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Financial Management Unit 5 Sikkim Manipal University Page No. 87 Unit 5 Cost of Capital Structure: 5.1 Introduction Learning objectives 5.2 Design of an Ideal Capital Structure 5.3 Cost of Different Sources of Finance Cost of debentures Cost of term loans Cost of preference capital Cost of equity capital Cost of retained earnings Capital asset pricing model approach Earnings price ratio approach 5.4 Weighted Average Cost of Capital Assignment of weights 5.5 Summary 5.6 Solved Problems 5.7 Terminal Questions 5.8 Answers to SAQs and TQs 5.1 Introduction Capital structure is the mix of long-term sources of funds like debentures, loans, preference shares, equity shares and retained earnings in different ratios. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardise the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economise the use of their funds and adapt to the changing conditions.
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Page 1: Slm Unit 05 Mbf201

Financial Management Unit 5

Sikkim Manipal University Page No. 87

Unit 5 Cost of Capital

Structure:

5.1 Introduction

Learning objectives

5.2 Design of an Ideal Capital Structure

5.3 Cost of Different Sources of Finance

Cost of debentures

Cost of term loans

Cost of preference capital

Cost of equity capital

Cost of retained earnings

Capital asset pricing model approach

Earnings price ratio approach

5.4 Weighted Average Cost of Capital

Assignment of weights

5.5 Summary

5.6 Solved Problems

5.7 Terminal Questions

5.8 Answers to SAQs and TQs

5.1 Introduction

Capital structure is the mix of long-term sources of funds like debentures,

loans, preference shares, equity shares and retained earnings in different

ratios.

It is always advisable for companies to plan their capital structure. Decisions

taken by not assessing things in a correct manner may jeopardise the very

existence of the company. Firms may prosper in the short-run by not

indulging in proper planning but ultimately may face problems in future. With

unplanned capital structure, they may also fail to economise the use of their

funds and adapt to the changing conditions.

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5.1.1 Learning objectives

After studying this unit, you should be able to,

Define cost of capital.

Bring out the importance of cost of capital.

Explain how to design an ideal capital structure.

Compute Weighted Average Cost of Capital.

5.2 Design of an Ideal Capital Structure

The design of an ideal capital structure requires five factors to be

considered (see in figure 5.1)

Figure 5.1: Design of an ideal capital structure

Return

The capital structure of a company should be most advantageous. It

should generate maximum returns to the shareholders for a considerable

period of time and such returns should keep increasing.

Risk

Debt does increase equity holders‘ returns and this can be done till such

time that no risk is involved. Use of excessive debt funds may threaten

the company‘s survival.

Flexibility

The company should be able to adapt itself to situations warranting

changed circumstances with minimum cost and delay.

Capacity

The capital structure of the company should be within the debt capacity.

Debt capacity depends on the ability for funds to be generated.

Revenues earned should be sufficient enough to pay creditors‘ interests,

principal and also to shareholders to some extent.

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Control

An ideal capital structure should involve minimum risk of loss of control

to the company. Dilution of control by indulging in excessive debt

financing is undesirable.

With the above points on ideal capital structure, raising funds at the appropriate

time to finance firm‘s investment activities is an important activity of the Finance

Manager. Golden opportunities may be lost for delaying decisions to this effect.

A combination of debt and equity is used to fund the activities. What should be the

proportion of debt and equity? This depends on the costs associated with raising

various sources of funds.

The cost of capital is the minimum rate of return of a company, which must earn to

meet the expenses of the various categories of investors who have made

investment in the form of loans, debentures and equity and preference shares.

A company now being able to meet these demands may face the risk of investors

taking back their investments thus leading to bankruptcy.

Loans and debentures come with a pre-determined interest rate. Preference shares

also have a fixed rate of dividend while equity holders expect a minimum return of

dividend, based on their risk perception and the company‘s past performance in

terms of pay-out dividends.

The following graph on risk-return relationship of various securities summarises the

above discussion.

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Figure 5.2: Risk return relationship

5.3 Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section.

5.3.1 Cost of debentures

The cost of debenture is the discount rate which equates the net proceeds

from issue of debentures to the expected cash outflows.

The expected cash outflows relate to the interest and principal repayments.

Kd =

2/)PF(

n/PF)T1(I

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture,

T is the corporate tax rate,

F is the redemption price per debenture,

P is the net amount realised per debenture,

n is maturity period.

Risk free

security

Govt bonds

Debt

Preference

share

Equity

share

Risk-Return relationship of various securities

Re

qu

ired

ra

te o

f re

turn

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5.3.2 Cost of Term Loans

Term loans are loans taken from banks or financial institutions for a

specified number of years at a pre-determined interest rate. The cost of term

loans is equal to the interest rate multiplied by 1-tax rate. The interest is

multiplied by 1-tax rate as interest on term loans is also taxed.

Kt = I (1—T)

Where I is interest,

T is tax rate

Solved Problem - 2

Yes Ltd. has taken a loan of Rs. 5000000 from Canara Bank at 9%

interest. What is the cost of term loan if the tax rate is 40%?

Solution:

Kt = I (1—T) = 9(1—0.4) = 5.4%

The cost of term loan is 5.4%

Solved Problem - 1

Lakshmi Enterprise wants to have an issue of non-convertible

debentures for Rs. 10 Cr. Each debenture is of a par value of Rs. 100

having an interest rate of 15%. Interest is payable annually and they are

redeemable after 8 years at a premium of 5%. The company is planning

to issue the NCD at a discount of 3% to help in quick subscription. If the

corporate tax rate is 50%, what is the cost of debenture to the company?

Solution

2/)PF(

n/)PF()T1(IKd

2/)97105(

8/)97105()5.01(15

101

15.7

%4.8r0084.0

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5.3.3 Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds

from preference capital issue to the dividend and principal repayments. It is

expressed as:

Kp = (D + {(F – P) / n} / ((F + P) / 2)

Where Kp is the cost of preference capital,

D is the preference dividend per share payable,

F is the redemption price,

P is the net proceeds per share,

n is the maturity period.

5.3.4 Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment.

There is no legal requirement (unlike in the case of loans or debentures

where the rates are governed by the deed) to pay regular dividends to them.

Solved Problem - 3

C2C Ltd. has recently come out with a preference share issue to the tune

of Rs. 100 lakhs. Each preference share has a face value of 100 and a

dividend of 12% payable. The shares are redeemable after 10 years at a

premium of Rs. 4 per share. The company hopes to realise Rs. 98 per

share now. Calculate the cost of preference capital.

Solution:

2/)PF(

n/)PF(DKp

2/)98104(

10/)98104(12

101

6.12

Kp = 0.1247 or 12.47%

The cost of preference capital now will be 12.47%

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Measuring the rate of return to equity holders is a difficult and complex

exercise.

There are many approaches for estimating return – the dividend forecast

approach, capital asset pricing approach, realised yield approach etc.

According to dividend forecast approach, the intrinsic value of an equity

share is the sum of present values of dividends associated with it.

Ke = (D1/Pe) + g

This equation is modified from the equation, Pe= {D1/Ke-g}.

Dividends cannot be accurately forecasted as they may sometimes be nil or

have a constant growth or sometime have supernormal growth periods.

Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a

company is not legally bound to pay dividends and also as the rate of equity

dividend is not fixed like preference dividends. This is not a correct view as

equity shareholders buy shares with the expectation of dividends and capital

appreciation. Dividends enhance the market value of shares and therefore

equity capital is not free of cost.

5.3.5 Cost of Retained Earnings

A company‘s earnings can be reinvested in full to fuel the ever-increasing

demand of company‘s fund requirements or they may be paid off to equity

holders in full or they may be partly held back and invested and partly paid

Solved Problem - 4

Suraj Metals are expected to declare a dividend of Rs. 5 per share and

the growth rate in dividends is expected to grow @ 10% p.a. The price of

one share is currently at Rs. 110 in the market. What is the cost of equity

capital to the company?

Solution

Ke = (D1/Pe) + g

= (5/110) + 0.10

= 0.1454 or 14.54%

Cost of equity capital is 14,54%

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off. These decisions are taken keeping in mind the company‘s growth

stages.

High growth companies may reinvest the entire earnings to grow more,

companies with no growth opportunities return the funds earned to their

owners and companies with constant growth invest a little and return the

rest. Shareholders of companies with high growth prospects utilising funds

for reinvestment activities have to be compensated for parting with their

earnings.

Therefore the cost of retained earnings is the same as the cost of

shareholders‘ expected return from the firm‘s ordinary shares. So,

Kr = Ke

5.3.6 Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of

a security and its systematic risks expressed as ―β‖. According to this model,

Ke = Rf + β (Rm — Rf)

Where Ke is the rate of return on share,

Rf is the risk free rate of return,

β is the beta of security,

Rm is return on market portfolio

The CAPM model is based on some assumptions, some of which are:

Investors are risk-averse.

Investors make their investment decisions on a single-period horizon.

Transaction costs are low and therefore can be ignored. This translates

to assets being bought and sold in any quantity desired. The only

considerations that matter are the price and amount of money at the

investor‘s disposal.

All investors agree on the nature of return and risk associated with each

investment.

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5.3.7 Earnings Price Ratio Approach

Under the case of earnings price ratio approach, the cost of equity can be

calculated as:

Ke = E1/P

Where E1 = expected EPS per one year

P = current market price per share

E1 is calculated by multiplying the present EPS with (1 + Growth rate).

Cost of Retained Earnings and Cost of External Equity

As we have just learnt that if retained earnings are reinvested in business for growth

activities, the shareholders expect the same amount of returns and therefore

Ke=Kr

However, it should be borne in mind by the policy makers that floating of a new

issue and people subscribing to the new issue will involve huge amounts of money

towards floating costs which need not be incurred if retained earnings are utilised

towards funding activities. From the dividend capitalisation model, the following

model can be used for calculating cost of external equity.

Ke = {D1/P0(1—f)} + g

Where, Ke is the cost of external equity,

D1 is the dividend expected at the end of year 1,

P0 is the current market price per share,

g is the constant growth rate of dividends,

f is the floatation costs as a % of current market price

The following formula can be used as an approximation:

K‘e = Ke/(1—f)

Solved Problem - 5

What is the rate of return for a company if its β is 1.5, risk free rate of

return is 8% and the market rate or return is 20%

Solution:

Ke = Rf + β (Rm — Rf)

= 0.08 + 1.5(0.2-0.08)

= 0.08 + 0.18

= 0.26 or 26%

The rate of return is 26%

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Where K‘e is the cost of external equity,

Ke is the rate of return required by equity holders,

f is the floatation cost.

5.4 Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in

the overall capital of the company. The term cost of capital refers to the

overall composite cost of capital or the weighted average cost of each

specific type of fund. The purpose of using weighted average is to consider

each component in proportion of their contribution to the total fund available.

Use of weighted average is preferable to simple average method for the

reason that firms do not procure funds equally from various sources and

Key Point

Dividends cannot be accurately forecasted as they might sometimes

become nil or have a constant growth or sometimes have supernormal

growth periods.

Solved Problem - 6

Alpha Ltd. requires Rs. 400 Cr to expand its activities in the southern

zone of India. The company‘s CFO is planning to get Rs. 250 Cr through

a fresh issue of equity shares to the general public and for the balance

amount he proposes to use ½ of the reserves which are currently to the

tune of Rs. 300 Cr. The equity investors‘ expectations of returns are

16%. The cost of procuring external equity is 4%. What is the cost of

external equity?

Solution

We know that Ke=Kr, that is Kr is 16%

Cost of external equity is

K‘e = Ke/(1—f)

0.16/(1– 0.04) = 0.1667 or 16.67%

Hence, cost of external equity is 16.67%

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therefore simple average method is not used. The following steps are

involved to calculate the WACC

Step I: Calculate the cost of each specific source of fund, that of debt,

equity, preference capital and term loans.

Step II: Determine the weights associated with each source.

Step III: Multiply the cost of each source by the appropriate weights.

Step IV: WACC = We Ke + Wr Kr + Wp Kp + Wd Kd + Wt Kt

Assignment of weights

Weights can be assigned based on any of the following methods

The book value of the sources of the funds in capital structure

Present market value of funds in the capital structure and

Adoption of finance planned for capital budget for the next period

As per the book value approach, weights assigned would be equal to each source‘s

proportion in the overall funds. The book value method is preferable. The market

value approach uses the market values of each source and the disadvantage in this

method is that these values change very frequently.

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Solved Problem -7

The capital structure of Prakash Packers ltd. is as shown in table 5.1

Table 5.1 : Capital structure in lakhs

Equity capital (Rs. 10 par value) 200

14% Preference share capital Rs. 100 each 100

Retained earnings 100

12% debentures (Rs. 100 each) 300

11% Term loan from ICICI bank 50

Total 750

The market price per equity share is Rs. 32. The company is expected to

declare a dividend per share of Rs. 2 per share and there will be a growth of

10% in the dividends for the next 5 years. The preference shares are

redeemable at a premium of Rs. 5 per share after 8 years and are currently

traded at Rs. 84 in the market. Debenture redemption will take place after 7

years at a premium of Rs.5 per debenture and their current market price Rs.90

per unit. The corporate tax rate is 40%. Calculate the WACC.

Solution

Step I is to determine the cost of each component.

Ke = ( D1/P0) + g

= (2/32) + 0.1

= 0.1625 or 16.25%

Kp = [D + {(F—P)/n}] / {F+P)/2}

= [14 + (105—84)/8] / (105+84)/2

=16.625/94.5

= 0.1759 or 17.59%

Kr = Ke which is 16.25%

Kd = [I(1—T) + {(F–P)/n}] / {F+P)/2}

= [12(1—0.4) + (105—90)/7] / (105+90)/2

= [7.2 + 2.14] / 97.5

= 0.096 or 9.6%

Kt = I(1–T)

= 0.11(1–0.4)

= 0.066 or 6.6%

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Solved Problem - 8

Johnson Cool Air Ltd would like to know the WACC. The following

information is made available to you in this regard.

The after tax cost of capital are

Cost of debt 9%

Cost of preference shares 15%

Cost of equity funds 18%

The capital structure is as follows

Debt Rs.6,00,000

Preference capital Rs. 4,00,000

Equity capital Rs. 10,00,000

Step II is to calculate the weights of each source.

We = 200/750 = 0.267

Wp = 100/750 = 0.133

Wr = 100/750 = 0.133

Wd = 300/750 = 0.4

Wt = 50/750 = 0.06

Step III Multiply the costs of various sources of finance with

corresponding weights and WACC is calculated by adding all these

components

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

= (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) +

(0.06*0.066)

= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004

= 0.1304 or 13.04%

The value of WACC is 13.04%

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Solved Problem - 9

Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds

next year for which it requires Rs. 20 Cr. to purchase new equipment.

The CFO has made available the following details based on which you

are required to compute the weighted marginal cost of capital

The amount required will be raised in equal proportions by way of

debt and equity (new issue and retained earnings put together

account for 50%)

The company expects to earn Rs.4Cr. as profits by the end of the

year after which it will retain 50% and pay-off rest to the shareholders.

The debt will be raised equally from two sources- loans from IOB

costing 14% and from the IDBI costing 15%.

The current market price per equity share is Rs.24 and the dividend

pay-out one year hence will be Rs.2.40. Tax rate is 50%

Solution

Ke =( D1/P0)

= (2.40 / 24) = 0.1 or 10%

Cost of equity Ke = cost of retained earnings

Kt = I(1 – T) [14% loan from IOB]

= 0.14(1 – 0.5) = 0.07 or 7%

Kt = I(1 – T) [15% IDBI loan]

= 0.15(1 – 0.5) = 0.075 or 7.5%

Solution

WACC is calculated from the table 5.2

Table 5.2: WACC

Fund source Amount Ratio Cost Weighted

cost

Debt Rs. 600000 0.3 0.09 0.027

Preference capital Rs. 400000 0.2 0.15 0.030

Equity capital Rs. 1000000 0.5 0.18 0.090

Total Rs. 2000000 1.0 0.147

WACC is 14.7%.

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Computation of weighted marginal cost of capital is as shown in table 5.3

Table 5.3 Weighted cost of capital

Source of funds Weights After tax cost Weighted cost

Equity capital 0.4 0.1 0.040

Retained earnings 0.1 0.1 0.010

14% loan from IOB 0.25 0.07 0.0175

15% IDBI loan 0.25 0.075 0.0188

Total 0.0863

Weighted average cost of capital 8.63%

WACC = 8.63%

Solved Problem - 10

Canara Paints has paid a dividend of 40% on its share of Rs. 10 in the

current year. The dividends are growing @ 6% p.a. The cost of equity

capital is 16%. The company‘s top Finance Managers of various zones

recently met to take stock of the competitors‘ growth and dividend

policies and came out with the following suggestions to maximise the

wealth of the shareholders. As the CFO of the company, you are

required to analyse each suggestion and take a suitable course keeping

the shareholders‘ interests in mind.

Alternative 1: Increase the dividend growth rate to 7% and lower Ke to 15%

Alternative 2: Increase the dividend growth rate to 7% and increase Ke to 17%

Alternative 3: Lower the dividend growth rate to 4% and lower Ke to 15%

Alternative 4: Lower the dividend growth rate to 4% and increase Ke to 17%

Alternative 5: increase the dividend growth rate to 7% and lower Ke to 14%

Solution

We all know that

P0 = D1/(Ke – g)

Present case = 4/(0.16-0.06) = Rs 40

Alternative 1 = 4.28/(0.15 – 0.07) = Rs. 53.5

Alternative 2 = 4.28/(0.17 – 0.07) = Rs. 42.8

Alternative 3 = 4.16/(0.15 – 0.04) = Rs. 37.8

Alternative 4 = 4.16/(0.17 – 0.04) = Rs. 32

Alternative 5 = 4.28/(0.14 – 0.07) = Rs. 61.14

Recommendation

The last alternative is likely to fetch the maximum price per equity share

thereby increasing the wealth.

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5.5 Summary

Any organisation requires funds to run its business. These funds may be

acquired from short-term or long-term sources. Long-term funds are raised

from two important sources – capital (owners‘ funds) and debt. Each of

these two has a cost factor, merits and demerits.

Having excess debt is not desirable as debt-holders attach many conditions

which may not be possible for the companies to adhere to. It is therefore

desirable to have a combination of both debt and equity which is called the

‗optimum capital structure‘. Optimum capital structure refers to the mix of

different sources of long term funds in the total capital of the company.

Cost of capital is the minimum required rate of return needed to justify the use of

capital. A company obtains resources from various sources – issue of debentures,

availing term loans from banks and financial institutions, issue of preference and

equity shares or it may even withhold a portion or complete profits earned to be

utilised for further activities.

Retained earnings are the only internal source to fund the company‘s future plans.

Weighted Average Cost of Capital is the overall cost of all sources of finance. The

debentures carry a fixed rate of interest. Interest qualifies for tax deduction in

determining tax liability. Therefore the effective cost of debt is less than the actual

interest payment made by the firm.

Self Assessment Question

Fill in the blanks:

1. ________ is the mix of long-term sources of funds like debentures,

loans, preference shares, equity shares and retained earnings in

different ratios.

2. The capital structure of the company should generate _______ to the

shareholders.

3. The capital structure of the company should be within the _____.

4. An ideal capital structure should involve _____ to the company.

5. _______ do not have a fixed rate of return on their investment.

6. According to dividend forecast approach, the intrinsic value of an equity

share is the sum of ______ associated with it.

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The cost of term loan is computed keeping in mind the tax liability. The cost

of preference share is similar to debenture interest. Unlike debenture

interest, dividends do not qualify for tax deductions.

The calculation of cost of equity is slightly different as the returns to equity

are not constant. The cost of retained earnings is the same as the cost of

equity funds.

5.6 Solved Problems

11. Deepak Steel has issued non-convertible debentures for Rs. 5 Cr.

Each debenture is of a par value of Rs. 100 carrying a coupon rate of

14%. Interest is payable annually and they are redeemable after 7

years at a premium of 5%. The company issued the NCD at a

discount of 3%. What is the cost of debenture to the company? Tax

rate is 40%.

Solution:

2/)PF(

n/)PF()T1(IKd

2/)97105(

7/)97105()4.01(14

101

14.14.8 = 0.094 or 9.4%

12. Supersonic industries Ltd. has entered into an agreement with Indian Overseas

Bank for a loan of Rs. 10 Cr with an interest rate of 10%. What is the cost of the

loan if the tax rate is 45%?

Solution:

Kt=I(1 – T) = 10(1 – 0.45) = 5.5%

13. Prime group issued preference shares with a maturity premium of

10% and a coupon rate of 9%. The shares have a face a value of

Rs. 100. and are redeemable after 8 years. The company is planning

to issue these shares at a discount of 3% now. Calculate the cost of

preference capital.

Solution :

2/)PF(

n/)PF(DKp

10.27%5.103

625.1.9

2/)97110(

8/)97110(9

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5.7 Terminal Questions

1. The following data is available in respect of a XYZ company. The market

value of Equity is Rs.10 lakhs and the cost of equity is 18%. The market

value of debt is Rs.5 lakhs, cost of debt 13%. Calculate the weighted

average cost of funds as weights assuming tax rate as 40%

2. Bharat chemicals has the following capital structure as shown in

table 5.4

Table 5.4: Capital structure

Rs. 10 face value equity shares Rs. 400000

Term loan @ 13% Rs.150000

9% Preference shares of Rs. 100, currently traded at Rs. 95 with 6 years maturity period

Rs. 100000

Total Rs. 650000

The company is expected to declare a dividend of Rs. 5 next year and the

growth rate of dividends is expected to be 8%. Equity shares are currently

traded at Rs. 27 in the market. Assume tax rate of 50%. What is WACC?

3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is Rs. 60 lakhs. The

cost of equity and debt are 15% and 12%. What is the WACC if the tax rate is 50%?

4. A company has 3 divisions – X, Y and Z. Each division has a capital structure with debt,

preference shares and equity shares in the ratio 3:4:3 respectively. The company is

planning to raise debt, preference shares and equity for all the 3 divisions together.

Further, it is planning to take a bank loan at the rate of 12% interest. The preference

shares have a face value of Rs. 100, dividend at the rate of 12%, 6 years maturity and

currently priced at Rs. 88. Calculate the cost of preference shares and debt if taxes

applicable are 45%

5. Tanishk Industries issues partially convertible debentures of face value of Rs. 100 each

and retains Rs. 96 per share. The debentures are redeemable after 9 years at a

premium of 4%, taxes applicable are 40%. What is the cost of debt if the coupon

interest is 12%

5.8 Answers to SAQs and TQs

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Answers to Self-Assessment Questions

1. Capital structure

2. Maximum returns

3. Debt capacity

4. Minimum risk of loss of control

5. Equity shareholders

6. Present values of dividends

Answers to Terminal Questions

1. Hint: Use the equation

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

Ans = 14.57%

2. Hint: Use the equation

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

3. Hint: Use the equation

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt

Ans = 8.97%

4. Hint: Apply the formula

2/)PF

n/)PF(DKp

5. Hint: Apply the formula

2/)(

/)()1(

PF

nPFTIKd

Ans 8.09%