pool Ne ees ee portant input in capital budgeting decisions.An investors’ investment in Cos of cai ch as shares, debentures, public deposits, etc. of a company are on the basis of eee v3 euurn An investment decision depends upon the cost of capital Cost of ce eae scp return that the company must earn on it investments. The chapter ical is he mit ¢ eae the concept of cost of capital and its measurement 1) INTRODUCTION Teco of capital is the most important and essential input for jaseeeeseremueniaaas bg francal decisions. Without considering cost of capital, no Cot a ere /fmom evaluate an investment project. Cost of capital serves aS | totum of hurdle rate. yardck forjudging how good a project is for the firm. A com- | sss i obains funds from different sources like equity share capital, preference share capi |@pidlforits investment needs. It can also plough back a part of its undistributed profit again into s.Allthese sources of capital has a cost. The firm should pay to the suppliers of funds at arate : eed or expected by them. Hence ,the cost of capital is that rate at which suppliers of hy aid. to obtain required funds for financing a firm’s investment activities. eer gay Shareholder’s wealth is regarded as the basic objective of financial management. hecreumaie nth @ view to increase the shareholder's wealth to the maximum possible ata rate ea, When raised funds has a cost then these funds should be employed by a mi rate of return, Beh should at least be equal to their cost. Hence, cost of capital is the ° tive investment dares business should earn on its investment, It acts as a cut-off-rate or Sl beng decision ne ane Ttis used as a discount rate for discounting future cashflows in Rigg funds, Italsodene, The cost of capital depends upon the degree of risk perceived by Pilot aig eas in a "pends upon the degree of risk undertaken by a business while invest- ‘torent sources oF fan Srerall cost of capital of a firm is the weighted average of cost of a: i ee re dey te pro! nearing he a Of Cost of Capi od Deena et pene saat eS ee reeset | Mae amd Cen eee of management oe Pounds aye matt cot of TS bef won pany, ised are eset ed on ‘view, cost of capital mest peminimum required rate of ag pipes OF COST OF CAPITAL icators of better project Te borOWINgTNE” acat of AP ty ‘of capi ‘camingorga Feeding EES os a il“ oe of capitals any discon tea Mites pesofcstoapial et caper raged avenge con APN ineconomictene® 4. gyptostand Implicit cost peau cash teams” TH F gediccostand Combined cost 5 Future costand eee sp_Besic eS offunds require erage c cost oy Ca Ben a 31 Baplct Cost and Implicit Cost stand Marginal cost F siete eg eae ct Cot plicit cost of capital isthe rate of nt rate for discounting Fut eerie ata fem pays to Tetum either pes Tecash fon alt cost of any Source of capital finance. As per | Explcl Sow el any aay capital isthe discokeg | ©2BtGl is he dongs eee mt rate that Ie ee present value ofthe cc on Seren ‘s that are | See j eae nt of he rncng pry wt | cian tan neetee Seta icc: (eee | Sater art rien Sea felctcostfcapital involves both cash peepee pla ie once Te 3 ee re tS pore catofiate Ee nc a en llbor 5 ber dene soles fried & Cotofa frum vnichonsis of risk frerehums pis be mi fr cpio ar projet Risk associated with a projects of two 7 coset ve la oes when cm " Se ee ese or dividend). The its busines | a Dis present value of cash outflows is rate which pcan opel ong onl eine reacting tance roma lose ens a Sey cial ance Co Pisa 72 uroRTANCE OF COST OF CAPITAL oe ee Tech nea cigcie Oe ene se ee piel Coleg af spas by ney ofiterest The explicit lb 1a lowed a Scat deco ae based on tect SPA Cost of expt as atinfow with € 1,00,000 payable that terial rate of retum foro evaluating iswestment decisions (0) deciding the debt content in overall capital suc tcplamount at the end of 5** year. apeble every yea as interest wd Sete tet maragement financial Perormance = ies as it Decisions: Inthe NPV method of capital budgeting apt ia (Gash Inflow & ‘Tocalculate NPY, all the cash flowsare ds 10,00,000 when the NPV tus out tobe positive. tal In the IRR method, a project i accepted es ° Femina atef eur or cost of ait tbe tic capi, In bh he case, cost fal 2 sll nr one hurlers. Therefore, n order tomes he 3 (re pasate ctl should beri. Sothe cost of capital isregarded as 4 Sandan toallocte the funds ofthe firm in various projets. 5 ion (Usage of Debt ints Capital-Structure: Costof capitals quit usefuin deciding hed 11,00,000" fe, Tis wil rece Egg ling the explicit cost of, [.*(1,00,000 + 10,00,000) ‘capital in the abox Wve example, the following equation may be inovenl cpl szuctue ofa fm Interest on deb is tax-deductib Faces finn which in tam duces it overall cot of capita ncrease in dot of debt d= ‘firm may increase its financial risk but this can be offset b) y lower cost ‘ac fe dal soe a ge RSE CHC, rate kportat smlderation in deciding an optimum pital = Ne aH aee G (2 Mages Peformance: Peormanc of te vvanagement canbe | Oily in trendy eimatine ie oped pelt sophie ca nt ofa TS et ts Beplict i Eg retum ofa projet can be compared with its cost of capital Mes! ‘which the funds are provided.gabe involves simple procedure Pines lesen 0 Tiecsieag ‘theca e. and debentures pn Fes of bods are specified This sate saved to fin ate Peso tofind the etfectivecostof | ‘The equity shareholders will perceive _ ja ne cers of debs it the capil sc need to be compensated for te pvlves fxd interest costs ad fms genera Fn sunt Butte interest ; is paid at ‘ died debt can matere ape at premise end fog eS isco ae due or maturity dates ean et on due oF matuity ates only. Afr hat dea gee Fim slice vetch also affect the cost of capitalism eth Pay it annually The, ‘of the investment tm ine at 4 one Coie ey & SY —— xeon demanded bythe VES hat cost of capital consist of three co a ne ni We Weasistl tesco, | siti deductible ths bangs downthe cxf detent mente ty oe (ESSE encom tes doge ee sources iness risk et ares can be calculated fort = tere, =Costof copia of iferet Pera atc both ed ia ‘ate ‘Sci ik prom. et : cemable (petal debt and 2 = Bosineserisk premium ie epunecease DeulPeetil Debt: The formula to pa {j= ancalisk resin 08 piredcemable debts Bere an 1 {a0 cars ye seme ae asumed to becontant Hence CANINE COs of xh Petit sete angedn suppl and demard for ach peat nh an ens crab ener payment anally ee Pt rebum which iat east equlg [H-Net proceeds o issue price of bond /d a cst vary withthe peo security fee np =Neto sae attends Toppan cm WaT i upontherikofhesecuiy, sey aC erence en cas ee par pt dts eee mt pei eee, riz Asweal know that debtis tax deductible here es of det gs reduced dues sted Sega pee Spa eet Therfore he acta oF real tof ets izes ed afer considering tax rate, f kaye Foe oe 755. MEASUREMENT OF COST OF CAPITAL otherwise decisions related to invesine ‘ham sha caefily estimate the cost of capt be taken wrongly or wsoptnals might be selected and acceptable propos nay reo urement of ost of capital is based on few assumptions even after acceptance of the prose t =) 10-8 (6) Tae business risk ofthe firm remains a Te theory ofthis assumptions based on the premise that very fnk ky= -Dorky= So ‘rel of business risk which is determined by the composition of ist jg eg aticceaaeta. amount saved ont ie a Fae yevfanew proposal isacepted itwillnot change the busines isk of et 6) Probes csumplion sat nancial sk ill also remain same, Financial rk do 1 =Annual interest payment ul = tpn tne proporion of ebtcontent inthe capitatrucare of the firm. This si INP =Netproceeds from sale ofbond. ‘plies tat he same degree of debt financing willbe maintained. mae { Seer Te Aime Ct ws een on tein bse ‘These cash flows are then discastl} I =Taxcrate rapa tolknow her present value, To ensure consistency inthe evaluation Po cost-of-eapital should also be calculated on after-tax-basis Ttis only the debt-financing fri = ae eqied because interest on debi is tax-deductible, For oter source preference shares and equity shares no-tax-adjustment is required. 7.6 MEASUREMENT OF SPECIFIC COSTS 7.6.1 Cost of Bonds and Debentures According to Weson and Brigham, Costf debt a ‘Soames eae n{ is defined asthe rat of return that ustbe eas eH apciooet hears eece equly accel Ltd. issued 10% perpetual debt 10000. Thecompany is (before tax as well as after) assuming he dee stsusl sar ————S—<“Als taken fom Table A vy ge to Table 3 (PVE for yen tae IEA ian 94, let uty at higher ne eet tere pa om mn sey the valu ae eres = 75(3.791) + 1,000(0 21) = 28454 6 lve calculated Pests aoe eh sano 21 = 60535 © at 10% premium 18, spoton Se ea stecsbcert i £10,000 «9.9999 = 9, ae he se Before-tax' = 37,10,000 = Om HALTS - 906-4 gy) Bagel -050) = 4.54% 20% A oe of redeemable debt, 4 sae pebt_wniecalatingcstoredeemable debt 22UN ay ky =9.048 2. Cost of edema ane pereret ral Ye ero icra eect ies lt of aon oh erest PY MEr unt then the cost of calculated from the followin juce these cumbersome calculat another jn one lump-sum amount Ge eee tons and time, Od called short-cut a ‘ede ge tiod (Redeemable Debentures) & CO, CO% | Sacto cota ma get a =F OO, + OF (ater csc iy = WEDHRV—NEyN Bie co & Gee” Ok) Sta arin i = QveNeA ga | Inflow or its net ne ee he = Cot FEE realeed it value; # = Taxa (acted teeters es roe ACT eaten Re qycSoepon he = Tet Ekim Correo + CO}, COI, = Cash oufiow on interest paymentin te pera 1 = Annual interest payment; ‘bers shouldbe = ) fC, + COIs C= ae year of maturity after adjustngae a] N/=Lifeof debentures in years rents pe eat Trot proceeds from issue of debenture ee cor Pinal epaymentinthe yen of may fp chae vale —Underwring brokerage Hite tan numberof annua intaliments then the cost of debt canbe “Discount + Premium ) 1eledt mn repayment 10-1) +(f +d+p, -, Gwenn? from the following formule: peavey, WE)+ d+, = pin Hoan Rich (QV+NPYZ ere tl ede $04, +OF a" 2 sky Luc ssues 15% debentures of the face value of 1000 redeemable ate Example2. ABC! ‘The debentures are cost of debentures given thatthe firm has 50% tax rate Solution: Cl, =® 1000 discount (& 50) - floatation cost (@ 10) = € 940 ‘Cash outflow on intrest payment after adjusting tax (for 1-5 years) = In the 5! year = & 1000 ( Repayment of Principal) the value of Fy would be $075, €1,000 130- Yey Usk? In the above equation the value of k can be obtained by trial and error method asin bea calelaton of IRR. ‘Putting the value in the above equation 940 =75(PVIFA, ,)+1,000 (PVIF, ‘The value of right side ofequation is be made equal to 940. Letustry 9% then =75(3.890) +1,000 (0.650) = 291.75 + 650 = € 941.75 floatation costs estimated La a aicount of 5%and the floatation costs estimated tobe Fail se short-cut method cannot be applied ies {f=Hoatation cost; d = Discount on issue of debentures, Premium on issue of debentures; p,= Premium on redemption of debentzes When the principal is repaid in many 970fF: ‘Concept and /Measurem, ; Cost of Copiay sesence Shares 4 amount ARE 7 pre rid securities, Th Example 4. issues 10% debenture of € 100 See eeatngt pot Pere called hy! Nese shares Ton pcan cheer eer eyes Te come #7 EH Del Ort so bh debt nd hee pal nave Of debt using short-cut meth Getic te oe ry cot | eres eae Se Solution: Fates 184) Terao the preference sharcholdess, SMe meee 50 ips tino te didi rcn paeaaentpatss or debentures ag5res88§ n cong, (oes hk mmitent ops) the pete cee PIC tn ample Acompary nd 7515s gt pins lal salle sh | pe ir wl es 2a al ithe ede shan SY So PS, The debeNTes ae to ea pa eS count of preference dividend ie fy arb St B Pid ety ‘ond of year 1. The interest @10% wil ye ett silaresr main in arrears then preference shareholders mip Stidend Poe stating rights ace given to them in such cases. Participate in the Principal ‘AferTax pest of preference shares is Very imtportant in alculating ove ct of “After tex intrest 2 Fax-deductible.Itis not an expense, itisan capital Teas | Renetes | Marerriseasy | Repamente | Coen Cutiye | eed Ot ested fr taxes There ne oe fect tee pee 20,000 20,0005, os sharesie 10,000 \ Bn.ot0saeo: de syle preference shares 1 20,000 ,000-+4,000 = 24, pede ference shares. 3 | Bon 20000 | 20,000-3.000= 250 | pref ee 6000 0000 | 20000%000« ty | A egable Preference Share: The formula for Sys rt ‘4 aoe 20,000 20,001,000 = atm font Host of irredeerable preference shares is a5 antes i acjusted for taxes because ‘be discounted at an appropriate rate 6 reference dividend is nat an “Test fern cash outflows may _ PD. ‘epense. an appar! araaTe Tole PV at 5 = NP oe aan a 6% 7% o% J, = Cot of preference share capital 0995 0926 23,375 23,150 #h =Corstant annual preference dividend per share ao ers 0857 noes nee Re roceeds on ie of preference share (Market price Toru Get) 23000 osi6 ore ores aera 4 Acompany issues 10% irredeemable preference shares ofthe face value of€ 100 each. 72.000 0763 tee 14973 14,301 ‘cs for such issue is estimated to be 4% of issue price. What would be the cost of 21,000 0713 °. pager’ sat shares if they are issued at (i) par (ii) 10% premium (if) 10 % discount? 94,854 z lox Computation of Cost of Irredeemable Preference Share Capital ‘Snorthe tial PV of cash outflows of € 4854 at 7%is almost equal to the net proceed faa Min sued at par saleof debentures of€ 95,000 hence the value of k= 7% (APPrOX) J 5 aa oat oaluating Debt asa Sorc of Capital: The cost of debts explicit costae is ns) 10-8 tesa at prem x aa et eae ante fits ax deduct. Ireduces th taxable at premium E: a ‘On he oer hand more and more use of debts increases financial risk of the fim r fy = 9.9 ose debts tobe paid on its due dates whether company ears profits or not. If company {90 jg, ‘ 110(1= 0.04) ~ 105.60 eee Mine irl affect the reputation and credibility ofthe fim a Messed at discount bringing down the market value ofits shares. Hence, debt is a risky capital for a company. principal amount has tobe repaid on maturity date, But from the point of view of the HV 2 safe investment because their dues are to be paid before payment of any dividen claims are tobe stifid first at the time of liquidation ofthe firm. 10 ete 157% P 91-004) 10 640a Concept ang ; Mensaeren con «plus Growth Approach oes Ea Price dh assumes constant streams of divi appa oe avaliable to equlty sheen et vera earning 3 luity shareholders Period of ioe se Seat ros fier a cna bert tine Hone Into account this growth prompect in th deat Died pt i, takes 7 al rating rowt lividends to cay de nae Eoring he ownage kas fee TET) Fundamentals of Financial Management Where, Pp = Current market price of equity shares (Market price at zero periggy 1D = Dividend in diferent years (Ds ~ Ps) K, = Cost of equity capital Py = Market price at the time of sale of sha Cost of equity share capital can be measured according to fllowing approach, () Drie pc sree eg ion mt rere (Dividend price plus growth approsch : gs go atv SY Thelema k= ahs, bay ts (@) When dividends grow at uniform rate. 0 9 beer of existing equity Be pr peed be a oyu, i 07 Oiiend per share] Doll + 8) where D, = lst See “current market price (Net proceeds) 7 pes cost of equity capital i calculated on the basis of exp, [ feos Sa ae tones on Sorts dertarmatmatermeronrs coment abc | geneuty = zone | emma } arin yam Hance the ola clea he ost of ne an fea aT aes cont “will be as follows: {f= Floatation cost ee E The current market price of an equity shares © 95. The expected divider per (a) Calattion of Cost of New Epi: 1 e ow at the ra ote vidend is expected to grow atthe rate of 6%, Caled il fia 4 the cost of equity capt a ut ice ofthe share atthe end ofthe year and 2 assuming conan roe ‘Where, K, = Cost of equity capital Le 1. y= Ege ie per uty Stare ae = Net proceeds from issue ofan equity share after Approach, cost of ee ee aa ae aia cain, spensatoniectan ©) Calculation of Cost of Equity: fe Hest tpressehoct | he fel Bone somone erie & +006 = 005+006-011=n% Nowthe market price of the share at the end of year 1 and 2 can be calculated as follows p, = alls) &=3) 5 pie then of yer) = ES = 0orthe present dividend is positive. £2) Dividend payout ratio is constant. Big. Gsrentmarket price isa function of future expected dividends ofthe Share ac 5 cles gon dS BR (-6%of 11) (11-0.66) 15 =14.50% 3g 0190 Solution:" _t y Coreo an Mensano Cn as te Ds (©) Varying growth ates in dividends: Following is the equation consid a in dividends, sages SANE Varying end of 7088 2 = (os Epc nda S ppdesy!, POs+a | = a ee Dy =D, +37 tyes) Po Baek Xan" (ky WH 1D, = 2001 + 68 =20 11236 «22247 nee yh goth rat for ist years ges rte en of Dad Yur = ATCA T6500 3, Biss the growth rate for next 5 years ie 610 years, a pce NppONSH the growth rate for 11th year and onward och market price ofthe egy share dpe po sis Pee vend paid by the company caring of the zane 12, Dep Tom hs befalowingterdofpaymentotdvidendsover hepa ea Years: Dividend per she ti This: ean es] Bt honing Acrngteappecse ‘ee 10.00 Eng or Joscees 10.50 Be James 411.00 en 5 41.50 whe 6 #200 ye Cost fealty capital ; j= Eaming per share Corent market rie ofa share is® 140, Floatation cost per shares ® 4. Calculate, Net proceeds of an equity share. @ Growth rates in dividends. me ae of equity share when market prices €140, pes sh (@) Costaf equity share wt PI 4, Frzmat mart price of teshare “1? Sie : 1 (0 Groth rates in dividends s/PRatio= 57 wai ‘12in6* year is equal o 950 (1+ g)° pe Total earning available to equity ~ cits +a Pe Total current value of equity shares : JP Eaming-price ratio and P/E = Price eamingratio ‘We will try to find compound values in Table A-1, growth rate for 5 years near to 1.26 i s 0) cana anirag 8 Fw Eity Cost of new equity can be find outby adjusting the fosationotsallows: - 4 Eaming per share ke we Re Fil) ™ Net proceeds per care 14 The current market price ofthe share ofa company is 100, The company'scuent e200, 000 Its shares outstanding ae 200,000. The company wants torus aos! £60000. The floatation cos is ® 10 per share (10%) and the company can sl sha a of 10% Find out the cost of equity assuming thatthe company's earings a Expected dividend Costofequity = eeced dividend R Current mkt price * Wt Rate Expected dividend = 12 (1 +5%) = 12.60 ey = 120 Costotegity = 2 + 5% =14% Example 13, A company is planning to declare dividend lof 20next year. The companyhasag% ‘ate of 6 and the shares are being eaded at & 120 per shave inthe market. Find the cost 2 share, Also find the price ofthe share ofthe company atthe end of year 2 Cost ety = ony Bites Been = 0.167 +006 = 0.227 =27.7%a Cntr ewe cay re the cost of equity capital itis ne ane calested by Slander net9 Ue onal (jv) Capital-Asset Pricing Model (CAPM) Approach, AAs per this approach, return on any security depends upon the level of secur. The expected tum roma scut # drety proportonl i gy, mentioned nthe cups ct oy Thehe ges the expectation of return and gt tk ay, me security. The higher isthe isk, hgher ithe expe Tetumand ine a a linear relationship between expected etum and 15k, There mebroaris Mi Te iar a security investment. = ee (9 Unoystematic isk Bso8 = (i) Sytematirsk et “= 3 Cee : change in La ee re scepabieate a er can be reduced o eminated trough stag 282 oat te ee ora eoany at ne ane a Henceitisa avoidable isk ia vsnmentfatrs lke goverment policy changein tag Lia Sete an Poli, was € 200 in Jan. 1, 2006. The present vag ea Tpeestates inflaton purchasing power ce icalledsyatngP price 4 al lmand an so ken nto account whe calculating the cost of equity. saa peepee 0% eprenthedathnmoageeg ch SE" Sa i in market value of a i ‘pets cofficient (factor which measures change fa Scat dc erie ae acim ot be avoided trough dveraton Hees Sa iso Basis diversifiable risk ay of Retained Earn “Assuming unsystematicriskhas been eliminated through diversification, Capt, i Corsaro dsouethe ne profi dren ee camingsarececes; Ey SE onthe basis of three parameters ty Ati | yt polders Some portion ofthe earings ae canara Model (CAPNO calculates the cos of equity betes se : ~ tchremands sano opteatirah neg lowing og ale pope erly tained Sen ee See om ah) vein tad beendsbbuted among the shares hy = rm E a es in ay of iid hen Mee et ese iterated some eum onit. Therefore the costofrta ei rm fregeety theshacoldesisoaled sy int wets ei sip gaa retained earnings atleast equal totheratethatwould sh ae ed by the shareholders if these earnings were wees ame f= Coeficient of systematic Hsk {= Expected return on the market (0) Realised Yield Approach 2 ‘This approach is based on the premise that actual returns earned by the investors inthe be repeated in the future. According to this approach, cost of equity capital shouldbe deve on the basis of retums actually realized by the investors on their equity shares, Past an dividends fora parcular period shouldbe considered while calculating cost of equity cn approach gives us good resis in those cases where companies are earnings good an step Example 15, A purchased 5 shares in a company ata cost of © 200 on January 1, 2006. Heit] ‘onJanuary, 2011 for® 252 The yearly dividends received by him in each year areas fllns we ie, As per this approach, the returns expected from |Al pa ha Odili ino es panne: liereined enrings somewhere cla ie ouside he ene cuiht tena: 72006 1100 compared withthe investment in company’s own | Maeweenieennrsoenbn 07 1.00 Spot firm ears 20% on its own project. Firmisavaiable Gongs mint veel 2008 1150 temalopportuity where returs wouldbe 6% ater _gonguysom pic Ed 11860 Tk Then the cost of retained earnings would be 16%. nears ani 1150 fio idthat the costof retained earings sequal cost of ety capita Againitisnottrue. lings is alw n the cost of ital because ofthe presence of Calculate the cost of equity capital. amings is always less tha eau capCOM ard Mester Cost ot capi civalve weights dohave some imitators pte securities Hctuateson day, Se luc pect the true value the security, 7°88 ieto vy ° eit price ofthe securities ae someting, brokerage cost while rising fresh equity and corporate dividend es while declaring gy. equity capital. The cost of retained earning canbe ce! ee (@) When there are no taxes and brokerage fee: "Atesot stock marta ya i ar oe (Ae coke weehtsdohavesome advange ys even ine a pe yf seas om te pata, (©) Onthe assumption of taxesand brokerage yf jyesdonat change on day today basis, statements, x =ka-D0-B) 1 xe fe fom agai of tock marty Pee parks and franc nstttions se book val Where, K, = Costofretainedeaming oe Marginal weightreferstothe provers 3 roporton in which afm K, = Costof equity capital se abe tothe shareholders ig = es a sources of funds. This method ‘Used when new findsarn neste ney CAPITAL(WACO)/OVERALL io according to the requirement ofthe firm, renee tase and that 7.7 WEIGHTED AVERAGE COST OF SF ries hn fener oa oe MEd ips rte “COST OF CAPITAL WAC” ifferent sources. New capital may tal capital tal ox compote cost of capital and fr ital may nottobe raed nah fn von, “Te term cost of capital means overall cost of Dio different sound th shortcoming of marginal weight systemisthatitigoretie capital structure (ale a weighted average cost of capital AT Ty tearing cc at diferent ogo ing For example if the marginal costo debs ea bart Shoe pee a a pig Pot of mop ek ao Pe POON Titled oe There co of opt tation of weighted average Mowardsone source of capital. The company may bla claro fad and hei respecte sic Comput ight BeCostohagte Fe icraptpenum roar kee ppt ncn (WACO involves following three step fic costs). . ‘of the cost of each source of fund (specific :_Intarget weights system, a firm wants to! avea. (ie wight ofeach sorcef fn in the capital stricture ete on thebacig ere fdleretsourcesof fiance Hence hae ee icc book value or market value. : op Ne oa oo) rapt structure is decided in advance. The firm raise additonal nn nT (Gi) Calculation of sum of the product of specific cost anc weight ‘source of fund. ietarget weights in the desired period. funds in sucha way to or ee 16, Thefollowing is the capital-structure of XYZ Ltd. 7.7.1 Assigning Weights r ‘Amount ae esgscne elegoied on the basi of) Historical weights nd (i) Marginal weighs ig © conta weights ees cae Ey soca | 40000 aa istorical Weights: ‘Historical weights are the weights based on in ree (4,00,000 equity shares Orr a eof fandsia the existing capital structure ofa firm. These canbe further ci ‘oft 10each) into (?) Book value weights and (ii) Market value weights. nae 10,00,000 o% | ‘Book Value Weights Vs Market Value Weights: ee of 08ach) | Book valu weihtsare th proportions ofthe diferent sources of finance as record eo 10% Debentures 30,00,000, » | ‘statement of the firm. When shares and debts instruement are traded in stock mai ae ‘of 71,000 each ‘marke pric is used fo calculate market value weights of different sources of finance. Markt Retained eamings 2000000 Aisi oa will differ from the values recorded inthe books. ‘Market value weights are preferred over book value weights 4 ae ‘actual amount tobe received from the sale of stich securities, (i) Fresh capital can be ‘market price, therefore true cost ofeach source of finance should be based on current not on book values. because: (It approsint its dentures are being traded at 92%, preference shares at par andthe eq shares at Fdout the WACC based on book value weights and marke value weigh.Fundamentals of Financial Management WAC based on book value weights Bok voi | Weight | Specific Cost or z wo Captal(K) Equity share capital ooo | o4 oat Proference share capital | 10.00.00 | 0.) 0.08 Debentures 300000 | 03 0.05 Rotained eaming | _zaon000 | 02 ont | oao0000 | 40 WAC based on book values is = 89% ‘Alternatively without assigning weights ‘Source Bve | Specific Cost of] Composite Capital) | Equtystarecaptal | 4000000 ont | proferenceshare capital | 10,00,000 0.08 -30,00,000 0.05 wacc= e Concept an Messier at x value of equity of € 5600000 400.000 Fs canescens tn £21) hasbeen, vn we ys equ value of WACC bused on book ee vals eos % oot Be os market value weighs. NTAL COS: CAPITAL / MARGINAL Cos; sT OF CAPTT/ rAL PP geo = te ineemenal cov of addtional api eject Iti caeulated when there ia | Wa = opal ne aero Tine erie Pista te evaluate ose rect which eee So of atone Pirate tani rom te sonal anes rise eee Geert ocak ene pr. fm cs cheng aoe ees rctre beau of intoduton of daa Wel Pi gemay OF may nO chan, nds. The ratio of diferent esc of Tak because new project may bere aoe, ease of the ae be relatively more o less risky pate are. Cost of equity will increase ae te afferent source of funds innew cil debts may ‘increase because lenders may demand: duction of more debts. Further cost of oerents of debts in capital structure. increasing rate of ines with Beof dove changes wl make teu of preset Te i rate for evaluating anew project faulty. eee oy peje ercemetal cost of capil ie mathe ih Perec cue Uoeul for capil cigar acca emceoeed ting decisions. The marginal 100,00, WACC based on market value weights can be calculated as follows: Spon of margin! | Sean rccrvauw | Wagnt | SpsaioGostot] Wari eget ean ee sed at price. ‘marginal cost of capital should — é oo Crs conten] | Mee reginlesarerst of raising of additional funds ee ‘Equity share capital assscs | oon ont 0.0499 ‘punderstand I ctmasgial coctcl coptal eeu an come Preference share capital , 00. 1 0.08 0.0085 is a aan ecco | 020% oe bol, SRL is presenti having its existing capita structure of qu commana | pe | 38 | tae | eel Se ge ae at #6000 | 01.000 0.0890 Source of ‘Market Value ‘Specific Cost ‘Alternatively without assigning weights eee Ear La 06) Equity 400 15 Debt 200 8 | 600 | funding of € 100 lakhs. The projectcan be Tecompany is evaluating a project requiring a total . The cost of new debt is 10% With the ty would increase to 16% from 15% SSniation of more debts in capital structure, the cost of equi marginal cost of capital.Solution: rine r ta 20 ndinB ‘at which the specific cost of capital ofa somes rel of ple funding up toa cern cntt spare ee ad ea 90 tn fllowing formu oe ale or a anding uP toacerin cos of pce sue Debt s ‘Moximum Funding fom the source at a certsincost wacc= | Proportion of source of sn neconceptletustakean example aes ee tblished a target capital 1cture from gR Limited has establish pital structure Hence, WACC of the new capital structure has increased from the old capital nc page Eg iste cost of iy and debit diferent evel ane rs peers of 12.67% to 13.86%. ef ie liffeent errr oeer Calculation of Marginal Cost of Capital a ple €100 lake ne Upto € 50 lakhs ae Ure € 100 and upto 150 lakhs 18% | Above 50nd upto 100lans 175 rome € 160 and unto 200 lakhs 20% ‘Above & 100 and up 150 alts. 14x Wrong Approach of Calculating Marginal Cost of Capital capital is treated as the weighted avenge cost of rising sayy Generally marginal cost of feance. Accordingly manginal cost of capital is calculated as follows: 50 50 WAC (wrong) = 35g *0.16+ 399 < 0.10 = 13% But this approachis wrong, This approach ignores the effect of raising of new fundsoneisg 4 gyagn Estimation of break points a different levels of fundi inga taxrate of 50%, find out WAC at following levels of overall funding () azn akns (i) € 300 lakhs, funding () 100 aks erentage composition in target capital structure: 60% capil of the Fon, With new capital siracture the cost of entire equity has change, Hoag Equity 40% impact should also be taken into consideration. ‘Correct Approach of Calculating Marginal Cost of Capital ae The correct approach of calculating marginal cost of capital is to calculate the incremental cg {heakpoints in debt funding: raising additional funds. This can be calculated as follows: @ Maximum permissible overall funding with 10% cost of debt (After tax k,=5%) Incremental co ee funds = Differential cost of equity + Cost of additional det Maximum debt funding upto 10% ast ‘= (450 x 0.16 - 400 x 0.15) + 0.10 x 50 SPREE TEES = (72-60) +5 E50 1aKS _ ea, =12+5=%17 lakhs . 0.40 ‘Marginal cost of capital (cost of new funds) (i) Maximum permissible overall funding with 12% cost of debt (After tax k, = 6%) a 100 lakhs faa aan = 17% Se 250 lakhs {€) Mexinum permissible overall funding with 14% (taxk,=7%) 2150 lakhs. a = 8375 lakhs Hence, marginal cost of capital is 17%, This cost takes into account the change Pe 04 ucture and the resultant specific cost of different sources of finance.PRTG] Fundamentals of Financial M e break-Points at. {375 lakhs are the respective break. . ile distant ate oF miki required asia of daidng te copter st any pe sachs plc ge Om At ct tr co Hence, 8125 lakhs, 250 lakhs, Ay opialis te CB gp cont avenge and marginal crt and 14% (Before tax cost of debt) ak points in equity financing: Roses ing wth 16% cost of esity eyo a - os ‘Maximum equity funding up to 16% cost La is = ©1667 lakhs 06 eal fading with 18% cost of equity (i) Maxima permissible : us = pao veo Seen corte i a ral fading with 20% cst of equity i i - = cate de preference shares canbe redeemable or — (Gi) Maximum permissible either tough tral and error method or ted as per divi shortcut method. be calculated as per dividend appro. ee pbequity Om i Ba tl overal cs of pil anit cca oa a £200 Sa lakhs Ge 65833 snaccisalo | ia ie inccecierial cost of Bo additonal finance ras pagent of capital ee ence € 16567 lk, & 250 lak and 353.38 lake are the respective breakpoins 18% and 20% cost of equity. } Calculation of specific cos at different levels of funding F GvoraiLovel Funding From ‘Specific Costs| Ss Prieta. ‘Eqully ‘Debt Equity | Debt eda ets intake) (intakes) | (Ciniakhs) | (Cinlokhs) | (Cinfokhsy Cy 40 16 | 5 i debt We 5 1% 2 8 . tt eat ED +0 20 2 7 J (0 Bfre Tex fon o ifferent level of funding ‘Computation of WACC at different I . oe. Funding level (® in lakhs) wacc a 100 06 x0.16 + 04 x 0.05 = 0.116 = 11.6% aa 200 0.6 x00.18 + 04 x 0.06 = 0.132 = 132% Zarate) 300 66x 020 +04 x 0.07 = 0.148 = 148% BE cies Saher ‘Note: Proportions of funding from equity and debt remain same at all levels. 1 Tee Because ofthe increase inthe specific costs at different break points (level of funding) oe es ky = MeO +d+ aD [Rvs Ne] ost of capital (WAC) has increased.% (ii) Short-Cut Method 1M. Cost of Equity (@) Dividend Price (@) Dividend Price Plus Growth Approach =A Oeey tke pD+(RV-NPYN = vena Lom be Bite and (0 Constant Growth Rate Ge=2) ti) Varying Growth Rates fad oat Yi $ Datta", $ Drs Pe 2 aeky en ORY AY Price () Earming-Price-Approach Ey Ey Fm * P(l-s) = -eypra , Beep “B/P Ration De Rat IW, Cost of Retained Earnings (@) When there are no taxes and brokerage fee: (8) On the assumption taxes and brokerage fee: V, Weighted Average Cost of Capital (WACC) i, aus Rats k= k{1-N-B) y= hy ty + hy 10g + by Wy + hy 1, thas issued 10% debt (irredeemabe) enpany JF the debt is issued ) for € 10,00,000, y The comy open, PNY isn 50% tae © Atdiscountof 15% 1a- NP © At premium of 155 japle debt = at Discount of 15% pretest 1000009500 ‘a ~ 8,50,000 ium of 15% pod at Premio of U oe 200,000 (4 9.5) = 4.3% Fa ~ 71,50,000 company issues € 100,000, 12% debentures of 10 each. The debentures ar redeenabe ond, ner period of 7 years. The company is in 35% tax bracket ant (c) 10% Premium (@ Per @)10% Dh 6, what wil be the cost of debentures issu is at ps? {9 brokerage is paid a (cA Pea ea (@00.-30)72 k, = 120=0.35)+ (100-110) 78-13 _ 9 uay — 600% oo i10)/2 1% 1 When debentures are issued at par and brokerage ae paid at 2 12(1-035)+(100-98)/7 = 00st? = 817% (100 +98)72i eH a enc of30% and Mostaton cmt 10% of ase a EE ten NP wide 4 Caen te cot of de forthe flowing Salon oo 1) thre wes at en ee not 1% hte is 10% of the - Ma nel coats Oa beep as i a ena HHCY EH dogg ‘years and tax-rate ist Peg nN 10¢1=05) +000 85/5 = (100+ 95)/2 occu finest pyment(COD wil he 5 nin wil be € 100 50 we willy tral and eror (COP) will be tal and ero mtg ‘SGferere discounting rates. Letustry at © and 79% ‘Year =| COWCOP a o i : az H 3 axe be taken as cost of det Bt for accurate unless sence 220-8_ ros (Asa Byitepalaton = + 5579) 51.50) ae atte = 617% ~10%+ (355) 10(1-05)+(000-945)/5 _ = 10 + 0.02 = 10.02% eI f= 00+ 9459/2 is planning toraise 1 crore by the Attematively, we can use trial and error method st Bae ‘ssue of 12% perference share of 100 expenses are expected to be 2%. Fi = ek « ind outthecstf pelea Rak! Oke aa ‘ne at the end of 108 year at 15% premium. Ue drt mth eae i 18. im, De Unset 208 | Year co PUPAGt Total PV at x oD 7% “oR 15 5 422. aso | 21060 5 10 oar ara | 74700 | “95760 year at 15% preniun: By interpolation = PD+(RV-NPYIN (RV+NPV2 y= e(tis-sayio | 1242.70 _ 70 (is+aey2* 01s ~ wis ~Furctamentais of France Magee eee mesean S crmatemen dt ene APTS HN Cy =e TSS SSS -s-nae mecpcr has Seared Scien of C4 Let pearand Benge! eos, agary capone carent pene of shares of the company ise)? yan F pacoee ns mt FE A eras See wey= &-5 D.=Da+p-40-me-s Rasy 1 an 2 aS | 3 2 4 22 5 seite en Concept and Measurement BEDI] Furcoretst arc onavore! < Ot Coat oh ingpriee Find hecostofextingeguiyy om EZ “Thefotatoncostistiey tbe dof ess ce BT 30. ity share f the current market prices aa owt rae in dividend 505 Ge pt=2F 1am Solution: Lets firstalaate the 6 qe M51 FIF Hr Sy ot ne a varot Pears a fee i nlaats os spun rien congress eng 47=0 eine nD py wsing Ta 48%) #16 cmc iden wie 1860198) ein Shinn sp sete Cost ty shares = aero M 1 Py= 100, g=6% 5383 dividend growth ate k Cont of nm eg) * Fi ostation =) Fp +0065 oosass 100 005353 + 06 «01135 1.35% 0, 468 595 «MB e9n = 11766 + 8% it te "7-6 m8 19.76% serene % ical Dy = Dy (t+ )=505 capitals 19.76% = Dy (1 + 8) = 5.05 (+006) = So cost of ew egy 193 Fe ie i Pee ao eee eee 58 Gacrtion 1) Ey ses PL. cael 60, Dividend expected atthe eng. ‘ a Ea compares of Sat ok 18% What she expec rye ‘oar of eg ron at 5353 Ke= “+006 = 006508 + 096 «0:25 «12594 to happen if de o some adverse development in capital mack = ti pl mace pg | Hr company’ tates uted nthe mat 20 care is opecd o rT oa at am na be eves smut pes vee perme ye Sees ‘Solution: Pe 6 ih tof capital = Dleg = 018-5 49> g=018- 1 adabeae cium. hye Gite 018s G48 $= 018-01-00.y PA sO To cpitl i per centand heaped owt a5 Changin rot ae projection wil have an impact on expected vier and te a, fp uBeaePanY trie the dividend of 1istobemainsned ee Cae sea Fs 1m. a ny D,=Ds(1+g) = 6=Dg(1+0.08) penuh cept ae = wi gosaten ofcotte ty capital () nye shy 356 ken +8 1D, =D,(0+9)=1(1 +005) =01.05) ,becase of cangein growin rate projection 15% P, =€20,g=005, see D,=556(1-+005)—> D, =5808 108 = 3 005 = 00525 + 005-0105 = a D5, — Sa _ BA cays, fe 2 a Pom Gag) Wi8-005) ~ 013 1 8 7833 shares fA Ltd. is currently selling in the market at€ 100. Dividends padi 05 £4.25 €4.60,€485 and 05.05, The company wants to issue new equity sharesandu Sears toe Peau ona tvlly obs per share Calas gorda, ABC Lele cvidend of 4 per sare lat yer. Th conpany ep ania eritng and new ex for be company. {BCom (i), Del Unset st pes pt scedle Solution: ane (©) Calculation of growth rte % We know, Fv=PV(+g" Where, FV = Future value =€5.05 ee * | DY = Present value= €4 % g = Growth rie, “| it = No.of periods =4 years Dy =D, (+g opie ate of return is 15%, advise whether the sare shouldbe bought fits prices € 4.—— Concept and Moa, EY fecerens trent amen tate = rina eae computation of WACC (Based on Marg Capita Ee elution: First of al we will aoa the vscnaiaoat Waoe Weigh | Wot Pu @ 15% Decode Fcight is 17.62% = ying capita srr of Be Dn z ‘Company Li, eee meine 00 shares of € 10 ex | Fares of €100 each 000 referee h Sato pee, £100 8 ce Dy ‘Where, D, = ted Dividend = rs puenneedasrbeynrt)" Zag Were epee Dividend «5.77159, Dee company’s egy shares £125 andi © orcar Divident growth rateis 8%, Pt Hated pre after 1 yee Wvidend of 812 er share es ck vate matty eee = oir te be cmp ed rept a , atin order to finance an expansion pln, he cong ee eka abe ated yen = 1489 «05725210 danse ef ue wb eco geet Pen ve = 1654 +5210 668.64 Sonera Desa dele eran tot en oe a a price of equity share is expected to dectne from 2125 10 pers OM Bae eather 86rupesGppon Hence apr is Problem stare hy a Cont, De in. 2 ) Det Usa) sa Caen of specie ons ofc jG) = pee Shee poasenveial O27 BF 2K Ts 100 = Arava Capital ace valu of ® 10) ce share) = 9% (given) so preference shares secre 1 cosy soca ay # ‘of Weighted Average Cost of Capita: ‘Stara’ 1 Pepe eben “0000 ‘amount | __Woorto) | Spat Con Ph | emcee ie) paratype hare ast en pad nthe pas odnary dividends hrepy 0000 oar Tat = ao mad thst frowns expected 1 conte Anncalnerest sede | srg f 667 he = Pees Tred saree cent qvoed at 2730 andthe eben a8 | OBEY somo | ove | an | em _| cane ered to enna te weighed average ost f capital (based on market as 00000 [1000 | _ eompar. [B.Com Deki aii ‘Sotin: Tred, WACC is 14.034 % rt aon wan oie onl en nn 2000 1 (hue og Whee, =Dy0.+4) = 201+ 030)=€220, Fy=82750, 29108 | et) ~ 20he010)~6220 Hak ¢ New con ot eqiy = 2S = f= OH 08-26 = mae Corto new er lan = 1-04) = 1% (1-04 6% Hore con ely and em an, weave alte WAC op as 4,= 25030 = 008 +010 = 018 = 18% 1 (@) y= jhe Where 1 12 of € 40000 = € 48.000: ‘Book Valve €| Weis (w) | Spee at Capea ato Mate rif eben = 0% of 4000 = 9.20000 Been 00) tan = | 800 : c= Sango =925 = 15% 500000 co. ea “ ‘Working: Calculation of market value of 20,00,000 ow __| __66 oy market vale of shareholders funds: T = €2750 + 80000 shares = 8200000 ne | aaIlustration 16, The following are the book values inthe capital structure of XY2 144, Eaquity shares Face value of € 10 cach) 8% Debentures (Face value of € 100 each) 12% Preference shares (Face value of € 100 each) 10% Term Loan © 15,00,000 “The company pad dividend of€ 9 per share last year. The dividend is expected Bom 5, vapteble tte conpay is 3% Al secre re traded inthe cy me Beiarante pay aura Dente 80 Pfc sare 00 man wo - lenge cot oop sing book vale weights and mart au wesc Find ot he 1B. Coma, Dan Seaton: Cleaton of Specific cost of Capital ney @ Costotequity capital h) = Dy(l+g) 2301 +005) <5 100 = 137% k, = 22S +005 =025 026% ee Mears WACCan pe Markt Valu Wg 10-1) | 80-03) Wve | Sow com (@ Costat debenture k= ype gy = 007 oF 7% ee 0% Content | PD 2 equtystere 8 | "405.000 (G) Costof preference shares (k) = Fm = jp =012= 12% en 2 < () Costoftemnioin ——(R) = K (1-1) = 10% (1-403) = 7% pet | ‘100 Serato (9 Calculation of Weighted Average Cost of Capital (Book Value Weights Basis) + _S# ‘WAC bad on Mate vale weighs 19.19% "Source of Capt a mnee il Woigh Coat) g ae ert) 3 [WAC as per market value weights is equal to 256% ar 16 050 2500 ee guts aati Boo oe a 2 unis 18. The balance sheet of M/s XYZ Company shows the following tems a tt Dewan doom | 01 7.09 au jen Teton room | 02 0700 ‘a Sg0 000 00 T5 Sources Re Hence, WACE based on book value weights is 175% Paid up Copal | | () Caleaiaonof lu We 400,000 equ shares ot? 10e8ch oman hed rere Cont of apt at Ve Weg Bas) See isa Source ot Ceptal a Market Value | — Walghts | Specific Cost ‘Weight Cost) 15% Non convertibie debentures, | ano000 SURES aS a. Cc) 10%. oa 14% Institutional oan seo | aut sha cept zsomo | oss 2800 15508 ——=—_— Preowee Share cape oom | axe 120 198 Sane Sm | oor | orm ome hm 7,90,000 0.101 07.00 1.397 700] — 10 acFRO] Fundamentals Financial Management Sa Conctot and Moss a c is 140 and the dividend prs Capa ‘Other relevant information about the company is given below: escent Te ey 0 pec oe ee, ie ee ee weighted average cost of melt veces | Dart. | mame ma | age ee Ot eg, th ee ® St computation of Speci Te eee | ar 3 = . Coney "Moerman aan 22) 4 450 » Calculate weighted average cost of capital Assume 2 1% rate of 50% 18Com, Da equity i) - Eaming price approach 750 30 “Sotaton (i) Calclation of cost of 15 =19% Be 208 > k= 5 5% 6 = Sao m7 = 97° 45 = 1 .015-19% m6 35 =° PDHRVNPN _B+(0-sy5 —evenry2 = +2 = RVENPY2~ —Gloorsay ys = 22 og etsef T= soispsasm 10-9 +RV-NPWN _ MA-059 5 7 EE wnekery bs ae ND ae 710585 7555 = "98.335 0.0768 = 768%, Hence 1, alo 1% = e ne ay 80-09-72 eee 2 : lanl fy = 16 (1 050) = = aco “Cetin of, 1% Institational foun: y= 14 ; @ Computation of Weighted Average cost of capital gon ea "0 | Skew [eames] ze | om | aap [7 Saeco! wes | serate | conc taro | om | S| um = Bs cm | sm | tS cam | 18% a | | is Frese suis cay | 1% ri = ————_| sae ‘shneremwetle Ss etna Be let value of equity share Le, 450000 has bended “a | he rato ofthe book values ,250 basen eet rom the follwing information, cau Hence, WACC (ofthe fis 11.50% a ing erecta amare ; 1 Saroie funds eae estration 19, otematina foods limited asthe following capital structure a ‘ io Paros ‘Book Vabe Meret vant eel = 2 aroved Funds aut cptl (250 shares of 10h) 250000 asn010 aD 7 Petre copt 0 sae 100 ae peas ocho pect ce) Tee oan (cluding inter corporat deposi) ™ Reseveand sais ‘walFeds s Derren 10 | ata rformatins a ‘ech camying 14 nee) ane [Noma yield on equity shareholders funds is 15% 640000 a acaren 2% = i bestonsecure loans is 1625% ett on unsecured loans is 20% ‘Taxtefor ABC Lt. is 40% com Deity 26271 ———S—i‘ eMa IDI tener rtm ange ar Conteh an Solution: Caleutaton of Specie cont of expel before tay avi ty aa Competition 8 WEE Reo be, by ator aed is * Greay OP a rT tea hee oT 20 020% SO ace (i) by fovtone rand 45) * 0d) #020 nh © ain ne tian ge Joan) # 40.25% (given pie) 0 207% (iver) ne tan) = 20% i) hy (anered (iu) hy (Unvmeured Ho (0) (ete tan) =f, (et a ‘an te 9 i 1 gona once, WACC (before tax) ofthe given capital structure Is 20.42% ‘Determine the weighted average cont of capital using book value weights based cn he Muatration 21. Mook Value Strcture! e 14% Pebenturon (100 per debenture) ‘40000 200000, fe: Cost of 8% debentures (k,) 19 Preference shares (€100 per share) Aaquiy sharon (€10 per share) Hecent market price ofall these necuritles are: aan ccd on BV win 123 a 3 ee i of pe oe at average cost of capital based on esting capi strecane weight but the price of share ‘unchanged rice will fall to 15 per share Jealation of wore Bae sunita company has the flloning cx 1 00000 shares) sono lope % 01000 oxutty shaves €20'M he company’ forever. The tax may be expected that Presumed at 8 ey cme, company 507 You ae Ried ener ted average cost of capital if the stat company raises an ures. This would result in fy aaitional € 20500 die my Specie dridend © tant ae 0B eco ceca D, Cont of Euity k= Png = Uni 203, 206, Sener Quon, 2 Heo - » =010+ 007-037 ost of Preference share (k,) = 6% (given) a 0-1 8% (1-050) = 4%, (jciialation of Weighted Average Cost of Capital (Book Value Weights B Debentures C180 per debenture; preference shares : € 120 per share; equity share: 22 per tae Mot | Sciex Om | Mase Dividend expected on equity ahares atthe end of the year is €2 per share; anticipated gov ividentstt Mc Hhecompany pay all learnings in the form of dividends, Corporate tx rls Solution: Calculation of Specific Costs of Capital », O hep en where, D, = Expected dividend €2, Py = €22.and g.=7% 2 A +0107 a» 0.0009 + 0.07 « 0.1609 » 16.09% M-9 ye {= Tex rate = 40%, NP = Net proceeds from issue or sales of debentures = €110 (1-04) Tig" 007636 = 7.64% rp as NP "io he where, I= Annual interest payment = 14% = € 14 per debenit (tat hea 125" 125% where, PD = 15% = € 15, NP= € 120 0500 ar = 0.125 is = os 4 | im cs a i Thelore, WAC is 10.75% li) When company raises an additional debt of & 20,00,000 by issuing 10% debenture: New cost of equity (k) = 4007 = 0.20 + 007 = 027 002% ‘Cost of 10% debentures (k,) = k, (11) = 10% (1-050) =5%. mof New Weighted Average Cost of Capital (Book Value Weighs Basis) eee[6% Proforonce share Revised WACC is 13.60% Mustration 23. Equity capital 6.000; +o,c,000 | enDebenure 3000000 10% Deberaze _2900.00 5900.00 00 9% Preference share 12% Debentures 10% Term Loan company hi ‘Theequity shares of the company has OfrTTowth rate is SY pa. Tax rate is 50% Cy [BBS (H) Delhi Unio Sem. 1t9 per share for the next year: The average cost of capital Soltion: Calculation of specific cost of capital D, Cosofequityeapitl k) =p +8 > 4-705 shares of € 100 each) 8 “ver Ltd. has the following the capital structure: 5,00,000 x 000 3,50,000, 5,00,000 ws current market price of 105and company deeared ry ene a Be +005 = 01357 or 1357% pn of ection of eat digg 35 *°95 0359, osm D, iS gcorarials) = ph +g = P0428 6005.9 mm 84 gprs te) = ane = 10=p ve = OD, as noe wp > 809 921% i) =K 0-9 = gotten oe 2% 1-03) cate of Weighed Averse Cos of Capital ook Vasey Weights Bas) ‘Spectic Coat at zt 186 al | ce ao he e | an iit onbook ve wephsisiaam | sion of Weighted A ted Average Cost of Cs Cont of preference shares) = 9% (given) col Mart Vas ¢ my Cotet aches ()= KCl) ma 12H (1-050) = 6, @ eon loon (is) Cost of term loan @= K0-9 = 1 x rane e Tighe Average Cost of Capital (Book Value Weighs Basis) ton = me ‘Book Valve € ‘Weagnts | Specific Cost | Composite Cos por be ‘Saredf Copia! a o 006) wah) 1357 4518 market value weights i 154% Egaty Share Cail 00.000 oa aon accep a aso 8 om take value of equity shares ie, 8257 treet | Bf ER ee bee se ee ao hn a an ee ae 00.000 600 se | Pi, The cop stuctur of XYZ Lids as unde tee 4500000 ‘Hence, WACC based on book value weights is 649% ‘9% Debentures : Noe 24. Bharat Li, haste following capital structure as per its Balance Sheet sa stark 11% Preference shares ae lastrtion eat Equity shares (face value € 10 pe share) 000) ‘shares of € 10 each) # 10,00,000, Fp Se Bre Capi (uy pi hres of 100 cach) i Vip ebene rat a i Ht eben redeemable at pr, has tin cd 0 es of may Te mat 125% Debentures (ally paid of 100 each) ec ieserre 15. 12% Term Loan oa ela per ee eee icerable st Par, has 3% floatation cost and 10 years of maturity. The ‘ _ (8 uty share has: Additonal formato: () Capenty quoted pices in the stock exchange: 4 lotation cost and market price pe shareof 24 The expt de 2 Eau Share, @ 6125, Preference Shares @ 60; Debentures @ 95 cet] eMBancal growth "The fimniasspackectpayagaenigpatetenldon ( Forthe lst yes he company had paid equity dividend of 8 er share whichis Capua income tax rate is 35% ‘grow @ 5% pa. forever. The Corporate tax rate is 30% ‘weighted average cost of capital (WACC) market value weight Cane Weighed verge Cs f Cpa sing) Book Value Weights) ait Ae ag Be cm fap NTE on, om, DAU 2 age pital using (a) ICARCE) BBS. (H) Delhi Unix. Sem eelation: Cakaaton of Specifics of Capita () Cost of Debenture(k) sy, 91=039}4100=10250)/19 ra-n+av-NON « 2°05 -10250)/2 wey? 585-028 «gis = 548% = ines preference shares (iy) ° earnings (,): The costo retain err er opa, 1200 MRSDV/I0 _, 1-02 oon es i oan cot 4 Ng _ AGN IDE « ~ qo0910282)/2 “Tora =0 ut Whe rey and may be calcalated ss fon fap a fo ere cage pee Dy, fa: caters cn (G@ Costat qty epi beg e8 > Ts 0m 0005-9, emer 2 905 = 0:10 +005 = 015 or 15 ono O38 oy Re Bits eas % computation of WACC based on Book Vale We, 5%, ; Market Value Weights, ‘Book Valve % ight ‘Computation of WACC based on ae & = otvaiet | wos | Ooo iy e ae Ee ail Ripe aioe 2p87 oe ry Deter 0 0138 1057 a ramecoencr | sama | ae | 1600 ca rata [_ 1000 ae a a £2 2200, 8 FT bs sets of € 52,000 fat have ben WCC is 50% yu the following informat pi eral Reserve of €3,60,000 and Debt of 10, byt ae an mamnacing company hat upped Yo te flowing inernaio ot tc eet dee were G23 Ca eee tg A =— ee mart vale of equly aso B00 a te eon rosa | es ea Use markt values weigh pear acres = 72000 | Faedosses eee ee, snato | Cirrtssels al ee : 450000 c. ; es Interest ra Prot er inerest = Tes Tax @ 40% == Profit ater tax ae ‘floatation ‘No. of Equity shares (N) 323880 a co) epauce shares ale price 10 pe share, 2 Hotton costs. PAT _ $2580 5 (ii) Eu shares: sale price 115 per share, floation costs €5 per share. 18,000 79833 oc Say 818 ‘WConputtion of Specific Costs: The corporat tax ates 35% and the expected growth in equity dividend is 8% per yest Te divide at ther of the current financial year's € per share. Assume that the company iss present capil structure and intends to maintain it. Detemine weighted average costo opt by Wp ‘value weights. {B.Com(#). Deli Solution: Calculation of Specific ns of Capita: PcutcDeent jee 10 +8V-NOyN _, 301-059)}40,05-2,480/20 _ 2754875 a (2.605+2,450)72 = 2S15 =k, ky =8% (1-04) = 48%boo structure & Crore) 15 1 20 10 125 ARV + NP? = SE 08072 69043533 «gyn37« 137% 0 (Cost of preference shares, P+ (RV-NP)2 = avenna 124(100-75)/10 *(100475)/2 (Gi) Cost of equity capital =P 4g 3M so07= a1sori6% a aaa 124250 75 6.57% =0.1657 (io) Cost of term loan (k) + Gi) =k (1-9 =11%(1-04) = 66% 4.150 hasbeen divide C2100 Ee ies: he (pbook value Weight (i) makati (885) Det 2 ac “no ighted “Chased on book value weights is 13.21% er wAct Sh market value of equity share MORCERL ang Average Com of Capita eg ‘Book Voie @ | = tow Fe ion of WEN AHI COR ila ap ace ae Merkot Value ® sh ay a | i asrnazesr snare capa = —_75,00,000 ere 42857 168 80000000, 128000000 | 1.250000 | oabert® | = tt va weigh 14305 60.00,00000 as eee and Retained eamings in the rato ofthe eek mes et ee ig DoerineCostl piling matateinenagren eee towing at sisgbookralcewegstadon eresooptl rue: ‘Debentures (€ 1,000 each per debenture) tH shares (10 enc per shar) une yy shares (10 each pet share) an vcutes are traded in the capital maths and ree msec Debenture 00 perdebne Pece shares ieee Equity shares 20 perstare Jape acing opportunities ae: {10 per debenture redeemable at par crying Sines Naty pedis esd flotation cost is 4%, Sale price & 1,000. eee {i €10 Preference shares redeemable at par carrying 10% dividend rat. Maturity perio i 1 yexs and flotation cost is 5%, sale price ¥ 10. (3) Equly shares; equity dividend at the en ofthe yearist20 persis prt 20 bd ‘growth rate in dividend is 5%. Corporate tax rate is 35% 1888 (0, Dei Un Sm. 1,203) Me:Ta rate given in question paper is 55%. thas been modified to 5%seer a : es of Capital cco ef 35) 0000-940)/20 tion: CHO TT 1-038) + 1000: ‘ ON ee ay aero Dy a nS ae 5242 _ possi = 551% 6 ors)! a q0-950/08 , 1400883 oct goat = on ca comet i eos ~qo-950)/2 975 a, Bear syonial a conserve? (oS Roa” ten always take issue price for coms sesnepic te ingen en nn = eights Basis) wae ast cf Capit Book Valve Wei a fp coast rock value weighs i 107% “Fees WACK based ca Cost of Capital (Market Value Weights Basis) (@) Caeton of Weighted Taat | Waeits [Costar Cantal | Weigh Coty | ‘Sarat all | to cor pat | ee fl 551 ts <5 mame | ai | ee | tm | Peanut com | | ta | Iwan si on povided by SRL, You st regu ein en Fo eg ro wean Nae vale wes Te Seleucia SRL 99000 Dette (10 pe dba) sng Pree pr sha) 2ap00 uy Share 10 pera) 0 etna ig za pa ‘Allthese secures ar tradedin the capital markets, Recent prices are 4 shares © 120 and equity shares @©€ 22. Anticipated external financing opportunites a8 eipeentse Mon ceperrso C1 redeemable at par 29 1 debenture Pat: 20-year mata pon are redeemable at re ference share Par: 15-year, at ag {Caper share foatation ons, ater tag ie expec cn trey te ne cent So itt p The corporat t Widen. The oro ie! of Specific cst of Capital ‘BV NDE 0056) 560029 8 gtr sae): PD+(V-Nny2 RV SNP) _10+100-95y5 ~ (00352 10403903 o75 | Cott equity capital (k,) ke = 00552 = 5.92% = 1060 = 10.60% Deze, Ka ql +s 3ry +005 [ Gotofretaned earnings k,) The cost of retained, D, 2 Seo anne Kap +8 > +005=1409% Clin of Weighted Average Cost of Capt ook Ve Weigh Ba dr, —— a to "tote earings (willbe equal costa A) But there is no floatation cost in respect of retained earnings. There te acta ec ‘anings willbe lower than equity and may be calculated as fulles. (he cont of reed z aah sue price (ale price i give, then always ike ine pic fo conpeabon a ‘Book Value € | Weights | Specie Coat | Weight Cost(A) (BY) CJ 3 a 10,00,000 | os | 582 Seed 8,00,000 0125 1060 1 20,00,000 0s so a 00,000 0125 408 = = Er zao000 | — 160 IMEC ed on book value weighs RATFundamentals of Financial Management (i) Calculation of Weighted Average Cost of Capital (Market Value Weights Basis) ? q ‘Source of Capital MarketValue® | Weights | CostofCapital | we | ch 2) (w% ‘OM Cos 95 | Debenture 41,00,000 0.1803 5.92 i Ps | Preference Share capital 6,00,000 0.0984 10.60 4 pe | Equity share capital 35,20,000 0.5770 15.00 ree Retained earings 8,80,000 0.1443 14,09 aia \ 61,00,000 7.000 ae ‘WACC as per market value weights is 12.80%. Note: Total market value of equity share ice., © 44,00,000 (2,00,000 x 22) has been divided bety, share capital and Retained earnings in the ratio of their book values, i.e., 5:1. eM ena Tlustration 31. ABC Ltd. wishes to raise additional finance of ® 20 lakhs for meeting its inves The company has &4,00,000in the form of retained earnings available for investment Purposes Trent are the further details : fli Debt equity ratio 25:75, Cost of debt at the rate of 10% (before tax) upto € 2,00,000 and 13% (before ia) that Eaming per share, 12. Dividend payout 50% of earnings. Expected growth rate in dividend 10y, ‘market price per share, ¥ 60. Company's tax rate is 30% and shareholder's personal tax rate is 20% (Calculate the post tax average cost of additional debt. Reshind (i Calculate the cost of retained earnings and cost of equity. (Git) Calculate the overall weighted average (after tax) cost of additional finance. [CA, PCE, May 2y Solution: (a) Pattern of raising capital : z ‘Debt (25/100) x 20,00,000 5,00,000 Equity (75/100) x 20,00,000 15,00,000 Total 20,00,000 Equity fund: Debt fun: Retained earning 4,00,000 10% debt Equity (additional) 11,00,000 13% debt Total 15,00,000, Total 0 K= Total terest 0) e occa <9 cooK 020) = 0.0826 = 8.26% Wi x=? += & +010 = 0.10 + 0.10 = 0.20 = 20% K,=K,(1-f) = 20(1-0.2)=16% where, , = shareholders’ personal tax rate (ii) Computation weighted average cost of capital Particulars ‘Amount After tax Equity Capital 11,00,000 20.00% Retained earning 4,00,000 16.00% Debt 5,00,000 8.26% Total 20,00,000 300 K 325,500, 109 = 16.27% 20,00,000