TUTORIAL COST OF CAPITAL

Q.1 The Kay company has the following capital

structure at 31 March 2003 which is considered
to be optimum.
14% Debentures
3,00,000
11% Preference Share
1,00,000
Equity (1,00,000 Shares)
16,00,000
The company shares has a current market price of
Rs 23.60 per share. The expected dividend per
share next year is 50% of the 2003 EPS. The
following EPS figure for the company during the
preceding ten years. The past trends are expected
to continue
Yea
r

9
4

95

96

97

98

99

0
0

01

02

03

EP
S

1.1
0

1.2
1

1.3
3

1.4
6

1.6
1

2.2

2.1
5

2.1
6

The company can issue 16% new debentures. The

companys debentures are currently selling at Rs
96. The new preference issue can be sold at net
price of Rs 9.20, paying a dividend of Rs 1.1 per
share. The companys marginal tax rate is 50%.
a) Calculate the after-tax cost (i) of new debt, (ii)
of new preference capital and (iii) of ordinary
equity, assuming new equity comes from
retained earnings.
b) Find the marginal cost of capital, assuming no
new ordinary shares are sold.
c) How much can be spent for capital investments
before new ordinary shares must be sold?
Assume that retained earnings available for
next years investment are 50% of 2003
earnings.
d) What is the marginal cost of capital (cost of
funds raised in excess of the amount calculated
in part (c) if the firm can sell new ordinary
shares to net Rs 20 a share? The cost of debt
and of preference capital is constant.
Q.2 The Keshari Engineering Ltd. Has the following
capital structure, considered to be optimum, on
31 June 2003.
14% Debt
93.75
10% Preference
31.25
Ordinary equity
375.00
Total
500.00
The company has 15 million shares outstanding.
The share is selling for Rs 25 per share and the
expected dividend per share is Rs 1.50, which is
expected to grow at 10%. The company is
contemplating to raise additional funds of Rs 100
million to finance expansion. It can sell new
preference shares at a price of Rs 23, less floatation
cost of Rs 3 per pays taxes at rate of 35% and
intends to maintain its capital structure.
You are required (i) calculate the after-tax cost (a)
of new debt, (b) of new preference capital, share. It
is expected that a dividend of Rs 2 per share will be
paid on preference. The new debt can be issued at
10% rate of interest. The firm and (c) of ordinary
equity, assuming new equity comes only from

retained earnings which is just sufficient for the

purpose, (ii) to calculate the marginal cost of
capital, assuming now new shares are sold, (iii) to
compute the maximum amount which can be spent
for capital investments before new ordinary shares
can be sold, if the retained earnings are Rs
7,00,000, and (iv) to compute the marginal cost of
capital if the firm spends in excess of the amount
computed in (iii). The firm can sell ordinary shares
at a net price of Rs 22 per share.
TUTORIAL COST OF CAPITAL
Q.1 The Kay company has the following capital
structure at 31 March 2003 which is considered
to be optimum.
14% Debentures
3,00,000
11% Preference Share
1,00,000
Equity (1,00,000 Shares)
16,00,000
The company shares has a current market price of
Rs 23.60 per share. The expected dividend per
share next year is 50% of the 2003 EPS. The
following EPS figure for the company during the
preceding ten years. The past trends are expected
to continue
Yea
r

9
4

95

96

97

98

99

0
0

01

02

03

EP
S

1.1
0

1.2
1

1.3
3

1.4
6

1.6
1

2.2

2.1
5

2.1
6

The company can issue 16% new debentures. The

companys debentures are currently selling at Rs
96. The new preference issue can be sold at net
price of Rs 9.20, paying a dividend of Rs 1.1 per
share. The companys marginal tax rate is 50%.
a) Calculate the after-tax cost (i) of new debt, (ii)
of new preference capital and (iii) of ordinary
equity, assuming new equity comes from
retained earnings.
b) Find the marginal cost of capital, assuming no
new ordinary shares are sold.
c) How much can be spent for capital investments
before new ordinary shares must be sold?
Assume that retained earnings available for
next years investment are 50% of 2003
earnings.
d) What is the marginal cost of capital (cost of
funds raised in excess of the amount calculated
in part (c) if the firm can sell new ordinary
shares to net Rs 20 a share? The cost of debt
and of preference capital is constant.
Q.2 The Keshari Engineering Ltd. Has the following
capital structure, considered to be optimum, on
31 June 2003.
14% Debt
93.75
10% Preference
31.25
Ordinary equity
375.00
Total
500.00
The company has 15 million shares outstanding.
The share is selling for Rs 25 per share and the
expected dividend per share is Rs 1.50, which is
expected to grow at 10%. The company is

contemplating to raise additional funds of Rs 100

million to finance expansion. It can sell new
preference shares at a price of Rs 23, less floatation
cost of Rs 3 per share. It is expected that a dividend
of Rs 2 per share will be paid on preference. The
new debt can be issued at 10% rate of interest. The
firm pays taxes at rate of 35% and intends to
maintain its capital structure.
You are required (i) calculate the after-tax cost (a)
of new debt, (b) of new preference capital, and (c)
of ordinary equity, assuming new equity comes only
from retained earnings which is just sufficient for
the purpose, (ii) to calculate the marginal cost of
capital, assuming now new shares are sold, (iii) to
compute the maximum amount which can be spent
for capital investments before new ordinary shares
can be sold, if the retained earnings are Rs
7,00,000, and (iv) to compute the marginal cost of
capital if the firm spends in excess of the amount
computed in (iii). The firm can sell ordinary shares
at a net price of Rs 22 per share.

Solution
2.
Problem 11
Market price of ordinary share (Rs)
Expected DIV (Rs)
Growth
Cost of internal equity (retained earnings):
Issue price of ordinary equity (Rs)
Cost of equity (new issue):
Issue price of preference share (Rs)
Flotation cost (Rs)
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
14% Debt (Rs mn.)
10% Preference (Rs mn.)
Ordinary equity (Rs mn.)
Total capital (Rs mn.)

25
1.5
0.1
0.16
22
0.168
23
3
20
2
0.1
0.17
0.5
0.085
700
0.75
933.33
1,000

Amount

Weights
(w)

93.75
31.25
375.00
500

0.1875
0.0625
0.7500
1.000

Retained earnings
Cost ( c )
wxc
0.085
0.100
0.160
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

New Issue
Cost ( c )
wxc
0.085
0.100
0.168

0.016
0.006
0.126
0.148