CA INTERMEDIATE – NOV 23 ATTEMPT

FINANCIAL MANAGEMENT
SUPER REVISION (MARATHON) :- PART I
S. NO. CHAPTERS
1 COST OF CAPITAL
2 LEVERAGE
3 CAPITAL STRUCTURE
4 WORKING CAPITAL MANAGEMENT
 COST OF CAPITAL - CONCEPTS
1. Cost of Capital
It is the weighted average of cost of various sources from which capital is raised.
It is the minimum return to be earned by the company to meet the expectations of the capital
providers.
2. Cost of Irredeemable Debt
!(#$%)
Kd = × 100
'(

3. Cost of Redeemable Debt – Approximation Method

!"#$%
!(#$%))* +
&
Kd = $%'!" × 100
* ( +

4. Cost of Redeemable Debt – YTM Method

Find Kd using approximation method say x.y%
Find NPV at x% and (x + 1)%
NPV = PVCI – PVCO
= [Int.(1 – t) ´ PVAF(r,n)] + [RV ´ PVF(r,n)] – Cost today
,-./0 02%/ '(3
Kd = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

5. Cost of Redeemable Debt in instalment

Calculate cash flows of each year
Cash flow = [Interest ´ (1 – t)] + Amortized maturity amount p.a.
,-./0 02%/ '(3
Kd = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

6. YTM vs Intrinsic Value

7. Decision on basis of Intrinsic value (IV)
(A) If IV > Current price
(B) If IV < Current price

8. Convertible Debentures
Redeemable value = Higher of either cash or equity value
Value of one equity share = P0 ´ (1 + g)n
9. Cost of Irredeemable Preference Shares
(9
Kp = '( × 100

10. Cost of Redeemable Preference Shares – Approximation Method

!"#$%
(9)* +
&
Kp = $%'!" × 100
* ( +

11. Cost of Redeemable Preference Shares – YTM Method

,-./0 02%/ '(3
Kp = IRR = Lower rate + (,-./0 02%/ '(3$4567/0 82%/ '(3) × (%&'ℎ *+,- − /01 *+,-)

12. Income Statement

13. Cost of Equity – Dividend Approach
9
Ke = (: × 100

14. Cost of Equity – Earning Approach

;
Ke = (: × 100

15. Cost of Equity – Dividend Growth Approach or Constant Growth Approach or

Gordon Model
9#
Ke = (: + '

16. Cost of Equity – Earning Growth Approach

;#
Ke = (: + '

17. Cost of Equity – Capital Assets Pricing Model

Ke = Rf + (Rm – Rf)(β)
18. Cost of Equity – Realized Yield Approach
<5=5</><)?2@5%2A B25>
Return of one year = !>=/C%D/>%
&
Ke = 4(1 + 51) × (1 + 52) × (1 + 53) … … … . (1 + 5:) − 1

Or If year wise price data is not given than use YTM method

19. Cost of Retained Earnings

Kr = Ke

Kr. = Ke

In case if personal tax is given than

Kr = Ke(1 – tp)(1 – B)

20. Weighted Average Cost of Capital (WACC = Ko)

- It is the weighted average of cost of all sources taken together.
- Ko = (Ke)(We) + (Kr)(Wr) + (Kp)(Wp) + (Ke)(Wd)
- Weights can be either book value or market value.

21. Points to Remember (PTRs)

- Flotation cost are not to be considered for calculating market value weights.
 - Term loan doesn’t have any market value. If market value is required than consider its
book value to be its market value.
- We always require ex-dividend or ex-interest values.
- Ex-dividend value = Cum-dividend value – Dividend amount
- Ex-interest value = Cum-interest value – Interest amount
- Market value of an equity share represents value towards face value and reserve &
surplus.
- If Kr ≠ Ke then distribute the total market value between face value and reserve and
surplus in the ratio of their book value.

22. Weighted Marginal Cost of Capital

It is the cost of raising additional rupee of capital.
 COST OF CAPITAL QUESTIONS
Question – 1
A company issues:
• 15% convertible debentures of `100 each at par with a maturity period of 6 years. On maturity,
each debenture will be converted into 2 equity shares of the company. The risk-free rate of return
is 10%, market risk premium is 18% and beta of the company is 1.25. The company has paid
dividend of `12.76 per share. Five years ago, it paid dividend of `10 per share. Flotation cost is
5% of issue amount.
• 5% preference shares of `100 each at premium of 10%. These shares are redeemable after 10
years at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.
(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate the cost of preference shares.

Year 1 2 3 4 5 6 7 8 9 10
PVIF0.03,t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF0.05,t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA0.03,t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA0.05,t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

Solution
(i) As per CAPM, Ke = Rf + [β × (Rm – Rf)] = 10 + (18 1.25) = 32.5%
Also, let growth rate = g
Now, 10(1 + g)5 = 12.76
(1 + g)5 = 1.276
From the Interest rate table, we can say that g = 5% as for five years at 5% value is 1.276.
!"
As per Constant growth model, Ke = #$ + "
"%.'(("*+.+,)
0.325 = #+
+ 0.05
".../0
0.275 = #+
P0 = 48.72
Thus, share price today = `48.72
Redemption value will be higher of:
(a) Cash value of debenture = `100
(b) Value of equity shares = 2 48.72 (1 + 0.05)6 = 2 48.72 1.340 = `130.57
Thus, redemption value will be `130.57
 As per approximation method,
1("23)*[(5627#)÷9]
Kd = [(7#*56)÷%]
I = 15% 100 = 15 t = 0.40 RV = 130.57 NP = 100 – 5% = 95
", ("2+.<+)*[{".+.,'2/,}÷(] "<./.
Kd = [{/,*".+..'}÷%]
= ""%.'0, = 0.1324 = 13.24%

(ii) Cost of Preference Shares using YTM Method:

Preference dividend = 5% 100 = 5
Redemption value = 100 years to maturity = 10
Investment = 100 + (100 10%) – (110 6%) = `103.40
NPV at 5% = PVCI – PVCO
= PV of Preference dividend + PV of Redemption Value – Investment
= [5 × 7.722] + [100 × 0.614] – 103.40 = - `3.39
NPV at 3% = PVCI – PVCO
= PV of Preference dividend + PV of Redemption Value – Investment
= [5 × 8.530] + [100 × 0.744] – 103.40 = `13.65
7#6! "..(,
Cost of Preference (Kp) = L + &7#6 ' () − +) = 3 + &"..(,2(2.../)' (5 − 3) = 4.60%
! 27#6"

Question – 2
SK Ltd. issued 12% Bonds of face value `2,000 each, which are redeemable after 5 years. Tax rate is
30% and the bonds are amortized equally over the life of bonds. Compute the value of the bond if the
investor expects a minimum return of 8% from the bonds.

Solution
Year Principal Principal Interest Payment Net of Total Cash Flows
Outstanding Repayment Tax
1 2,000 400 2,000×12%×70% = 168 568
2 1,600 400 1,600×12%×70% = 534.40
134.4
3 1,200 400 1,200×12%×70% = 500.80
100.80
4 800 400 800×12%×70% = 67.20 467.20
5 400 400 400×12%×70% = 33.60 433.60
Value of the bond
= [568×PVF(8%,1)] + [534.40×PVF(8%,2)] + [500.80×PVF(8%,3)] + [467.20×PVF(8%,4)] +
[433.60×PVF(8%,5)]
= (568×0.926) + (533.40×0.857) + (500.80×0.816) + (467.20×0.763) + (433.60×0.713)
=`2,057.38
Question – 3
From the following information, calculate the cost of equity according to (a) Dividend price approach;
(b) Dividend price plus growth approach; (c) Earning Price Ratio approach; (d) Earning price plus
growth approach; (e) Capital assets pricing model;
1) Current market price of an equity share : `100
2) Expected earnings per share at the end of the year : `10
3) Dividend Payout ratio : 80%
4) Growth Rate : 6%
5) Rate of return on risk free investment : 8%
6) Rate of return on market portfolio : 18%
7) Volatility of securities return relative to the return of a broad based market portfolio : 1.275
Solution
(a) Dividend Price Approach
! 0+% $@ "+
Ke = ## = "++
= 8%
$

(b) Dividend Price Plus Growth Approach

! 0+% $@ "+
Ke = ## + " = "++
+ 6%= 14%
$

(c) Earning Price Approach

A "+
Ke = ## = "++= 10%
$

(d) Earning Price plus Growth Approach

A "+
Ke = ## + g = "++ + 6% = 16%
$

(e) Capital Assets Pricing Model

Ke = Rf + b ´ (Rm - Rf) = 8% + 1.275 ´ (18% - 8%) = 20.75%

Question – 4
The shares of a chemical company are selling at `20 per share. The firm had paid dividend @ `2 per
share last year. The estimated growth of the company is approximately 5% per year.
(a) Determine the cost of equity capital of the company.
(b) Determine the estimated market price of the equity share if the anticipated growth rate of the firm
(i) rises to 8%
(ii) fall to 3%
Solution
(a) Net Proceeds (P0) = `20
Next expected dividend (D1) = D0×(1+g) = 2×(1+0.05) = `2.10
!" %."+
Cost of equity (Ke) = #+ + " = %+
+ 0.05 = 0.155 = 15.50%
(b) (i) Growth rate (g) = 8% = 0.08
 !"
Ke = +"
#+
%("*+.+0)
0.155 = #$
+ 0.08
%."(
0.075 = #$
P0 = `28.80

(ii) Growth rate (g) = 3% = 0.03

!"
Ke = #+ + "
%("*+.+.)
0.155 = #$
+ 0.03
%.+(
0.125 = #$
P0 = `16.48

Question – 5
Following data relates to SK ltd.:
Year 1 2 3 4 5
Dividend per share 2.00 2.00 2.40 2.50 2.30
Price per share (at the beginning) 18.00 19.50 23.00 22.00 21.20
Calculate the cost of equity using realized yield approach.
Solution
Firstly, we have to compute the annual yield or return generated by the share over the years. For this
purpose, we will assume that share was purchased at the beginning of year 1 (as no purchase data is
provided).
!"*#" %*"/.,+
1+Y1 = #+
= "0.++
= 1.1944
!%*#% %*%..++
1+Y2 = #"
= "/.,+
= 1.2821
!.*#. %.<+*%%.++
1+Y3 = #%
= %..++
= 1.0609
!<*#< %.,+*%".%+
1+Y4 = #.
= %%.++
= 1.0772
Now we will calculate geometric mean of the above returns to calculate the cost of equity (realized
return p.a.)
Ke = [(1+Y1) × (1+Y2) × …….. × (1+Yn)](1/n) – 1
Ke = [1.1944 × 1.2821 × 1.0609 × 1.0772](1/4) – 1 = 1.15 – 1 = 0.15 = 15%

Question – 6
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of `20 and
proposes to pay 60% dividend at the current year end. With a PE ratio 6.25, it wants to offer the issue
at market price. The flotation cost is expected to be 4% of the issue price.
Required: Determine the required rate of return for equity share (cost of equity) before the issue and
after the issue.
Solution
Current market price (P0) = EPS × PE Ratio = 20 × 6.25 = `125
Rate of return (r) = 1 ÷ PE Ratio = 1 ÷ 6.25 = 16%
Retention ratio (b) = 100 – Dividend payout ratio = 100 – 60% = 40% = 0.40
Growth rate = b × r = 0.40 × 0.16 = 0.064
D0 = EPS × Dividend payout ratio = 20 × 60% = `12
D1 = D0 × (1 + g) = 12 × (1+0.064) = `12.768
Proceeds from new issue of shares = 125 – (125 × 4%) = `120

!" "%.'(0
Cost of equity before issue (ke) = #+ + " = "%,
+ 0.064 = 0.1661 = 16.61%

!" "%.'(0
Cost of equity after issue (ke) = #+ + " = "%+
+ 0.064 = 0.1704 = 17.04%

Question – 7
The capital structure of PQR Ltd. is as follows:
`
10% Debentures 3,00,000
12% Preference Shares 2,50,000
Equity Share (face value `10 per share) 5,00,000
10,50,000
Additional Information:
(i) `100 per debenture redeemable at par has 2% flotation cost & 10 years of maturity. The market
price per debenture is `110.
(ii) `100 per preference share redeemable at par has 2% flotation cost & 10 years of maturity. The
market price per preference share is `108.
(iii) Equity share has `4 flotation cost and market price per share of `25. The next year expected
dividend is `2 per share with annual growth of 5%. The firm has a practice of paying all earnings
in the form of dividends.
(iv) Corporate Income Tax rate is 30%.
Required:
Calculate weighted average cost of capital (WACC) using market value weights.
Solution
!" %
Ke = #+ + " = (%,2<) + 0.05 = 0.1452 = 14.52%
1("23)*[(5627#)÷9] "+ ("2+..+)*[{"++2(""+2%%)}÷"+] (.%%
Kd = [(7#*56)÷%]
= [{"++*(""+2%%)}÷%]
= "+../+ = 5.99%
#!*[(5627#)÷9] "%*[{"++2("+02%%)}÷"+] "".<"(
Kp = [(7#*56)÷%]
= [{"++*("+02%%)}÷%]
= "+%./% = 11.09%
 Computation of WACC (By Market Value Weights)
Source Market Value (A) Cost (B) A×B
10% Debentures .,++,+++ 5.99% 19,767
× 110 = "++
3,30,000
12% Preference Share Capital %,,+,+++ 11.09% 29,943
"++
× 108 =
2,70,000
Equity Share Capital ,,++,+++ 14.52% 1,81,500
"+
× 25 =
12,50,000
18,50,000 2,31,210
%,.",%"+
Weighted Average Cost of Capital = "0,,+,+++ × 100 = 12.498%

Question – 8
The latest Balance Sheet of SK Ltd. is given below: (`‘000)
Ordinary shares (50,000 shares) 500
Share Premium 100
Retained profits _600
1,200
8% Preference shares 400
13% Perpetual debts (Face value `100 each) _600
2,200
The ordinary shares are currently priced at `39 ex-dividend each and `25 preference share is priced
at `18 cum-dividend. The debentures are selling at 110% ex-interest and tax is paid by SK Ltd. at
40%. SK Ltd. has a beta of 0.90, risk free return is 10% & market return is 20%. Calculate the weighted
average cost of capital, (based on market value) WACC of SK Ltd.
Solution
Cost of equity (Ke) = Rf + (Rm – Rf)(β) = 10 + (20 – 10)(0.90) = 19%
Since there is no flotation cost, thus cost of retained earning (Kr) = Ke = 19%
Price of preference share ex-dividend = 18 – (25 × 8%) = 18 – 2 = `16
#CD@. !EFEGD9G %,×0%
Cost of preference shares (Kp) = #+
= "(
= 12.5%
Market price of debenture = 100 × 110% = `110
1("23) "++×".%
Cost of debt (Kd) = #+
= ""+
× 100 = 7.09%
Calculation of weighted average cost of capital
Source Market Value (`) (A) Cost (B) A×B
Equity shareholder fund 50,000×39 = 19,50,000 19% 3,70,500
Preference Share <,++,+++ 12.50% 32,000
%,
× 16 = 2,56,000
 Debentures (,++,+++ 7.09% 46,794
× 110 = 6,60,000
"++

28,66,000 4,49,294
<,</,%/<
Weighted average cost of capital = %0,(+,+++ × 100 = 15.68%

Question – 9
Following are the information of TT Ltd.:
Particulars
Earnings per share `10
Dividend per share `6
Expected growth rate in Dividend 6%
Current market price per share `120
Tax rate 30%
Requirement of Additional Finance `30 lakhs
Debt Equity Ratio (For additional finance) 2:1
Cost of Debt
0 - 5,00,000 10%
5,00,001 – 10,00,000 9%
Above 10,00,000 8%
Assuming that there is no Reserve and Surplus available in TT Ltd. You are required to:
(a) Find the pattern of finance for additional requirement
(b) Calculate post tax average cost of additional debt
(c) Calculate cost of equity
(d) Calculate the overall weighted average after tax cost of additional finance
Solution
(a) Pattern of raising capital
Debt (30,00,000 × 2/3) = `20,00,000
Equity (30,00,000 × 1/3) = `10,00,000
Equity Fund:
Equity (additional) = `10,00,000
`10,00,000
Debt Fund:
10% Debt = `5,00,000
9% Debt = `5,00,000
8% Debt = `10,00,000
`20,00,000

193DCDI3 ("23) [(,,++,+++×"+%)*(,,++,+++×/%)*("+,++,+++×0%)]("2+..+)

(b) Kd = #+
× 100 = %+,++,+++
× 100
",%%,,++
= %+,++,+++ × 100 = 6.125%

!("*J) (×("*+.+() ,..(

(c) Ke = #+
+"= "%+
+ 0.06 = "%+
+ 0.06 = 0.113 = 11.3%
(d) Weighted average cost of capital
Source Amount (`) Weight Cost of capital after tax WACC
Equity Fund 10,00,000 1/3 11.3 3.767
Debt Fund 20,00,000 2/3 6.125 4.083
Total 30,00,000 1 7.85

Question – 10
The SK Company has following capital structure at 31st March, 2021 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% of the 2021 EPS. The EPS of last 10 years is as follows. The past trends are
expected to continue:
Year 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
EPS 1.000 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14% 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%.
(a) Calculate the after tax cost (i) of a new debts and new preference share capital, (ii) of ordinary
equity assuming new equity comes from the retained earnings.
(b) Calculate the marginal cost of capital
(c) 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 are 50% of 2021 earnings.
(d) What will be marginal cost of capital {cost of fund raised in excess of the amount calculated in
part (c)} if the company can sell new ordinary shares to net `20 per share? The cost of debt and
of preference capital is constant.
Solution
Existing Capital Structure Analysis
Source of Capital Amount Ratio
Equity 19,20,000 0.80
Preference Shares 1,20,000 0.05
Debentures 3,60,000 0.15
24,00,000 1
1("23) ("<%×"++)("2+.,+)
(a) (i) Cost of new debt = Kd = #+
= /0
= 0.07143 = 7.143%
 #! ".%+
Cost of new preference shares = Kp = = = 0.12245 = 12.245%
#+ /.0+
!" %.''.×,+%
(ii) Cost of retained earnings = Kr = #+ + " = %'.',
+ 0.12 = 0.17 = 17%
%.''.
Here g = %.<'( − 1 = 0.12 = 12%
(b) Marginal Cost of Capital
Source of Capital Weight Cost WMCC
Equity 0.80 0.17 0.1360
Preference Shares 0.05 0.12245 0.0061
Debentures 0.15 0.07143 0.0107
1.00 0.1528 or
15.28%
(c) Amount of retained earnings available = 2.773 × 50% × 2,00,000 = `2,77,300
The ratio of equity in the total capital is 80%.
%,'',.++
Therefore, investment that can be done before issuing new equity shares = 0+%
= `3,46,625
!" %.''.×,+%
(d) Cost of new issue of equity shares = #+ + " = %+
+ 0.12 = 0.1893 = 18.93%
Marginal Cost of Capital
Source of Capital Weight Cost WMCC
Equity 0.80 0.1893 0.1514
Preference Shares 0.05 0.12245 0.0061
Debentures 0.15 0.07143 0.0107
1.00 0.1682 or
16.82%