Financial Management Unit 5

Unit 5 Cost of Capital

Structure:
5.1 Introduction
Objectives
5.2 Meaning of Cost of Capital
5.3 Cost of Different Sources of Finance
Cost of debentures
Cost of term loans
Cost of preference capital
Cost of equity capital
Dividend forecast approach
Capital Asset Pricing Model approach
Earnings price ratio approach
Cost of retained earnings
5.4 Weighted Average Cost of Capital
Assignment of weights
5.5 Summary
5.6 Glossary
5.7 Solved Problems
5.8 Terminal Questions
5.9 Answers
5.10 Case Study

5.1 Introduction
In the last unit, we discussed about the valuation of bonds and shares. In
this unit, we will learn about the meaning of cost of capital, cost of different
sources of finance, and weighted average cost of capital. 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. We have
discussed in the previous units that all the financial 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 the future. With unplanned

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capital structure, they may also fail to economise the use of their funds and
adapt to the changing conditions.
Objectives:
After studying this unit, you should be able to:
 define cost of capital
 explain how cost of different source of finance is determined
 compute weighted average cost of capital

5.2 Meaning of Cost of Capital

Capital, like any other factor of production, involves a cost. The cost of
capital is a significant element in capital expenditure management. The cost
of capital of a company is the average cost of different components of
capital of all long-term sources of finance. Understanding the cost of capital
concept is very helpful in making investment and financing decision. A
combination of debt and equity is used to fund the activities of a company.
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 it must
earn to meet the expenses of the various categories of investors who have
made investment in the form of loans, debentures, equity, and preference
shares.
A company 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 predetermined 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 payout dividends.

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Figure 5.1 depicts the risk-return relationship of various securities.

Equity
share
Required rate of return

Preference
share

Debt

Govt bonds

Risk free
security

Risk-Return relationship of various securities

Figure 5.1: Risk-Return Relationship

The concept of cost of capital is a very important concept in financial

management decision making. Any efficient management team will take
cost of capital into consideration while taking any financial decisions. This
concept is rather relevant in the following managerial decisions:
 Capital budgeting decision
 Designing the capital/ financial structure of the firm
 Ascertaining the best method/mode of financing
 Performance of top management
 Other areas include dividend decisions, working capital policy, etc.

5.3 Cost of Different Sources of Finance

In making investment decisions, cost of different types of capital is
measured and compared. The source, which is the cheapest, is chosen and
capital is raised.
The area to be focussed on is how to measure the cost of different sources
of capital. It is based largely on forecasts and is subject to various margins
of error. While computing the cost of capital, care should be taken for factors
like needs and requirements of the company, the conditions under which it

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is raising its capital, corporate policy constraints, and level of expectations of

investors.
A company raises funds from different sources, and therefore, composite
cost of capital can be determined after specific cost of each type of fund has
been obtained. It is, therefore, necessary to determine the specific cost of
each source in order to determine the minimum obligation of a company,
i.e., composite cost of raising capital.
In order to determine the composite cost of capital, the specific costs of
different sources of raising funds are calculated. The weighted arithmetic
average of the cost of different financial resources that a company uses is
termed as its cost of capital.
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.
I (1  T )  F  P  / n
Kd=
(F  P ) / 2

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

Solved Problem – 1
Lakshmi Enterprise wants to have an issue of non-convertible
debentures (NCD) for Rs. 10 crore. 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?

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Solution:
I(1 T )  ( F  P ) / n
Kd 
(F  P ) / 2
15 (1 0.5 )  (105  97 ) / 8

(105  97 ) / 2
7 .5  1

101
 0.084 0 r 8.4%

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 predetermined 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 tax
deductible.
Kt = I (1—T)
Where I is interest rate,
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%

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)

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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

Solved Problem – 3
C2C Ltd. has recently come out with a preference share issue to the tune
of Rs. 100 lakh. 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:
D  ( F  P ) / n
Kp 
(F  P ) / 2

12  (104  98 ) / 10 12.6
 
(104  98 ) / 2 101

Kp = 0.1247 or 12.47%
The cost of preference capital now will be 12.47%

5.3.4 Cost of equity capital

Equity shareholders, unlike preference shareholders, do not have a fixed
rate of return on their investment. There is no binding legal requirement
(unlike in the case of loans or debentures where the rates are governed by
the deed) to pay regular dividends to them. Measuring the rate of return to
equity holders is always a difficult and complex exercise.
There are many approaches for estimating return – the dividend forecast
approach, capital asset pricing approach, realised yield approach,
earnings – price ratio approach, and bond yield plus risk premium approach.
We will have a brief look at some of these models in the following pages.
5.3.4.1 Dividend forecast approach
According to dividend forecast approach, the intrinsic value of an equity
share is the sum of present values of dividends associated with it.

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

have a constant growth or sometimes have supernormal growth periods.
Hence, it is not possible to arrive at the price per equity share on the basis
of forecast of future streams of dividends.
The following is a simplified equation that arrives at the rate of return
required by the equity shareholders.
Ke = (D1/Pe) + g
This equation is modified from the equation, Pe= {D1/Ke-g}. This equation is
arrived at with the assumption that there is a constant growth in dividends.
If the current market price of the share is given (Pe), and the values of
D1 and ‘g’ are known, the equation is then rewritten as Ke = (D1/Pe) + g
5.3.4.2 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 rate of return on market portfolio
Beta (β) of a security is a measure of a stock's volatility in relation to the
market. By definition, the market has a beta of 1.0, and individual stocks are
ranked according to how much they deviate from the market. A stock that
swings more than the market over time has a beta above 1.0. If a stock
moves less than the market, the stock's beta is less than 1.0. High-beta
stocks are supposed to be riskier but provide a potential for higher returns.
Low-beta stocks pose less risk but also lower returns.
Beta is a key component for the Capital Asset Pricing Model (CAPM), which
is used to calculate cost of equity. We know that the cost of
capital represents the discount rate used to arrive at the present value of a
company's future cash flows. All things being equal, the higher a company's
beta, the higher its cost of capital discount rate. The higher the discount
rate, the lower the present value placed on the company's future cash flows.
In short, beta can impact a company's share valuation.

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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.

Solved Problem – 4
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%

5.3.4.3 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 for the next year
P = current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).
This ratio assumes that the EPS will remain constant from the next year
onwards.
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

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appreciation. Dividends enhance the market value of shares and therefore,

equity capital is not free of cost.

Solved Problem – 5
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%

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
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 and return the funds earned to their
owners. 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
shareholder’s expected return from the firm’s ordinary shares. So,
Kr = Ke
The cost of retained earnings is always less than the cost of new issue of
ordinary shares due to absence of floating costs.
Some regard that cost of retained earnings is nil but it is not so. Retained
earnings also have opportunity cost which can be computed.

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If the entire earning is not distributed and the firm retains a part, then these
retained earnings are available within the firm. Companies are not required
to pay any dividend on retained earnings. It is generally observed that this
source of finance is cost free, but it is not true. If earnings were not retained,
they would have been paid out to the ordinary shareholders as dividend.
This dividend forgone by the equity shareholders is opportunity cost. The
firm is required to earn on retained earnings, at least equal to the rate that
would have been earned by the shareholders, if they were distributed to
them. So the cost of retained earnings may be defined as opportunity cost in
terms of dividends forgone by withholding from the equity shareholders.
This can be expressed as:

Where, Kr = Cost of retained earnings

Ti = Marginal income tax rate applicable to an individual
T0 = Capital gain tax
D = Dividends per share
P = Price of share
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. This need not be incurred if
retained earnings are utilised towards funding activities.
Cost of external equity comes into picture when the floatation costs arise in
the process of raising equity from the market. It is the rate of return that the
company must earn on the net funds raised in order to satisfy the equity
holder’s demand for return.

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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 percentage of current market price
The following formula can be used as an approximation:
Ke = Ke/(1—f)
Where Ke is the cost of external equity
Ke is the rate of return required by equity holders
f is the floatation cost
This formula can be used for all other approaches for which there is no
particular method for accounting for the floatation costs.

Solved Problem – 6
Alpha Ltd. requires Rs. 400 crore to expand its activities in the southern
zone of India. The company’s CFO is planning to get Rs. 250 crore
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 crore. The equity investor’s 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
Ke = 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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Key Point
Dividends cannot be accurately forecasted as they might sometimes
become nil or have a constant growth or sometimes have supernormal
growth periods.

Activity 1:
Make a list of companies which have declared dividends and/or bonus
shares in the last 3 years.
Refer: websites

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 to 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
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: Add these weighted costs, as calculated in Step III, to determine
the WACC as given below:
WACC = W e Ke + W r Kr + W p Kp + W d Kd + W t 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
 Adoption of finance planned for capital budget for the next period

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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.

Solved Problem – 7
Table 5.1 depicts the capital structure of Prakash Packers Ltd.
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: 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%

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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%
Step II: 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 – 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
Solution:
Table 5.2 depicts the calculated WACC.
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%.

Solved Problem – 9
Manikyam Plastics Ltd. wants to enter into the arena of plastic moulds
next year for which it requires Rs. 20 crore 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. 4 crore as profits by the end of the
year after which it will retain 50% and payoff rest to the shareholders.
 The debt will be raised equally from two sources - loans from IOB
costing 14% and from the IDBI costing 15%.

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 The current market price per equity share is Rs. 24 and hence the
dividend payout one year 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%

Table 5.3 depicts the computation of weighted marginal cost of capital.

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%

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 at 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 competitor’s 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 shareholder’s
interests in mind.
Alternative 1: Increase the dividend growth rate to 7% and lower
Ke to 15%

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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 to14%
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.

Self Assessment Questions

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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5.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 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 (owner’s 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.
 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 Glossary
Cost of debenture: The discount rate which equates the net proceeds from
issue of debentures to the expected cash outflows.

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Term loans: Loans taken from banks or financial institutions for a specified
number of years at a predetermined interest rate.

5.7 Solved Problems

11. Deepak Steel has issued non-convertible debentures for Rs. 5 crore.
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:
I(1 T )  ( F  P ) / n
Kd 
(F  P ) / 2
14 (1 0.4 )  (105  97 ) / 7 8.4  1.14
 = 0.094 or 9.4%
(105  97 ) / 2 101
12. Supersonic industries Ltd. has entered into an agreement with Indian
Overseas Bank for a loan of Rs. 10 crore 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 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:
D  ( F  P ) / n
Kp 
(F  P ) / 2
(110  97 ) / 8  9  .1.625
9   10.27%
(110  97 ) / 2 103.5

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Financial Management Unit 5

5.8 Terminal Questions

1. The following data is available in respect of a XYZ company. The market
value of Equity is Rs. 10 lakh and the cost of equity is 18%. The market
value of debt is Rs. 5 lakh and cost of debt is 13%. Calculate the
weighted average cost of funds as weights assuming tax rate as 40%.
2. Table 5.4 depicts the capital structure of Bharat chemicals.
Table 5.4: Capital Structure

Rs. 10 face value equity shares Rs. 400000

Term loan at 13% Rs.150000
9% Preference shares of Rs. 100, currently traded at Rs. Rs. 100000
95 with 6 years maturity period
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 lakh and equity is Rs. 60
lakh. 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 with face value
of Rs. 100 each and retains Rs. 96 per share. The debentures are
redeemable after 9 years at a premium of 4% and taxes applicable are
40%. What is the cost of debt if the coupon interest is 12%?

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5.9 Answers

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

Terminal Questions
1. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Ans. = 14.57%
2. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
3. Hint: Use the equation
WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Ans. = 8.97%

4. Hint: Apply the formula Kp  D 

( F  P ) / n
F P ) / 2

I (1  T )  ( F  P) / n
5. Hint: Apply the formula Kd 
( F  P) / 2
Ans. = 8.09%

5.10 Case Study: Sources of Finance

Sources of Finance
KARE Ltd. is a healthcare concern that was established in 1993. It was
founded with the aim of manufacturing life-saving immuno-biologicals which
were in shortage in the country and imported at high prices. Thereafter,
several life-saving biologicals were manufactured in abundance at prices
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Financial Management Unit 5

affordable to common man. As a result, the country was made self-sufficient

for Tetanus, Anti-toxin, and Anti-snake Venom serum followed by DTP
(Diphtheria, Tetanus, and Pertussis) group of Vaccines and then later on
MMR (Measles, Mumps, and Rubella) group of vaccines.

The company has recently set up KARE Park in Special Economic Zone
(SEZ). The Park is adjoining the company’s existing manufacturing unit and
is a sector-specific SEZ meant for biotechnology and pharmaceutical
products. The SEZ will allow the company to avail various tax benefits such
as income tax, import duty on capital goods, etc. This has encouraged a lot
of foreign companies to partner with KARE to avail and share these
benefits.

The company’s financial data is given below:

Sources of Funds:
Shareholder’s funds:
Fully paid-up equity share capital 300
Reserves and Surplus 600 900
Loan funds:
Secured Loans:
12% non-convertible debentures 400
14% term loan from IDBI 528
Working Capital loan from IOB 150 1,078
Unsecured Loans:
Fixed Deposits 50 50
2,028
Application of Funds:
Fixed Assets (net) 1,250
Investments 250
Current assets – loans and advances 750
(-) current liabilities and provisions 350 400
Miscellaneous expenditures and losses 128
2,028

The following information is also provided:

1. The equity share capital consists of 30 lakh equity shares with par value
Rs. 10. The market value of the equity capital is Rs. 450 lakh. Hence, the

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Financial Management Unit 5

dividend per share expected a year is Rs. 1.50 per share. The dividends
are expected to grow at a rate of 5% per annum.
2. 12% non-convertible debentures consist of 4 lakh debentures which
were issued at par (Rs.100). The issue cost was Rs.28 lakh. The
difference between the redemption price and the net amount realised
after issue will be written off evenly over the life of the debentures; it is
assumed that the amount so written off will be a tax-deductible expense.
The debentures will be redeemed after 10 years at a premium of 3%.
The market value of the debenture capital is Rs. 384 lakh.
3. The market value of the term loan can be considered equal to its book
value.
4. The tax rate of the company is 35%.
Discussion Questions:
1. Is equity capital free of cost? What is your view on that? Draw references
from the above example.
(Hint: Refer to cost of capital)
2 Calculate the cost of different long-term sources of finance employed by
KARE Ltd.
(Hint: Refer to cost of sources of finance)
3. Calculate the WACC using the market values of the long-term sources of
finance as weights.
(Hint: Refer to WACC)
4. Which factors, according to you, affect the WACC?
(Hint: Refer to WACC)
5. What is the use of calculating WACC? Explain and justify your answer.
You may draw inference from the example case above.
(Hint: Refer to WACC)
Source: www.moneycontrol.com

Reference:
 Pandey I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
E-Reference:
 www.moneycontrol.com retrieved on 12/12/2011

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