Module 5: Cost of Capital

1. Calculate the Cost of Equity Capital in the following cases:

2. Suppose you estimate that eBay’s stock has a beta of 1.45. for UPS beta is 0.79. If the risk-
free interest rate is 3% and you estimate the market’s expected return to be 8%, calculate the
equity cost of capital for eBay and UPS. Which company has a higher cost of equity capital?

3. Valence Industries wants to know its cost of equity. Its chief financial officer (CFO)
believes the risk-free rate is 5 percent, equity risk premium is 7 percent, and Valence’s equity
beta is 1.5. What is Valence’s cost of equity using the CAPM approach?

4. Here are stock market and Treasury bill returns (in %) between Year 1 and Year 5:
Year Index Return T-Bill Return
(Rm) (Rf)

1 1.31 3.9

2 37.43 5.6

3 23.07 5.21

4 33.36 5.26

5 28.58 4.86

What is the average risk premium?

5. Dexter ltd is planning to raise money from the capital markets. Sensex is expected to give a
10% return in the last one year. The 10 year government yield going rate is 8%. The
Covariance of the Rm and Company’s returns is 0.12 and their market variance is 0.9.
Calculate the cost of equity based on CAPM model.

6. Suppose that the beta of a publicly traded company’s stock is 1.3 and that the market value
of equity and debt are, respectively, C$540 million and C$720 million. If the marginal tax rate
of this company is 40 percent, what is the asset beta of this company?
7. Suppose we want to find the beta of an unlisted company with debt and equity in a ratio of
0.4:1. The comparable company operating in the same line of business has a beta of 1.2 and a
debt - to - equity ratio of 0.125 the project. The marginal tax rate is 35 percent. Calculate the
beta for the unlisted company.

8. Cyclone Software Co. is trying to estimate its optimal capital structure.  Cyclone’s current
capital structure consists of 25 percent debt and 75 percent equity; however, management
believes the firm should use more debt.  The risk-free rate is 5 percent, the market risk
premium, is 6 percent, and the firm’s tax rate is 40 percent.  Currently, Cyclone’s cost of
equity is 14 percent, which is determined on the basis of the CAPM.  What would be
Cyclone’s estimated cost of equity if it were to change its capital structure from its present
capital structure to 50 percent debt and 50 percent equity?

9. Berta ltd, issues 11% irredeemable preference shares of the face value of Rs. 100 each.
Floatation costs are estimated at 5% of the expected sale price. What is the Cost of Preference
Shares, if preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount?

10. Delta ltd has Rs. 100 preference share redeemable at a premium of 10% with 15 years’
maturity. The coupon rate is 12%. Floatation cost is on sales 5% (additional info). Sale price is
Rs. 95 (net)(after flotation). Calculate the cost of preference shares.

11. Max ltd has 10% perpetual debt of Rs. 1,00,000. The tax rate is 35%. Determine the cost of
capital (before tax as well as after tax) assuming the debt is issued at (i) par, (ii) 10% discount,
and (iii) 10% premium

12. Calculate the explicit cost of debt (after tax) for Annie Lenox limited in each of the
following situations:
 Debentures are sold at par and floatation costs are 5%
 Debentures are sold at premium of 10% and floatation costs are 5% of issue price
 Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is 10 years
and tax rate is 35%

13. Acme Industries issues a bond to finance a new project. It offers a 5-year, 5 percent coupon
bond. Upon issue, the bond sells at $1,025. What is Acme’s before tax cost of debt? If Acme’s
marginal tax rate is 35 percent, what is Acme’s after-tax cost of debt? Use YTM to calculate cost
of debt. Face Value of the Bond is $ 1,000 and Redemption Value is also the same $ 1000.
14. Calculate the cost of debt for the below listed companies if tax rate is 40% and the risk free
rate is 3.5%.

Company EBIT Interest Category

Disney 6819 821 > $ 5 billion

Aracruz 574 155 < $ 5 billion

Tata chemicals 6263 1215 < $ 5 billion

Bookscape 3575 575 < $ 5 billion

15. Star Cements ltd has given you the following capital structure, Calculate WACC based on
book values and market values. Cost of capital is net of tax.
Sources Market Book Cost
Values Values (%)
(Rs Cr) (Rs Cr)
Equity 80 120 18
Preference 30 20 15
Debentures 40 40 14
16. Alpha limited is considering raising of funds of about Rs. 100 lakhs by one of the two
alternative methods viz., 14% institutional term loan and 13% non-convertible debentures. The
term loan option would attract no major incidental cost. The debentures would have to be
issued at a discount of 2.5% and would involve a cost of issue of Rs. 1 lakh. You are to advise
the company as to the better option based on the effective cost of capital in each case. Assume
a tax rate of 50%.

17. Aries limited wishes to raise additional finance of Rs. 10 lakhs for meeting its investment
plans. It has Rs. 210,000 in the form of retained earnings available for investment purposes.
The following are the further details:
Debt-equity mix 30:70
Cost of debt up to 180,000, 10 percent (before tax); beyond 180,000, 12 percent (before tax)
EPS = Rs. 4 per share
Dividend payout, 50 percent of earnings
Expected growth rate in dividend, 10 per cent
CMP = Rs. 44 (on BSE).
Tax rate = 35%
You are required to
(a) Determine the pattern for raising the additional finance, assuming the firm intends to
maintain debt-equity mix 30:70
(b) to determine post –tax average cost of additional debt
(c) to determine cost of retained earnings and cost of equity
(d) compute overall cost of capital after tax of additional finance.
18.

The Market price per equity share is Rs.12 & per debenture is Rs.93.75. Assume 100%
Dividend Payout Ratio. Debentures Face value is Rs 100 per Debenture.
a) What is the earning per share?
b) What is the percentage of cost of capital to the company for the debenture fund and the
equity?
c) What is the weighted average cost of capital based on the Market Value Weights?

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