Chapter 9: The Cost of Capital

Problem 1
Face value (Rs)
Before-tax Interest (Rs)
Period (years)
Discount
Underwriting
Premium (Rs)
Tax
After-tax interest (Rs)
Cash inflow (face value less discount & underwriting
commission)

14%
3%
3%

1000
140
7
30
30
30

35%
91
940

Cash inflow (face value plus premium less underwriting

comm.)

1000

Yearly discount write-off

Tax saved on discount write-off
Yearly underwriting comm. write-off
Tax saved on underwriting comm. write-off
Yearly premium income
Tax on premium

4.29
1.50
4.29
1.50
4.29
1.5

Year

ATINT

Tax
saved

Tax saved

Tax on

Discount

outflow

discount

on underwriting
comm.

Premium

NCF

0
1
-91
1.5
1.5
2
-91
1.5
1.5
3
-91
1.5
1.5
4
-91
1.5
1.5
5
-91
1.5
1.5
6
-91
1.5
1.5
7
-91
1.5
1.5
7 Year 7 cash flows include repayment
After-tax cost of debenture
Debenture issued at discount
7

940=

t=1

88 t
t

1, 000
7

1k d 1 k d

k d =10 . 03
Debenture issued at premium
7

940=

t=1

91 t
t

1, 000
7

1k d 1 k d

k d =9 . 10
Problem 2
Rs
million
Face (and maturity) value

-1.5
-1.5
-1.5
-1.5
-1.5
-1.5
-1.5

940
-88
-88
-88
-88
-88
-88
-1,088
-1,000
10.03%

Net proceeds
Interest
Period (years)
Tax rate
Market value after 4 years
After-tax interest: 0.27 (1 - 0.52)
After-tax interest cost
After-tax yield after 4th year

13.50%
7
52%

1.8
0.27

2.2
0.130
8.43%
2.95%

After-tax cost of debenture:

7

1. 8=

0. 13t

t=1

2. 0

1k t 1k d

Aftertax cost=8. 43%

After-tax yield at the end of 4th year:
3

2. 2=

t=1

0. 13t
t

2 .0
3

1k t 1k d

Aftertax cost=2. 95%

Problem 3
Face value
Dividend, DIV
Current market price, P
Cost of preference capital, DIV/P = 9.75/80

9.75%

100
9.75
80
12.19%

Problem 4
Current market price, P0
Book value, B0
EPS0
DIV0
Retention ratio: (EPS0 - DIV0 )/EPS0
ROE: EPS0/B0
Growth, Retention ratio x ROE
Expected dividend: DIV1
Cost of equity:

DIV 1
1. 61
g=
0. 12
P0
25

25
18
3.6
1.44
60%
20%
12%
1.61
18.45%

Problem 5
Current market price, P0
Book value, B0
EPS0
DIV0
Net issue price, I0
ROE, EPS0/B0
Retention ratio: (EPS0-DIV0)/EPS0
Growth: Retention ratio x ROE
DIV1
Cost of new issue:

96
65
10
7
80
15.4%
30%
4.62%
7.32

13.8%

Cost of new issue:

DIV 1
7 .32
g=
0. 046
I0
80

13.8%

Problem 6
DIV
Current market price, P0
Cost of equity: DIV/P0: 3/33
It is a no-growth share.

3
33
9.09%

Problem 7
Year
1
2
3
4
5
6

DIV
2.00
2.20
2.42
2.66
2.93
3.22

Growth
0.1
0.1
0.1
0.1
0.1

Growth in dividend
10%
Current market price, P0
150
Expected dividend next year, DIV1
3.55
Issue price, I0
140
Flotation cost per share
10
Cost of equity (including flotation cost):
DIV 1
3 . 55
g=
0 . 10
12.7%
I 0 f
14010
Cost of equity (ignoring flotation cost):
DIV 1
3. 55
g=
0. 10
12.5%
I0
140
Theoretically, it is appropriate not to adjust floating cost in the calculation of the
cost of equity. Rather, this cost should be adjusted to the initial cost of the
investment project.
Problem 8
BV
(Rs mn.)
Ordinary shares
Reserves
Preference share
Debt
Total capital

Tax rate
Face value of debenture, F
Underwriting commission, c
Net proceeds from debenture issues, I = 1,000 - 20
Interest rate
Interest on debenture, INT = 1,000 x 16%
Period (years), N
Before-tax cost

30
10
20
40
100

35%
1000
20
980
16%
160
20

Weight
(wb)
0.3
0.1
0.2
0.4
1.0

MV
(Rs mn.)

Weight
(wm)

Cost of
capital

60

0.5

24
36
120

0.2
0.3
1.0

15.57%
15.00%
9.76%
10.57%
WACC

INT
1
2

1
20

F I

160
=

FI

1
20

16.26%

1, 000 980

1, 000 980

After-tax cost, 0.1626(1-0.35)

Face value of preference share, F
Issue price , I
Underwriting commission, c
Net proceeds from preference issues, I
Preference dividend rate
Preference dividend, PDIV
Cost of pref. Share =
PDIV 11

10.57%
100
120
7.25
112.75
11%
11
9.76%

112.75

Current price of ordinary share, P0

DIV1
Growth
Issue price, I0
Flotation cost, f
Net proceeds, 145 - 5
Cost of retained earnings:
DIV 1
12
g=
0. 07
P0
150
Cost of new issue of share:
DIV 1
12
g=
0 . 07
I 0 f
1455

150
12
7.00%
145
5
140
15.00%

15.57%

Problem 9
(a)

Cost of debenture:

Tax rate
Current market price of debenture
Face value of debenture
Interest on debenture
Remaining period (years)

35.00%

10.00%
5

100
100
100
100
1,100

1
2
3
4
5
1k d 1k d 1k d 1k d 1k d
k d =0.114 or 11. 4%
A fter-tax cost of debenture=0
.1141-0.35=0.074 or 7. 4%

950
1,000
100

950=

(b)

7.4%

Cost of preference share

Current market price of preference. P0

Preference dividend, PDIV
Cost of preference, kp =PDIV/P0

60
6
10.00%

( c ) Cost of equity
Growth in dividend, g:

Year
1
2
3

Annual
DIV
Growth
2.00
2.16
0.080
2.37
0.097

4
5
6
7
8

2.60
2.80
3.08
3.38
3.70

Average

0.097
0.077
0.100
0.097
0.095
0.092

Alternatively, dividend growth can be calculated as a geometric average follows:

g=

1/7

3. 70
2. 00

1=0. 092

Current market price of equity, P0

Current dividend, DIV0
Dividend growth
Expected dividend, DIV1 = 3.7(1.092)
Cost of equity:

4 .04
0.092
50

0.092
50
3.7
9.2%
4.04
17.3%

(d) Weighted average cost of capital:

(Rs 000)
Debenture
Preference
Ordinary share
Total
WACC

500
400
600
1500

Weight
(w)
0.333
0.267
0.400
1.000

Problem 10
Investor's opportunity cost
Expected return
Tax rate
Brokerage
Funds available after brokerage, (1 - 0.03)
After-tax return from reinvestment, 0.18 0.97 (1 0.30)
Firm's opportunity cost

0.18
0.30
0.03
0.97
0.122
0.12

Since the investors opportunity cost is higher, dividends maybe distributed.

Problem 11
Market price of ordinary share (Rs)
Expected DIV (Rs)
Growth
Cost of internal equity (retained earnings):

1.5 0
0.10
25
Issue price of ordinary equity (Rs)
Cost of equity (new issue):
1. 50
0.10
22
Issue price of preference share (Rs)
Flotation cost (Rs)

25
1.5
0.1
0.16
22
0.168
23
3

Cost (c)
0.074
0.100
0.173

wxc
0.025
0.027
0.069
0.120
12.0%

Net proceeds from pref. share issue (Rs), [23 - 3]

Preference dividend (Rs)
Cost of preference: 2/20
Cost of debt
Tax rate
After-tax cost of debt: 0.17(1 - 0.5)
Retained earnings (Rs 000)
Equity weight
Investment before new equity (Rs 000), [700/0.75]
Investment planned (Rs 000)

Source of capital

20
2
0.1
0.17
0.5
0.09
700
0.75
933.33
1,000

Amount

Weights
(w)

Retained earnings
Cost ( c )
wxc

14% Debt (Rs mn.)

93.75
0.1875
0.085
10% Preference (Rs mn.)
31.25
0.0625
0.100
Ordinary equity (Rs mn.)
375.00
0.7500
0.160
Total capital (Rs mn.)
500
1.000 WACC
The firm will have to issue new equity share to finance its funds requirement in excess of Rs 933,333.

0.016
0.006
0.120
0.142

Problem 12
Current equity share price (Rs)
Expected dividend, DIV1 (Rs)
Growth, g
Cost of equity:

36
3.6
0.08

3.60
0.08
36

0.18

Preference dividend (Rs)

Market price of irredeemable preference share (Rs)
Cost of irredeemable preference share: 10/81.81
Market price of redeemable preference share (Rs)
Remaining maturity of redeemable preference share
Cost of redeemable preference share:

9 3=

10
1

10
2

10
3

1k p 1k p 1k p

10
81.81
0.122
93
7

10
10
10
110

4
5
6
7
1k p 1k p 1k p 1k p

11.51%

k f =0.1 1 5 1o r 1 .15 1 %
Before-tax cost of term loan
Tax rate
After-tax cost of term loan: 0.14(1 - 0.35)

0.14
0.35
0.09

Weighted average cost of capital (WACC):

Source of capital
Equity capital
Reserve & surplus
10% Irredeemable pref. share
10% Redeemable pref. share
12% Term loan
Total capital

Problem 13
Growth in dividends:

(Rs mn)
563.50
485.66
56.00
28.18
377.71
1511.05

Weight
(w)
0.3729
0.3214
0.0371
0.0186
0.2500
1.0000

Cost (c)
0.1800
0.1800
0.1222
0.1151
0.0910

WACC
0.0671
0.0579
0.0045
0.0021
0.0227
0.1544
15.44%

New Issue
Cost ( c )
0.085
0.100
0.168

Year

y = (Y5.5)

EPS

ln EPS

y x ln EPS

1
2
3
4
5
6
7
8
9
10
Avg.

1
2
3
4
5
6
7
8
9
10
5.5

-4.5
-3.5
-2.5
-1.5
-0.5
0.5
1.5
2.5
3.5
4.5

2.24
3.00
4.21
3.96
4.80
4.40
5.15
5.05
6.00
6.80

0.80648
1.09861
1.43746
1.37624
1.56862
1.48160
1.63900
1.61939
1.79176
1.91692

-3.6291
-3.8451
-3.5937
-2.0644
-0.7843
0.7408
2.4585
4.0485
6.2712
8.6262
8.2285

ln (1+g) = 8.228/82.85 = 0.09974

(1+g) = 1.10488
g, (growth) = 1.10488 - 1 = 0.10488 or (approx.) 10.5%

0.09974
1.105
0.105

Market value per equity share (Rs)

Equity dividend (Rs)
Expected equity dividend (Rs), DIV1
Cost of equity: (4.42/50) + 0.105
Face value of preference (Rs)
Market value per preference share (Rs)
Pref. dividend rate
Pref. dividend (Rs)
Cost of preference share: 10/77.5
Long-term debt interest rate
Tax rate (assumed)
After-tax cost of long-term debt: 0.14(1 - 0.35)
Debenture interest
After-tax cost of debenture: 0.13(1 - 0.35)

50
4
4.42
0.193
100
77.5
0.1
10
0.129
0.14
0.35
0.09
0.13
0.085

Weighted average cost of capital:

Amount
(Rs 000)

Source of capital
Equity (Rs 25 par)
Reserves
Preference (Rs 100)
Debentures
Long-term debt
Total capital

Weight
(w)

Cost (c)

66412
65258
3000
30000
5360
170030

0.3906
0.193
0.3838
0.193
0.0176
0.129
0.1764
0.085
0.0315
0.09
1.0000 WACC

EPS
2
21.55
22.14
26.40
20.16
20.40

DPS
3
5.28
5.76
5.76
6.53
7.68

wxc
0.075
0.074
0.002
0.015
0.003
0.170
17.0%

Problem 14
Year
1
1
2
3
4
5

AMP
4
143.04
187.52
312.32
587.52
366.72

ROE
5
0.21
0.19
0.12
0.110
0.1

Retention
(6)=[(2-3)/2]
0.755
0.740
0.782
0.676
0.624

6
7
Average

23.09
22.00
22.25

11.53
7.68
7.17

416.64
355.20
338.42

0.1
0.08
0.1291

0.501
0.651
0.6754

Calculating growth rate:

(1) Internal growth: The average growth in dividend is 8%: g = ROE x Retention = 0.116 x 0.675 = 0.08 or 8%.
(2) The regression approach: This approach applied to dividend per share (DPS), gives a growth of 10.5%.

Y (year)
(Y - 4) = y
DPS
ln DPS
y x ln DPS
y2
ln (1+g) = 2.8/28 = 0.09999
(1+g)
g = 1.10516 - 1

1
-3
5.28
1.664
-4.992
9
0.09999
1.10516
10.52%

2
-2
5.76
1.751
-3.502
4

3
-1
5.76
1.751
-1.751
1

4
0
6.53
1.876
0.000
0

5
1
7.68
2.039
2.039
1

Similar approach gives a negative growth for EPS (- 4%).

(3) Geometric (average) growth:

g=

1 /6

7. 68
5. 28

1=0 . 064 or 6 . 4%

0.064
Different methods give different growth rates. Since the regression approach provides objective estimates, we use 10.5% as the growth rate.
Cost of equity:

DIV 1

7. 68 1. 105
g=
0.105
P0
355. 20
k e =0. 129=12. 9
k e=

12.9%

Cost of debt:

After-tax cost of debt

Interest rate
0.11
Tax rate
0.5
0.15(1 - 0.5) = 0.075 or 7.5% 5.5%

Weighted average cost of capital:

BV
(Rs
million)
Share capital
Reserve
Net worth
Long-term loans
Total capital

6,808
34,857
41,665
538,220
579,885

Share capital
EPS in 2003
Number of shares: 6,808/22
Average market price of share in 2003
Market value of equity (Rs million)

6,808
22
309
338.42
104726

Problem 15

BV
weights
0.012
0.060
0.072
0.928
1.000

Cost

12.9%
5.5%

BV
WACC

0.009
0.051
0.060

MV
(Rs million)

104,726
538,220
642946

Year
1
1
2
3
4
5
6
Average

EPS
2
6.21
10.91
11.57
11.47
10.44
11.23
10.31

DPS
3
2.00
2.50
2.50
2.70
3.00
3.20
2.65

BV
4
26.03
34.44
43.52
37.98
45.42
53.45
40.14

Cost of equity:
g
Average Growth (retention x ROE)
Growth =[( DPS91/DPS85)1/5 -1]
Growth =[( EPS91/EPS85)1/5 -1]

0.193
0.099
0.126

Avg.
yield
0.017
0.02
0.02

ke
0.210
0.116
0.143

AMV
5
100.00
205.00
209.38
164.00
138.88
155.00
162.04

ROE
(6)=(2/4)
0.239
0.317
0.266
0.302
0.230
0.210
0.261

Premium
NCF

1000
-91
-91
-91
-91
-91
-91
-1,091
-1,000
9.10%

Weighted cost
Book-value
Marketvalue
0.047
0.015
0.020
0.042
0.124
12.4%

0.078
0.000
0.020
0.032
0.129
12.91%

New Issue
wxc
0.016
0.006
0.126
0.148

y2
20.25
12.25
6.25
2.25
0.25
0.25
2.25
6.25
12.25
20.25
82.5000

Growth
Div. yield
BV
(7)=(5 x 7)
(8)=(3/5) (9)=(2/ 5)
0.158
0.0369
103.11
0.138
0.0307
119.03
0.091
0.0184
225.64
0.074
0.0111
183.27
0.059
0.0209
214.74

0.052
0.055
0.0895

0.0277
0.0216
0.0239

6
2
11.53
2.445
4.890
4

7
3
7.68
2.039
6.116
9

224.17
261.90
190.27

Avg./Sum
4

2.800
28.00

se 10.5% as the growth rate.

MV
weights

0.163
0.837

Cost

12.9%
5.5%

MV
WACC

0.021
0.046
0.067

Payout
Retention Growth
Div. yield Earn. yield
(7)=(3/2)
(8)=(1-7) (9)=(6 x 8) (10) = (3/5) (11) = (2/5)
0.322
0.678
0.162
0.020
0.062
0.229
0.771
0.244
0.012
0.053
0.216
0.784
0.208
0.012
0.055
0.235
0.765
0.231
0.016
0.070
0.287
0.713
0.164
0.022
0.075
0.285
0.715
0.150
0.021
0.072
0.262
0.738
0.193
0.017
0.065

How often you go for shopping in organised

retail store

weekly
more than
once a
week

Percent
31.4

5.7
60
2.9
100

monthly
quarterly
Total

how often you go for shopping in organised retail store

weekly
more than once a week
monthly
quarterly

Rate your preference according to the best retail

outlet for shopping
Percent
easy day
vishal mega
mart
big bazaar
best price

34.3
10
54.3
1.4

ganised retail store

Percent
1%
34%

54%

10%