QUESTION BANK

A. Short Answer Type (1 mark each) (Answer in a word or a sentence)

1. What are cumulative preference shares?
2. What are cumulative convertible preference shares?
3. What are retained earnings?
4. Define debentures?
5. What are convertible debentures?
6. What are term loan?
7. Define cost of capital.
8. What is weighted average cost of capital?
B. Paragraph type (2 marks each) (Answer in a short paragraph consisting of
about 50 word.
1. Distinguish between implicit cost of capital and explicit cost of capital.
2. Explain how cost of debt is determined.
3. Explain how cost preference capital is calculated.
4. Explain how cost of retained earning is computed.
5. Explain why the cost preference share is less than the cost of equity.
6. Explain why the cost of retained earnings is less than the cost of new equity.
7. State the assumption on which cost of capital is computed.
C. Short Essay Type. (4 marks each) (Answer in a paragraph consisting of
about 100 words or 4 or 5 points with explanation)
1. What is cost capital? State the importance of cost of capital.
2. Write a note on capital asset pricing model. What are its merits and demerits?
3. Explain critically the different approaches to the calculation of cost of equity
capital. As retained earnings cost free?
4. What are the assumptions on which Gordon model for the cost of equity is
based?
5. What is weighted average cost of capital? How is it computed?
6. What are merits of using market value weights over book value weights in the
computation of weighted average cost capital?
7. What are the factors determining cost of capital?
Problems
1. 20 year 12.5% debentures of a firm are sold at a a rate 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.
(8.57%)
2. A company has issued debentures having coupon rate 14%, floatation cost 10%
and face value 100. The company is in the tax bracket of 35%. The debentures
would be redeemed after 5 years at a premium of 10%. Find the cost of debt.
(12.33%)
3. A company has issued debentures having coupon rate 14%, floatation cost 15%
and face vale Rs. 100. The company is in the tax bracket of 35%. The debentures
would be redeemable after 5 years at a discount of 5%. Find the cost of debt.
((12.33%)
4. A company issues 5,000 12% debentures of Rs. 100 each at a discount of 5%.
The commission payable to underwriters and brokers is Rs. 25,000. The
debentures are redeemable after 5 years Compute the after-tax cost of debt
assuming a tax rate of 50%.
(8.42%)
5. (i) A company issues 1,000 10% preference shares of Rs. 100 each at a discount
of 5%. Coats of raising capital are Rs. 2,000. Compute the cost of preference
capital.
(ii) Assume that the firm pays tax at 50%. Compute the after-tax cost of capital
of a preferred share sold at Rs. 100 with a 9% dividend and a redemption price
of Rs. 110, if the company redeems
((i) 10.75%; (ii) 10.47%)
6. A company is considering raising of funds of about Rs. 100 lakhs by one of two
alternative method viz, 14% institutional term loan and 13% non-convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5% and would involve cost
of issue of Rs. 1 lakh. Advise the company as to the better option based on the
effective cost of capital in each case. Assume a tax rate of 50%.
 (7% and 6.74%)
7. Calculate the cost of capital in the following cases:
(i) X Ltd. Issues 12% debentures of face value Rs. 100 each and realizes Rs. 95
per debenture. The debentures are redeemable after 10 years at a premium of
10%.
D. Long Essay Type. (15 marks each) (Answer not to exceed 3 pages)
1. What is cost capital? Explain how you would determine the cost of the equity
capital.
2. Examine critically the different approaches to the calculation of cost equity
capital.
3. What is the weighted average cost of capital? Examine the rationale behind the
use of weighted average cost of capital.