Cost of Capital

Practice Problem

The stock of Sohrab Industries, a mature company, sells for Rs16.8 and last year’s dividend was
Rs3 per share. The stock has a par value of Rs10 per share. A flotation cost of 5 percent would
be required to issue new common stock. Three different security analysts are projecting that the
common dividend will grow at a constant rate; 2 percent, 2.5 percent, 3 percent, a year, Sohrab’s
10% preferred stock, 100 face value, pays a dividend of Rs10 per share and currently selling at
Rs90 per share. The company will incur 2.5% floatation cost if it issues new preferred stock. The
company has outstanding bond with characteristics; par value Rs1000, coupon rate 10%, 10 year
to maturity, current price Rs811, and its marginal tax rate is 40 percent. Management believes
that the company will earn an expected return on equity in next year 30% with 90% dividend
payout ratio. The target GDP rate was once 4.1% but now cut down to 2% because the flood
has devastated the economic growth. The interest rate on short term debt is 1 year -KIBOR plus
2%.

Requirements:

• Calculate the after tax cost of debt?

• Calculate the cost of common equity if the company retains earnings and does not issue
new common stock, using all the approaches discussed?

• What the cost of preferred stock for the company?

• What would be the investor’s required rate of return if the company issues new stock?

• What is the company’s WACC, assuming the company will issue new stock?

• Also calculate the retained earnings breakeven and suggest that up to what capital budget
level retained earnings would be sufficient to meet the equity requirements? Is it written
is stone that a company has to issue stock after that point?
Note: The incorporation of floatation cost is left at the discretion of the students.

Sohrab Industries
Balance Sheet, As on June 30
Items 2010(mn) 2009(mn)
Cash and equivalents 58 10
Short-term investments 10 150
Accounts receivable 358 160
Inventories 265 175

Total current assets 693 495

Net plant and equipment 615 550

Total assets 1306 1045

Accounts payable 60 30

Notes payable-Bank loan 110 60

Accruals 140 130

Total current liabilities 310 220

Long-term bonds 754 580
Total liabilities 1064 800
Preferred stock (400,000 shares) 40 40
Common stock (13,000,000 shares) 130 130

Retained earnings 72 75
Total common equity 202 205
Total liabilities and equity 1306 1045
 Sohrab Industries
Income Statement, For the year ended,June 30
Items 2010(mn) 2009(mn)
Net sales 3000 2850
Operating costs excluding depreciation and 2616 2497
amortization
Earnings before interest, taxes, depreciation, 384 353
and amortization (EBITDA)
Depreciation 100 90
Amortization 0 0
Depreciation and amortization 100 90
Earnings before interest and taxes (EBIT, or 284 263
operating income)
Less interest 92 66
Earnings before taxes (EBT) 192 197
Taxes (40%) 77 79
Net income before preferred dividends 115 118
Preferred dividends 4 4
Net income 111 114
Common dividends 39 39
Addition to retained earnings 72 75
Per-Share Data
Common stock price 16.8 15.0
Earnings per share (EPS) 8.6 8.8
Book value per share (BVPS) 15.6 15.8
 Rates of Treasury Securities

Security Maturity Rate (%)

Treasury Bill 3-Month 12.10

Treasury Bill 6-Month 11.00

Treasury Bill 12-Month 11.00

Pakistan Investment 3-Year 12.27

Bond

Pakistan Investment 5-Year 12.37

Bond

Pakistan Investment 7-Year 12.47

Bond

Pakistan Investment 10-Year 12.47

Bond

Pakistan Investment 15-Year 12.90

Bond

Pakistan Investment 20-Year 13.09

Bond

Pakistan Investment 30-Years 13.55

Bond

Historical Data of EPS and DPS

Year EPS DPS
1999 4 2.4
2000 4.3 2.8
 2001 4.6 2.9
2002 5.3 3
2003 6.2 3
2004 6.9 3
2005 7.4 3.1
2006 8.3 3.2
2007 9.2 3.3
2008 7.5 3.1
2009 8.8 3.5

KIBOR September 23, 2010.

Tenor BID (%) OFFER (%)

1-Week 11.53 12.03

2-Week 11.79 12.29

1-Month 12.20 12.70

3-Month 12.57 12.82

6-Month 12.71 12.96

9-Month 12.77 13.27

1-Year 12.84 13.34

2-Year 12.97 13.47

3-Year 13.07 13.57

Source: www.sbp.org.pk, 23-10-2010.

Months P Rm Rs
1 0.06 0.21 0.35
2 0.02 -0.42 -0.61
3 0.01 -0.09 -0.11
4 0.09 0.11 0.15
5 0.03 0.25 0.36
6 0.11 0.27 0.18
7 0.04 -0.07 -0.12
8 0.01 -0.03 -0.01
9 0.11 0.26 0.20
 10 0.10 0.17 0.13
11 0.01 -0.04 -0.06
12 0.04 0.28 0.37
13 0.02 0.27 0.30
14 0.01 0.43 0.53
15 0.02 0.27 0.21
16 0.15 0.20 0.09
17 0.02 -0.08 -0.08
18 0.15 0.28 0.23

Compiled by:

Mudassar Hasan

MBA(QAU)