Chapter 10

THE COST OF CAPITAL

1(a) Define rD as the pre-tax cost of debt. Using the approximate yield formula, rD can
be calculated as follows:

14 + (100 108)/10
rD = ------------------------ x 100 = 12.60%
0.4 x 100 + 0.6x108

(b) After tax cost = 12.60 x (1 0.35) = 8.19%

2. Define rp as the cost of preference capital. Using the approximate yield formula rp
can be calculated as follows:

9 + (100 92)/6
rp = --------------------
0.4 x100 + 0.6x92

= 0.1085 (or) 10.85%

3. WACC = 0.4 x 13% x (1 0.35)

+ 0.6 x 18%
= 14.18%

4. Cost of equity = 10% + 1.2 x 7% = 18.4%

(using SML equation)
Pre-tax cost of debt = 14%
After-tax cost of debt = 14% x (1 0.35) = 9.1%
Debt equity ratio = 2:3
WACC = 2/5 x 9.1% + 3/5 x 18.4%
= 14.68%

5. Given
0.5 x 14% x (1 0.35) + 0.5 x rE = 12%

where rE is the cost of equity capital.

Therefore rE 14.9%
Using the SML equation we get
11% + 8% x = 14.9%
where denotes the beta of Azeezs equity.
Solving this equation we get = 0.4875.

6 (a) The cost of debt of 12% represents the historical interest rate at the time the debt was
originally issued. But we need to calculate the marginal cost of debt (cost
of raising new debt); and for this purpose we need to calculate the yield to
maturity of the debt as on the balance sheet date. The yield to maturity will not
be equal to 12% unless the book value of debt is equal to the market value of
 debt on the balance sheet date.

(b) The cost of equity has been taken as D1/P0 ( = 6/100) whereas the cost of equity is
(D1/P0) + g where g represents the expected constant growth rate in dividend per share.

7. The book value and market values of the different sources of finance are
provided in the following table. The book value weights and the market value
weights are provided within parenthesis in the table.

(Rs. in million)
Source Book value Market value
Equity 800 (0.54) 2400 (0.78)
Debentures first series 300 (0.20) 270 (0.09)
Debentures second series 200 (0.13) 204 (0.06)
Bank loan 200 (0.13) 200 (0.07)
Total 1500 (1.00) 3074 (1.00)

8.
(a) Given
rD x (1 0.3) x 4/9 + 20% x 5/9 = 15%
rD = 12.5%,where rD represents the pre-tax cost of debt.

(b) Given
13% x (1 0.3) x 4/9 + rE x 5/9 = 15%
rE = 19.72%, where rE represents the cost of equity.

9. Cost of equity = D1/P0 + g

= 3.00 / 30.00 + 0.05
= 15%
(a) The first chunk of financing will comprise of Rs.5 million of retained earnings
costing 15 percent and Rs.25 million of debt costing 14 (1-.3) = 9.8 percent.
The second chunk of financing will comprise of Rs.5 million of additional equity
costing 15 percent and Rs.2.5 million of debt costing 15 (1-.3) = 10.5 percent.

(b) The marginal cost of capital in the first chunk will be :

5/7.5 x 15% + 2.5/7.5 x 9.8% = 13.27%
The marginal cost of capital in the second chunk will be :
5/7.5 x 15% + 2.5/7.5 x 10.5% = 13.50%

Note : We have assumed that

(i) The net realisation per share will be Rs.25, after floatation costs, and
(ii) The planned investment of Rs.15 million is inclusive of floatation costs

10. The cost of equity and retained earnings

rE = D1/PO + g
= 1.50 / 20.00 + 0.07 = 14.5%
The cost of preference capital, using the approximate formula, is :
11 + (100-75)/10
rE = = 15.9%
 0.6x75 + 0.4x100
The pre-tax cost of debentures, using the approximate formula, is :
13.5 + (100-80)/6
rD = = 19.1%
0.6x80 + 0.4x100

The post-tax cost of debentures is

19.1 (1-tax rate) = 19.1 (1 0.5)
= 9.6%
The post-tax cost of term loans is
12 (1-tax rate) = 12 (1 0.5)
= 6.0%

The average cost of capital using book value proportions is calculated below:

Source of capital Component Book value Book value Product of

cost Rs. in million proportion (1) & (3)
(1) (2) (3)
Equity capital 14.5% 100 0.28 4.06
Preference capital 15.9% 10 0.03 0.48
Retained earnings 14.5% 120 0.33 4.79
Debentures 9.6% 50 0.14 1.34
Term loans 6.0% 80 0.22 1.32
360 Average cost 11.99%
capital

The average cost of capital using market value proportions is calculated below :

Source of capital Component Market value Market value Product of

cost Rs. in million
(1) (2) (3) (1) & (3)

Equity capital
and retained earnings 14.5% 200 0.62 8.99
Preference capital 15.9% 7.5 0.02 0.32
Debentures 9.6% 40 0.12 1.15
Term loans 6.0% 80 0.24 1.44

327.5 Average cost 11.90%

capital

11.
(a) WACC = 1/3 x 13% x (1 0.3)
+ 2/3 x 20%
= 16.37%

(b) Weighted average floatation cost

= 1/3 x 3% + 2/3 x 12%
= 9%
(c) NPV of the proposal after taking into account the floatation costs
= 130 x PVIFA (16.37%, 8) 500 / (1 - 0.09)
= Rs.8.51 million