Chapter 3 Cost Of Capital

Cost Of Capital
Solution 4:
Particulars Year 1 (₹) Year 2 (₹) Year 3 (₹) Year 4 (₹)
Principal Outstanding 20,000 15,000 10,000 5,000
Principal repaid 5,000 5,000 5,000 5,000
Add: Interest at 12.5% p.a. on Principal
Outstanding = Coupon Payment 2,500 1,875 1,250 625
Total Cash Flows p.a. (A) 7,500 6,875 6,250 5,625
𝑛
(1 + 0. 12) where n = nth year (B) 1.1200 1.2544 1.4049 1.5735
PV of Cash Flows (A)/(B) 6,696 54,811 4,448 3,575
Hence, Present value of Bond = Total of PV of Cash Flows = ₹ 20,200

Solution 5:
The amount of interest for five years will be:
First year ₹ 5,000 × 0.08 = ₹ 400;
Second year (₹ 5,000 – ₹ 1,000) × 0.08 = ₹ 320;
Third year (₹ 4,000 – ₹ 1,000) × 0.08 = ₹ 240;
Fourth year (₹ 3,000 – ₹ 1,000) × 0.08 = ₹ 160; and
Fifth year (₹ 2,000 – ₹ 1,000) × 0.08 = ₹ 80.
The outstanding amount of bond will be zero at the end of fifth year.
Since Reserve Bank of India will have to return ₹ 1,000 every year, the outflows every year will consist of
interest payment and repayment of principal:
First year ₹ 1,000 + ₹ 400 = ₹ 1,400;
Second year ₹ 1,000 + ₹ 320 = ₹ 1320;
Third year ₹ 1,000 + ₹ 240 = ₹ 1,240;
Fourth year ₹ 1000 + ₹ 160 = ₹ 1,160; and
Fifth year ₹ 1000 + ₹ 80 = ₹ 1080.

V8 = 1,400/(1.06)1 + 1,320/(1.06)2 + 1,240/(1.06)3 + 1,160/(1.06)4 + 1,080/(1.06)5

= 1,400 × 0.943 + 1,320 × 0.890 + 1,240 × 0.840 + 1,160 × 0.792 + 1,080 × 0.747
= 1,320.20 + 1,174.80 + 1,041.60 + 918.72 + 806.76
= ₹ 5,262.08

Solution 26:
𝐷1 ₹17.716
1. Cost of Equity (K ) = 𝑃𝑜−𝐹 + 𝑔 = ₹125−₹5
+ 0. 10 *

Ke = 0.2476
*Calculation of g:
₹ 10 (1+g)5 = ₹ 16.105
16.105
Or, (1+g)5 = 10
= 1.6105
Table (FVIF) suggests that ₹ 1 compounds to ₹ 1.6105 in 5 years at the compound rate of 10
percent. Therefore, g is 10 per cent.

𝐷1 ₹17.716
(ii) Cost of Retained Earnings (K ) = 𝑃𝑜
+g = 125
+ 0.10 = 0.2417

𝑃𝐷 ₹15
(iii) Cost of Preference Shares (Kp) = 𝑃𝑜
= ₹105 =0.1429

(iv) Cost of Debentures (Kd) =

𝐼(1−𝑡)+ ( 𝑅𝑉−𝑁𝑃
𝑛 )
( 𝑅𝑉 +𝑁𝑃
2 )

=
₹15(1−0.30)+ (₹100−₹91.75*
11 𝑦𝑒𝑎𝑟𝑠 )
₹100+₹91.75
2

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 Chapter 3 Cost Of Capital

₹15×0.70+ ₹0.75 ₹11.25

= ₹95.875
= ₹95.875
= 0.1173

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer
debentures at discount.

Market price of debentures (approximation method)

= ₹ 15 ÷ 0.16 = ₹ 93.75
Sale proceeds from debentures = ₹ 93.75 – ₹ 2 (i.e., floatation cost) = ₹91.75
Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11 years)
P0 = ₹ 15 × 5.0287 + ₹ 100 × 0.1954

P0 = ₹ 75.4305 + ₹ 19.54 = ₹ 94.9705

Net Proceeds = ₹ 94.9705 – 2% of ₹ 100 = ₹ 92.9705
Accordingly, the cost of debt can be calculated

Total Cost of capital [BV weights and MV weights]

(Amount in (₹) lakh)
Weights Specific Total cost

Source of capital BV MV Cost (K) (BV × K) (MV × K)

Equity Shares 240 320** 0.2476 59.4240 79.2320
Retained Earnings 60 80** 0.2417 14.502 19.336
Preference Shares 72 67.50 0.1429 10.2888 9.6458
Debentures 18 20.80 0.1173 2.1114 2.4398
Total 390 488.30 86.3262 110.6536

**Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings i.e.,
240:60 or 4:1.
Weighted Average Cost of Capital (WACC):

₹86.3262
Using Book Value = ₹390
= 0.2213 or 22.13%

₹110.6536
Using Market Value = ₹488.30
= 0.2266 or 22.66%

Solution 28:
Statement of WACC
Source Amount Weight Cost of Capital WACC
Equity (2,00,000 × 30) ₹ 60,00,000 0.6 17.00% 10.20%
Preference Capital ₹ 10,00,000 0.10 12.00% 1.20%
Debt ₹ 30,00,000 0.30 5.40% 1.62%
Total ₹ 1,00,00,000 1.00 WACC = K0 13.02%
Working Notes:
𝐷𝑃𝑆 ₹3
(1) Revised Ke = 𝑀𝑃𝑆 + g = ₹ 30
+ 7% = 17.00%
(2) Kd = 9% × (100% – 40%) = 5.40%

Solution 31:
(a) Cost of Equity / Retained Earnings (using dividend growth model)
𝐷1
Ke = 𝑃𝑜
where D1 = Do (1 + g) = 2 (1 + .10) = 2.2

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 Chapter 3 Cost Of Capital

2.2
Ke = 44
+ 0.10 = 0.15 or 15 %
(b) Cost of Debt (Post Tax)
Kd = I (1-t)
Upto 3,60,000 Kd = .08 (1-0.4) = 0.048
Beyond 3,60,000 = .12 (1-0.4) = 0.072
Thus, post-tax cost of additional debt = 0.048 x 3,60,000 / 6,00,000 + 0.072 x 2,40,000/ 6,00,000 = 0.0288 +
0.0288 = 0.0576 or 5.76%
(c) Pattern for Raising Additional Finance
Debt = 20,00,000 x 30% = 6,00,000
Equity = 20,00,000 x 70 % = 14,00,000
Out of this total equity amount of
₹ 14,00,000 - Equity Shares = 14,00,000 – 4,20,000
= 9,80,000
And Retained Earnings = 4,20,000
(d) Overall Weighted Average after tax cost of additional finance
WACC = Kd x Debt Mix + Ke x Equity Mix
= 0.0576 x 30% + 0.15 x 70% = 0.01728 + 0.105 = 0.1223 or 12.23% (approx.)

Solution 34:
Calculation of Cost of Equity
(i) D0 = ₹ 5x 60%
D0 = ₹ 3
g = b x r = (1-0.6) x 10% = 4%

D1 = D0 x (1 + g) = 3 x (1 + 4%) = 3 x 1.04 = 3.12

𝐷1
Ke= 𝑃𝑜 + 𝑔
3.12
Ke= 20.8
+ 0. 04
Ke= 19%

(ii) Calculation of Cost of Preference Shares

N =10 years
NP = ₹ 90
PD = ₹ 15
RV = ₹ 100
𝑃𝐷+(𝑅𝑉−𝑁𝑃)/𝑁
Kp= (𝑅𝑉+𝑁𝑃) ×100
15+(100−90)/10
Kp= (100+90)/2
× 100
Kp = 16/95 x 100
Kp= 16.84%

(iii) Calculation of Cost of Debentures

N = 6 years
NP = ₹ 75
Interest = ₹ 14 RV = ₹ 100
T = 40%
𝐼𝑛𝑡(1−𝑡)+(𝑅𝑉−𝑁𝑃)/𝑁
Kd = (𝑅𝑉+𝑁𝑃)/2
× 100
14×(1−0.04)+(100−75)/6
Kd = (100+75)/2
× 100
8.4−4.17
Kd= 87.5
× 100
Kd= 14.37%

(iv) Cost of Term Loan

Kd = Interest rate (1-t) Kd = 13% (1-40%)
Kd = 7.8%

Calculation of Weighted Average Cost of Capital (WACC) (using market weights)

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 Chapter 3 Cost Of Capital

Capital Cost of Market Value Market Value Product (Cost x

Capital Weights weights)
Equity 19.00% 20.8 x 50,00,000 ₹10,40,00,000 0.6218 11.81%
Preference Shares 16.84% 90 x 50,000 ₹ 45,00,000 0.0269 0.45%
Debentures 14.37% 75 x 2,50,000 ₹ 1,87,50,000 0.1121 1.61%
Term Loan 7.80% ₹ 4,00,00,000 0.2392 1.87%
Total ₹16,72,50,000 1 15.74%
WACC= 15.74%

(b)Calculation of Marginal Cost of Capital (MACC)

The required capital of ₹ 50,000,000 will be raised as follows:
Equity = 60% of ₹ 50,000,000 = ₹ 30,000,000
Deby = 20% of ₹ 50,000,000 = ₹10,000,000
Retained Earnings= 20% of ₹ 50,000,000 = ₹ 10,000,000
3.12
Marginal Cost of Equity= 1.4 + 0. 04
= 26.28%
Marginal Cost of Debt
13% 𝑜𝑓 ₹40,00,000 + 15% 𝑜𝑓 ₹60,00,000
Cost of Debt (before tax)= ₹1,00,00,000
₹5,20,000+₹9,00,000
= ₹1,00,00,000
= 14.2%
Cost of Debt (after tax)). = 14.2% (1-t)
= 14.2% (1-0.4)
= 8.52%
Calculation of marginal cost of capital
Capital Cost of Capital Value Weights Product (Cost x
weights)
Equity 26.28% ₹ 3,00,00,000 0.6 15.77%
Reserves 26.28% ₹ 1,00,00,000 0.2 5.26%
Debt 8.52% ₹ 1,00,00,000 0.2 1.70%
Total ₹ 5,00,00,000 1 22.73%
Marginal Cost of Capital (MACC) = 22.73%

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