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FINANCIAL MANAGEMENT

SOLVED PROBLEMS – COST OF CAPITAL

Problem 1

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 Deben
The Debentures are redeemable after 10 years at a premium of 10%.
ii) Y. Ltd. issues 14% preference shares of face value Rs. 100 each Rs. 92 per share. The s
are repayable after 12 years at par.

Note: Both companies are paying income tax at 50%.

Solution

(i) Cost of Debt

[Int + (RV – SV) / N] (1 – t)
kd
(RV + SV) / 2

Int = Annual interest to be paid i.e. Rs. 12
t = Company’s effective tax rate i.e. 50% or 0.50
RV = Redemption value per Debenture i.e. Rs. 110
N = Number of years to maturity = 10 years
SV = issue price per debenture minus floatation cost i.e. Rs. 95

[12 + (110 – 95) / 10] (1 – .5)
kd =
(110 + 95) / 2

[12 + 2.5](0.5) 7.25
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[12 + 2.5](0.5) 7.25
= = = 7.43%
97.50 97.50

(ii) Cost of preference capital

D + (RV – SV) / N
kp
(RV + SV) / 2
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Where,
D = Dividend on Preference share i.e. Rs. 14
SV = Issue Price per share minus floatation cost Rs. 92
N = No. of years for redemption i.e. 12 years
RV = Net price payable on redemption Rs. 100

Rushi Ahuja

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14 (100 – 92) / 12
kp =
(110 + 95) / 2

14 + .67
=
95

= 15.28%

Problem 2

a) A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share 
Rs. 10 each. Find out the cost of preference share capital when it is issued at (i) 10% premium, a
(ii) 10% discount.

b) A company has 10% redeemable preference share which are redeemable at 6the end of 10
from the date of issue. The underwriting expenses are expected to 2%. Find out the effective cost
preference share capital.

c) The entire share capital of a company consist of 1,00,000 equity share of Rs. 100 each. Its curren
earnings are Rs. 10,00,000 p.a. The company wants to raise additional funds of Rs. 25,00,000 by
issuing new shares. The flotation cost is expected to be 10% of the face value. Find out the cost o
equity capital given that the earnings are expected to remain same for coming years.

Solution

(a) Cost of 10% preference share capital
(i) When share of Rs. 10 is issued at 10% premium

Kp = D / P 0

= 10 / 11 x 100

= 9.09%
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= 9.09%

(ii) When share of Rs. 10 is issued at 10% discount
kp = PD / P0

= 10 / 9 x 100

= 11.11%

(b) The cost of preference share (face value = Rs. 100) may be found as follows:

Page D + (RV – SV) / N
kp = View Full Document
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(RV+ SV) / 2

Rushi Ahuja

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FINANCIAL MANAGEMENT

In this case D = 10
Page
RV = 100
SV = View Full Document
100 – 2 = Rs. 98
1 / 16
10 + (100 – 98) / 10
kp =
(100 + 98) / 2

= 10.3%

(c) In this case, the net proceeds on issue of equity shares are Rs. 100 – 10 = Rs. 90 and earnings per
share is Rs. 10.

Cost of new equity is:

ke = D1 / p0

= 10 / 90 11.%

Problem 3

A company is considering raising of funds of about Rs. 100 lakhs by one of two alternative method,
viz., 14% institutional term loan or 13% non­convertible debentures. The term loan option would att
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. 1,00,000.

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