ABC Limited has the following book value capital structure:

Equity Share Capital (150 million shares, Rs.10 par)

Rs.1,500 million

Reserves and Surplus

Rs.2,250 million

10.5% Preference Share Capital (1 million shares, Rs.100 par)

Rs.100 million

9.5% Debentures (1.5 million debentures, Rs.1000 par)

Rs.1,500 million

8.5% Term Loans from Financial Institutions

Rs.500 million

The debentures of ABC Limited are redeemable after three years and are quoting at Rs.981.05 per debenture. The applicable income tax
rate for the company is 35%.
The current market price per equity share is Rs.60. The prevailing default-risk free interest rate on 10-year GOI Treasury Bonds is 5.5%.
The average market risk premium is 8%. The beta of the company is 1.1875.
The preferred stock of the company is redeemable after 5 years is currently selling at Rs.98.15 per preference share.
Required:
(i)

Calculate weighted average cost of capital of the company using market value weights.

(ii)

Define the marginal cost of capital schedule for the firm if it raises Rs.750 million for a new project. The firm plans to have a target
debt to value ratio of 20%. The beta of new project is 1.4375. The debt capital will be raised through term loans. It will carry interest
rate of 9.5% for the first 100 million and 10% for the next Rs.50 million.
(PE-II- May 2004) (9 marks)

Answer
Working Notes:
1)

Computation of cost of debentures (K d) :

981.05

95

(1 ytm)

Yield to maturity (ytm)

3)

(1 ytm)

1095
(1 ytm) 3

ytm (1 Tc)

10% (1 0.35)

6.5%

Computation of cost of term loans (K T) :

=

i ( 1 Tc)

8.5% ( 1 0.35)

5.525%

Computation of cost of preference capital (K P) :

98.5 =

4)

95

10% (approximately)

Kd

2)

10.5
1

(1 YTM)

10.5
(1 YTM)

YTM

11% (approximately)

Kp

11%

10.5
(1 YTM)

Computation of cost of equity (K E) :

=

rf + Average market risk premium Beta

5.5%+ 8% 1.1875

15%

10.5
(1 YTM)

10.5
(1 YTM) 5

5)

Computation of proportion of equity capital, preference share, debentures and term loans in the market value of capital
structure:
(Rs. in million)

Equity share capital

Rs.60)

Market value of capital

structure
Rs.

Proportion

9,000

81.3000

(150 million share

10.5% Preferential share capital

(1 million shares 98.15)
9.5 % Debentures
(1.5 million debentures Rs.981.05)

98.15

0.889

1,471.575

13.294

8.5% Term loans

500

4.517

11,069.725

(i)

Weighted Average cost of capital (WACC) : (Using market value weights)

WACC = Kd

D
T
P
E
K T KP KE
V
V
V
V

6.5% 0.1329 + 5.25% 0.04517 + 11% 0.0089 + 15% 0.813

0.008638 + 0.002495 + 0.00097 + 0.12195

13.41%

* For the values of K d, KT, KP and K E and weights refer to working notes 1 to 5
(ii)

100

respectively.

Marginal cost of capital (MCC) schedule :

KE (New Project) = 5.5% + 8% 1.4375
Kd

MCC

17%

9.5% ( 10.35)

6.175%

10% (10.35)

6.5%

17% x 0.80 + 6.175%

14.86% (Approximately)

100
50
6 .5 %
750
750