Unit 3 : Cost of Capital

Cost of debt

1. A Company sells a fresh issue of 10% irredeemable debentures at par to raise Rs 200,000
and realizes the full face value of Rs 100. What is the cost of debt to the firm?

2. Private Ltd issued 10,000 , 10% debentures of Rs 100 each on 1st April. The cost of issue
was Rs 25,000. Determine the cost of debentures if they were issued a) at premium
b) at discount
3. A company raises Rs 200,000 by the issue of 10% debentures of Rs 100 each payable at
par after 10 years. If the tax rate is 50%.what is the cost of debt to the firm.

4. A company issues 10% irredeemable debentures of Rs 100,000. The company is in the

55% tax bracket. Calculate the cost of debt ( before and after tax) if the debentures are
issued :
a) At par b) 10% discount c) 10% premium.

5. A Company issues 3000 , 8% debentures of Rs 100 each for which the

Company will have to incur the following expenses
Underwriting commission 2%; Brokerage 1% and printing expenses amounts to Rs
2500. Calculate the cost of debt

6. B Ltd issues 10 year 10% debentures of the face value of Rs 100 at Rs 90. The marginal
tax rate is applicable as 55%. Calculate the cost of debt before and after tax.

7. ABC LTd issues 12% debentures of Rs 600,000. The tax rate applicable is 30%. Compute
the cost of debt capital i) at par ii) at 10% premium iii) at 10% discount.( SE: Dec 2015/
Jan 2016)

8. A firm issues 10% debentures of Rs 100,000 after allowing 2% commission and realizes
Rs 98,000. The debentures are due for maturity at the end of the 10th year, Calculate the
cost of debt before tax.

9. A company issues 8% debentures of the face value of Rs 100 at a discount of 10% for 10
years. Assuming 50% tax rate, Calculate the cost of debt after tax .

10. A company issues 2000 , 10% debenture of Rs 100 each at a par for a period of 5 years.
The debenture issue expenses are Rs 5 per debenture. The corporate tax rate is 50%.
Calculate the cost of debt before and after tax.

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 11. A company issues 10% debentures of Rs 100 each at a premium of 10% for a period of 10
years. The debenture issue expenses are expected to be Rs 2 per debenture . The corporate
tax rate is Rs 2 per debenture. The corporate tax rate is 50%. Calculate the cost of debt
before and after tax.

12. A company issue Rs 10,00,000, 13% debenture at a discount of 5%. The debenture
redeemable after 5 years at a premium of 5%. The company’s tax rate is 50%.Calculate the
cost of debt before and after tax.

13. Compute the cost of debt in the following cases

a) A Ltd issues Rs 50,000, 8% debentures at par. The tax rate applicable to the company
is 50%.
b) B LTd issues Rs 50,000, 8% debentures at a premium of 10%. The tax rate applicable
to the company is 60%.
c) C. Ltd issues Rs 50,000, 8% debentures at a discount of 5%. The tax rate is 50%.
d) D Ltd. Issues Rs 100,000 , 9% debentures at a premium of 10%. The costs of floatation
are 2%, the tax rate applicable is 60%.

Cost of preference share

1. X Ltd issues 9% per irredeemable preference shares of Rs 100 each at a premium of Rs

5 per share. The share issue expenses amounts to Rs 3 per share. Compute the cost of
irredeemable preference share capital.

2. Aneel Ltd Mumbai issued 20,000 , 10% preference shares of Rs 100 each. The cost of
such issue is 2%. Calculate the cost of Preference shares of capital if :
a) Issued at par b) Issued at Premium of 10% c) Issued at a discount of 10%.

3. XYZ & Co. issues 20,000 , 12 % preference shares of Rs 100 each at :

a) Par b) premium c) discount

4. ABC and Co. issues 2000, 10% preference shares of Rs 100 each at Rs 95 each
redeemable at the end of the 10th year from the year of issue. Calculate the cost of
preference share capital.
a) ri
5. A company issues 8% , 5000 preference shares of Rs 100 each at par. It incurs the
following expenses in connection with the issue of preference share.
Underwritting commission 3% Brokerage 1.5% Printing and other expenses Rs 5000.
Calculate the cost of Preference share capital

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 6. A company issues 1000, 8% preference shares of Rs 100 each. The expenses of capital
issue are:
Underwriting commission 2% Brokerage 2% and Printing expenses is Rs 500.
Calculate the cost of preference share if the shares are issued at:
a) At Par b) 5% discount c) 5% premium.

7. B Ltd issues 7% redeemable preference shares of Rs 100 each at a premium of 10%.

The shares are redeemable after 5 years. Compute the cost of redeemable preference
share capital.
8. A company issued 20,000, 10% redeemable preference shares of Rs 10 each. The
preference share is redeemable at the end of 10th year. The cost of issue is 2%. Calculate
the cost of Preference capital .
9. A company issues 5000 , 8% preference shares of Rs 100 each repayable after 8 years
at a premium of 8%. The cost of issue of preference shares is Rs 4 per share.
Calculate the cost of preference share capital.

Cost of equity

( Dividend Capitalization Approach)

1. A company issues 15,000 equity shares of Rs 100 each. Its current market price is Rs 1000,
and the current dividend is Rs 50. Compute the cost of equity capital.

2. A Company issues 1000 equity shares of Rs 100 each at a premium of 10%. The company
has been paying 20% dividend to equity shareholders for the past 5 years and expects to
maintain the same in future also. Compute the cost of equity capital. What will be the
difference if the market price of equity share is Rs 160?

3. XYZ is currently earning Rs 100,000, its current market price, per share is 100 outstanding
equity shares are 10,000. The company decided to raise an additional capital of Rs 250,000
through the issue of equity shares to the public. It is expected to pay 10% as flotation costs.
Equity shares are issued at a discount of 10%. The company is interested to pay a dividend
of Rs 8 per share. Calculate the cost of equity.

4. A company declared a dividend of Rs 2 per share, market price per share is Rs 20, income
tax rate is 60% and the expected brokerage is to be 2 %. Compute cost of retained earnings.

5. ABC Company’s cost of equity ( Ke) is 14%, the average tax rate of an individual
shareholder is 40% and the expected to spend 2 % on brokerage cost that the shareholders

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 will have to pay while investing their dividends in alternative securities. What is the cost
of retained earnings.

6. Life style Garment Manufacturing Co., has a net earnings of Rs 20 lakhs and all of its
shareholders are in the tax bracket of 50 %. The management estimates that under present
conditions stockholders required rate of return is 10%. 3% is the brokerage to be paid if
stockholders want to invest in alternative securities. Compute cost of retained earnings.

7. BPL Company’s equity share is currently selling at Rs 350.75 and it is currently paying a
dividend of Rs 5.25 per share. The dividend is expected to grow at 15 % per annum for one
year. Income tax rate is 40% and brokerage is 2%. Calculate the cost of retained earnings.

8. A Ltd issued 20,000 equity shares of Rs 10 each at a premium of Rs 2.00 each. The
company has incurred issue expenses of Rs 10,000. The equity shareholders expect the rate
of dividend to be 16% p.a Calculate the cost of equity share capital.

Earnings Capitalisation Approach

1. Well Do Company Ltd is currently earning is 15% operating profit on its share capital
of Rs 20,00,000 (FV of Rs 200 per share).It is interested to go for an expansion
programme for which the company requires an additional share capital of Rs 10,00,000.
The company is raising this amount by issue of equity shares @10% premium and the
expected floatation costs is 5%.Calculate the cost of equity.

2. A Company has issued 5000 equity shares of Rs 100 each fully paid. The market price
of the share is Rs 160. The company had paid a dividend of Rs 8 per share. Find out
the cost of equity share capital.

3. A Company has issued 5000 equity share of Rs 100 each fully paid. The company has
earned a profit of Rs 30,000 after tax.

Dividend Capitalisation plus growth rate Approach( S)

1. Equity share of a paper manufacturing company is currently selling at Rs 100. It wants

to finance its capital expenditure of Rs 1 Lakhs by retained. earnings or selling new
shares. If a company seeks to sell share, the issue price will be Rs 95. The expected
dividend for the next year is Rs 4.75 and it is expected to grow at 6% perpetually.
Calculate the cost of equity capital( internal and external).

2. XYZ LTd market price of the shares are at Rs 120 each. The expected dividend for the
next year is to be Rs 30 per share and further the dividends are expected to grow at an

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 annual rate of 5% of the previous year’s dividend. What is the cost is the cost of equity
share?

3. The current market price of an equity share of the company is Rs 90. The current
dividend per share is Rs 4.50. The expected growth rate of dividend is 7%. Calculate
the cost of equity capital.

4. A company shares are currently trading at a price of Rs 70 with outstanding shares of

Rs 500,000. Their expected profit after tax for the coming year is Rs 84,00,000.
Calculate the cost of equity capital as per earnings yield method.

5. The current price of an equity share of Rs 10 is quoted at market of Rs 20. The earnings
per share is Rs 3. Growth rate in earnings is given to be 10% p.a. Calculate the cost of
equity based on earnings growth model.

6. A Company plans to issue 5000 equity shares of Rs 100 each at par. The share issue
charges are expected to be 2% of the share price. The Company pays a dividend of Rs
10 per share initially and the growth rate in dividend is expected to be 10%. Compute
the cost of new issue of equity shares.
7. From the following particulars, calculate the cost of equity share capital:

Market price per equity share : Rs 120

Average dividend paid for last seven years 8%
Growth rate of dividend : 10%

Cost of retained earnings

1. A Company declares a dividend of Rs 2 per share, market price per share is Rs 20, income
tax rate is 60% and the expected brokerage is to be 2%. Compute cost if retained earnings.
2. A company’s return available to shareholders is 15%. The average tax rate is 50%. It is
expected that 3% is the brokerage cost that the shareholders will have to pay while
investing their funds in alternative securities, Calculate the cost of retained earnings.

3. ABC Company’s cost of capital of equity ( Ke) is 14%, the average tax rate of an individual
shareholder is 40% and it is expected to spend 2% on brokerage cost that shareholders will
have to pay while investing their dividends in alternative securities. What is the cost of
retained earnings?

4. Life Style Garment Manufacturing Co. has a net earnings of Rs 20 lacs and all of its
stockholders are in the tax bracket of 50%. The management estimates that under present

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 conditions stockholders required rate of return is 10%. 3 % is the expected brokerage to be
paid if the stockholders wants to invest in alternative securities. Compute cost of retained
earnings.

5. BPL Company’s equity share is currently selling at Rs 350.75 and it is currently paying a
dividend of Rs 5.25 per share. The dividend is expected to grow at a 15% p.a. for one year.
Income tax rate is 40% and brokerage is 2%. Calculate the cost of retained earnings.

CAPM – Capital Asset Pricing Model

1. The Capital Ltd wishes to calculate its cost of equity capital using the Capital Asset
Pricing Model ( CAPM) . Company’s analyst found that its risk free rate of return
equals 12%, beta equals 1.7 and the return on market portfolio equals 14.5 %.
2. Calculate return on investment from the following data:
Risk free rate of return: 10%
Market return : 12.5%
Beta : 1.5

3. Calculate the return on investment from the following data/ information:

Risk free return 10%

Market return 12%
Beta 1.5
4. The market is giving an average return of 18%. The risk free return is 11%.
Calculate : a) What return would be expected from an investment having a β-factor of
0.9?
b) What β-factor would be necessary for an investment to yield a return of 21.6%?

5. Calculate the required rate of return on four equity shares with beta values shown
against them.
Stock A B C D
β 0.9 1.1 1.6 1.9
The risk free rate is 20% and the rate of return on the market portfolio is 32 %.

6. B Ltd wishes to calculate its cost of equity capital using the CAPM . The company’s
analyst found that its risk free rate of return equals 12% and beta equals 1.7 and the
return on market portfolio equals 14.5%..

7. Om Sai Enterprises issued 9 % preferences shares ( irredeemable) four years ago. The
preference share that has a face value of Rs 100 is currently selling at Rs 93. What is
the cost of preference share with 8% dividend tax

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Problems on weighted Average Cost of Capital:

1. X Ltd. Presents the following capital structure data:

Source Rs
Ordinary share( 1000 shares) 50,000
10% Preference shares 20,000
12% Debentures 15,000
The dividend payment of the Company is @ 5%. Further the company raises additional
funds for replacement of assets of 14% debenture amounting Rs 10,000.
You are asked to find out the weighted average cost of capital as well as new capital
structure.

2. The sources of capital structure are enumerated below:

Source Rs
Equity share 800,000
14% Preference share 500,000
10% Term Loan 10,00,000
The expected dividend on equity capital is 10%. The company tax rate is 50%. You are
required to calculate the weighted Average cost of capital, before and after tax.

3. From the following information of Excel Ltd., determine the WACC using a) book
value weights and b) market value weights. How are they different? Can you think a
situation where the WACC would be the same using either of the weights?

Source of finance Book Value Market Value Costs(%)

Equity Capital 300,000 600,000 15
Retained Earnings 100,000 ---- 13
Preference Capital 50,000 60,000 8
Debt Capital 200,000 190,000 6

4. On the basis of the following information, determine the weighted average cost of
capital( Assume tax rate applicable: 40%)
Capital component Details

a) Equity share capital 10,00,000 Equity Share of Rs 100 market

value per Share Rs 250.Growth rate of
dividend 6%

b) Retained earnings Rs 5 crores

c) Debentures 100,000 debentures of Rs 100 each,

interest rate 15%, current market value Rs
110 each
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 d) Preferential capital 50,000 shares of Rs 100 each, dividend
rate 11%, current market price Rs 90 each.

5. Data below show the various sources of finance used in the capital structure of
company.
Sources Book Value( Rs) Market value(Rs)
Equity share( 10% 40,000 70,000
Expected dividend)
Retained Earnings 10,000 Nil
10% Preference shares 20,000 15,000
Debentures 30,000 35,000
The after tax cost of Retained Earnings 10%, and Debentures 8%
You are asked to :
a) Calculate the weighted cost of capital using Book value weights
b) Calculate the weighted cost of capital using market value weighs.

6. The Company is expecting to raise various sources of finance i.e., equity shares,
preferences shares and debentures. The following are the book values and market
values of the issue of sources of finance.
Sources Book Value( Rs) Market value(Rs)
Equity shares 250,000 300,000
Preference shares 150,000 180,000
Debentures 250,000 220,000
Total 650,000 700,000
Other information:
a) The tax bracket of the company is @50%
b) The current sales price of equity share is Rs 100
c) It is expected that the company pays current dividend of Rs 5 per share at the end
of next year and the expected growth rate of dividend is 5%. The cost incur for
raising share is Rs 8 per share.
d) The face value of Rs 100, 10% preference share sells at Rs 150.The Company has
to bear underwriting commission of Rs 8 per preference share.
e) 10% Debenture with the face value of Rs 100, for 10 year can be sold by the
company. The company has to incurred 5% underwriting fee on issued price of
debenture.
You are required to calculate the weighted average cost of capital using:
i) Book Value Weighs ii)Market value
7. From the following capital structure of a firm, Compute WACC based on the existing
capital structure.
Sources of finance Amount Specific cost(%)
Equity shares 900,000 18
Retained Earnings 300,000 -

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 Preference Capital 200,000 11
Debentures 600,000 8

8. A Company’s after tax , cost of capital of the specific sources is as follows( SE: Jan
2017/ Dec 2016)
Sources of finance Book Value( Rs) Market Value( Rs) Specific Cost(%)
Debt Capital 400,000 380,000 5
Preference Capital 100,000 110,000 8
Equity capital 600,000 900,000 15
Retained Earnings 200,000 300,000 13
Compute WACC based on a) book Value weight b) Market value Weights.

9. A Corporation has the following capital structure at the end of 31-12-03.

Sources of Finance Amount( Rs) Specific cost(%)
Equity Stock 48,00,000 -
Preference stock 40,00,000 9
Debt( Pre-tax) 60,00,000 14
The Company tax rate is 50%. It is expected to pay a dividend of Rs 15 per share in the
current year and this dividend is expected to grow at the rate of 8% per annum forever.
The company’s equity share is currently selling at Rs 13 per share. Calculate WACC.

10. ABC LTd has the following capital structure ( SE: June / July 2017)
4000 equity share of Rs 100 each Rs 400,000
10% preference shares Rs 100,000
11% debentures Rs 500,000
The current market price of the share is Rs 102. The company is expected to declare a
dividend of Rs 10 at the end of the current year, with an expected growth rate of 10%
and tax rate is 50%.
a) Find the cost of equity capital and WACC.
b) Assuming that the company can raise Rs 300,000, 12% debentures find out the new
WACC if
i) if dividend rate is increased from 10 to 12%.
ii) Growth rate reduced to 8%
iii) Market price is Rs 98.

11. XYZ company supplied the following information. Compute the cost of capital based
on the book values and market values( SE: June / July 2011)
Source of finance Book values( Rs) Market Value( Rs) After tax cost( %)
Equity capital 10,00,000 15,00,000 12
Long term debt 800,000 750,000 07
Short term debt 200,000 200,000 04
Total 20,00,000 24,50,000

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12. PQR has the following book value capital structure ( Rs in crores)
Equity capital ( in shares of Rs 10 each) Rs 15
12% preferential capital( in shares of Rs 100 each Rs 1
Retained earnings Rs 20
11.5% debentures ( of Rs 100 each) Rs 10
11% Term loans Rs 12.5
The next expected dividend on equity shares per share is Rs 3.60, the dividend per share
is expected to grow at the rate of 7%. The market price per share is Rs 40. Preference
share, redeemable after 10 years is currently selling at Rs 75 per share. Debentures,
redeemable after six years are selling at Rs 80 per debenture. The income tax rate for
the company is 40%. You are required to calculate WACC at Book value and market
value weights. (SE: June /July 2015)

13. Chethan Ltd has the following book value capital structure
i)Equity capital( 10 million shares @ 10 per share = Rs 100 million
ii)Preference share capital 11% ( 100,000 shares, Rs 100 per share) = Rs 10 million
iii)Debentures 13.5% ( 500,000 debentures, Rs 100 each) = Rs 50 million
iv)Retained earnings = Rs 120 million
The expected dividend per share is Rs 1.50 . The dividend per share is expected to grow
@ 7%. The market price per share is Rs 20. Preference share, redeemable after 6 years
are selling for Rs 80 per debenture. The tax rate is 50%. Calculate the weighted average
cost of capital using a) book value proportions b) market value proportions. ( SE:
June / July 2015)

14. On the basis of the following information determine the weighted average cost of
capital assuming tax rate is 40%.
Capital component Details
a) Equity capital 10,00,000 equity shares of Rs 100 market value per
share Rs 250. Growth rate of dividend is 6%. Dividend
per equity share is Rs 25.
b) Retained earnings Rs 5 crore
c) Debentures 100,000 debentures of Rs 100 each. Interest rate is
15%.Current market value of Rs 110 each
d) Preference capital 50,000 shares of Rs 100 each dividend rate 11%
current market price of Rs 90.

SE: Dec 2015/ Jan 2016

15. The Sanika Ltd has the following capital structure

Common shares ( 20,000 shares) 40,00,000
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10% Preference shares 10,00,000
14% Debentures 30,00,000
Total 80,00,000
The shares of the company sells for Rs 20 . It is expected that the company will pay
next year a dividend of Rs 2 per share which will grow @ 7%. Assume tax rate 50%.
Compute the weighted average cost of capital based on the existing capital structure.
SE: June / July 2018.

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