Lesson 21

Chapter 6
Concept and measurement of cost of capital
Unit 2
Long term investment decisions

Now that you have learnt everything about cost of capital I will
test your understanding by doing certain questions.

Multiple Choice Questions

1. The key sources of value (earning an excess return) for a company can be attributed
primarily to __________.

a) Competitive advantage and access to capital

b) Quality management and industry attractiveness
c) Access to capital and quality management
d) Industry attractiveness and competitive advantage

2. The overall (weighted average) cost of capital is composed of a weighted average of

__________.

a) The cost of common equity and the cost of debt

b) The cost of common equity and the cost of preferred stock
c) The cost of preferred stock and the cost of debt
d) The cost of common equity, the cost of preferred stock, and the cost of debt

3. What is the overall (weighted average) cost of capital in the following situation? The
firm has $10 million in long-term debt, $2 million in preferred stock, and $8 million in
common equity -- all at market values. The before-tax cost for debt, preferred stock, and
common equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40% tax
rate.

a) 6.40%
b) 6.54%
 c) 9.30%
d) 10.90%

4. For which of the following costs is it generally necessary to apply a tax adjustment to
a yield measure?

a) Cost of debt
b) Cost of preferred stock
c) Cost of common equity
d) Cost of retained earnings

5. Which of the following is not a recognized approach for determining the cost of
equity?

a) Dividend discount model approach

b) Before-tax cost of preferred stock plus risk premium approach
c) Capital-asset pricing model approach
d) Before-tax cost of debt plus risk premium approach

6. In estimating a firm's cost of equity, you decide to use the 3 methods discussed in the
text and then to take a simple average of the three separate estimates as you feel that in
this instance all 3 methods seem equally justified. The before-tax cost of debt is 8%, risk
premium above debt is assumed to be 6%, the risk-free rate is 5%, the beta is .90, and the
expected market return is 16%. In addition, the firm is expected to grow dividends at a
constant 8.1% rate indefinitely and will pay a $2.00 dividend next year. The firm's
common equity is currently selling at $25 per share. The average figure that you come up
with should be closest to __________.

a) 17.0%
b) 16.0%
c) 15.0%
d) 14.0%

7. Jacques Fauxpas is attempting to determine his company's weighted-average cost of

capital. His first step was to determine the required rates of return for his company's long-
term debt, preferred stock, and common stock. He then adjusted these required rates of
return by multiplying each return by one minus the company's marginal tax rate. Jacques
is planning on using these three adjusted required return figures as his component costs of
capital. How is Jacques doing so far?
 a) All three of Jacques' components cost figures are incorrect.
b) All three component cost figures are correct.
c) Only the required return (yield) on preferred stock and debt should have been
adjusted for taxes.
d) Only the required return (yield) on debt should have been adjusted for taxes.

8. What is the difference between economic profit and accounting profit?

a) Economic profit includes a charge for all providers of capital while accounting
profit includes only a charge for debt.
b) Economic profit covers the profit over the life of the firm, while accounting profit
only covers the most recent accounting period.
c) Accounting profit is based on current accepted accounting rules while economic
profit is based on cash flows.
d) All of the above are correct.

9. What is the idea behind project-specific required rates of return for a firm or division?

a) Different projects should have different required rates of return because they are
not alike with respect to risk.
b) Each firm should have a different required rate of return because firms are not
alike with respect to risk and have been created historically by projects taken that
differ with regards to risk.
c) A division of the firm will always have a required rate of return different from the
firm's overall weighted average cost of capital because the risk of the division
always differs from that of the firm.
d) All of the above are correct.

10. A company that has more than half of its voting shares owned by another company is
generally referred to as a __________ of the other firm.

a) Joint-venture partner
b) Proxy
c) Subsidiary
d) Division

11. Which of the following is correct regarding the capital component costs for a group?

a) The component cost of common equity is based on the firm's component cost of
common equity.
b) The component cost of debt is based on the firm's component cost of debt.
c) Both of the above answers (a. and b.) are correct.
 d) All of the above answers are incorrect.

12. Which of the following statements is correct regarding the risk-adjusted discount rate
(RADR) approach?

a) Under the RADR approach, we should accept a project if its net present value
(NPV) calculated using a risk-adjusted discount rate is positive.
b) Adjusting the firm's overall cost of capital upward is required if the project or
group are of higher than average risk.
c) Under the RADR approach, we would still compare a project's internal rate of
return (IRR) to the firm's overall weighted-average cost of capital in order to
decide acceptance/rejection.
d) Adjusting the firm's overall cost of capital downward is required if the project or
group are of lower than average risk.

13. Assume management is looking at a set of possible projects with regards to their
expected NPV, standard deviation, and management's risk attitude. The firm should
attempt to take the set of projects __________.

a) That fall on the lowest indifference curve

b) That fall on the highest indifference curve
c) Where the choice is on the indifference curve that is the farthest to the southeast
d) That has the lowest standard deviation

14. Which one of the following projects -- A, B, C, or D -- should be accepted? The

expected return on the market is 16% and the risk-free rate is 6%.

a) Project A, which has a beta of 0.50 and has an expected return of 11.2%
b) Project B, which has a beta of 2.50 and has an expected return of 25.4%
c) Project C, which has a beta of 1.25 and has an expected return of 18.2%
d) Project D, which has a beta of 1.00 and has an expected return of 15.8%

Answers to above
1) Industry attractiveness and competitive advantage

2) The cost of common equity, the cost of preferred stock, and the cost of debt

3) 9.30%

4) Cost of debt
 5) Before-tax cost of preferred stock plus risk premium approach

6) 15.0%

7) Only the required return (yield) on debt should have been adjusted for taxes.

8) Economic profit includes a charge for all providers of capital while accounting
profit includes only a charge for debt.

9) Different projects should have different required rates of return because they are
not alike with respect to risk.

10) Subsidiary

11) The component cost of debt is based on the firm's component cost of debt.

12) Under the RADR approach, we should accept a project if its net present value
(NPV) calculated using a risk-adjusted discount rate is positive.

13) That falls on the highest indifference curve

14) Project A, which has a beta of 0.50 and has an expected return of 11.2%

True or False
1. A company can be viewed as a collection of projects.

TRUE
FALSE

2. The firm should use its weighted average cost of capital (WACC) to discount the cash
flows of all projects.

TRUE
FALSE

3. The firm beta is directly influenced by financial leverage.

TRUE
FALSE
Answers to above
1 TRUE

2. FALSE

3. TRUE

Self-assessment Questions and problems

1) The capital structure of Vikas Ltd. as follows:

Source Book Value Market Value

Equity share capital 10,00,000 20,00,000

(200% of book value)
Retained earnings 5,00,000 -
14% Preference share capital 7,00,000 7,00,000
(Just par)
12% Debentures 6,00,000 6,00,000
(Just par)

After tax, cost of capital of these different sources is Equity share capital 18%, Retained
earnings 15%, Preference share capital 14%, and debenture 8%. Calculate the weighted
average cost of capital of the company.

2) Good health Ltd. has a gearing of 30%. The cost of equity is computed at 21%
and the cost of debt 14%. The corporate tax rate is 49%.
Calculate WACC of the company.

3) Hindustan Chemical Ltd.has paid up equity ccapital6, 00,000 equity share of

Rs.10 each. The current market price of share is Rs 24. During the current year,
the company has declared a dividend of RS.6 PER SHARE. The company has
also previously issued 14% preference share of Rs.10 each aggregating RS 30
lakhs and 13% 50,000 debenture of Rs 100 each. The company’s corporate tax
 rate is 40%, the growth in dividends on equity share is expected at 5%. In case of
preference share the company has received only 95% of the face value of share
after deducting issue expenses.
Calculate WACC of the company.

4) The detail of dividend paid by Cool Ltd. on existing equity share of Rs 10 each
for the past 6 years is given below:

YEAR DIVIDEND PER SHARE

1995 1.05
1996 1.10
1997 1.16
1998 1.21
1999 1.27
2000 1.34

The current price of Equity share is Rs. 40. It is expected to maintain the fixed dividend
payout ratio in the future. The company has issued new equity share of Rs.0.50 per share.
The expected dividend to be declared for the current year is Rs. 1.40.
Using the above information calculate the cost of equity capital.

5) The shares of Campbell Ltd. are selling at Rs.24 per share. The firm has paid
dividend @ Rs 24 PER SHARE. The firm had paid the dividend @Rs 1.30 per
share last year. The estimated growth of the company is approximately 5% per
year. Determine the cost of equity capital of the company.

6) Falcon Ltd. has paid up capital of 10,00,000. Equity share off Rs 10 each and the
current market price of its equity shares is Rs 42. The dividend declared by the
company during the last five year is given below:
 Year Dividend declared
1996 9,00,000
1997 10,50,000
1998 15,00,000
1999 18,00,000
2000 21,00,000

Calculate the cost of capital.

(a) What is the importance of cost of capital in the capital Budgeting decision?
Write short notes on Calculation of cost of equity based on price earning method and
capital asset pricing models.

7). Spectacular Internet Providers is an all-equity financed company. While the company
is privately owned, it is quite similar to an NYSE stock, McQue ISP, which has a beta of
1.5. The S&P 500 stock index has an average annual return of 14%, and a 1-year
Treasury bill is currently yielding 8 percent.

Spectacular is evaluating a new project code-named "A", which is considered to have

"average" risk. What rate of return should be required in order to accept the project?
Project A would require an initial cash outlay of $10 million. It is expected to produce
annual after-tax incremental operating cash flows of $3 million for 10 years. Should
Spectacular accept this project?

8). The capital structure of Foster Medical (given in terms of both book value and market
value) is as follows: Book Value Market Value After-tax Cost
Bonds $15,000,000 $13,000,000 7.0%
Preferred stock 2,000,000 2,500,000 9.0%
Common equity 9,000,000 18,500,000 14.0%
Retained Earnings 4,000,000 _________
Totals $30,000,000 $34,000,000

a. What is the weighted average cost of capital using both Book Value and Market Value
calculations for Foster Medical?
b. What is theoretically the best weighting method? Why?

Case study

Lakeside Oil Company Case

Mr. Kardar, Treasurer of the Lakeside oil company, received a memorandum in January
1971 from Mr. Burman, manager of the service station division. A few days earlier Mr.
Burman had submitted an appraisal of a plan to lease and operate a chain of service
station and restaurants. The capital investment committee of which Mr. Kardar was a
member had rejected this proposal on the ground that it did not show an adequate return
on the investment. In this memorandum, Mr. Burman set out to explain and support his
belief that the proposal did, in fact, show an adequate return.

The proposal referred to was the operation of a chain of ten service stations, and four
restaurants that were to be built on the side of a highway. When the proposition first
came to Lakeside’s attention, Mr. Burman had proposed that Lakeside lease the
properties from the State Road Transport Corporation (SRTC) for 25 years agreeing to a
flat minimum annual rental of Rs. 782300 plus an additional annual rental based on sales
of petrol and food. In the course of negotiation the flat minimum rental was increased by
a supplemental annual amount of Rs. 474800 to be paid during the first five years only.
The supplemental amount was occasioned by an unexpected increase in the estimated
costs of building the properties.
These minimum rental figure were equal to the level repayment schedule needed to
amortize loan of Rs. 10000000 and Rs. 2000000 over 25 and 5 years respectively both
including interest at 6 percent. The SRTC intended to borrow these amounts.

The calculation originally made by Mr. Burman to evaluate this proposal are
summarized in Exhibit-1 He considered that from lakeside stand point the lease was a
form of investment since it committed the company to a fixed financial burden over a
number of years in the future and he calculated the amount of the investment by taking
the present value of all the flat annual payment guaranteed by lakeside. For this
calculation he used a discount rate of 2.25 percent which was the after tax cost of long
term borrowing to lakeside. Lakeside had recently successfully sold Rs. 215000000 of its
25 years bonds at 4.5 percent. The effective cost of this money after allowance for
income taxes at 50 percent was therefore 2.25 percent.

Exhibit-1
Summary of Mr. Burman’s First Appraisal

Capital Investment Rs.

Annual Flat Rental, Rs782300 Capitalised at a discount rate of 2.25%

over 25 years after taxes of 5 percent on the rental
(782300 X 50 percent 78.47) 7224500
Annual Supplemental Rental Rs. 474800 capitalised at a discount rate of
2.25 percent over 5 years after taxes (474800 X 50 X 468)
1111000

Total present value of future minimum flat rental of equipment and fittings 150000

Total capital investment 8485500

Profit
Price per gallon of Rs. Per years at 40 million
motar fuel gallon
Gross Margin:

Motar fuel 11.1 4440000

Motar Oil 1.5 600000
Service and labour 0.6 240000
Miscellaneous Sales 3.7 1480000

Total Gross Margin 18.0 7200000

Less: 5.2 2080000

Pre tax profit before

Fixed expense12.8 5120000

Less Fixed Expenses 454000

Pre tax profit before

Gallnage sales rental 4666000

Gallonage Sales Rental Rental Base Rs. Per years

Motor Fuel, 4 crores gallon paise4.4 per gallon 1760000

Motor Oil (sales Rs.2000000) 4% 80000

Service and Labour (Rs.400000) 4% 16000

Miscellaneous sales(Rs.1800000) 4% 72000

Restaurant Sales (rs.8960000) 10% 896000

Total 2824000

Pre tax profit after sales rental 1842000

Income tax at 50% 921000

After tax income for

Appraisal purposes (Does
not include lease expenses) 921000

Calculation of rate of return

Present value of Re.1 per year for
25 years at 10% 9.077
Present value of Rs. 921000 annual
Payment for 25 years(Rs. 921000
X 9.0777) 8360000

Since Rs. 8360000 is approximately equal to the investment of Rs 8485000, the rate of
return is approximately 10 percent.

The revenue from the investment from lakeside viewpoint was the profit expected to be
derived from sales of petrol and food less the additional rental based on sales volume.
Past experience with similar projects had shown the profit ratios and operating costs that
might be expected. Mr. Burman applied these estimate to traffics forecasts supplied by
the SRTC. Theses forecasts indicated that lakeside could conservatively expect to sell an
average of 4,00,00,000 gallons of motor fuel per year. He thus calculated average annual
income after taxes to be Rs. 9,21,000.
Mr. Burman then calculated the discount factor, which made this stream of earnings over
25 years equal the original investment. This was approximately 10% and therefore he
calculated that the project had a rate of return of 10%.

On the basis of some informal discussion, Mr. Burman gathered the impression that at
least one or two members of the capital investment committee would approve this
method of treating the investment costs and rate of return calculations.

However before my formal action could be taken on the matter an unexpected problem
arose. In the original plan the SRTC intended to borrow the funds needed for the
construction of the property from the bank using the long-term lease from lakeside as
security. In December however the SRTC legal counsel ruled that such a loan would be
illegal. Under the relevant legislation the SRTC had been setup as a special corporation
wholly owned by the state. The legislation clearly defined limits on the type and amount
Of the fund the SRTC could borrow. In December 1970 the top limit on bank loan had
been reached and a further extension of credit was therefore not possible.

Mr. Burman thereupon conceived the idea of creating a special corporation that would act
as an arms length intermediary thereby over coming the legal restriction on financing.
This corporation temporarily called X company would lease the properties directly from
the SRTC and immediately sub lease as security. X Company would borrow the funds
needed, which it could then advance to the SRTC. The money would be borrowed by X
company from the bank under exactly the same condition as had been previously
arranged for the SRTC. Two separate loans, for Rs. 10000000 and for Rs. 2000000 each
at 6% were to be made. The former would be repaid over each of the next 25 years
including interest by equal annual payment of Rs. 782300 the latter would similarly be
repaid over each of the next 5 years by equal payments of Rs. 474800. lakeside would
pay exactly the same annual rent as previously arranged, but in this case payments would
be made to X company instead of to the SRTC.
The only change, which Mr. Burman made in a new study, which is summarized in
Exhibit-2, was to use a different discount rate in calculating the present value of the lease.
In his opinion all other costs were identical with those in his original study. He used a
rate of 3 percent because this was the after-tax cost of this particular piece of credit. The
use of this new rate changed the total investment cost to Rs. 80,54,800, and subsequently
resulted in a higher rate of return i.e. 10.5 percent.

However, when this report was submitted to the capital investment committee, it was
rejected. In particular, the committee did not accept Mr. Burman’s figure for the cost of
the investment. Its argument was that as X company was a wholly owned subsidiary its
borrowing placed just as much of a strain on Lakeside’s credit as borrowing made by
Lakeside itself. Thus, the investment should be Rs. 1,20,00,000 the face value of the loan.
On such an investment the indicated rate of return was only 5.5 percent as shown in
Exhibit-3. The committee felt that this was too low a return, and they therefore,
recommend rejection of the scheme.

Exhibit-2
Summary of Mr. Burman’s Second Appraisal
Capital Investment Rs.
Annual flat rental Rs.7,82,300
(Amortizes Rs. 1,00,00,000 6% bank
loan over 25 years)
Capitalized at 3% and after taxes of 50%
On the rental (7,83,300 x 17.413 x 50%) 68,19,800
Annual supplement rental Rs. 4,74,800
( Amortizes Rs. 20,00,000 6% bank loan over
5 years) capitalized at 3% and after taxes at
50% ( 4,74,800 x 4570 x 50%) 10,85,000
Equipment and fittings 1,50,000
Total Capital Investment 80,54,800

After-Tax Income for Appraisal Purposes

( as calculated in Exhibit-1) 9,21,000
Calculation of Rate of Return
Present value of Re. 1 per year for 25 years at 10%
Present value of Rs. 9,21,000 annual payments
For 25 years (9,21,000 x 8.75) 80,58,000

Since Rs. 80,58,700 is approximately equal to the investment of Rs. 72,36,000, the
rate of return is approximately 10.5 percent.

Exhibit-3’
Capital Investment Committee’s Appraisal

Capital Investment Rs.

 X company’s Rs. 1,00,00,000 Laon at 6% 1,00,00,000
X company’s Rs. 20,00,000 loan at 5% 20,00,000

Equipment & Fittings 1,50,000

-----------------
Total Investment 1,21,50,000
-------------------
Calculation of Rate of Return
Present value of Re. 1 per year at 5.5% 13.15

Present value of Rs, 9.21,000 annual payments

For 25 years (9,21,000 x 13.15) 1,21,11,000

In this memorandum, asking for a reconsideration of this decision Mr. Burman disagreed
With the attitude expressed by the committee members and explained his viewpoint as
follows:

“I reasoned that under this financing agreement the proper measure of the effect upon
lakeside credit would be the present value of lakeside 25 flat annual after tax rental
payments discounted at either”

8 percent the weighted after tax cost of capital to lakeside

2.25 percent the after tax cost of long term borrowing to lakeside

3 percent the after tax cost of this specific piece of lakeside credit.

“I chose the 3 percent rate as being the most logical in the belief that respective
lenders evaluate the effect of long term lease commitment on our credit at
something less than the long term borrowing rate. I do not agree that lakeside
investment under such circumstances the face value of X company debts. It seems to
me that such an evaluation departs completely from the discounted cash flow
appraisal technique officially recognized by lakeside on May 4, 1964”.

“None the less I shall of course defer to the judgment of the investment committee”.

Mr. Kardar considered this memorandum carefully. More and more of the company’s
investment were taking the form of leases. It was important that there should not be such
wide difference of opinion among the senior executives of the company on such a basic
matter. He wondered what position he should take at the following days meeting of the
capital investment committee.

Questions:

1. Which of the analysis if any shows the correct rate of return for the proposed
project?
2. If none of the analysis given in the case is correct what is the correct rate of return
on the proposed project?
3. What will be your decision on the acceptance/rejection of the proposed project?

The 8 percent figure for the weighted after tax cost of capital included the cost of equity.
The latter item was considered higher than that of debt