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The company’s share has a current market price for Rs. 23.60/share. The expected
dividend per share for next year is 50% of the 2003 EPS. Following are the earnings per
share figure of the company during the preceding 10 years. (The past trends are
expected to continue)
The company can issue 16% new debentures. The company’s debentures are currently
selling at Rs. 96. The new preference issue can be sold at a net price of Rs. 9.20, paying
a dividend of Rs. 1.1/share. The company’s marginal tax is 50%.
Questions:
I. Calculate the after tax cost (i) of new debt, (ii) of new preference capital & (iii) of
ordinary equity, assuming new equity comes from retained earnings.
II. Find the marginal cost of capital, again assuming no new ordinary shares are sold.
(WACC=MACC)
III. How much can be spent for capital investment before new ordinary shares must
be sold? Assume that retained earnings available for next year’s investment are
50% of 2003 earnings.
IV. What is the marginal cost of capital (cost of funds raised in excess of the amount
calculated in Q II), if the firm can sell new ordinary shares to net Rs. 20/share?
The cost of debt & of preference capital is constant.
Solutions:
Since there is no change in capital structure, marginal cost will be same as that to
WACC.
III. Retained earnings = no. of equity shares X 50% of EPS Rs. 2.36 = 1,00,000 X
1.18
= Rs. 1,18,000
Investment before equity= retained earnings / % equity= 1,18,000 / 50% = Rs.
1,47,500
IV. For spending any amount over Rs. 1,47,500, new equity shares will have to be
issued.
Cost of equity = 1.18/20 + 0.10 = 0.059 + 0.10 = 0.159
MACC or WACC:
Q 2. A firm is thinking of raising funds by the issuance of equity capital. The current
market price of the firm’s share is Rs. 150. The firm is expected to pay dividend of
Rs 3.55 next year. The firm paid dividend in past years as follows: