FINANCIAL MANAGEMENT

COST OF CAPITAL
QUESTIONS

Question 1

Mr. snookums had purchased a share of puppies Limited for ` 1,000. He received
dividend for a period of five years at the rate of 10 percent. At the end of the fifth
year, he sold the share of puppies Limited for ` 1,128. You are required to compute
the cost of equity as per realised yield approach.

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Question 2

Pookie Ltd. has the following capital structure which is considered to be optimum
as on 31st March, 2017.
`
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ` 23.60. Next year dividend per share is
50% of year 2017 EPS. The following is the trend of EPS for the preceding 10 years
which is expected to continue in future.
Year EPS (`) Year EPS (`)
2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
The company issued new debentures carrying 16% rate of interest and the current
market price of debenture is ` 96.
Preference share ` 9.20 (with annual dividend of ` 1.1 per share) were also issued.
The company is in 50% tax bracket.
A. Calculate after tax:
i. Cost of new debt
ii. Cost of new preference shares
iii. -New equity share (consuming new equity from retained earnings)
B. Calculate marginal cost of capital when no new shares are issued.
C. How much can be spent for capital investment before new ordinary shares
must be sold. Assuming that retained earnings for next year’s investment are
50 percent of 2017.
D. What will the marginal cost of capital when the funds exceeds the amount
calculated in (C), assuming new equity is issued at ` 20 per share?

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Question 3

Determine the cost of capital of pookums Limited using the book value (BV) and
market value (MV) weights from the following information:
Book Value Market
Sources
(`) Value(`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000

Additional information :
i. Equity : Equity shares are quoted at ` 130 per share and a new issue priced at
` 125 per share will be fully subscribed; flotation costs will be ` 5 per share.
ii. Dividend : During the previous 5 years, dividends have steadily increased
from ` 10.60 to ` 14.19 per share. Dividend at the end of the current year is
expected to be ` 15 per share.
iii. Preference shares : 15% Preference shares with face value of ` 100 would
realise` 105 per share.
iv. Debentures : The company proposes to issue 11-year 15% debentures but
the yield on debentures of similar maturity and risk class is 16% ;
flotation cost is 2%.
v. Tax : Corporate tax rate is 35%. Ignore dividend tax.

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Question 4

The snuggles Ltd. has following capital structure at 31st December 2015,
which is considered to be optimum:
(`)
13% Debenture 3,60,000
11% Preference share capital 1,20,000
Equity share capital (2,00,000 shares) 19,20,000
The company’s share has a current market price of `27.75 per share. The expected
dividend per share in next year is 50 percent of the 2015 EPS. The EPS of last 10
years is as follows. The past trends are expected to continue:
Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
EPS(`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14 percent new debenture. The company’s debenture is
currently selling at ` 98. The new preference issue can be sold at a net price of
` 9.80, paying a dividend of ` 1.20 per share. The company’s marginal tax rate is
50%.
i. Calculate the after tax cost (a) of new debts and new preference share capital,
(b) of ordinary equity, assuming new equity comes from retained earnings.
ii. Calculate the marginal cost of capital.
iii. How much can be spent for capital investment before new ordinary share
must be sold? (Assuming that retained earnings available for next year’s
investment is 50% of 2015 earnings.)
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 ordinary shares to
net ` 20 per share ? The cost of debt and of preference capital is constant.

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Question 5

You are analysing the beta for snowflakes Computers Ltd. and have divided the
company into four broad business groups, with market values and betas for each
group.
Business group Market value of equity Unleveraged beta
Main frames ` 100 billion 1.10
Personal Computers ` 100 billion 1.50
Software ` 50 billion 2.00
Printers ` 150 billion 1.00
Snowflakes Computers Ltd. had ` 50 billion in debt outstanding.
Required:
i. Estimate the beta for snowflakes Computers Ltd. as a Company. Is this beta
going to be equal to the beta estimated by regressing past returns on
snowflakes Computers stock against a market index. Why or why not?
[Part (i) is out of syllabus and this topic is covered in Final Level paper]

ii. If the treasury bond rate is 7.5%, estimate the cost of equity for
snowflakes Computers Ltd. Estimate the cost of equity for each division.
Which cost of equity would you use to value the printer division? The
average market risk premium is 8.5%.

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Question 6

Snow white Ltd. has furnished the following information :

- Earning Per Share (EPS) `4
- Dividend payout ratio 25%
- Market price per share ` 50
- Rate of tax 30%
- Growth rate of dividend 10%
The company wants to raise additional capital of ` 10 lakhs including debt of
` 4 lakhs. The cost of debt (before tax) is 10% up to ` 2 lakhs and 15% beyond
that. Compute the after tax cost of equity and debt and also weighted average cost
of capital.

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Question 7

The following projections were made by little heartsEnterprises Ltd. for the year
2003-04:
Increase in retained earnings Rs.25 lakh
Increase in assets Rs.75 lakh
Increase in spontaneous liabilities Rs.30 lakh
The amount of external funds required by the firm, on the basis of the above
projections, is?

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Question 8

The following information is given with respect to sunshine Ltd.

Current dividend = Rs.2.00 per share
Constant rate of growth in dividends = 5 percent
Expected return from the market index = 12 percent
Beta of the stock = 1.50
Risk free rate of return = 6 percent
The present market price per share will be approximately equal to….?

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Question 9

AJ’amore Company wants to raise additional finance of ` 5 crore in the next

year. The companyexpects 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 isexpected 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 .

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