Advanced Financial Management 6th semester B.

Com (NEP)

UNIT – 1

COST OF CAPITAL
Problems on Cost of Debt:
Meaning :

Cost of Debt is the rate of interest payable on debt, it is denoted by Kd

Formula to calculate cost of debt

Intrest Intrest
A. Kd = or
Principle Net Proceedings

[Note: Net Proceedings = FV + Premium - Discount - Flotation cost or Cost of issue]

Cost of Irredeemable Debentures:

Intrest
B. Kd ( before tax) =
Net Proceedings

B. Kd ( after tax) = Kd ( before tax) [1 – Tax Rate]

Cost of Redeemable Debentures:

Before Tax
1
intrest+ (Principal−Net Procedings)
A. Kd = 1
n
(Principal+Net Procedings)
2

1
intrest + (Redemption Value−Net Procedings)
B. if redeemable value is given: Kd = 1
n
(Redemption Value+Net Procedings)
2

After Tax

C. Kd ( after tax) = Kd ( before tax) [1 – Tax Rate]

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem 1

a. X Ltd, issued Re. 50000 8% debentures at par. The tax applicable is 50%.
Calculate cost of debt

b. Y Lid issued Rs.50000 8% debentures at premium of 10%. The tax rate is 60%
Calculate Ki/Kd

c. X Ltd, decided to float 8% redeemable debentures of Rs.50000 at a discount of

5% Calculate cost of debt assuming that the corporate tax is 50%

d. B Ltd, issued Rs.100000 9% debentures at a premium of 10%, the cost of

floatation is 2%, tax rate is 60% Calculate cost of Debt. [Hints: Flotation cost 2% of
FV and Premium is to be taken)

Problem 2

XYZ Company Limited decides to float 12% perpetual debentures of Rs.100 each.
The tax rate is 50%. Calculate cost of debentures.

Problem 3

Rama Company Limited has 15% irredeemable debentures of Rs 100 each for Rs
1000000 The tax rate is 35%. Determine debenture cost assuming it is issued at:

a. Face value ( At Par)

b. 10% premium

c. 10% Discount

Problem 4

A Company is willing to issue 1000, 7% debentures (irredeemable) of Rs.100 each

and for which the company will have to incur the following expenses. Find out the
cost of capital.

• Underwriting commission 1.5%

• Brokerage 0.5% printing and other expenses Rs.500

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem 5 B.Com VI Semester April 2019 (5 marks)

A Company issues 10% Debentures for Rs.200000. Rate of tax is 30%. Calculate
the cost of debt after tax, if the debentures are issues:

a. At par

b. At discount of 10%

c. At premium of 10%

Problem 6

A company Issues Rs 1000000 10% redeemable debentures at a discount of 5%.

The costs of flotation amounts to Rs.30000. The debentures are redeemable after 5
years at par. Calculate before tax and after tax cost of debt assuming a tax rate of
50%

Problem 7

BE Company issues Rs.100 per value of debentures carrying 15% interest. The
debentures will be redeemed after 7 years at face value. The cost of issue is 3%
and tax rate is 35%. Calculate cost of debt.

Problem 8

A company issues 5000, 12% debentures of Rs.100 each at a discount of 5%. The
commission payable to underwriters and brokers is Rs.25000. The debentures are
redeemable after 5 years. Compute the cost of debt assuming a tax rate of 50%.

Problem 9

Twenty year 12.5% debentures of a firm are sold at a rate of Rs.75. the face value
of each debenture is Rs.100 and the rate of tax is 50%. You are required to
compute the cost of debt capital.

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Redeemable Debentures (Debt) with redemption value

Problem 10

A five year Rs.100 debentures of a firm can be sold for a net price of Rs.96.50. The
coupon rate of interest is 14% per annum and the debentures will be redeemed at
5% premium on maturity. The firm's rate is 40%. Compute the after tax cost of
debentures.

Problem 11

Ten year 10% debentures of a firm are sold at a rate of Rs.90. The face value of
debentures is Rs.100, 50% tax is assumed. Find the cost of debt assuming that
the debt is redeemed at a premium of 10%.

Problem 12

20% debentures of a company are sold at a rate of Rs. 180. The face value of the
debenture is Rs. 200. Debentures are redeemable after 20 years at a premium of
20%. Find out the cost of debt.

Problem 13: ABC Company issued Rs.750000 10% redeemable debentures at a

discount of 5%. The floatation costs are Rs.25000. Debentures are redeemable
after 5 years at a premium of 20%. Calculate cost of debt.

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problems on Cost of Preference Shares

Cost of Preference share capital is a function of dividend expected by its investors.

It is denoted by its Kp

Dividend
Kp = Preference share Capital

Or

Kp = Net Dividend
Proceedings
Dividend (1+Dt)
( if the dividend tax is given then) Kp =Net Proceedings

Dt = Dividend tax

Cost of Redeemable Preference Shares:

𝟏
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝+ ( 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞−𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐢𝐧𝐠𝐬)
Kp = 𝟏
𝐧
( 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞+𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐢𝐧𝐠𝐬)
𝟐

Problem 1

A Company issues 10000, 10% Preference Shares of Rs.100 each Cost of issue is
Rs.2 per share. Calculate cost of preference capital if these shares are issued at

a. Par

b. At premium of 10%

c. At discount of 10%

Problem 2:

HHC Limited issued 100000, 12% perpetual preference shares with face value of
Rs 200 each. Compute cost of preference shares.

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem 3

Sai Ram and Company is planning to issue 14% perpetual preference shares of
face value of Rs.100 cach. Flotation cost is estimated to be at 4%. Compute cost of
preference shares if they are issued at:

a. Face value

b. 10% premium

c. 5% discount

Also compute cost of preference shares in above cases assuming 5% dividend tax.

Problem 4

Om Sai Enterprises issued 9% preference shares (irredeemable) four year ago.

The preference shares that has a face value of Rs.100 is currently selling at Rs.93.

What is the cost of preference shares.

Problem 5

A Company issues 10000. 10% Preference Shares of Rs. 100 each, redeemable
after 10 years at a premium of 5%. The cost of raising capital is Rs.2 per share
Calculate the cost of preference capital.

Problem 6:

A Company issue 1000, 7% Preference Shares of Rs. 100 each at a premium of

10% redeemable after 5 years at par. Compute the cost of preference capital

Problem 7: A company issues Rs.100000, 10% preferences shares of Rs.100 each

redeemable after 10 years at face value. Cost of issue is 10%. Calculate cost of
preference shares.

Problem 8 B.Com VI Semester - April 2019

A Company issues 100000, 10% preference shares of Rs.10 each. Calculate the
cost of preference shares redeemable at par after 10 years.

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problems on Cost of Equity

The cost of equity is the maximum rate of return that the company must earn on
equity financed portion of its investment in order to leave unchanged the market
price of its stock.

It is denoted by Ke

Formula to calculate Ke
A. Dividend Yield Method or Dividend /Price Ratio Method
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 (𝐃)
Ke = 𝐍𝐏 𝐨𝐫 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

B. Dividend Yield Method Plus Growth in Dividend Method

D1
Ke = NP or Market Price per share + Growth rate

(Where D1= D0 (1+G) [ D0 = Dividend Paid in the Last year ]

C. Earning Yield Method / Earning Capitalisation Method

𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞
Ke = 𝐍𝐏 𝐨𝐫 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

Growth Rate = br

b = Retention Ratio; r = Required Rate of Return / Return on Investment

Problem 1: A company issues 1000 equity shares of Rs.100 each at a premium of

10%. The company has been paying 20% dividend to equity shareholders for the
past five years and expects to maintain the same in the future also.

Compute the cost of equity capital. Will it make any difference if the market price
of the equity share is Rs.160?

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem 2: A company plans to issue 1000 new equity shares of Rs.100 each par.
The flotation costs are expected to be 5% of the share price. The company pays a
dividend of Rs.10 per share initially and the growth rate in dividend is expected to
be 5%

a. Compute the cost of new issue of equity shares.

b. If the current market price of share is Rs.150, calculate the cost of existing
equity share?

Problem 3: The share of a company is selling at Rs.40 per share and it had paid a
dividend of Rs.4 per share in the last year. The investor's market expects a growth
of 5% per year.

a. Compute the company's cost of equity capital

b. If the anticipated growth rate is 7% per annum, calculate the indicated market
price per share

Problem 4: Equity shares of a paper manufacturing company is currently selling

at Rs.100. It wants to finance its capital expenditure of Rs.1 lakhs either by
retaining earnings or selling new shares. If company seeks to sell shares, the issue
price will be Rs.95. The expected dividend for the next year is Rs.4.75 and it is
expected to grow at 6% perpetually, Calculate cost of equity capital (internal and
external)

Problem 5: A Company has earnings available to ordinary shareholders is

Rs.500000. It has equity share capital of Rs.5000000; face value of Rs.100 each.
The company's share is selling at Rs.200. Compute cost of equity using both book
value and market value [Assuming 100% dividend payout ratio].

Problem 6: SSS Company is currently earning Rs.1000000 and its share is selling
at a market price of Rs.160. The firm has 200000 shares outstanding and has no
debt. The earnings of the firm are expected to remain stable and it has a payout

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

ratio of 100%. What iske? If the firm's payout ratio is assumed to be 70% & that it
earns 15% of return on investment opportunities, then what iske?

Problem 7: Woodlands Company's share is currently selling at Rs.134. Current

dividend per share is Rs.3.5 and it is expected to grow at 8% for the next 4 years
and that at a rate of 15% for every year thereafter. Calculate Company's Cost of
Equity?

WACC
Weighted Average cost of Capital 12 Marks

Weighted Average cost of capital is the expected average future cost of funds over
the long run founded by weighting the cost of each specific type of capital by its
proportion in the firm’s capital structure.

∑𝑋𝑊
Weighted Average cost of Capital (KW) =
∑𝑊

Where X= Cost of Specific sources of finance

W= Weight, Proportion of specific Sources of finance

Problem - 1

The following is the capital structure and firms expected after tax component cost
of the various sources of finance

Sources of finance Amount Expected after tax cost (%)

Equity share capital 650000 20
Retained earnings 250000 20
Preference share Capital 150000 15
Debt Capital 450000 12

Calculate the weighted average cost of capital

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem – 2

A firm has the following capital structure and after tax cost for the different
sources of funds used

Sources of finance Amount Expected after tax cost (%)

Debt 1500000 5
Preference share Capital 1200000 10
Equity shares 1800000 12
Retained earnings 1500000 11
Total 6000000

You are require to calculate the weighted average cost of capital

Problem – 3

A Company is considering the most desirable capital structure, the following

estimates of the debt and equity capital ( after tax) have been made at various level
of debt – equity mix

Debt as a % of total capital employed Cost of debt Cost of equity

0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 6 14
50 6.5 16
60 7 20

Determine the optimal debt – equity mis for the company by calculating overall
cost of capital

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem – 4

XYZ Company supplied the following information to you and requested to compute
cost of capital based on book values as well as market values

Sources of finance Book Values Market Values After Tax Cost

Equity Capital 100000 1500000 12
Long term debt 800000 750000 7
Short term debt 200000 200000 4

Problem – 5

A Company has on its books the following amounts and specific cost of each type
of capital

Determine the Weighted average cost of capital using

1. Book Values

2. Market Values

Types of capital Book Values Market Value Specific Cost(%)

Debt 400000 380000 5
Preference 100000 110000 8
Equity 600000 1200000 15
Retained Earnings 200000 ? 13
Total 1300000 1690000

How are they differing? Can you think of a situation where the weighted average
cost of capital would be the same either of the weights?

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem – 7 (15- Marks: April -2019)

A Firm Presents the following information relating to cost of capital:

Capital sources Amount Cost of capital after tax

Equity 100000 12%

Debt 100000 4%

The firm wishes to rise a fund for Rs 50000 for the purpose of investment
proposal. It also decides to take it the same from a financial institution at a cost of
10%. Compute the weighted average cost of capital before and after additional
financing assuming that the corporate rate of tax is 40%

Problem – 8

MN Ltd. has the following capital structure:

Equity share capital (20,000) shares ₹40,00,000

10% Preference share capital ₹10,00,000

14% Debentures ₹30,00,000

80,00,000

The share of the company sells for ₹ 20. It is expected that the company will pay
next year a dividend of ₹ 2 per share which will grow at 7% forever. Assume 50%
tax rate.

a) Compute the weighted average cost of capital based on the existing capital
structure.

b) Compute the new Weighted Average Cost of capital if the company raises an
additional ₹20,00,000 debt by issuing 15% debentures. This would increase the
expected dividend to 3 and leave the growth rate unchanged but the price of share
will fall to ₹15 per share.

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

Problem – 9

From the following capital structure of a company, caluculatevthe overall cost of

capital using:

i) Book value weights and

ii) Market value weights

Source Book value Market value

Equity Share capital (10 per share) 45000 90000

Retained earnings 15000 Nill

Preference share capital 10000 10000

Debenture 30000 30000

The after tax cost of different source of finance is as follows: Equity share capital
14% retained earnings 13% preference capital 10%, debenture 5%

Problem – 10

Alpha Ltd. Has the following capital structure as per its balance sheet as at
31.3.2021:

In lakhs

Equity share capital (fully paid share of 10 each) 8

18% Preference share capital ( fully paid share of 100 each) 6

Reserves and surplus 2

12.5% debenture ( fully paid debenture of 100 each) 16

12% term loan 8

Additional information

a) The current market price of the company’s share is ₹ 64.25. The prevailing
default risk free interest rate on 10 year GOI treasury bonds is 5.5%. The average
market risk premium is 8%. The beta of the company is 1.1875

Bettaswamy C S Asst. Prof. VVFGC

Advanced Financial Management 6th semester B.Com (NEP)

b) The preference share of the company which are redeemable after 10 years are
currently selling at 90 per preference share.

c) The debenture of the company which are redeemable after 5 years are currently
quoted at 90 per debentures.

d) The corporate tax rate is 30%

Required:

Calculate weighted average cost of capital using

a) Book value weights

b) Market value weights

Bettaswamy C S Asst. Prof. VVFGC