Financial Management related

1. Cost of Capital

2. Cost of Capital
 Also called discount rate, interest rate, cut off rate, hurdle rate, target rate
etc
 For financing its operation , a firm can raise funds by using debt, preference
shares, equity shares for these interest, dividend should be paid for utilising
this source
 “it is the minimum rate of return which a firm requires as a condition for
undertaking an investment.

3. Cost of debt
 Returns expected by the potential investors of debt securities of a firm
 As level of interest rate increases cost of debt increases
 As the default risk increases cost of debt increases
 Tax advantage : after tax cost of debt is lower than pre tax cost

4. Cost of Irredeemable debt
 Not redeemed during the life time of the firm
 Interest payable on such debt is cost of irredeemable debt
A. Cost of debt before tax (Kdb) = Interest /Net Proceeds
Interest calculated on the face value not on issue price
NP at par= Face value- Issue expenses
NP at premium = Face value +Securities premuim- Issue expenses
NP at discount =Face value- Discount - Issue expenses

5.  Cost of irredeemable debt after tax (Kda) = Interest- Tax savings /Net
Proceeds
Or Kda= Kdb(1- tax rate)
 Sakthi Ltd issued 20,000 8% debentures of Rs 100 each on 1st April 2009. The
cost of issue was Rs 50,000. Tax rate is 35%. Determine the cost of debentures
(before and after tax) if they were issued
At par
At premium (10%
At discount (10%
 (Issued at par) :Janaki Ltd., issued 12,000 10% Debentures of Rs.100 each a
par.
The tax rate is 50%, Calculate before tax and after tax cost of debt.

6.  Kalyan Ltd., issued 50,000 12% Debentures of Rs.100 each at par. The tax rate
is 40%. Calculate cost of debt before tax and after tax.
 (Issued at premium): Vikram Ltd. issued Rs.3,00,000 8% Debentures at a
premium
of 10%. The flotation costs ( issue expenses) are 2%. The tax rate is 50%. You
are
required to ascertain cost of debt before tax and after tax
 Ganesh Ltd. issued 2,000 9% Debentures of Rs. 100 each at a premium of 10%.
The issue expenses are 3 %. The tax rate is 40 % . Calculate cost of debt
before tax and after tax.

7. Cost of Redeemable debt
 Repayable after a stipulated period
Cost of debt before tax (Kdb)
= Annual cost before tax/Average value of debt
Cost of debt after tax (Kda)
=Annual cost –Tax savings /Average value of debt
Or
Kdb(1-tax rate)

8. Annual cost before tax
Rs
Interest on debt
Add : Issue expenses, amortised p.a
Add: Discount on issue, amortised p.a
Add: Premium on redemption of debt, amortised p.a (in case
redeemed at premium)
- Premium on issue of debt, amortised p.a (in case issue at premium)
Annual cost before tax
*Issue expenses are to be calculated at face value or issue price
whichever is higher

9. Average Value of Debt
 Average value of debt = Net proceeds+ Redemption value /2
 Here net proceeds = Gross proceeds – Cost of issue

10.  Kinely ltd issued 50,000, 10% debentures of Rs 100 each, redeemable in 10
years time at 10% premium .The cost of issue was 2.5%.The company’s tax
rate is 35%. Determine the cost of debt( before as well as after tax) if they
were issued
At par
At premium of 5%
At discount of 10%
 A firm issues debentures of Rs 1,00,000 and realises Rs 98,000 after allowing
2% commission to brokers. Debentures carry interest rate of 10%. The
debentures are due for maturity at the end of 10th year at par.Calculate cost
of debt
 HW:KKL LTD issued 10% debentures of 5,00,000 and realised Rs 4,85,000 after
allowing 3% commission to brokers. The debentures are due for maturity at
the end of the 10th year. Calculate the effective cost of debt before tax

11.  Srinivas ltd issued 10,000 10%debentures at Rs 100 each. The debentures are
redeemable after 10 years at a premium of 5%. If tax rate is 50%. Calculate
cost of debt before and after tax
 Mauli Ltd issued 15,000 12% debentures of 100 each at a discount of 10%. The
debentures are redeemable after 10 years at a premium of 10%.Calculate the
cost of debt before and after tax, if tax rate is 40%

12. Cost of Preference Share Capital
 It refers to the dividend paid to preference shareholders
 Preference dividend is not tax deductible therefore there is no need for tax
adjustment in calculating the effective cost of capital
 Two types redeemable and irredeemable

13. Cost of Irredeemable preference share
capital
 Kp =Annual preference dividend/Net proceeds
 Net proceeds :
NP at par= Face value- Issue expenses
NP at premium = Face value +Securities premuim- Issue expenses
NP at discount =Face value- Discount - Issue expenses

14.  Malaiya Ltd issued 60,000 15% irredeemable preference shares of 100 each .
The issue expenses were Rs. 60,000 .Determine the cost of preference share
capital if shares are issued
a)At par
b)At premium of 10%
c)At discount of 5%
 Dinesh ltd has issued 9% 10,000 preference shares of 100 each. The issue
expenses is Rs 3/share. Find cost of preference share capital if
a)At par
b)At premium of 10%
c)At discount of 5%
 Sumo ltd issued 6000 8% preference shares of 100 each. The floating cost is Rs
10,000. Find the cost of preference share capital is
a)At par
b)At premium of 10%
c)At discount of 10%

15. Cost of Redeemable Preference share
 Kp= Annual cost/Average value of RPS
Annual Cost
Rs
Annual Preference dividend
Add: Issue expenses, amortised p.a ,discount on issue, amortised
p.a. (in case of issue at discount)
Premium on redemption amortised p.a
Less :Premium on issue amortised p.a
ANNUAL COST

16.  Computation of average value of RPS
= Net proceeds+ Redemption value/2
Net proceeds:
NP at par= Face value- Issue expenses
NP at premium = Face value +Securities premuim- Issue expenses
NP at discount =Face value- Discount - Issue expenses
Asin ltd issued 15000 12%preference shares of Rs 100,redeemable at 10%after 20
years.The floatation cost at 5%
Find Kp
At par
At premium at 5%
At discount at 10%

17.  (Issued at par, Redeemable at premium): Sadhiya Ltd., has issued 12,000
12% Preference shares of Rs.100 each. The shares are redeemable after 10 years at
a premium of 10%. Floatation costs are 4%. Calculate the effective cost of
redeemable preference share capital.
 Samyo Ltd., issued 11,000 11 % Preference shares of Rs.100 each. The shares are
redeemable after 11 years at a premium of 5%. The iSsue expenses are Rs.3 per
share. You are asked to find out the cost of redeemable preference share capital.
 (Issued at premium, Redeemable at par): JJ Ltd., issued 7,500 8% Preference
shares of Rs. 100 each at a premium of 10%. The shares are redeemable at par
after 7 and half years. The floatation costs are 5%. Compute the effective cost of
redeemable preference capital
 KKR Ltd., issued 8,800 10 % Preference shares of Rs. 100 each at a premium of
5%. The shares are redeemable at par after 8 years. The issue expenses are
4%.Calculate the cost of redeemable preference capital.
 (Issued at discount, Redeemable at par) : Bhagat Ltd., has issued 4,400
10% Preference shares of Rs.100 each at a discount of 10 %. The shares are
redeemable after 8 years and the issue expenses are 4%. Ascertain the effective
cost of preference share capital.

18. Cost of Equity Capital
 Minimum rate of return that must be earned on new equity capital financed
investment in order to keep the earnings available to the existing
shareholders of the firm
 METHOD 1:DIVIDEND YIELD METHOD
Ke= D1/NP (cost of new equity)
D1 is the expected dividend per share
Np-net proceeds per share
If floating charges there then subtract from NP
Ke= D1/MP (existing equity shares)
D1 is the expected dividend per share
MP- market price per share

19.  Ajit Ltd. has a stable income and stable dividend policy. The average annual
dividend payout is Rs. 25 per share (face value : Rs. 100). You are required to
ascertain:
(a) Cost of equity capital
(b) Cost of equity capital if the market price of the share is Rs. 150
(c) Expected market price in year 2 if cost of equity is expected to rise to20%
(d Dividend payout in year 2 if the company were to have an expected market
price of Rs. 160 per share, at the existing cost of equity

20.  ARR Ltd., issued 5,00,000 Equity shares of Rs.10 each at a premium of 10 %.
The company has been paying a dividend of 27 % regularly for the past 5
years. It is
expected to maintain the dividend in future also. You are required to
calculate:
(a) the cost of equity capital : (b) the cost of equity capital if the market
price of the share is Rs.50?

21.  METHOD 2:DIVIDEND YIELD + GROWTH METHOD
Ke= D1/NP +g(cost of new equity)
D1 is the expected dividend per share
Np-net proceeds per share
G- growth rate in dividend
If floating charges there then subtract from NP
Ke= D1/MP +g (existing equity shares)
D1 is the expected dividend per share
MP- market price per share
G- growth rate in dividend
Usually rate of growth in dividend is equal to the growth rate in EPS

22.  Allen Ltd pays a dividend of Rs 4 per share. Its shares are quoted at Rs 40
presently and investors expected a growth rate of 10% per annum
Calculate the cost of equity capital
b)Expected market price per share if anticipated growth rate is 11%
c)Market price if dividend is Rs 4, cost of capital is 16% and growth rate is 10%
 The market price of an equity share of Mills Ltd., is Rs. 120. The expected
equity dividend is Rs.2.40 per share. The shareholders anticipate a growth of
10% in dividends. You are required to Calculate the cost of equity capital
Calculate the cost of equity capital from the following particulars presented
by X ltd.The current market price of a equity share of the company is Rs. 80.
The current dividend per share is Rs.6.40. Dividends are expected to
grow@8%.

23. Cost of equity - earnings/price method
 In case of new issue of shares
Ke =EPS/Np
EPS is earning per share
Np-net proceeds per share
EPS=Profit after tax/no of equity shares
In case of existing shares
Ke =EPS/MP
EPS is earning per share
MP per share
Suitable when
a) EPS is expected to remain
constant
b) The payout is 100%
c) The firm does not use debt

24.  Kaniska Ltd wants to raise Rs 30,00,000 by issue of new equity shares. The relevant information is
given below
No of existing equity shares 50,000
Profit after tax Rs 3,00,000
Market value of existing equity shares Rs 20,00,000
a)Compute the cost of existing equity capital
b)Compute the cost of new equity capital if the shares are issued at a price of Rs 35 per share and
floatation cost is Rs 5 per share.
Nacho ltd has issued 40,000shares of 10 each fully paid. The company has erned a profit of 40,000
after tax. The market price of these shares is Rs 16. The company has paid a dividend of Re 0.80 per
share. Calculate the cost of equity on the basis of dividend yield and earnings price method

25. Cost of equity- CAPM MODEL
Risk free return 12%
Beta coefficient is 1.75
 Calculate cost of equity CAPM Model if expected market return is 15%,
 Calculate cost of equity if beta coefficient rises to 2.25
 Calculate cost of equity Beta coeeficent Falls to 1.50

26.  From the following information calculate the cost of equity under CAPM given that the beta
factor is 0.905

Year 2004 2005 2006 2007 2008 2009
Rf 0.07 0.05 0.08 0.09 0.06 0.08
Rm 0.15 0.04 0.22 0.27 0.05 0.12
Year Rf Rm
1 0.06 .14
2 0.05 .03
3 0.07 .21
4 0.08 .26
5 0.09 .03
6 0.07 .11

27. Cost of retained earnings
 No income tax or floating charges
 Therefore cost is lower
1.Cost of Equity
- tax on cost of equity
- brokerage (% on Cost of Equity and tax on cost of equity
COST OF RETAINED EARNINGS
Or
Kr= Ke(1-t)(1-b)
t- tax rate
b-brokerage

28.  In case brokerage expenses not given we can also use this formula to find Kr
 Kr=E(1-t)/MP
Here E- earnings on the retained shares
MP-market price of the retained shares

29.  The rate of return of equity shareholders in Eva ltd is 20% and the personal
tax applicable to shareholders is 22%. It is expected that the shareholders will
have to bear a brokerage cost of 3% when they invest their dividends in
alternative securities. Compute the cost of retained earnings
 A company's cost of equity capitalis 12%. The brokerage cost of purchase of
securities is 2%. The personal tax rate of shareholders is 50%. Compute Kr
 Maran holds 220 shares of 100 each in Asha Ltd.Asha ltd has earned Rs 10 per
share and distributed Rs 6 per share as dividend among shareholders and
balance is retained. The market price of the shares is Rs 110. If personal tax
rate applicable is 40%. Find Kr

30. WACC –Weighted average cost of capital
 Ko
 Average of costs of each source of fund employed by the firm, properly
weighted by the proportion they hold in the capital structure of the firm.
 Steps:
1.Calculate cost of specific sources i.e. cost of equity, debt etc
2.Multiply the cost of each source by its proportion in capital structure
3.Add the weighted components cost to get the firm WACC

31. Format
Sources of funds Amount Proportion to
total
After tax cost Weighted cost
Debt xxx W1 Kda Kda *W1
Preference share
capital
xxx W2 Kp Kp *W2
Retained earnings xxx W3 Kr Kr *W3
Equity share
capital
xxx W4 Ke Ke *W4
Total xxx WACC xxx

32.  Following information is available with regards to the capital structure of Edwards Ltd
Calculate WACC
Amount After tax cost of
capital
Debentures 12,00,000 5%
Preference share
capital
4,00,000 10%
Equity share capital 8,00,000 15%
Retained earnings 16,00,000 12%

33.  A company was recently formed to manufacture a new product. It has the
following capital structure
The market price of equity shares is Rs 80. A dividend of Rs 8 per share is
proposed. The company has marginal tax rate of 50%and shareholders individual
tax rate is 25%. Calculate WACC
9% Debentures 10,00,000
7% Preference share capital 4,00,000
Equity share capital (48,000 shares) 16,00,000
Retained earnings 10,00,000
40,00,000

34.  Excel Industrial Ltd. has assets of Rs. 1,60,000 which has been financed with Rs. 52,000 of debt
and Rs. 90,000 of equity and a general reserve of Rs. 18,000. The firm's total profits after
interest and taxes for the year ended 31st March 2007were Rs. 13,500. It pays 8% interest on
borrowed funds and is in the 50% tax bracket. It has 900 equity shares of Rs. 100 each selling at
a market price of Rs. 120
per share. What is the weighed average cost of capital?

35. The following information has been extracted from the balance sheet of Fashion
Ltd as on 31-12-94
a) Determine the weighted average cost of capital of the company. It had been
paying dividends at a consistent rate of 20% per annum
(b) What difference will it make if the current price of the Rs. 100 share is Rs.
160?
(c) Determine the effect of income tax on the cost of capital under both
premises (tax rate 40%).

36.  From the following capital structure of the company, Compute the overall cost using Book value
weights and market value weights
The after tax cost of different sources of finance is as follows:
Equity share capital -14%
Retained earnings-13%
Preference share capital-10%
Debentures-5%
Book value Market value
Equity share capital (Rs
10/share)
45,000 90,000
Retained Earnings 15,000 -
Preference share capital 10,000 10,000
Debentures 30,000 30,000