PROBLEMS OF COST OF DEBT

1. X ltd issues Rs. 50,000 8% debentures at par. The tax rate applicable to the company is 50%.
Compute the cost of debt capital.
2. X ltd issues Rs. 50,000 , 8% debentures at premium of 10%. The tax rate applicable to the
company is 60%. Compute cost of debt capital.
3. A ltd issues Rs. 50,000 8% debentures at a discount of 5%. The tax rate is 50%. Compute the
cost of debt capital.
4. A company issues Rs. 10,00,000, 10% redeemable debentures at a discount of 5%. The cost of
floatation amount to Rs. 30,000. The debentures are redeemable after 5 years. Calculate
before tax and after tax cost of debt assuming a tax rate of 50%.
5. A five year Rs. 100 debenture of a firm can be sold for a net price of Rs. 96.50. the coupon rate
of interest is 14 per cent per annum and the debenture will be redeemed at 55 premium on
maturity. The firms tax rate is 40%. Compute before tax and after tax cost of debentures.
6. AB ltd issue Rs. 1,00,000 9% debentures at a premium of 10%. The cost of floatation is Rs.
2,500. The tax rate applicable is 50%. Compute the cost of debt capital
7. A firm issues debentures of Rs. 1,00,000 and realizes Rs. 98,000 after allowing 2% commission to
brokers. The debentures carry interest @ 10%. The debentures are due for maturity at the end
of 10th year. Calculate effective cost of debt before and after tax assuming corporate tax rate of
55%.

PROBLEMS ON COST OF PREFERENCE CAPITAL

1. A company issues 10,000 10% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference capital if these shares are issued at;
a. Premium of 10% and
b. Discount of 5%
2. A company issued 10,000 10% preference shares of Rs. 100 each redeemable after 10 years at
a premium of 5%. The cost of issue is Rs. 2 per share. Calculate the cost of preference capital.
3. A company issues 1,000 7% preference shares of Rs. 100 each at a premium of 10% redeemable
after 5 years at par. Compute the cost of preference capital.

PROBLEMS ON RETAINED EARNINGS

1. A firm’s Ke (returns available to shareholders) is 15%, the average tax rate of shareholders is
40% and it is expected that 2% is brokerage cost that shareholders will have to pay while
investing their dividends in alternative securities. What is the cost of retained earnings?
2. Excellent fans ltd needs Rs. 5,00,000 for the expansion of its activities and it is expected to earn
a rate of return of 10% on its investment. The management of the company is considering to
finance this amount by retaining profit which otherwise shall be distributed to the shareholders.
The shareholders on an average are in 60% tax bracket. If the shareholders reinvest their
dividends, they will earn 12% on new investment but have to incur a 2% brokerage cost on the
 purchase of new securities. What is your recommendation to the management keeping in view
the shareholders.

PROBLEMS ON COST OF EQUITY SHARE CAPITAL

PROBLEMS ON DIVIDEND YIELD METHOD

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

PROBLEM ON DIVIDEND YIELD PLUS GROWTH IN DIVIDEND METHOD

1. A company plans to issue 1000 new shares of Rs. 100 each at par. The floatation cost are
expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially
and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity
shares.

If the current market price of an equity share is Rs. 150 calculate the cost of existing equity

share capital.

PROBLEMS ON EQRNING YIELD METHOD

1. A firm is considering an expenditure of Rs. 60 lakh for expanding its operations. The relevant
information is as follows:-
Number of existing equity shares 10 lakhs
Market value of existing shares Rs. 60
Net earnings 90 lakhs
Compute the cost of existing equity share capital and of new equity capital and of new equity
capital assuming that new shares will be issued at a price of Rs. 52 per share and the costs of
new issue will be Rs. 2 per share.
WEIGHTED AVERAGE COST OF CAPITAL
It is the average cost of various sources of financing. It is also known as composite cost of
capital, overall cost of capital or average cost of capital.

MARGINAL COST OF CAPITAL

Sometimes, we may be required to calculate the cost of additional funds to be raised, called the
marginal cost of capital. It is the weighted average cost of new capital calculated by using the
marginal weights. It represents the proportion of various sources of funds to be employed in
raising additional funds.

PROBLEMS
1. A firm has the following capital structure and after tax cost for different sources of funds
used:-
Sources of funds Amount (Rs.) Proportion (%) After tax cost (%)
Debt 15,00,000 25 5
Preference shares 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained earnings 15,00,000 25 11
TOTAL 60,00,000 100
You are required to compute the weighted average cost of capital.

2. From the following capital structure of a company calculate weighted average cost of
capital
Sources Book value (Rs.) After tax cost (%)
Equity share capital (Rs. 10) 45,000 14
Retained Earnings 15,000 13
Preference share capital 10,000 10
Debentures 30,000 5
1,00,000

3. A firm has the following capital structure and after tax costs for the different sources of
funds used:
Sources of funds Amount (Rs.) Proportion (%) After tax cost (%)
Debt 4,50,000. 30 7
Preference Capital 3,75,000 25 10
Equity capital 6,75,000 45 15
15,00,000 100
a. Calculate the weighted average cost of capital using book value weights
b. The firm wishes to raise further Rs. 6,00,000 for the expansion of the project as below:
Debt Rs.3,00,000
Preference Capital Rs. 150,000
Equity Capital Rs.1,50,000
Assuming that specific costs do not change, compute the weighted marginal cost of
capital.
4. MN Ltd has the following capital structure.
Equity share capital (20,000) shares Rs. 40,00,000
6% preference share capital Rs. 10,00,000
8% debentures Rs. 30,00,000
80,00,000
The share 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 at 7% forever. Assuming 50% tax rate.
a. Compute the weighted average cost of capital based on the existing capital structure
b. Compute the new weighted average cost of capital if the company raises an additional
Rs. 20,00,000 debt by issuing 10% debentures. This would increase the expected
divided to Rs. 3 and leave the growth rate unchanged but the price of share will fall to
Rs. 15 per share.

5. The following is the capital structure of Saras Ltd as on 31-12-2020

Equity shares – 20,000 shares of Rs. 100 each 20,00,000
10% preference shares of Rs. 100 each 8,00,000
12% debentures 12,00,000
40,00,000
The market price of the company’s share is Rs. 110 and it is expected that a dividend of Rs.
10 per share would be declared after 1 year. The dividend growth rate is 6%.
a. If the company is in the 50% tax bracket, compute the weighted average cost of capital.
b. Assuming that in order to finance an expansion plan, the company intends to borrow a
fund of Rs. 20 lakhs bearing 14% rate of interest, what will be the company’s revised
weighted average cost of capital? This financing decision is expected to increase
dividend from Rs. 10 to Rs. 12 per share. However the market price of equity share is
expected to decline from 110 to 105 per share.