Cost of Capital Capital_structure

Question 1  XYZ Ltd. has the following book value capital structure:  Equity Capital in shares shares of !s. "# each$ fully paid up% at par& ""( ""( )reference )reference Capital in shares of !s. "## each$ fully paid up% at par&  !etained Earnings "+.'( ,ebentures of !s. "## each& "'( -er Loans

!s. "' crores crores  !s. " crore crore !s. *# crores crores !s. "# crores !s. "*.' crores

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 maret price per share is Rs. !0. "reference stoc# redeema$e after ten years# is currenty seing at Rs. 7& per share. 'e$entures# redeema$e after six years# are seing at Rs. (0 per de$enture. The )ncome tax rate for the company is !0%.  !equired  i& i& Calc Calcul ulat atee the the wei weigh ghte ted d aver averag agee cos costt of of cap capit ital al usin using: g: a& book value proport proportions/ ions/ and  b& arket value proporti proportions. ons. ii& ii& ,efine ,efine the the weigh weighted ted ar argi ginal nal cost cost of of capita capitall schedu schedule le for for the the copany copany$$ if if it rais raises es !s. !s. "# crores crores ne0t year$ given the following inforation: a& the aount aount will be raised raised by equity equity and debt debt in equal equal proporti proportions ons;; b& the copany e0pects e0pects to retain retain !s. ".' crores crores earnings earnings ne0t year/ c& the additi additional onal issue issue of equity equity shares shares will result result in the the net price per share share being fi0ed at   !s. +*/ d& the debt debt capital capital raised raised by way of of ter ter loans loans will cost "'( for for the the first first !s. *.' crore croress and  "1( "1( for for the the ne0 ne0tt !s. !s. *.' *.' cro crorres. 2in 2inal al%% 3ov 3ov.. *### *###&& "* "* ark arks& s&

Answer (i) (i)

(a) (a) Stat Statem emen entt show showin ing g comp comput utat atio ion n of weigh weighte ted d aver averag agee cost cost of capi capita tall by using using Bookv Bookval alue ue proportions

Source of of fifinance

Equity capital

Amount (Book  value) (Rs. in crores) 15

Weight  (Book value  proportion)

(a) 0.256

Cost of  capital 

Weighted  cost of  capital 

(b) (c)= (a)(b) 0.16 0.04096 (Refer to !orking note ")

11% Preference capital

1

Retained earnings

20

13.5% e!entures

10

15% ter" l#ans eig&ted a'erage c#st #f capital

0.017

0.1543

(Refer to !orking note #) 0.342 0.16 (Refer to !orking note ") 0.171 0.127 (Refer to !orking note $) 0.214 0.09  (Refer to !orking note %) 1.00

12.5  $$$$  5(.5

0.00262

0.05472 0.02171 0.01926 0.1393 )R 13.93%

(b) Statemen Statementt showing showing computat computation ion of weighted weighted average average cost of capital capital by using using market market value proportions Source of finance

Amount (Rs. in crores)

Equity capital

60.00 (Rs. ".' crores  Rs. %) 11% Preference capital 0.75 (Rs. " lakh  Rs. ') 13.5% e!entures (.00 (Rs. " lakhs  Rs. *) 15% *er" l#ans 12.50

eig&ted a'erage c#st #f capital

(1.25

Weight  Cost of  Weighted cost of  capital  capital  (&arket value  proportions) (a) (b) (c)=(a)(b) 0.739 0.16 0.11(24 (Refer to !orking note ") 0.009 0.1543 0.0013( (Refer to !orking note #) 0.09( 0.127 0.01245 (Refer to !orking note $) 0.154 0.09 0.013(6 (Refer to !orking note %) 1.00 0.14593 #r 14.59%

 *ote+ ,ince retained earnings are treated as equity capita for purposes of cacuation of cost of specific source of finance# the maret vaue of the ordinary shares may $e taen to represent the com$ined maret vaue of equity shares and retained earnings. The separate maret vaues of retained earnings and ordinary shares may aso $e wored out $y aocating to each of these a  percentage of tota maret vaue equa to their percentage share of the tota $ased on $oo vaue. -ii -ii ,tatem ,tatement ent showin showing g weight weighted ed marg margina ina cost cost of capita capita schedu schedue e for for the the comp company any## if if it raises Rs. /0 crores next year# given the foowing information+

Chun k 

/.

2.

3.

 Source of  finance

 Amount  (Rs. in crores)

Weight

Cost of of capital 

b& c&4a&0b& 0 ./ 6 0.0( !efer to working note "& 0 .0  0.0!& !efer to working note 1&

Retained earnings

/ .&

a& 0 .&

'e$t

/ .&

0 .&

1eighted average cost of 1eighted capita quity shares /

0 .&

'e$t

0 .&

/

0./2& or /2.&%

1eighted average cost of 1eighted capita quity shares 2 .&

0 .&

'e$t

0 .&

2 .&

Weighted cost of capital 

0./(2& 0.0/2& !efer to working note '& 0.0  0.0!& !efer to working note 1& 0./362& or /3.62&% #."5*' 0.0/2& !efer to working note '& 0.06 0.0!( !efer to working note 1& 0./32& or /3.2&%

1eighted average cost of 1eighted capita Working Notes: 1. Cost Cost of equi equity ty capi capita tall and and retain tained ed earn earnin ings gs (K e) ,1 +g +0 4  5 e

1here#

4 e

5 ost of equity capita '/ 5 xpected dividend at the end of year / "0 5 urrent maret price of equity share g 5 rowth rate of dividend  *ow# it it is given that '/ 5 Rs. 3.60# "0 5 Rs. !0 and g5 7% Rs. 3.60 + 0.07 Rs. 40 Therefore# 4 e 5 or 4 e 5 /6% . Cost of preference capital (K p)  -  − +  ,+   n   -  + +    4  p 5  n  1here#' 5 "reference dividend 8 5 8ace vaue of preference sh shares " 5 u urrent mar mare ett pr price of of pr preference nce sha sharres  * 5 Redemption period of preference shares

 *ow# it is given that '5 //%# 85Rs. /00# "5 Rs. 7& and n5 /0 years

 Rs. /00 9 Rs. 7&   /0  × /00  !s./00 +  !s.7&    n2

// + 

Therefore

4  p

5

5 /&.!3 % !.

Cost of debentures (K d ) 

 -  − +   n   -  + +   n 

r ,1 − t + 

Where,

4 d

5

r t F P n

= Rate of interest = Tax rate applicable to the company = Face value of debentures = Current market price of debentures = Redemption period of debentures

 *ow it is given that r5 /3.&%# t5!0%# 85Rs. /00# "5Rs. (0 and n56 years  Rs. 100 - Rs. (0  13.5,1 − 0.40+ +   6   × 100  Rs. 100 + Rs. (0    6   Therefore# 4 d 5 5 /2.70% ".

$.

Cost of ter# loans(K t ) 4 t 5 r-/:t 1here# r 5 Rate of interest on term oans t 5 Tax rate appica$e to the company  *ow# r 5 /&% and t5 !0% Therefore# 4 t 5 /&% -/:0.!0 5 % Cost of fres% equity s%are (K e)  1  + +g 4 e 5 

 *ow# Therefore#

4 e

'/ 5 Rs. 3.60# "5 Rs. 32 and g50.07  Rs. 3.60   Rs. 32  + 0.07  5  5 /(.2&%

&.

Cost of de't (Kd ) 4 d 5 r-/:t -8or first Rs. 2.& crores r 5 /&% and t5 !0%

Therefore#

4 d

5/&% -/:!0% 5 % -8or the next 2.& crores  r 5 /6% and t5 !0% Therefore# 4 d 5 /6% -/:!0% 5 .6%

Question 2 A Company earns a prot of Rs!",##,### per annum after meetin$ its %nterest liability of Rs!&,'#,### on &'( debentures! The Tax rate is )#(! The number of *+uity hares of Rs!&# each are -#,### and the retained earnin$s amount to Rs!&',##,###! The company proposes to take up an expansion scheme for .hich a sum of Rs!/,##,### is re+uired! %t is anticipated that after expansion, the company .ill be able to achieve the same return on investment as at present! The funds re+uired for expansion can be raised either throu$h debt at the rate of &'( or by issuin$ *+uity hares at par . Required:

(i)

Compute the Earnings Per Share (EPS), if: the additional funds were raised as debt  −  −  the additional funds were raised by issue of equity shares. (ii) d!ise the "ompany as to whi"h sour"e of #nan"e is preferable. 0P*1%%1 2ov! '##'3 04 marks3

Answer Working Notes+

1.Capital e#ployed 'efore epansion plan : Rs.

2.

*+uity shares 5ebentures (Rs.$,%&,&&&'$%) ×   $&& Retained earnin$s

-,##,### &#,##,## # &',##,## #

*#tal capital e"pl#yed

3000000

Earnings before the payment of interest and tax (EBIT) Prot %nterest *6%T

3.

Rs. ",##,## # &,'#,## # /,'#,## #

Return on investment (ROI)

.B/0  Capital e"pl#yed

× 100 =

Rs.420000 Rs.3000000

× 100

R7% =  = &/( . Earnings before the payment of interest and tax (EBIT) after expansion

After expansion, capital employed = Rs!"/,##,### 5esired *6%T = &/( × Rs!"/,##,### = Rs!/,84,### (i)

tate#ent s%owing *arning +er %are (*+) (Under present and anticipated expansion scheme)

  Present situation

Epansion s"heme  dditional funds raised as ebt Equity   Rs. Rs. /,84,### /84,### (Refer to *or+ing note  )

Rs. /,'#,###

*6%T9 0A3

( Refer to *or+ing note % %)

%nterest − 7ld capital &,'#,### − 2e. capital 1111111111

 Total interest 9 063 *6T9:0A3 −063; ess9 Tax (/&- of E01) PAT *P

&,'#,### ",##,###

&,'#,### /-,###   (Rs.,&&,&&& $%-) &,4-,### ",#-,###

&,)#,###

&,'#,### 111111111 ×  

&,'#,### ",)4,###

&,)/,###

&,)#,### &!-8)    

&,)/,### &!<') (Rs.$,/,&&&'  2&,&&&)

&,8-,###

   

&,8-,### &!/(Rs.$,32,&&&'  $,%&,&&&)

(Rs.$,/&,&&&'    2&,&&&) (ii) Ad,ise to t%e Co#pany + ,ince ", is greater in the case when company arranges additiona funds as de$t. Therefore# de$t scheme is $etter.

Question 3 acuate the eve of earnings $efore interest and tax -)T at which the ", indifference point  $etween the foowing financing aternatives wi occur. i& Equity share capital of !s.1$##$### and "*( debentures of !s.6$##$###
Answer Computation of level of earnings before interest and tax (EB!)

4n "ase alternati!e (i) is a""epted, then the EPS of the #rm would be: EP

=

lternati'e,i+

,E* − nterest+ ,1 − ta rate+ /#. #f equity s&ares

,.B/0  − 0.12 × Rs.400000+ ,1 − 0.35+ 60000

5

%n case the alternative 0ii3 is accepted, then the *P of the rm .ould be EP lternati'e,ii+

=

,E* − 0.12 × Rs.400000+ ,1 − 0.35+  ,0.14 × Rs.200000+ 40000

4n order to determine the indi6eren"e le!el of E041, the EPS under the two alternati!e plans should be equated as follows: ,E* − 0.12 × Rs.40000 0+ ,1 − 0.35+ 60000

7r  7r 7r 7r  7r

0.65 E* − Rs.31200 3

=

,E* − 0.12 × Rs.40000 0+ ,1 − 0.35+ − ,0.14 × Rs.20000 0+

=

40000

0.65 E* − Rs.59200 2

$.8& E041 −  Rs.9%,&& ($./ −  $.8&) E041 E041 E041

5 $./ E041 −  Rs.$,33,9&& 5 Rs.$,33,9&& −  Rs.9%,&& 5 Rs.$,$/,%&& Rs.11520 0 0.65 5 5 Rs.$,33,%8$

Question 4 =4> >td. has the foowing $oo:vaue capita structure as on ?arch 3/# 2003. Rs. Equity share "apital (%,&&,&&& shares) &,&&,&&& $$./- preferen"e shares $&,&&,&&& $&- debentures 8&,&&,&&& 2&,&&,&&&  The e+uity share of the company sells for Rs!'#! %t is expected that the company .ill pay next year a dividend of Rs!' per e+uity share, .hich is expected to $ro. at )( p!a! forever! Assume a ")( corporate tax rate! Re+uired9

(i) Compute weighted a!erage "ost of "apital (*CC) of the "ompany based on the eisting "apital stru"ture. (ii) Compute the new *CC, if the "ompany raises an additional Rs.%& la+hs debt by issuing $%- debentures. 1his would result in in"reasing the epe"ted equity di!idend to Rs.%.& and lea!e the growth rate un"hanged, but the pri"e of equity share will fall to Rs. $9 per share.

(iii) Comment on the use of weights in the "omputation of weighted a!erage "ost of "apital. 0P*1%%1 ay! '##"3 0- marks3

Answer (i) Weig%ted A,erage Cost of Capital of t%e Co#pany (0ased on Eisting Capital Stru"ture) Parti"ulars fter ta *eights *eighted "ost  (Refer to "ost  wor+ing note ) (a) (b) (a) ×   (b)

*+uity share capital cost (Refer to wor+ing note $) Cost of preference share capital >&&!)( (Refer to wor+ing note %) Cost of debentures (Refer to wor+ing note 8) Wei$hted avera$e cost of capital Working Notes: 1.

#!)#

#!#8)

#!&&)

#!&')

#!#&/"8)

#!#4)

#!"8)

#!#'/"8 &&!"8)(

!ost of e"uity #apita$% 8e

'!

#!&)

=

i'idend +g urrent "aret price #f s&are Rs.2 + 5% = 15% #r 0.15 = Rs.20

!ost of preferen#e share #apita$% nnual preference s&are di'idend = /et pr#ceedsin t&e issue #f preference s&are Rs.11500 0 = Rs.1000000 = #!&&)

"!

!ost of &ebentures : 1 (nterest − *a ) /et pr#ceeds = 1 (Rs.30000 0  Rs.10500 0) Rs.30000 00 =

= #!#4) 4.

"eights of e#uity share capital$ preference share capital and debentures in total investment of %s&'$$

Wei$ht of e+uity share capital

=

*#tal equity s&are capital *#tal in'est"ents

= Wei$ht of preference share capital

=



Rs.1000000 Rs.(000000  0.125 *#tal de!entures *#tal in'est"ents



Rs.3000000 Rs.(000000  0.375

 eig&t #f de!entures

(ii)

Rs.4000000 Rs.(000000 = #!)# *#tal preference s&are a"#unt *#tal in'est"ents

New Weig%ted A,erage Cost of Capital of t%e Co#pany (0ased on new "apital stru"ture)  fter ta *eights *eighted "ost  "ost  (Refer to wor+ing note ) 0b3 (a) (a) ×   (b)

Cost of e+uity share capital (Refer to wor+ing note %) Cost of preference share Cost of debentures > &#( Cost of debentures >&'( Wei$hted avera$e cost of capital

#!'#

#!/#

#!#-#

#!&&)

#!&#

#!#&&)

#!#4)

#!"#

#!#&<)

#!#8-

#!'#

#!#&)4 &'!44(

'oring otes% (*)

'eights of e"uity share #apita$* preferen#e share and debentures in total investment of %s&*$$ Rs.4000000

Wei$ht of e+uity share capital

=

Rs.10000000 Rs.1000000

Wei$ht of preference share capital

=

Rs.10000000

= 0.4

= 0.1

Rs.30#00#000

Wei$ht of debentures >&#(

=

Rs./#00#00#000 Rs.20#00#000

0'3!

Wei$ht of debentures >&'( !ost of e"uity #apita

%$=

Rs./#00#00#000

= 0.30 = 0.20

8e

=

i'idend +g urrent "aret price #f s&are Rs.2.40 + 5% = 20% Rs.16 

)n the computation of weighted average cost of capita weights are (iii) Co##ent +  preferred to $oo vaue. 8or exampe# weights representing the capita structure under a corporate financing situation# its cash fows are preferred to earnings and maret. aance sheet is preferred to $oo vaue $aance sheet.

Question 5  @ >imited has the foowing $oo vaue capita structure+ Equity Share Capital ($/& million shares, Rs.$,/&& million Rs.$& par) Reser!es and Surplus Rs.%,%/& million $&./- Preferen"e Share Capital ($ million Rs.$&& million shares, Rs.$&& par) ./- ebentures ($./ million debentures, Rs.$,/&& million Rs.$&&& par) 2./- 1erm oans from ;inan"ial Rs./&& million 4nstitutions

1he debentures of 0C imited are redeemable after three years and are quoting at Rs.2$.&/ per debenture. 1he appli"able in"ome ta rate for the "ompany is 8/-. 1he "urrent mar+et pri"e per equity share is Rs.9&. 1he pre!ailing default< ris+ free interest rate on $&
 

(/.0& 5

,1 + yt"+1

+

95 ,1 + yt"+ 2

+

1095 ,1 + yt"+ 3

Aied to maturity -ytm 4 d

)

!)

5 5 5 5

/0% -approximatey ytm × -/ − Tc /0% × -/− 0.3& 6.&%

Co#putation of cost of ter# loans (K -) : 5 i × - /− Tc 5 (.&% - /− 0.3& 5 &.&2&% Co#putation of cost of preference capital (K +) : 10.5

+

10.5

+

10.5

+

10.5

+

10.5

,1 + :*;+1 ,1 + :*;+2 ,1 + :*;+3 ,1 + :*;+4 ,1 + :*;+5 (.& 5 AT? 5 //% -approximatey 4  p 5 //% ") Co#putation of cost of equity (K *) : 5 r f   B @verage maret ris premium × eta 5 &.&%B (% × /./(7& 5 /&% $) Co#putation of proportion of equity capital preference s%are de'entures and ter# loans in t%e #arket ,alue of capital structure: (Rs. in million &

&arket value of capital structure Rs.

 )roportion

Equity s&are capital ("' million share ×    Rs.1) 10.5% Preferential s&are capital (" million shares ×   2*."') 9.5 % e!entures (".' million debentures ×   Rs.2*".') (.5% *er" l#ans

9000

(1.3000

 9(.15

0.((9

1471.575

13.294

  &00

!.&/7

""312.#'

(i)

"

Weig%ted A,erage cost of capital (WACC) : =sing arket value weights& 

+ 8* ×

*

+ 8P ×

P

+ 8E ×

E

< < < 4d   × < 5 6.&% × 0./32 B &.2&% × 0.0!&/7 B //% × 0.00( B /&% × 0.(/3 5 0.00(63( B 0.002!& B 0.0007 B 0./2/& 5 /3.!/% C 8or the vaues of 4 d# 4 T# 4 " and 4  and weights refer to woring notes / to & respectivey. (ii) /arginal cost of capital (/CC) sc%edule : 4  -*ew "roDect 5 &.&% B (% × /.!37& 5 /7% 4 d 5 .&% × - /−0.3& 5 6./7&%

1@ 5

5

/0% × -/−0.3&

5

6.&% 100

?

5 5

/7% x 0.(0 B 6./7&% × 750 /!.(6% -@pproximatey

+ 6.5% ×

50 750

Question 6 Consider a firm that has existing assets in which it has capital invested of Rs. 100 crors. The after- tax operating income on asets –in – place is Rs.15 crores,. The return on capital  emploed of 15! is expectd to "e sustained on perpetunit, and compan has a cost of capital  of 10!. #stimate the present valuse of economic value added $#%#& of the firm from its assetsin-place. 'C.( )# – ** + 0 

Answer :  7perating pro#t after ta 5 Rs.$/ Crores ess: "apital employes >*CC 5$&& > $&5 Rs.$& Crores E"onomi" ?alue dded (E?) 5 Rs. / Crores Sin"e this E? is sustained till perpunity, Present !alue of E? 5 E? @ Cost of "apital 5 Rs. $/ Crores $&5 Rs.$/& Crores

Question 7  , Ltd. is foreseeing a growth rate of "*( per annu in the ne0t two years. -he growth rate is likely to be "#( for the third and fourth year. 7fter that the growth rate is e0pected to stabilise at 5( per annu. 8f the last dividend was !s. ".'# per share and the investor>s required rate of return is "1($ deterine the current value of equity share of the copany. -he ).?. factors at "1( Year " * + 6  ).?. 2actor .51* .6+ .16" .''* (PE!!"a# $%%&) (' marks) Answer The current vaue of equity share of ' >td. is sum of the foowing+ -i "resenty vaue -"E of dividends payments during /:! years; and -ii "resent vaue -"E of expected maret price at the end of the fourth year $ased on constant growth rate of ( per cent. "E of dividends 9 year /:! 4ear  +5 factor at "16 0otal +5 (in Rs.) 'ividend

1 2 3 4

1.50,1 = 0.12+1.6( 1.6( ,1=0.12+ 1.(( 1.(( ,1 = 0.10+2.07 2.07 ,1 = 0.10+ 2.2( *#tal

0.(62 0.743 0.641 0.552

1.45 1.40 1.33 1.26 5.44

"resent vaue of the maret price -" 4  + end of the fourth year 9  5

" 4  5 '  F -4e:g 5 Rs. 2.2( -/.0( F -/6% − (% "E of Rs. 30.7( 5 Rs. 30.7(×0.&&2 Gence# Eaue of equity shares Rs. &.!! + Rs. /6.

5 Rs. 30.7( 5 Rs. /6. 5 Rs. 22.!3

Question 8 -he !@A Copany has following capital structure at +" st  9arch *##6$ which is considered to be optiu:  !s. "+( debenture +$1#$### ""( preference share capital "$*#$###  Equity share capital *$##$### "<$*#$###  shares& -he copany>s share has a current arket price of !s. *.' per share. -he e0pected dividend  per share in ne0t year is '# percent of the *##6 E)B. -he E)B of last "# years is as follows. -he  past trends are e0pected to continue: Year ", -Rs.

"<<' /.00

"<<1 /./20

"<< /.2&!

"<<5 /.!0&

"<<< /.&7!

*### /.762

*##" /.7!

*##* 2.2//

*##+ 2.!76

*##6 2.773

-he copany can issue "6 percent new debenture. -he copany>s debenture is currently selling at !s. <5. -he new preference issue can be sold at a net price of !s. <.5#$ paying a dividend of  !s. ".*# per share. -he copany>s arginal ta0 rate is '#(. i& Calculate the after ta0 cost a& of new debts and new preference share capital$ b& of ordinary equity$ assuing new equity coes for retained earnings. ii& Calculate the arginal cost of capital. iii& ow uch can be spent for capital investent before new ordinary share ust be sold D  7ssuing that retained earning available for ne0t year>s investent are '#( of *##6 earnings. iv& hat will be arginal cost of capital cost of fund raised in e0cess of the aount calculated in part iii&&if the copany can sell new ordinary shares to net !s. *# per share D -he cost of debt and of preference capital is constant. )E%88%9ay *##'& *F"F*F*4 arks&

Answer The existing capita structure is assumed to $e optimum.

 Eisting Capital Structure Anal#sis 1ype of "apital mount (Rs)

&"( debentures &&( Preference *+uity  Total (i)

(a)

(')

",4#,### &,'#,### &<,'#,### '/,##,###

Proportions #!&) #!#) #!-# &!##

14 × d 9( @fter tax cost of de$t 5 4  5 -/ 9 0.& 5 0.07/!3 @fter tax cost of preference capita -new 1.20 4p5 9.(0 5 0./22!! @fter tax cost of retained earnings 1.3(65 27.75 B g 4 e 5 -here HgI is the growth rate 5 0.0& B 0./2 5 0./7

(ii) Types of capital  (1)

5ebt Preference *+uity ar$inal cost of capital at existin$ capital structure

Proportion (2)

Specic cost  (3)

Product  (2) × (3)

!&) !#) !-#

!#8&/" !&''//< !&8

!# !##4& !&"4# !&)'- or &)!'-(

 The company can spend the follo.in$ amount .ithout increasin$ its CC and .ithout sellin$ the ne. shares! ×  ',##,### =',88,"## Retained earnin$s = &!"-4)  The ordinary e+uity 0retained earnin$s in this case3 is -#( of the total (iii)

277300 × (0 capital! Thus investment before issuin$ e+uity 0  &## 3 = Rs ",/4,4')

if the company spends more than Rs", /4,4') , it .ill have to issue ne. shares ! The cost of ne. issue of ordinary share is 9 (i,)

1.3(65 ? e = 20

@ #!&' = #!&-<"  The mar$inal cost of capital of Rs ",/4,4') Types of capital  (1)

Proportion (2)

Specic cost  (3)

Product  (2) × (3)

5ebt Preference *+uity0ne.3 ar$inal cost of capital at existin$ capital structure

!&) !#) !-#

!#8&/" !&''//< !&-<"

!# !##4& #!&)&// #!&4-'/ or &4!-' (

+uestion ,

  Company needs Rs. 8$,%/,&&& for the "onstru"tion of new plant. 1he following three plans are feasible: 4 1he Company may issue 8,$%,/&& equity shares at Rs. $& per share. 44 1he Company may issue $,/9,%/& ordinary equity shares at Rs. $& per share and $/,9%/ debentures of Rs,. $&& denomination bearing a 2- rate of interest. 444 1he Company may issue $,/9,%/& equity shares at Rs. $& per share and $/,9%/ preferen"e shares at Rs. $&& epr share bearing a 2- rate of di!idend. (i) if the CompanyAs earnings before interest and taes are Rs. 9%,/&&, Rs. $,%/,&&&, Rs. %,/&,&&&, Rs. 8,3/,&&& and Rs. 9,%/,&&&, what are the earnings  per share under ea"h of three #nan"ial plans B ssume a Corporate 4n"ome ta rate of &-. 0ii3 Which alternative .ould you recommend and .hy (iii) etermine the E041
Answer (i) Co#putation of *+ under t%ree0financial plans. +lan : *quity 2inancing

*6%T

Rs! 4',)##

%nterest *6T

# Rs! 4',)##

ess9  Taxes /#( PAT

'),###

Rs! &,'),### # Rs! &,'),### )#,###

Rs! ',)#,### # Rs! ',)#,### &,##,###

Rs! ",8),### # Rs! ",8),### &,)#,###

Rs! 4,'),### # Rs! 4,'),### ',)#,###

Rs! "8,)##

Rs! 8),###

Rs! &,)#,###

Rs! ','),###

Rs! ",8),###

2o! of e+uity shares *P

",&',)##

",&',)##

",&',)##

",&',)##

",&',)##

Rs! #!&'

#!'/

#!/-

#!8'

&!'#

+lan : 3e't 4 *quity /i

*6%T

Rs! 4',)## &,'),###

Rs! &,'),### &,'),###

Rs! ',)#,### &,'),###

Rs! ",8),### &,'),###

Rs! 4,'),### &,'),###

04',)##3 '),###B

# #

&,'),### )#,###

',)#,### &,##,###

),##,### ',##,###

0"8,)##3 &,)4,')#

# &,)4,')#

8),### &,)4,')#

&,)#,### &,)4,')#

",##,### &,)4,')#

", C

-Rs. 0.2!

0

0.!(

0.6

/.2

+lan  )T

: +reference %ares 4 *quity /i Rs. 62#&00 Rs /#2� Rs. 2#&0#000

ess9 %nterest *6T ess9  Taxes /#( PAT 2o! of e+uity shares

 The Company .ill be able to set o losses a$ainst other prots! %f the Company has no prots from operations, losses .ill be carried for.ard! Rs. 3#7�

Rs. 6#2�

 Less: )nterest

0

0

0

0

0

T  Less: Taxes -!0% "@T  Less: "ref. dividend "@T for ordinary sharehoders  *o. of quity shares

62#&00 2�

/#2� &0#000

2#&0#000 /#00#000

3#7� /#&0#000

6#2� 2#&0#000

37#&00 /#2�

7� /#2�

/#&0#000 /#2�

2#2� /#2�

3#7� /#2�

-(7#&00

-&0#000

2�

/#00#000

2#&0#000

/#&6#2&0

/#&6#2&0

/#&6#2&0

/#&6#2&0

/#&6#2&0

",

-0.&6

-0.32

0./6

0.6!

/.60

The choice of the financing pan wi depend on the state of economic conditions. )f the (ii) companyIs saes are increasing# the ", wi $e maximum under "an ))+ 'e$t 9 quity ?ix. Jnder favoura$e economic conditions# de$t financing gives more $enefit due to tax shied avaia$iity than equity or preference financing.

(iii)

*5- 4 *+ ndifference +oint : +lan  and +lan  ,E*>+ × ,1  * + ,E* > −nterest + × ,1 − * +

=

/1 E* > ,1 − 0.40+ 312500

=

/2 ,E* > −125000+ × ,1 − 0.40+ 156250

312500 × 125000 312500 − 156250

)TC 5

5 Rs. 2#&0#000 *5- 4 *+ ndifference +oint: +lan  and +lan  E* > ,1 − *c + E* > ( 1 − *c ) − Pref. i'. = /1 /2 )TC 5

/1 Pref. i'. × /1 − /2 1  *

312500 × 125000 5 312500 − 156250 1 − 0.4 6 7s. "1&&&&.&8

Question 10 A Company issues Rs! &#,##,### &'( debentures of Rs! &## each! The debentures are redeemable after the expiry of xed period of 8 years! The Company is in ")( tax bracket! Required: (i) Cal"ulate the "ost of debt after ta, if debentures are issued at   )ar (a) $"& 10! iscount   $c& 10! )remium. (ii) %f brokera$e is paid at '(, .hat .ill be the cost of debentures, if

issue is at par 0P*1%%1ay '##4304 marks3

Answer 8d =

,R< − /P+ /  R< + /P        2  

 ,1 − *c + +

Where, % = Annual %nterest Payment 2P= 2et proceeds of debentures RD = Redemption value of debentures  Tc = %ncome tax rate

2 = Eife of debentures (i)

(a)

Cost of de'entures issued at par.

=

= (')

,1000000− 1000000+ 7  1000000+ 1000000     2    

120000× ,1 − 0.35+ +

7(000 1000000

= 7.(%

Cost of de'entures issued at 19 discount

,1000000 − 900000+ 7 = + 1000000 900000        2     7(000 + 142(6 = = 9.71% 950000 120000 × ,1 − 0.35+ +

(c)

Cost of de'entures issued at 19 +re#iu#

8d

0ii3

=

,1000000− 1100000+ 7  1000000+ 1100000      2    

120000 × ,1 − 0.35+ +

=

7(000 − 142(6 1050000

= 6.07%

!ost of debentures* if broerage is paid at 2+ and debentures are 8d

issued at

=

par

=

,1000000− 9(0000+ 7  ,1000000− 20000+ + 1000000     2    

120000× ,1 − 0.35+ +

(0(57 990000

= (.17%

Question 11   td.Fs operating in"ome (before interest and ta) is Rs. ,&&,&&&. 1he #rmFs "ost of debts is $&- and "urrently #rm employs Rs. 8&,&&,&&& of  debts. Required: Cal"ulate "ost of equity 

 Answer  !a$#u$ation of #ost of E"uity

Calculation of value of rm 0v3 = *6%T ÷7verall cost of capital 0? #3 = <,##,###÷#!&' = Rs! 8),##,###

arket value of e+uity 03 = D  5ebts = 8),##,###1 "#,##,### = Rs! /),##,### arket value of debts 053 ? e 0cost of e+uity3

= "#,##,###

= ? # 0D÷3 1 ? d 005÷3

Question 12 (a)

A6C Etd! .ishes to raise additional nance of Rs! '# lakhs for meetin$ its investment plans! The company has Rs! /,##,### in the form of retained earnin$s available for investment purposes! The follo.in$ are the further details!  

    

5ebt e+uity ') 9 8)! Cost of debt at the rate of &#( 0before tax3 up to Rs! ',##,### G &"( 0before tax3 beyond that! *arnin$ per share, Rs! &'! 5ividend payout )#( of earnin$s! *xpected $ro.th rate in dividend &#(! Current market price per share, Rs! 4# CompanyHs tax rate is "#( and shareholderHs personal tax rate is '#(!

Re+uired9 i3 Calculate the post tax avera$e cost of additional debt! ii3 Calculate the cost of retained earnin$s and cost of e+uity! iii3 Calculate the overall .ei$hted avera$e 0after tax3 cost of additional nance!

Answer :  Pattern of raisin$ capital 5ebt *+uity

= = =

#!')I '#,##,### ),##,### &),##,###

= = =

Rs! /,##,### Rs! &&,##,### Rs! &),##,###

= = =

Rs! ',##,### Rs! ",##,### Rs! ),##,###

E"uity fund 0Rs! &),##,###3

Retained earnin$ *+uity 0additional3  Total &ebt fund 0Rs! ),##,###3 &#( debt &"( debt  Total

0i3

? d

= Total %nterest 0&1t3 J Rs! ),##,### = K'#,### @ "<,###L 0& 1#!"3J ),##,### or 0/&,"## J ),##,###3I&## = -!'4( 0ii3

? e ? r

0iii3

= *PI payout J mp @ $ = &' 0)#(3 J 4#I&## @ &#( &#( @ &#( = '#( = ?e 0&  tp3 = '# 0&1#!'3 = &4(

Weighted average cost of capital

,arti#u$ar

-mount

*+uity Capital &&,##,### Retained earnin$ /,##,### 5ebt ),##,###  Total '#,##,### ?o = 0",'),"## J '#,##,###3I &##

-fter tax

!ost

'#!##( &4!##( -!'4(

','#,### 4/,### /&,"## ",'),"##

= &4!'8(

Question 13  1he data relating to two "ompanies are as gi!en below Company  Company 0 Equity Captal Rs. 9,&&,&&& Rs. 8,/&,&&& $%- ebentures Rs. ,&&,&&& Rs.9,/&,&&& 7utput (units) per annum 9&,&&& $/,&&& Selling pri"e per unit Rs. 8& Rs. %/& ;ied "ost per annum Rs.3,&&,&&& Rs.$,&&,&&& ?ariable "ost per unit Rs. $& Rs.3/ / r reuried to calculate the operating leverage, financial leverage and com"ined leverage of two compnies.

Answer :  Computation of degree of -perating leverage$ .inancial l everage and Combined leverage of two companies

Company  )utput units per annu" elling price ? unit ales re'enue 7ess8
Company 0

60000 Rs. 30 1(00000 (13 units ×   Rs.$)

15000 Rs. 250 3750000 ("'3 units ×   Rs.#')

600000

1125000

(13 units ×   Rs.")

("'3 units ×   Rs.')

1200000 700000 500000 4(000 452000

2625000 1400000 1225000 7(000 1147000

#ntri!uti#n ,+ 7ess8 @ied c#sts E* 7ess8 nterest A 12% #n de!entures P*



DOL = E* E*

DFL = P*

2.4 (Rs."#33 9 Rs.'33)

2.14 (Rs.#13#'3 9 Rs."#3#'3)

1.11 (Rs.'33 9 Rs.%3'#3)

1.07 (Rs."#3#'3 9 Rs.""3%3)

2.66 (#.%×  ".""

DCL = DOL × DFL

 

#.#2 (#."%×  ".)

Question 14  Gou are analysing the beta for 0C Computers td. and ha!e di!ided the "ompany into four broad business groups, with mar+et !alues and betas for ea"h group. 0usiness group

Har+et !alue of equity

Inle!eraged beta

Hain frames

Rs. $&& billion

$.$&

Personal Computers

Rs. $&& billion

$./&

Software

Rs. /& billion

%.&&

Printers

Rs. $/& billion

$.&&

 0C Computers td. had Rs. /& billion in debt outstanding . Required: (i) Estimate the beta for 0C Computers td. as a Company. 4s this beta going to be equal to the beta estimated by regressing past returns on 0C Computers sto"+ against a mar+et inde. *hy or why not B (ii) 4f the treasury bond rate is 3./-, estimate the "ost of equity for 0C Computers td. Estimate the "ost of equity for ea"h di!ision. *hi"h "ost of  equity would you use to !alue the printer di!ision B 1he a!erage mar+et ris+   premium is 2./-. (PE<44<o!. %&&) (9 mar+s)

Answer 

(i)

Beta of /BC Computers  1.10 × 2?( = 1.50 ×2?( = 2 ×1?( = 1 × 3?(  1.275

 eta coefficient is a measure of volatilit of securities return relative to the returns of  a "road "ased mar2et portfolio. 3ence "eta measures volatilit of (C Computers stoc2 return against "road "ased mar2et portfolio. *n this case we are considering  four "usiness groups in computer segment and not a "road "ased mar2et portfolio , therefore "eta calculations will not "e the same. (ii) Cost of equity  rf = a' "t ris pre"iu" ×β  7.5% = 1.275 × (.5%  1(.34% ;ain fra"e 8E

 7.5% = 1.10 × (.5%  16.(5%

P

8E

 7.5% = 1.5

#ftBare

8E

 7.5% = 2 ×(.5%  24.5%

Printers

8E

 7.5% = 1 ×(.5%  16%

× (.5%  20.25%

To vaue printer division# the use of /6% 4 is recommended

Question 15  0he follo!ing summarises the percentage changes in operating income3 percentage changes in revenues3 and  betas for four pharmaceutical firms.

;irm

Change in re!enue

Change in operating in"ome

0eta

PJR td.

%3-

%/-

$.&&

RS1 td.

%/-

8%-

$.$/

1I? td.

%8-

89-

$.8&

*KG  td.

%$-

&-

$.&

Re:uired8 (i)

Calculate the degree of operating leverage for each of these firms. Comment also.

(ii)

;se the operating leverage to eplain !h< these firms have different beta. (+//>ov. #%) (1 marks)

Answer  % &ange in )perating inc#"e (i)

egree #f #perating le'erage PCR Dtd

.



 25% ? 27%

% &ange in Re'enues 

0.9259

R* Dtd.



0.32 ? 0.25



1.2(

*< Dtd.



0.36 ? 0.23



1.5652

F: Dtd.



0.40 ? 0.21



1.904(

t is le'el specific. (ii) Gig& #perating le'erage leads t# &ig& !eta. *&e s#urces #f ris are t&e cyclic nature re'enues #perating ris and financial ris.

 Question 16    Company had the following 0alan"e Sheet as on Har"h 8$, %&&9: iabilities and Equity  Rs. (in "rores) Equity Share Capital (one "rore shares of Rs. $& ea"h) Reser!es and Surplus $/- ebentures

ssets

Rs. (in "rores)

$&

;ied ssets (et) Current ssets

%/ $/

% %&

Current iabilities

2

LLL

 & 1he additional information gi!en is as under:

 

&

;ied Costs per annum (e"luding interest)

:Rs. 2 "rores

?ariable operating "osts ratio

: 9/-

1otal ssets turno!er ratio

: %./

4n"ome
: &-

Required: Cal"ulate the following and "omment: (i) Earnings per share (ii) 7perating e!erage (iii) ;inan"ial e!erage (i!) Combined e!erage.

(PE<44<o!. %&&9)(2 mar+s)

Answer  Total Assets

= Rs! /# crores

 Total Asset Turnover Ratio Mence, Total ales

= '!) = /# × '!) = Rs! &## crores

!omputation of ,rots after Tax (,-T) (Rs. in crores)

ales

&##

ess9 Dariable operatin$ cost > 4)( Contribution ess9 Fixed cost 0other than %nterest3 *6%T ess9 %nterest on debentures 0&)( × '#3 P6T ess9 Tax /#( PAT

4) ") '8 " '/
(i) Earnings per share

∴ EP 

Rs. 14.4 cr#res 1 cr#re equity s&ares = Rs! &/!/#

(ii) Operating /everage )perating le'erage 

#ntri!uti#n E*



35 27

 1.296

%t indicates the choice of technolo$y and xed cost in cost structure! %t is level specic! When rm operates beyond operatin$ break1even level, then operatin$ levera$e is lo.! %t indicates sensitivity of earnin$s before interest and tax 0*6%T3 to chan$e in sales at a particular level! (iii)

0inan#ia$ /everage @inancial De'erage 

E* P*



27 24

 1.125

 The nancial levera$e is very comfortable since the debt service obli$ation is small vis1N1vis *6%T! (iv)

!ombined /everage #"!ined De'erage 

#ntri!uti#n E*

×

E* P*

= &!'<4 × &!&') = &!/) The combined levera$e studies the choice of xed cost in cost structure and choice of debt in capital structure! %t studies ho. sensitive the chan$e in *P is vis1N1vis chan$e in sales!

 The levera$es − operatin$, nancial and combined are measures of risk

Question 17   0C imited has an a!erage "ost of debt at $& per "ent and ta rate is & per "ent. 1he  ;inan"ial le!erage ratio for the "ompany is &.9&. Cal"ulate Return on Equity (R7E) if its  Return on 4n!estment (R74) is %& per "ent.

Answer  = R7* = KR7% @ :0R7%  r3 O5J*;L 0&  t3 = K#!'# @ :0#!'#  #! O#!4#;L 0&  #!/#3 =K #!'# @ #!#4L O#!4# = #!&)4# R7* = &)!4#(

Question 18 (a)

 

1he following details of RS1 td. for the year ended 8$ st   Har"h, %&&9 are gi!en below: 7perating le!erage $. Combined le!erage %.2 ;ied "ost (E"luding interest) Rs. %.& la+hs Sales Rs. 8&.&& la+hs $%- ebentures of Rs. $&& ea"h Rs. %$.%/ la+hs Equity Share Capital of Rs. $& ea"h Rs. $3.&& la+hs 4n"ome 1a rate 8&Required: i) Cal"ulate ;inan"ial le!erage ii) Cal"ulate P'? ratio and Earning per Share (EPS) iii) 4f the "ompany belongs to an industry, whose assets turno!er is $./, does it  ha!e a high or low assets le!erageB i!) t what le!el of sales the Earning 0efore 1a (E01) of the "ompany will be equal to MeroB

 Answer  (a) (i) Financial Leverage Combined Leverage = Operating Leverage (OL) ×Financial Leverage (FL) 2.8 = 1.4 ×FL FL = 2 Financial Leverage = 2 (ii)

P/V ratio and EPS

P/V ratio = {(C×S) ×100} Operating Leverage = {C ÷(C-F) ×100} 1.4 = {C- (C-!04!000)} 1.4 (C-!04!000) = C 1.4C -!"#!$00 = C C = !"#!$00÷0.4 C = %!14!000 P/V = {(%!14!000÷&0!00!000)×100} = &."' ere*ore! P/V ratio = &."'

+PS = (Pro*it a*ter ta, ÷o. o* eit are) +2 = Sa3e V- FC- 5nteret = &0!00!000- !"$!000- !04!000 -!##!000 = !##!000 P6 = +2 a, = !##!000-%$!#00 = 1!%"!#00 +PS = (1!%"!#00÷1!%0!000) = 1.0# (iii)

Assets turnover  Assets turnover = (Sales ÷Total Assets) = (&0!00!000÷&"!#!000)

= 0.%"4 0.%"4 71.# means lower than industry turnover. (iv) ET !ero means "##$ redu%tion in ET. Sin%e %om&ined levera'e is .* sales have to  &e dro++ed &y 100/." = &#.%1'. ,en%e new sales will &e &0!00!000×(100 -&#.%1) = 18!"!%00 There-ore* at "**/## level o- sales* the earnin's &e-ore ta0 o- the %om+any will &e e1ual to !ero.

Question 19  A -irm has Sales o- 2s. 3# la4hs5 6aria&le %ost o- 2s. 7 la4hs5 Fi0ed Costs o- 2s. 8 la4hs5 "#$ de&ts o- 2s. 9# la4hs5 and E1uity Ca+ital o- 2s. 37 la4hs. 7 ×

2e1uired: Cal%ulate o+eratin' and -inan%ial levera'e  Answer: Calculation of operating and Financial Leverage Sales Less: 6aria&le %ost Contri&ution (C) Less: Fi0ed Cost E;T Less: ;nterest ET O+eratin' levera'e = C ÷E;T = "7*##*###÷*##*### = ".8/ Finan%ial levera'e = E;T ÷ET = *##*###÷8*##*### = ".7#

2s. 3#*##*### 7*##*### "7*##*### 8*##*### *##*### 9*##*### 8*##*###

Question 20 The following data relate to RT 4td  #arning "efore interest and tax $#*T&  6ixed cost  #arning efore Tax $#T&  Reuired Calculate com"ined leverage

Rs. 10,00,000 70,00,000 8,00,000

Answer (iii) ontri!ution"

C E;T "#*##*###

= S < 6 and =C
Question #1 $ii& ( compan operates at a production level of 1,000 units. The contri"ution is Rs. 90 per unit, operating leverage is 9, and com"ined leverage is 7. *f tax rate is :0!, what would  "e its earnings after tax; 

 Answer o$putation of Earnings after ta%

Contri&ution = 2s. 8# ×"*### = 2s. 8#*### O+eratin' Levera'e (OL) >Finan%ial Levera'e (FL) = Com&ined Levera'e (CL) 8×Finan%ial Levera'e = 3 Finan%ial Levera'e = 3 O+eratin' Levera'e = Contri&ution÷ E;T = 8#*###÷ E;T = 8 E;T = 8#*###÷ 8 = "#*### FL = E;T÷ET = 3

ET = E;T ÷3 = "#*###÷ 3 = *7## Sin%e ta0 rate = 9#$ Earnin's a-ter Ta0 (EAT) = ET (" ? #.9#) = *7## (#./#) Earnin' A-ter Ta0 (EAT) = "*/7#

Extra sus! +uestion *  < 4td. a widel held compan is considering a ma=or expansion of its product ion facilities and the  following alternativ es are availa"le

 >hare Capital 1! e"entures  4oan from a 6inancial *nstitution ? 18! p.a. Rate of *nterest.

 (lternatives $Rs. in la2hs&  (  C  5  70 10 0 70 15 10 75

   

 #xpected rate of return "efore tax is 75!. The rate of dividend of the compan is not less than 70!. The compan at present has low de"t. Corporate taxation 50! @hich of the alternatives ou would choose;

$6inal- +ov.1AAB& $8 mar2s&

-ns1er (Rs. in lakhs) Return #n Rs. 50 la&s A 25% 7essH nterest #n e!entures nterest #n l#an *aa!le pr#fit nc#"e ta 50% Pr#fit after ta a'aila!le t# s&are &#lders Rate #f return #n s&are capital

 A 12.50   12.50 6.25 6.25 12.5%

B 12.50 2.(0 1.(0 7.90 3.95 3.95 19.75%

@r#" t&e s&are&#lders p#int #f 'ieB lternati'e  ,&ig&est+ is t# !e c&#sen.

C 12.50 2.10 4.50 5.90 2.95 2.95 29.5%

uestion 2 The following figures are made availa"le to ou 9.

 +et profits for the ear

 

1"!00!00  0 

 4ess *nterest on secured de"entures at 15! p.a. $e"entures were issued : months after the commencement of the ear&

1!1!#00  1$!"%!#0  0 

 4ess *ncome –tax at :5! and dividend distri"ution tax     )rofit after tax   

"!4&!%#0 

 +um"er of euit shares $Rs. 10 each&

1!00!000 

 ar2et uotation of euit share

 

"!4&!%#0  9. 108.% 

The compan has accumulated revenue reserves of Rs. 17 la2hs. The compan is examining a pro=ect calling for an investment o"ligation of Rs. 10 la2hsD this investment is expected to earn the same rate of return as funds alread emploed. Eou are informed that a de"t euit ratio $e"t divided " de"t plus euit& higher than 90! will cause the price earning ratio to come down " 75! and the interest rate on additional "orrowals will cost compan :00 "asic points more than on the current  "orrowal on secured de"entures. Eou are reuired to advise the compan on the pro"a"le price of the euit share, if  $a& the additional investment were to "e raised " wa of loansD or $"& the additional investment were to "e raised " wa of euit. $6inal-a 1AA8& $10 mar2s&

-ns1er "orking 0ote +resent earning9share8 Pr#fit !ef#re taes 7ess8 *aes at 35% Pr#fit after ta /#. #f equity s&ares E.P..



Rs! &#,<4,-8) &,##,###

E.P..  Rs. 10.97 ;aret Price  Rs. 109.70

Rs! &#,<4,-8) &,##,###

Rs. 16(7500 590625 1096(75 100000

Gence P?E



 10

(a) 1robable 1rice2share$ if the additional investment were to be raised by way of loans

 )resent capital emploed  Rs. E1uity

"#*##*###

De&enture (Lon' term)

"#*##*###

2evenue reserves

"*##*###

Total

9*##*###

@reinterest and +reta0 +ro-its 'iven 2s. " la4hs

Rs! &- lakhs x &## Rs!="' lakhs 9ate o* retrn +25

= #$.#%

 e"t euit ratio, if Rs. 10 lacs $additional investment& were to "e "orrowed $e"t Rs. 70 lacs and euit Rs. 77 lacs&, will "e

Rs! '# lacs x &## Rs! /' lacs

= 3/.8$

Sin%e* the de&t e1uity ratio will not e0%eed 8#$ @E will remain same. ;- 2s. "# la%s is to &e &orrowed* the earnin' will &e as under: 9.

2eturn o- 78.7$ on 2s. 3 la%s

&!$!#0 0

 4ess ;nterest at "7$ on e0istin' 2s. "# la%s de&entures ;nterest on -resh &orrowed amount o- 2s. "# la%s at "$

1!#0!00 0 1!"0!00 0

@ro-it a-ter interest &e-ore ta0

@ro-it a-ter ta0 Bo. o- e1uity shares

&,##,###

= 2s. "9."

@ro&a&le +ri%e o- e1uity share = 2s. "9." 0 "# (2e-er to wor4in' note)

&!&0!000 0!&!#0 0 %!11!&%# 1&!1!1# 1!00!000

 4ess Ta0 at 97$

[email protected]. = Rs! &",'&,&')

9.

= 2s. "9."# (b) Probable Price/sare! if additional invest"ent were to be raised b# wa# of  e$uit#%

;- 2s. "# la%s were to &e raised &y way o- e1uity shares to &e raised at mar4et rates. The e0istin' mar4et +ri%e o- 2s. "#./# may %ome down a little and may +ossi&ly settle at 2s. "##. ,en%e* new e1uity shares to &e raised will &e : 2s. "#*##*### 2s. "## = "#*### shares  *f Rs. 10 lacs is to "e raised " wa of euit shares, the earning will "e as under 8 Rs.

Prot before interest and tax ess: %nterest on debentures Prot after interest before tax ess: Tax > ")( Prot after tax 2o! of e+uity shares *!P!!=Rs! &/,"-,&')

&,&#,###

'",4',)## &,)#,### '',&',)## 8,8/,"8) &/,"-,&') &,&#,### = Rs! &"!#8

Probable price of e+uity share = Rs!&"!#8 x &# 0Refer to .orkin$ note3 = Rs! &"#!8#

 The su$$ested solution .ill be to issue fresh debentures to nance expansion

uestion 3 The odern Chemicals 4td. reuires Rs. 75,00,000 for a new plant. This plant is expected  to ield earnings "efore interest and taxes of Rs. 5,00,000. @hile deciding a"out the  financial plan, the compan considers the o"=ective of maximising earnings per share. *t  has three alternatives to finance the pro=ect- " raising de"t of Rs. 7,50,000 or Rs. 10,00,000 or Rs. 15,00,000 and the "alance, in each case, " issuing euit shares. The companFs share is currentl selling at Rs. 150, "ut is expected to decline to Rs. 175 in case the funds are "orrowed in excess of Rs. 10,00,000. The funds can "e "orrowed at the rate of 10! upto Rs. 7,50,000, at 15! over Rs. 7,50,000 and upto Rs. 10,00,000 and at 70! over Rs. 10,00,000. The tax rate applica"le to the compan is 50!. @hich form of   financing should the compan choose; $6inal- +ov. 1AAA& $B mar2s&  Answer

!a$#u$ation of Earning per share for three a$ternatives to nan#e the proe#t  Alternatives +articulars

/ 0o raise debt of 

// 0o raise debt of Rs.

/// 0o raise debt of Rs.

Earnings !ef#re interest and ta 7ess8 nterest #n de!t at t&e rate #f

Earnings !ef#re ta 7ess8 *a ,A 50%+ Earnings after taH ,+ /u"!er #f s&ares H,+ (Refer to !orking note) Earning per s&are H ,+?,+

Rs.#3'3 and  e:uit< of Rs.  ##3'3 Rs. 500000

"33 and e:uit< of  Rs. "'33 Rs.

"'33 and e:uit< of  Rs. "33 Rs.

500000

500000

25000 ,10% #n Rs. 250000+

137500 ,10% #n Rs. 250000+ ,15% #n Rs. 750000+

475000 237500 237500 15000

362500 1(1250 1(1250 10000

237500 ,10% #n Rs. 250000+ ,15% #n Rs. 750000+ ,20% #n Rs. 500000+ 262500 131250 131250 (000

15(33

1(125

16406

Decision: e earning per are i iger in a3ternative 55 i.e. i* te :o;pan *inan:e te

proet o* 9. 10!00!000 an> ie eit are o* 9. 1#!00!000. ere*ore te :o;pan o3> :ooe ti a3ternative to *inan:e te pro
Working Note: 63ternative 

+it *inan:ing ? (6) @arAet pri:e per are? (2) ;er o* eit are? (6)/(2)

5

55

555

9. !#0!000 9. 1#0

9. 1#!00!000 9. 1#0

9. 10!00!000 9. 1#

1#!000

10!000

"!000

 

+uestion 3 1he following is the "apital stru"ture of Simons Company td. as on 8$.$%.$2: Equity shares : $&,&&& shares (of Rs. $&& ea"h) $&- Preferen"e Shares (of Rs. $&& ea"h) $%- ebentures

Rs. $&,&&,&&& ,&&,&&& 9,&&,&&& %&,&&,&&&

 The market price of the companyHs share is Rs! &&# and it is expected that a dividend of Rs! &# per share .ould be declared for the year &<<-! The dividend $ro.th rate is 4(9 (i) 4f the "ompany is in the /&- ta bra"+et, "ompute the weighted a!erage "ost of "apital. (ii) ssuming that in order to #nan"e an epansion plan, the "ompany intends to borrow a fund of Rs. $& la+hs bearing $- rate of interest, what will be the "ompanyFs re"ei!ed weighted a!erage "ost of "apitalB 1his #nan"ing de"ision is epe"ted to in"rease di!idend from Rs. $& to Rs. $% per share. Nowe!er, 1he mar+et pri"e of equity share is epe"ted to de"line from Rs. $$& to Rs. $&/ per share. (;inal< o!. $) ($& mar+s)

/nswer ,i+

!omputation of the 1eighted average #ost of #apita$

Sour"e of #nan"e

Proportion

(a) *+uity share

(b) #!)

&#( Preference #!' share &'( #!" 5ebentures Wei$hted avera$e cost of capital

fter ta "ost (-) ($
*eighted a!erage "ost  of "apital (-)

4!##

&!-#

(d)5(b)(") 8!)/

'!##

&&!"/

(ii) !omputation of Revised 'eighted -verage !ost of !apita$

Sour"e of #nan"e

Proportion

fter ta "ost (-) ($
*eighted a!erage "ost of "apital (-)

(a)

(b)

(")

(d) 5 (b)>(")

*+uity shares

#!"""

)!-#

&#( Preference shares &'( 5ebentures

#!&""

&8!/' (Refer to wor+ing note %) &#!##

&!""

#!'##

4!##

&!'#

&/( Eoan #!""" Revised .ei$hted avera$e cost of capital

8!##

'!"" &#!44

'oring otes%

($) Cost of equity shares (+ e ) ,ividend per share

ke

= &arket pri ce per share

+ ?ro!th rat e

10

+ 0.06 = 100 = #!&)#< or &)!#<(

0'3 Re!ised "ost of equity shares (+ e ) 12

Revised ke = 105

+ 0.06

= #!&8/' or &8!/'(

Question 4 1he following is the "apital stru"ture of a Company: Sour"e of "apital Equity shares O Rs. $&& ea"h  per "ent "umulati!e  preferen"e shares O Rs. $&& ea"h $$ per "ent debentures Retained earnings

0oo+ !alue Rs. 2&,&&,&&&

Har+et !alue Rs. $,9&,&&,&&&

%&,&&,&&&

%,&&,&&&

9&,&&,&&& &,&&,&&&

99,&&,&&& − 

%,&&,&&,&&& %,/&,&&,&&& 1he "urrent mar+et pri"e of the "ompanyFs equity share is Rs. %&&. ;or the last   year the "ompany had paid equity di!idend at %/ per "ent and its di!idend is li+ely  to grow / per "ent e!ery year. 1he "orporate ta rate is 8& per "ent and shareholders personal in"ome ta rate is %& per "ent. Gou are required to "al"ulate: (i) Cost of "apital for ea"h sour"e of "apital.

(ii) *eighted a!erage "ost of "apital on the basis of boo+ !alue weights. (iii) *eighted a!erage "ost of "apital on the basis of mar+et !alue weights.  

(PE< 44<o!. %&&2) (3 mar+s)

Answer (i)

Calculation of Cost of Capital for each source of capital H 1.

#st #f Equity apitalH

8e =

=

P ,1 + g+ ;P

× 100 + g

25 ,1 + 0.05+ 200

=

× 100 + 5

26.25 × 100 + 5 200

 13.125 = 5  1(.125%. 2.

#st #f preference capital #r 8p  9%.

3.

#st #f e!enturesH 8 d ,after ta+

 r ,1 - *+  11 ,1 - 0.3+  7.7%.

4.

#st #f Retained EarningsH 8 r  8 e ,1 - *p+  1(.125 ,1 - 0.2+  14.5%.

(ii) "eighted average cost of capital (-n the basis of Book 4alue "eights)

Sour"e

0&3 *+uity Capital Preference Capital 5ebentures Retained earnin$s

mount   *eight  s (0oo+  ?alue) (Rs.)

0'3

0"3

-#,##,### '#,##,###

#!/ #!&

4#,##,### /#,##,###

#!" #!'

Cost of  *CC Capital (after  (-) ta) (-) 0/3 0)3 = 0"3 × 0/3 &-!&') 8!') < #!<#

8!8 &/!)

',##,##,### &!## Mence, WACC on the basis of 6ook Dalue Wei$hts = &"!"4(!

'!"& '!<# &"!"4

(iii)

'eighted -verage !ost of !apita$ (On the basis of 4aret va$ue 1eights)

Sour"e

mount   *eigh ts (Har+et  ?alue) (Rs.)

0&3

0'3

*+uity Capital Preference Capital

0"3

Cost of  Capital (after ta) (-)

0/3

*CC (-)

&,4#,##,### '/,##,###

#!4/# #!#<4

&-!&') <

0)3 = 0"3 × 0/3 &&!4## #!-4/

44,##,###

#!'4/

8!8

'!#""

−

−

−

−

',)#,##,###

&!###

5ebentures Retained earnin$s

&/!/<8

Gence# 1@ on the $asis of ?aret Eaue 1eights 5 /!.!7%

Question 5   new proe"t is under "onsideration in ip td., whi"h requires a "apital in!estment  of Rs. ./& "rore. 4nterest on term loan is $%- and Corporate 1a rate is /&-. 4f the ebt Equity ratio insisted by the #nan"ing agen"ies is % : $, "al"ulate the point of  indi6eren"e for the proe"t. (PE<44
Answer %f nancin$ a$encies insist ' 9 & 5ebt e+uity ratio then company has t.o options9 0i3 To Arran$e .hole amount the company can issue e+uity shares! 0ii3 Company should arran$e " crores by &'( term loan and &!)# crore throu$h e+uity share so that '9& 5ebt1e+uity ratio can be maintained! n rst option interest .ill be ero and in second option the interest .ill be Rs!

"4,##,### Point of %ndierence

(  − R1 ) ( 1 − * ) /1

(  − R 2 ) (1 − * ) /2

=

(  − 0 ) (1 − 0.5) or

450 Da&s

(  − 36 Da&s) ( 1 − 0.5 ) =

150 Da&s

0.5 0.5 − 1( = 150 or 450

or 8)x = '')x  -&## or -&## = '')x  8)x or -&## = &)#x (100 = 54 Da&s 150 x=

*6%T at point of %ndierence .ill be Rs!)/ Eakhs! ote%  The aforesaid solution is based on the assumption that the face value of 

a share is Re! &! Mence, the number of shares in denominator bein$ /)# lakhs and &)# lakhs respectively! Mo.ever, if a student assumes face values bein$ Rs! &# per share and Rs! &## per share, the conclusion .ill remain the same!  Alternati"e presentations are as follows!

0A3 Point of %ndierence at share value bein$ Rs! &#!

(  − R1 ) ( 1 − * ) /1

(  − R 2 ) (1 − * ) /2

=

(  − 0) ( 1 − 0.5) 45 Da&s

or

(  − 36 Da&s) ( 1 − 0.5) 15 Da&s

=

0.5 0.5 − 1( = 45 15 or

or 8!)x = ''!)x  -&# or -&# = ''!)x  8!)x or -&# = &)x (10

x = 15

= 54 Da&s

*6%T at point of %ndierence .ill be Rs!)/ Eakhs! 063 Point of %ndierence at share value bein$ Rs! &##!

(  − R1 ) ( 1 − * ) /1

(  − R 2 ) (1 − * ) /2

=

(  − 0) (1 − 0.5) or

4.50 Da&s

(  − 36 Da&s) (1 − 0.5) =

0.5 0.5 − 1( = 1.50 #r 4.50 #r 0.75

 2.25 - (1

#r (1  2.25 - 0.75 #r (1  1.5

1.50 Da&s

(1   1.5

= 54 Da&s

E* at p#int #f ndifference Bill !e Rs.54 Da&s.

Question 6 Gou are required to determine the weighted a!erage "ost of "apital of a #rm using (i) boo+
2,&&,&&&

Preferen"e shares of Rs. $&& ea"h

%,&&,&&&

Equity shares of Rs. $& ea"h

$&,&&,&&& %&,&&,&&&

 ll these se"urities are traded in the "apital mar+ets. Re"ent pri"es are: ebentures O Rs. $$&, Preferen"e shares O Rs. $%& and Equity shares O Rs. %%.  nti"ipated eternal #nan"ing opportunities are as follows: (i) Rs. $&& per debenture redeemable at par : %& years maturity 2- "oupon rate, - Qoatation "osts, sale pri"e Rs. $&&. (ii) Rs. $&& preferen"e share redeemable at par : $/ years maturity, $&di!idend rate, /- Qoatation "osts, sale pri"e Rs. $&&. (iii) Equity shares : Rs. % per share Qoatation "osts, sale pri"e Rs. %%. 4n addition, the di!idend epe"ted on the equity share at the end of the year  is Rs. % per share the anti"ipated growth rate in di!idends is /- and the #rm has the pra"ti"e of paying all its earnings in the form of di!idend. 1he "orporate ta rate is /&-. (PE<44
Answer (a) 'oring otes% etermination of Spe"i#" Costs:

0i3 Cost of 5ebentures before tax 0k d 3 ,P − /P+ n ,P + /P+ 2

+

kd =

Where, %

=

Annual interest payment

P

=

RedeemableJpayable value of debenture at maturity

2P

=

2et sale value from issue of debentureJface value  expenses

,100 − 96+ 20 ,100 + 96+ 2

(+

kd =

( + .20 9(

=

= .0(36 #r (.36%

Cost of debenture after tax = ? d 0& t3 = -!"4 0&!)#3 = /!&-(!

0ii3 Cost of Preferen"e Shares (+  p ) ,P − /P+ n ,P + /P+ 2

+

 k p = Where, 5

=

Fixed annual dividend

P

=

Redeemable value of preference shares

n

=

2umber of years to maturity!

10 +

,100 − 95+

15 ,100 + 95+

10.33 = .1059 #r 10.59% 97.5 =

2

? p =

0iii3 Cost of Equity (+ e )  +g /P ke =

Where, 5

=

*xpected dividend per share

2P

=

2et proceeds per share

$

=

Qro.th expected in dividend

2

ke = 22 − 2

+ .05 =

2 20

+ .05 = .10 + .05 = .15 #r 15%.