional share capital by existing equity shareholders. The cost of retained earnings is the opportunity cost of the foregone dividends. The cost of retained earnings, kr, is often taken as equal to the cost of equity share capital, ke, since the retained earnings are viewed as the fresh subscription to equity share capital. If a firm has to decide whether to raise funds by issuing new equity shares or by retaining the earnings, it will have to find out the rate of return at which the investors will be indifferent between whether the firm distributes these earnings or re-invests these earnings for future growth. This is reflected in the market price of the share which is used to determine the cost of equity. kr = ke . However cost of retained earnings is not to be adjusted for tax , for floatation cost and for under pricing.

6. Assuming that the firm pays a tax @ 50%, compute the after tax cost of debt in the following cases: (i) a 14.5% preference share sold at par (ii) a perpetual bond sold at par, coupon rate being 13.5% (iii) a ten year 8%, Rs.1,000 per bond sold at Rs.950 (iv) a common share selling at a market price of Rs.120 and paying a current dividend of Rs.9 per share which is expected to grow at a rate of 8%. 7. A companys share is quoted in the market at Rs.20 currently. The co. has paid dividend of Re.1 per share and the investors market expects a growth rate of 5% per year. Calculate: (i) the co.s equity cost of capital (ii) if the co.s cost of capital is 8% and the anticipated growth rate is 5% p.a, calculate the market price if the dividend of Re.1 is to be paid at the end of one year.

Once specific cost of capital of each long term source have been ascertained then the next step is to calculate the overall cost of capital to the firm. This overall cost of capital is of utmost importance as this rate is to be used as the discount rate or the cut-off rate in evaluating the capital budgeting proposals. The overall cost of capital may be defined as the rate of return that must be earned by the firm in order to satisfy the requirements of the different investors . Thus the overall cost of capital is the minimum required rate of return on the assets of the firm. This overall cost of capital should take care of the relative proportion of different sources in the capital structure of the firm. It would be calculated as the weighted average rather than simple average of different specific cost of capital.

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WACC = ke. w1 + kd. w2 + kp . W3

where WACC = weighted average cost of capital ke = cost of equity capital kd = cost of debt kp = cost of preference shares w1 = proportion of equity capital in the capital structure w2 = proportion of debt in the capital structure

w3 = proportion of preference capital in the capital structure

In order to calculate the WACC, there is a system of assigning weights to different specific cost of capital. Historical weights : based on the actual or existing proportions of different sources in the overall capital structure. Marginal weights: refers to the proportions in which the firm wants or intends to raise funds from different sources. In case of marginal weights the firm calculates the actual WACC of the incremental funds.

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Target weights: refer to the proportion in which the firm plans to raise the funds from the various sources in the long run. It reflects the desired long term financial plans or capital structure of the firm. Use of target weights is the best option as it incorporates the long term perspective of the firm.

Book value and market value weights:

with respect to choice between the book value and market value weights, the following points are noteworthy: Book value is more reliable than market value because the former is not as volatile the WACC based on market value will generally be greater than the WACC based on book values. The reason being that the equity capital having higher specific cost of capital usually has a market value above the book value. However this is not a rule. The choice between the book value and the market values is relevant only for historical and target weights. In case of marginal weights, weighing system will be market value based only.

a)

b)

c)

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Following is the capital structure of ABC Ltd. Source Equity share capital (2,00,000 shares of Rs.10 each) Preference share capital (50,000 shares of Rs.10 each) Retained earnings 9% debentures of Rs. 1,000 each Amount Rs.20,00,000 Rs.5,00,000 Rs.10,00,000 Rs.15,00,000 Specific C/C 11% 8% 11% 4.5%

presently, the debentures are being traded at 94%, preference shares at par and equity shares at Rs.13 per share. Find out the WACC based on book value weights and market value weights.

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Suppose a firm has raised total funds by the issue of equity share capital (E) and debt (D). The WACC for the firm can be derived as: WACC = [D/(D+E)]*kd + [E/(D+E)] *ke where kd is after tax cost of debt ke is cost of equity share capital

A firm has raised 70% and 30% of its total funds by the issue of equity shares and 12% debentures. The required rate of return for equity capital is 16%. Tax rate is 30%.The WACC of the firm: kd = .12(1-.3) ke =.16 WACC = [.3/(.3+.7)] *.84 +[.7/(.3+.7)] *.16 =13.72%

The WACC is often denoted by ko, i.e. overall cost of capital.

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PQR and Co. has the following capital structure as on Dec31, 2002. Equity sh. Cap (5,000 shares of 100 each) Rs.5,00,000

9%, Preference shares

10% debentures

2,00,000
3,00,000

The equity shares of the company are quoted at Rs.102 and the company is expected to declare a dividend of Rs.9 per share for the next year. The co. has registered a dividend growth rate of 5% which is expected to be maintained.
1.

Assuming the tax rate applicable to the company is 50%, calculate the WACC Assuming the company can raise additional term loan at 12% for Rs.5,00,000 to finance its expansion calculate the revised WACC. The co.s expectation is that the business risk associated with the new financing may bring down the market price from Rs.102 to Rs96 per share.
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2.

WACC focuses on the calculation of cost of capital when the firms total financing and its pattern of financing is given remains constant. However in practice, the investment proposal may require funds to be raised from new internal/external sources and thus increasing the total funds also. When this happens the cost of capital of additional funds is called marginal cost of capital.

If the additional financing uses more than one source, say a combination of debt and preference share capital, then the WACC of the new financing is called the Weighted Marginal Cost of Capital (WMCC).
The following variables may affect the marginal cost of capital of a specific source and thereby may affect the WMCC: The investors may perceive an increase in business risk of the firm. The financial risk of the firm may also change as a result of change in composition of the capital structure. The increase in business and financial risk may increase the marginal cost of capital and thus some of the proposals may become unviable.
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a) b)

c)

 i.

Calculation of WMCC: The WMCC is calculated on the basis of market value weights because the new funds are to be raised at the market values. The specific cost of capital can be accurately calculated. No external financing for new proposals: if a firm has sufficient retained earnings with it as required by the new proposal, then the firm may not raise any external finance. In such situations the WMCC is equal to the specific cost of capital of the retained earnings. Ex: a firm has financed 70% of its total requirements by equity shareholders funds (C/C =13%) and 30% by the issue of 12% bonds (after tax C/C =6%). The WACC of the firm: 0.6*.3 +.7*.13 = 10.9% However the WMCC of the firm will be 13% as the new financing is provided only by the retained earnings.

ii.

External financing with the same cost of capital and same proportions as existing: if a firm raises new capital funds in the same proportion as the present and the same specific cost of capital as at present, then WMCC is equal to the WACC. Consider a firm having obtain 50%, 40% and 10% of the total funds by the issue of equity sh.cap, pref. sh.cap and 10% debt.
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These sources have 10%,9% and 5% as their specific cost of capital. Now WACC = .5(.10)+ .4(.09) +.1(.05) = .091 OR 9.1%.
In order to finance an investment proposal of Rs.10,00,000, the firm proposes to procure Rs.5,00,000 by the issue of equity share capital, Rs.4,00,000 by the issue of preference share capital and Rs.1,00,000 by the issue of 10% debentures. It estimates that the cost of capital of additional funds will be same as at present. Since the proportion of different sources of new financing in the total new financing is the same as at present , i.e. 50% equity capital, 40% equity capital, 40% preference share capital and 10% debentures. The WMCC = .5(.10) +.4(.09) + .1 (.05) = .091 OR 9.1% So WMCC is equal to the WACC.

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Different cost of capital with changed proportions: it is possible that the specific costs of capital of different sources may be affected by the amount of funds raised and the proportion of a particular source may also change as a result of new funds. Consequently, the WMCC may also change and vary differently. Ex: Source Equity sh.cap Amount (Rs.) 25,00,000 Weight .50 Specific C/C 11%

Retained earnings 11% debentures

12,50,000 12,50,000

.25 .25

11% 5.5%

the WACC of the firm may be calculated as follows: WACC = .5(.11) +.25(.11)+.25(.055) = .096 OR 9.6% The rate of interest on debentures is 11% but the specific cost of debt is given as 5.5%, therefore the tax rate is 50%. Now suppose the firm has an investment proposal of Rs.10,00,000 and expect to generate retained earnings of Rs.2,00,000 from the current operations. The remaining funds are raised by the issue of equity share capital (Rs.6,00,000 at 12%) and 12% bonds (Rs.2,00,000). The WMCC of the firm will be:
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WMCC = .6(.12)+ .2 (.06) =10.6%

the WACC of the firm can now be calculated as:

Source Equity sh.cap Equity sh.cap Retained earnings Retained earnings 11% Debentures 12% debentures Amount (Rs.) Weight Rs.25,00,000 6,00,000 12,50,000 2,00,000 12,50,000 2,00,000 .417 .100 .208 .033 .209 .033 C/C .11 .12 .105 .105 .055 .060 Weight * C/C .0458 .0120 .0228 .0036 .0115 .0020

The WACC of the firm is .0977 or 9.77%. So the WACC has increased from 9.6% to 9.77% as a result of WMCC of 10.6% ( which was higher than the then WACC). So, the WMCC has lifted the WACC.

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Breaks in Specific Cost of Capital: the specific costs of capital may also be affected by the amount of finance the firm wants to raise. As the amount of raising financing increases, the costs of various sources may also increase. These increasing costs are attributable to the fact that the investors would require greater returns to be compensated for the increased risk resulting from the larger volumes of new financing. Consequently, the WMCC tends to rise as the firm seeks more and more funds. Breaks in specific cost of capital occur as a function of the amount of funds being raised. The levels at which the specific cost of capital of a particular source of a particular source increases are called breaking points. The firm must find out at what levels of total new financing, the breaks in specific cost of capital and consequently breaks in WMCC occur and should also measure the WMCC at each of such breaks.

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The following procedure should be used to measure the WMCC when the specific cost of capital depends upon the amount raised:
1. 2.

Establish the percentage composition of new financing. Prepare a list for each such source of financing giving the amount of funds that can be obtained and the specific cost of capital associated with each amount to be raised. The specific cost of capital can be determined through an analysis of the current market conditions. On the basis of the percentage composition of the total new financing (step1) estimate the breaking points in the WMCC. The break points identify the levels of the total new financing at which the WMCC increases. The breaking points for a particular source can be calculated: BPi = TFi Wi where BPi = breaking points for source I TFi = maximum financing available from source I at breaking point

3.

Wi = weight of source, I
4. After determining the breaking points for each source, the WMCC can be determined at each breaking point over a range of total financing.
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A firm wishes to raise funds up to Rs.10,00,000 and finds that its WACC depends upon the amount of funds raised. The firm has a set pattern of financing , i.e. 75% shareholders funds and 25% debt. The shareholders funds may be taken as consisting of retained earnings and capital. The following specific cost of capital for each source have been estimated at different levels of financing from that source: Source Shareholders funds Amount (Rs.) Up to Rs.1,50,000 1,50,000-6,00,000 6,00,000 9,00,000 Bonds Up to Rs.1,00,000 1,00,000- 2,00,000 2,00,000-3,00,000 Specific C/C 12% 14% 17% 10% 12% 16%

Find out the WMCC at different breaking points given that (i) the tax rate is 50% and (ii) retained earnings of Rs.1,50,000 will be provided by the current earnings at specific cost of capital of 12%. Additional needed shareholder funds will have to be raised by the issue of share capital.
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Estimation of WMCC breaking points: Step 1: percentage composition of shareholders funds percentage composition of bonds

Step 2: find out the breaking points at different levels of each source
as follows: BPi = TFi Wi Source Sh. funds Amt. Rs Weight Breaking point (Rs.) 2,00,000 8,00,000 12,00,000 4,00,000 8,00,000 12,00,000 Total funds (Rs.) Up to 2,00,000 2,00,000-8,00,000 8,00,000-12,00,000 Up to 4,00,000 4,00,000-8,00,000 8,00,000-12,00,000
35

Specific C/C .12 .14 .17 .05 .06 .08

1,50,000 .75 6,00,000 .75 9,00,000 .75 1,00,000 .25 2,00,000 .25 3,00,000 .25

Step 3: calculation of WMCC for each range of financing. Range (Rs.) Up to 2,00,000 Source Sh.funds Debt Weight .75 .25 C/C .12 .05 Weighted C/C .0900 .0125 .1025 WMCC

2,00,000-4,00,000 4,00,000-8,00,000
8,00,000-12,00,000

Sh. Funds Debt Sh.funds

Debt Sh.funds Debt

.75 .25 .75

.25 .75 .25 WMCC

.14 .05 .14

.06 .17 .08

.1050 .0125 .1050

.0150 .1275 .0200 .1475 .1200

.1175

Therefore the WMCC at different levels of financing are: Level of Financing Up to Rs.2,00,000 2,00,000 4,00,000 4,00,000 -8,00,000 8,00,000 12,00,000 10.25% 11.75% 12.00% 14.75%
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The WMCC can be effectively used in the capital budgeting process by analyzing WMCC in conjunction with the firms investment opportunities. The WMCC can be used as a discount rate or the cut-off rate in evaluation of investment proposals. A proposal may be considered desirable if its NPV discounted at WMCC is zero or positive. As long as the IRR of the proposal is more than the WMCC , the proposal may be accepted. NPV under constant WMCC : if a firm has constant WMCC the different proposal maybe evaluated on the basis of this WMCC. The proposal having the highest NPV should be accepted. It is implied that unlimited funds can be procured at the given WMCC to finance all acceptable proposals. NPV and increasing WMCC: if a firms WMCC has break points over increasing levels of new financing then determining the optimal capital budgeting procedure is difficult. As a firm increases the amount of investments, the return from projects will decrease since generally the first project accepted will have the highest return, the next project selected will have the next highest return and so on. The return on investment will decrease as the firm accepts more and more proposals. At the same time WMCC will increase because additional amounts of new financing will be required. The firm would accept, therefore the proposals up to the point where the WMCC is just equal to marginal return on investment. Beyond this point, the return will be less than the costs.
37

A firm finds break points in its WMCC at the following levels of new financing: Level of financing WMCC

Rs. 12,00,000
18,00,000 28,00,000 36,00,000

10%
12% 16% 21%

Analyze the above and set the acceptance criterion for the selection of proposals.

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The information given denotes that additional funds can be procured by the firm only at increasing WMCC. So the firm has to decide as to which investment proposal be accepted and which are to be rejected. In the first instance the firm should evaluate the proposals which require funds up to Rs.12,00,000 only at the discount rate of 10%. Projects having positive NPV maybe accepted. Then it should proceed to evaluate those investment proposals which require funds up to Rs.18,00,000 at discount rate of 12%. Repeat the process for investment proposals requiring funds up to Rs.28,00,000 at discount rate of 16% and so on. Suppose the firm gets the following values of NPV at different financing constraints and different discount rates: Levels of financing Rs.12,00,000 18,00,000 28,00,000 36,00,000 NPV (Rs.) 5,00,000 9,00,000 15,00,000 13,00,000

So the highest positive NPV of Rs. 15,00,000 occurs when the firm accepts proposal requiring funds of Rs.28,00,000 and discounted at 16%. In view of the objective of maximization of shareholders wealth, the optimal capital budgeting consists of the investment requiring funds up to Rs.28,00,000 and returning a NPV of Rs.15,00,000. the funds for these proposals maybe raised at 16% cost of capital.
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12.

S co. has the following capital structure on 1st July 2006:

equity shares (4,00,000 ) 10% preference shares 14% debentures Rs.80,00,000 20,00,000 60,00,000

1,60,00,000
The share of a company currently sells for Rs.25. It is expected that the company will pay a dividend of Rs.2 per share which will grow at 7% forever. Assume a 50% tax rate.
13.

The following information has been extracted from the balance sheet of Fashions Ltd. As on 31.12.2006: Equity Share Capital 12% debentures 18% term loan Rs. 400 lakhs 400 lakhs 1,200 lakhs 2,000

a)

Determine the weighted average cost of capital of the company. It had been paying dividends at a consistent rate of 20% per annum. What difference will it make if the current price of the Rs.100 share is Rs.160? Determine the effect of income tax on the cost of capital under both premises. (tax rate 40%)
40

b)

c)

14.

The following figures are taken from the current balance sheet of Delware and Co. capital (shares of Rs.10 each) share premium reserves Rs.8,00,000 2,00,000 6,00,000

shareholders funds
12% irredeemable debentures

16,00,000
4,00,000

An annual ordinary dividend of Rs.2 per share has just been paid. In the past, ordinary dividends have grown at a rate of 10% p.a. and this rate is expected to continue. Annual interest has recently been paid on the debentures. The ordinary shares are currently quoted at Rs.27.5 and the debentures at 80%. Ignore taxation. Estimate the weighted average cost of capital (based on market values) for Delware and Co.

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15.

ABC Co. has the following capital structure which is considered to be optimum: Equity share capital (1,00,000 shares) 11% Preference share capital 16% debentures Rs.16,00,000 Rs.1,00,000 Rs.3,00,000

20,00,000
The companys share has a current market price of Rs.20 per share. The expected dividend per share next year is Rs.1.18 with a growth rate of 10%. The 165 new debentures can be issued by the company. The companys debentures are currently selling at Rs.96 per debenture. The new 11% preference share can be sold at a net price of Rs.9.15 (face value Rs.10 each). The co.s tax rate is 50%.
a)

Calculate the after tax cost of (i) new debt , (ii) new preference share capital, (iii) equity share capital Calculate the WMCC How much can be spent for capital investment before new equity shares must be sold? (assume that the retained earnings available for the next years investment are 50% of 2000 earnings) What marginal cost of capital (cost of funds raised in excess of the amount calculated in part (c ) if the firm can sell new equity shares to net Rs.20 per share? kd and kp is constant.
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b) c)

d)

16. The XYZ and Co. wishes to find out its weighted marginal cost of capital, WMCC , based on target capital structure proportions. Using the data given below, find out the WMCC . Source Equity share capital Proportion Range 50% Up to Rs.3,00,000 3,00,000 m- 7,50,000 7,50,000 and above Preference shares Long term debt 10% 40% Up to Rs.1,00,000 1,00,000 and above up to Rs.4,00,000 4,00,000 8,00,000 8,00,000 and above Cost 13.00% 13.30% 15.50% 9.33% 10.60% 5.68% 6.50% 7.10%

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