Chapter # 03

Cost of Finance
Zero Coupon Debentures:
Post tax cost of debt = {(Redemption value ÷ Issue value*) 1/n – 1} x (1 – tax)
Where:
n = years to redemption.
*Market value shall be used in case of previously issued debentures.

Illustrative Example # 01:

Z Limited has just issued zero coupon bond at 40% discount which are redeemable at par (Rs. 100) in 8 years’ time. Income tax rate is 30%.
Required:
Calculate cost of debt for use in calculation of WACC.

Answer:
Post tax cost of debt = {(Redemption value ÷ Issue value) 1/n – 1} x (1 – tax)
Post tax cost of debt = {(Rs. 100 ÷ Rs. 60) 1/8 – 1} x (1 – 0.30) = 4.62%

Illustrative Example # 02:

Five years ago C Limited issued zero coupon bond at 50% discount on par value (Rs. 100) which are currently trading at Rs. 65. Bonds are
redeemable at 5% premium after 6 years. Income tax rate is 30%.
Required:
Calculate post tax cost of debt.

Answer:
Post tax cost of debt = {(Redemption value ÷ Issue value) 1/n – 1} x (1 – tax)
Post tax cost of debt = {(Rs. 105 ÷ Rs. 64) 1/6 – 1} x (1 – 0.30) = 6.02%
LO 04: WEIGHTED AVERAGE COST OF CAPITAL (WACC):
The weighted average cost of capital (WACC) is a weighted average of the (after-tax) cost of all the
sources of capital for the company. The different costs are weighted according to their market values.
This can be done using following formula:

(𝑬𝒒𝒖𝒊𝒕𝒚 𝒙 𝒌𝒆)+(𝑫𝒆𝒃𝒕 𝒙 𝒌𝒅)

WACC =
𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕
Example # 25:
A company has 10 million shares each with a value of Rs.4.20, whose cost is 7.5%. It has Rs.30 million of 5% bonds with a
market value of 101.00 and an after-tax cost of 3.5%.
It has a bank loan of Rs.5 million whose after-tax cost is 3.2%. It also has 2 million 8% preference shares of Rs.1 whose market
price is Rs.1.33 per share and whose cost is 6%.

Required:
Calculate the WACC.
Question # 34:
Orange Ltd has the following detail:
Share Capital (10,000 shares of Rs. 10 each) 100,000
Reserve 50,000
10% Redeemable Debt (Term 3 Years) 25,000
12% Irredeemable Debt 20,000
Cost of Equity 16%
Dividend growth rate 5%
Last dividend paid (Per Share) Rs. 9.50
Post tax kd for Redeemable debt 8%
Post tax kd for Irredeemable debt 9%
Tax rate observed in the country is 30%

Required:
Calculate WACC for Orange Ltd.
Question # 02: {Exam Standard Question}
Educare Plc is listed on the Karachi Stock Exchange. The company’s statement of financial position at 31 August 20X3 showed
the following long-term financing:

Rs. In Million
1.2 million ordinary shares of Rs. 25 each 30
Reserves 55
85
9% loan stock 20X5 30

On 31 August 20X3 the shares were quoted at Rs. 121 cum div, with a dividend of Rs. 5.2 per share due very shortly. Over
recent years, dividends have increased at the rate of about 5% a year. This rate expected to continue in the future.
The loan stock is due to be redeemed at par on 31 August 20X5. Interest is payable annually on 31 August. The post-tax cost
of the loan stock is 5.5%. The company’s corporation tax rate is 30%.
Required:
Determine the company’s WACC at 31 August 20X3.
Question # 03: {ICAP Model Paper Q # 09, 06 Marks}
Jamal Limited (JL) is intending to expand its existing operations and considering to issue bonds to finance the expansion. You
have been provided with the following extracts from JL’s financial statements:

Statement of Financial Position

Rs. in ‘000’
3 Million Ordinary Shares of Rs. 100 each 300,000
Retained Earnings 400,000
10% Long Term Loan 650,000

The shares are quoted at Rs. 475 cum dividend.

The dividend of Rs. 25 per share is due shortly. JL has paid out following dividends during the past four years:

Years 20X1 20X2 20X3 20X4

Dividend per 10 15 18 20

The loan was obtained from a bank 2 years ago and is repayable in 10 years' time. Tax rate applicable to JL is 30%.
Required:
Determine JL’s weighted average cost of capital (WACC).