Description
concept of cost of capital, classification of costs, computation of cost of capital. It also explains various methods of cost of capital.
Cost of Capital
The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects
It is a concept of vital importance in the financial decisionmaking. It is useful as a standard for:
• evaluating investment decisions, • designing a firm’s debt policy, and • appraising the financial performance of top management
Three different View Points: 1. Investor’s View Point: “ Measurement of the sacrifice made by him in capital formation” 2. Firms Point: “ Minimum required ROR needed to justify the use of capital” 3. Capital Expenditure point: “ Minimum required ROR, hurdle or target rate or discounting rate used to value cash flows. “Cost of capital is the minimum required rate of earnings or the cut off rate of Capital expenditures.”
Basic concept of Cost of Capital
1. Rate of Return: 2. Minimum rate of return 3. Cost of capital comprises of three components: R0 = Normal rate of return at zero risk level b= Premium for business risk f= premium for financial risk
K = R0 + b + f
Significance of Cost of Capital
Designing Optimal Corporate Capital Structure
Financial Performance Analysis
Investment Evaluation/ Capital Budgeting
Classification of Costs
1. 2. 3. 4. 5. 6. 7. 8. 9.
Marginal Cost of Capital Average Cost/ Composite/ Overall Cost Book Cost/ Historical Cost Future Cost Specific Cost Spot Cost Opportunity Cost Explicit Cost (IRR) Implicit Cost (opportunity cost)
Computation of Overall Cost of Capital 1. Determination of the type of funds to be raised and their individual share 2. Computation of cost of each type of funds 3. Assigning weight to each costs 4. Multiplying the cost of each of the sources by the assigned weights 5. Dividing the total weighted cost by the total weights to get overall Cost of capital
Computation of Cost of Capital A. Computation of cost of specific source of finance B. Computation of weighted average cost of capital
A. Computation of Specific source of Finance
1. Cost of Debt: (Irredeemable debt)
A.
Debt issued at par: (Before tax)
Before tax cost of debt is the ROR required by the lender
Interest paid on debt is tax deductible. Higher the interest charges, the lower will be the amount of tax payable by the firm.
Kd = I/P
Kd = Before tax cost of debt
I = Interest P = Principal
B. Debt issued at par: (After tax)
Kd = I (1-t) /P
Kd = Before tax cost of debt I = Interest P = Principal
C. In Case the debt is raised at premium or discount, P will be net proceeds received From the issue and not the face value of securities
Kd = I/NP
NP = Net proceeds
Q1. a. X ltd. Issues Rs 50000 8% deb. at par. The tax rate applicable to the co. is 50%.Compute the cost of debt capital. Kd = I/NP (1-t)
Kd = 4000 (1-.5) /50000 = 4%
B. X ltd. Issues Rs 50000 8% deb. at premium of 10%. The tax rate applicable to the co. is 60%. Compute the cost of debt capital. Kd = I/NP (1-t)
Kd = 4000 (1-.60) /55000
Kd = 2.91%
C.
X ltd. Issues Rs 50000 8% deb. Issued at 5% discount. The tax rate applicable to the co. is 50%.Compute the cost of debt capital.
Kd = I/NP (1-t) Kd = 4000 (1-.5) /47500 = 4.21%
B. X ltd. Issues Rs 10,00,000 10% deb. at premium of 1%. The flotation cost is 2%. The tax rate applicable to the co. is 60%. Compute the cost of debt capital. Kd = I/NP (1-t)
NP = 100000 + 10000 – (2% of 110000)
NP = 107800
Redeemable debts:
1. Before tax cost of redeemable debts
K = {I +1/n(RV – NP)}/1/2(RV +NP)
I = Annual Interest Rate N = no of years in which debt is to be redeemed RV = Redeemable value of debt NP = Net proceeds of debentures
2. After Tax cost of Redeemable debts K = {I(1- t) +1/n(RV – NP)}/1/2(RV +NP)
Q. A co. issues Rs 10,00,000, 10% redeemable debentures at a discount of 5%. The Cost of flotation amount to rs 30000. The debentures are redeemed after 5 years. Calculate before tax and after tax cost of debt assuming a tax rate of 50%. A. Before tax
K = {100000 + 1/5 (10,00,000-920000)/ ½ (1000000 + 920000)} = 12.08%
B. After Tax K= {1,00,000 (1 -.5) + 1/5 (10,00,000-920000)/ ½ (1000000 + 920000)}
6.875%
Cost of Preference Shares
Cost of irredeemable preference shares Kp = D/P
Kp = Cost of preference capital D = Annual Preference Dividend P = Preference Share Capital (Proceeds)
Q.
A co. issues 10000, 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 par, Premium 10% and at discount 5%.
1. Kp = 100000/ 980000 * 100 = 10.2%
2. Kp = 100000/(1000000+100000-20000) * 100 = 9.26% 3. Kp = 100000/(1000000 - 50000-20000) * 100 = 10.75%
Cost of redeemable preference shares:
K = {D+1/n(RV – NP)}/1/2(RV +NP)
A company issues 10000, 10% preference shares of RS 100 each redeemable after 10 years at a premium 5%. The cost of issue is Rs 2 per share. Calculate the cost of preference Capital. Kp = 100000 + 1/10(1050000 – 980000)/ ½ (1050000 + 980000) * 100
10.54%
Cost of equity share capital
Cost of External Equity:
• • • • Dividend Yield method or Dividend/price ratio Method Dividend Yield plus growth in dividend method Earning yield method CAPM
Cost of Internal Equity: • Dividend Growth Model a. Normal Growth
Dividend Yield Method:
Discount rate that equates the present value of expected future dividends Per share with the net proceeds of a share. It means investors arrives at a MP for a share by capitalizing dividend at a normal rate of return.
Ke = D/NP
D = Expected dividend per share NP = Net proceeds per share
Q. A co. issues 1000 equity shares of Rs 100 each at a premium of 10%. The co. has been paying 20% dividend to equity shareholders for the past 5 years and expects to maintain the same in the future also.
K = D/NP = 20/110 = 18.18%
Limitation: 1. It does not consider future earning 2. It ignores earning on retained earning 3. It does not take into account the capital gain
Q1. XYZ ltd. Is currently earning Rs 1,00,000 its current share MP of Rs 100 Outstanding equity shares is 10,000. The Co. decided to raise an additional capital of RS 2,50,000 through issue of equity shares to the public. It is expected to pay 10% per share as flotation cost. Equity capital is issued at a discount rate of 10%, Per share. The co. is interested to pay a dividend of RS 8 per share. Calculate the Cost of equity
K = D/Np * 100 K = 8/ (100 -10-10) * 100 K = 10%
Earning Yield Method
Earning yield method equates the present value of expected future Earnings per share with the net proceeds
K = Earning per share/Net proceeds
Q. A firm
is considering an expenditure of RS 60 lakhs for expanding its operations. The relevant information is as follows: 10 lakhs 60 90 lakhs
Number of existing equity shares Market value of existing shares Net earnings
Compute the cost of existing share 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 Rs2 per share
Cost of equity share capital Ke = EPS/MP EPS = 90,00,000/10,00,000 = Rs 9 K = 9/60 * 100 = 15%
Cost of new equity capital:
K = EPS/ NP = 9/(52 -2 ) *100 = 18%
Limitation: 1. All earning are not distributed to the equity shareholders as dividend. 2. Earning per share may not be constant 3. Share price also does not remain constant
Q2. A firm is currently earning Rs 1,00,000 and its share is selling at MP of Rs 90. The firm has 10,000 shares outstanding and has no debt. Compute the cost of equity.
K = E/MP * 100
K = 10/90 = 11..11
C. Dividend yield plus growth in dividend method:
When dividend of the firm grow at constant rate and the dividend Payout ratio is constant. Ke =D1/NP + G Ke = D0(1+g)/NP + G Where, D1 = expected dividend per share at the end of the year D0 = Previous year’s dividend G = Rate of growth in dividend
Q. A co. plans to issue 1000 new shares of Rs 100 each at par. The flotation costs are expected to be 5% of share price. The co. 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.
Ke =D1/NP + G
K = {10/(100- 5) + 5%} K = 15.53%
Q. The shares of a company are selling at Rs 40 per share and it had paid a dividend of Rs 4 per share last year. The investor’s market expects a growth rate of 5% per Year. a. Compute the co’s equity cost of capital b. If the anticipated growth rate is 7% per annum, calculate the indicated market price per share.
K = D1 /MP + g D1 = D0(1+G)/ MP + G
= 4 (1.05)/40 + 5%
= 4.20/40 + 5% = 15.5% K = D/ MP + g 15.5% = 4(1.07)/ MP + 7% MP = 4.28/8.5% = Rs 50.35
Cost of Internal Equity: (Retained Earning) K = DIV1/P0 + G K = Expected dividend yield + Capital gain
Weighted Average Cost of Capital
Q1. A firm has the following capital structure as the latest statements shows:
Sources of Funds Debt Preferences Shares Equity Share Retained Earnings Total
Rs 30,00,000 10,00,000 20,00,000 40,00,000 100,00,000
After Tax Costs 4 85 115 10
Based on the book values compute the cost of capital
Source of weights Weights Debt Preferences Shares Equity Share Retained Earning .30 (30,00,000/100,00,000) .10 .20 .40
Specific Cost (%) .04 .08 .11 .10
Weighted Cost .012 .008 .022 .040
1.00
.082
Overall Cost of Capital (K0) = Total Weighted Cost * 100 .082 * 100 = 8.2 %
Factors Affecting WACC: 1. Controllable factors : (Internal Factor) Capital Structure policy Dividend Policy Investment Policy 2. Uncontrollable Factors: ( External Factor) Tax Rates Level of Interest Rates Market Risk premium
Q2. XYZ company supplied the following information and requested you to compute the cost of capital based on book values and market values.
Source of Finance Equity Capital Long term Debt
Book Value 10,00,000 8,00,000
Market Value 15,00,000 7,50,000
After Tax Cost (%) 12 7
Short term debt Total
2,00,000 20,00,000
2,00,000 24,50,000
4
Computation of cost of capital based on book value
Source of Finance Book of Value Equity Capital Long term debt Short Term debt Total 10,00,000 8,00,000 2,00,000 20,00,000
Weights .50 .40 .10 1.00
Specific cost .12 .07 .04
Weighted Cost .060 .028 .004 0.092
Cost of Capital = 0.092*100 = 9.2%
Cost of Capital Based on Market value weight
Source of Finance Equity Capital Long term debt Short Term debt Total
Book of Value 15,00,000 7,50,000 2,00,000 24,50,000
Weights .613 .307 .080 1.000
Specific cost .12 .07 .04
Weighted Cost .074 .022 .003 .099
Cost of Capital = 100 * 0.099 = 9.9%
Marginal Cost of Capital : Cost of additional Funds to be raised:
Q3. HLL has provided the following information and requested you to calculate a. WACC using book value weights b. Weighted marginal cost of capital
Source of Finance Equity Capital
Amount 14,00,000
Weights (5%) .452
After Tax Cost (%) 9
Preference Capital
Debentures
8,00,000
9,00,000
.258
.290
12
16
HLL wishes to raise an additional capital of Rs 12,00,000 for the expansion of the project. The details are as follows: Equity Capital Preference Capital Debentures Rs 6,00,000 Rs 3,00,000 Rs 3,00,000
Source of Finance
Amount
Weights (5%)
After Tax Cost (%)
Equity Capital
Preference Capital Debentures
Total
.50
.25 .25
.09
.12 .16
.045
.030 .040
.115
WACC = 0.115*100 = 11.5 %
Q A firm finances all its investments by 40% debt and 60% equity. the estimated required rate of return on equity is 20% after tax and that on debt is 8% after tax. The firm is considering an investment proposal costing Rs 40,000 with an expected return that will last forever. What amount must the proposal yield per year so that the MP of the share does not change? Show calculations to prove your point. The min overall required ROR is: Debt .40*.08 Equity .60*.20 Weighted average
= =
.032 .120 .152
Thus, the investment proposal must earn .152 * 40000 = Rs 6080 Per year.
Annual Return before taxes
Rs 6080
Less Interest .08*.40*40000
ROE
Rs 1280
4800
After tax rate of return on equity 4800/ (.60 * 40000) 4800 / 24000 = .20
Q. The servex co has the following capital structure on 30th June 2004:
(Rs’ 000) 4,000 1,000 3,000 8,000
Ordinary shares (2,00,000 shares) 10% preferences shares 14% debentures
The share of the co. sells for Rs 20. It is expected that co. will pay next Year a dividend of Rs 2 per share, which will grow at 7% forever. Assume a 50% tax rate. You are required: a. Compute a WACC based on existing capital structure b. Compute new WACC if the co. raises an additional RS 2,00000 debt by issuing 15% deb. This would result in increasing the expected Dividend to Rs 3 and leave the growth rate unchanged but the price of share will fall to 15 per share
WACC = Existing capital structure
Source of Finance Ordinary
After tax cost .17
Weights (5%) .500
weighted cost .0850
10% preference .10 14% Debenture .07 WACC
Cost of ordinary share is K = DIV/p + G K = 100/1000 K = 420(.50)/3000 =
.125 .375
.0125 .0262 .1237
2/20 + .07
= .17 = .10 =.07
WACC : Changed growth rate
Source of Finance Ordinary
Amount 4,000
After tax cost .27
Weights weighted cost .40 .108
10% preference 14% Debenture 15% debenture WACC
Cost of ordinary shares is K =
1,000 3,000 2,000
.10 .07 .075
.10 .30 .20
.010 .021 .015 .154
3/15 + .07
=
.27
Cost of 15% deb K = 300(.50)/2000 = .075
WACC : Changed growth rate Source of Finance Ordinary Amount After tax cost 4,000 .30 Weights .40 weighted cost .120
10% preference 14% Debenture 15% debenture WACC
1,000 3,000 2,000
.10 .07 .075
.10 .30 .20
.010 .021 .015 .166
Cost of ordinary share is: Ke = 3/15 + .10 = .30
No. Purpose
Formula
1
2 3
Before tax cost of debt
After tax Cost of debt Before tax cost of redeemable debt
K = I / NP
K = I (1 –t)/ NP K = {I + (RV – NP)/n}/ (RV + NP )/2
4
5 6 7.
After tax cost of redeemable debt
Cost of irredeemable preference Cost of redeemable preference Cost of equity Dividend yield Dividend yield plus growth in dividend Earning yield method Cost of retained earning WACC
K = {I(1-t) + (RV – NP)/n}/ (RV + NP )/2
K = D/NP K = {D + (MV –NP)/n}/(MV + NP)/2 Ke = D/NP Ke = D0(1+g)/NP + G K = EPS/Net proceeds
8. 9.
K = D/NP + G K = XW/W
doc_472792079.pptx
concept of cost of capital, classification of costs, computation of cost of capital. It also explains various methods of cost of capital.
Cost of Capital
The project’s cost of capital is the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of investment projects
It is a concept of vital importance in the financial decisionmaking. It is useful as a standard for:
• evaluating investment decisions, • designing a firm’s debt policy, and • appraising the financial performance of top management
Three different View Points: 1. Investor’s View Point: “ Measurement of the sacrifice made by him in capital formation” 2. Firms Point: “ Minimum required ROR needed to justify the use of capital” 3. Capital Expenditure point: “ Minimum required ROR, hurdle or target rate or discounting rate used to value cash flows. “Cost of capital is the minimum required rate of earnings or the cut off rate of Capital expenditures.”
Basic concept of Cost of Capital
1. Rate of Return: 2. Minimum rate of return 3. Cost of capital comprises of three components: R0 = Normal rate of return at zero risk level b= Premium for business risk f= premium for financial risk
K = R0 + b + f
Significance of Cost of Capital
Designing Optimal Corporate Capital Structure
Financial Performance Analysis
Investment Evaluation/ Capital Budgeting
Classification of Costs
1. 2. 3. 4. 5. 6. 7. 8. 9.
Marginal Cost of Capital Average Cost/ Composite/ Overall Cost Book Cost/ Historical Cost Future Cost Specific Cost Spot Cost Opportunity Cost Explicit Cost (IRR) Implicit Cost (opportunity cost)
Computation of Overall Cost of Capital 1. Determination of the type of funds to be raised and their individual share 2. Computation of cost of each type of funds 3. Assigning weight to each costs 4. Multiplying the cost of each of the sources by the assigned weights 5. Dividing the total weighted cost by the total weights to get overall Cost of capital
Computation of Cost of Capital A. Computation of cost of specific source of finance B. Computation of weighted average cost of capital
A. Computation of Specific source of Finance
1. Cost of Debt: (Irredeemable debt)
A.
Debt issued at par: (Before tax)
Before tax cost of debt is the ROR required by the lender
Interest paid on debt is tax deductible. Higher the interest charges, the lower will be the amount of tax payable by the firm.
Kd = I/P
Kd = Before tax cost of debt
I = Interest P = Principal
B. Debt issued at par: (After tax)
Kd = I (1-t) /P
Kd = Before tax cost of debt I = Interest P = Principal
C. In Case the debt is raised at premium or discount, P will be net proceeds received From the issue and not the face value of securities
Kd = I/NP
NP = Net proceeds
Q1. a. X ltd. Issues Rs 50000 8% deb. at par. The tax rate applicable to the co. is 50%.Compute the cost of debt capital. Kd = I/NP (1-t)
Kd = 4000 (1-.5) /50000 = 4%
B. X ltd. Issues Rs 50000 8% deb. at premium of 10%. The tax rate applicable to the co. is 60%. Compute the cost of debt capital. Kd = I/NP (1-t)
Kd = 4000 (1-.60) /55000
Kd = 2.91%
C.
X ltd. Issues Rs 50000 8% deb. Issued at 5% discount. The tax rate applicable to the co. is 50%.Compute the cost of debt capital.
Kd = I/NP (1-t) Kd = 4000 (1-.5) /47500 = 4.21%
B. X ltd. Issues Rs 10,00,000 10% deb. at premium of 1%. The flotation cost is 2%. The tax rate applicable to the co. is 60%. Compute the cost of debt capital. Kd = I/NP (1-t)
NP = 100000 + 10000 – (2% of 110000)
NP = 107800
Redeemable debts:
1. Before tax cost of redeemable debts
K = {I +1/n(RV – NP)}/1/2(RV +NP)
I = Annual Interest Rate N = no of years in which debt is to be redeemed RV = Redeemable value of debt NP = Net proceeds of debentures
2. After Tax cost of Redeemable debts K = {I(1- t) +1/n(RV – NP)}/1/2(RV +NP)
Q. A co. issues Rs 10,00,000, 10% redeemable debentures at a discount of 5%. The Cost of flotation amount to rs 30000. The debentures are redeemed after 5 years. Calculate before tax and after tax cost of debt assuming a tax rate of 50%. A. Before tax
K = {100000 + 1/5 (10,00,000-920000)/ ½ (1000000 + 920000)} = 12.08%
B. After Tax K= {1,00,000 (1 -.5) + 1/5 (10,00,000-920000)/ ½ (1000000 + 920000)}
6.875%
Cost of Preference Shares
Cost of irredeemable preference shares Kp = D/P
Kp = Cost of preference capital D = Annual Preference Dividend P = Preference Share Capital (Proceeds)
Q.
A co. issues 10000, 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 par, Premium 10% and at discount 5%.
1. Kp = 100000/ 980000 * 100 = 10.2%
2. Kp = 100000/(1000000+100000-20000) * 100 = 9.26% 3. Kp = 100000/(1000000 - 50000-20000) * 100 = 10.75%
Cost of redeemable preference shares:
K = {D+1/n(RV – NP)}/1/2(RV +NP)
A company issues 10000, 10% preference shares of RS 100 each redeemable after 10 years at a premium 5%. The cost of issue is Rs 2 per share. Calculate the cost of preference Capital. Kp = 100000 + 1/10(1050000 – 980000)/ ½ (1050000 + 980000) * 100
10.54%
Cost of equity share capital
Cost of External Equity:
• • • • Dividend Yield method or Dividend/price ratio Method Dividend Yield plus growth in dividend method Earning yield method CAPM
Cost of Internal Equity: • Dividend Growth Model a. Normal Growth
Dividend Yield Method:
Discount rate that equates the present value of expected future dividends Per share with the net proceeds of a share. It means investors arrives at a MP for a share by capitalizing dividend at a normal rate of return.
Ke = D/NP
D = Expected dividend per share NP = Net proceeds per share
Q. A co. issues 1000 equity shares of Rs 100 each at a premium of 10%. The co. has been paying 20% dividend to equity shareholders for the past 5 years and expects to maintain the same in the future also.
K = D/NP = 20/110 = 18.18%
Limitation: 1. It does not consider future earning 2. It ignores earning on retained earning 3. It does not take into account the capital gain
Q1. XYZ ltd. Is currently earning Rs 1,00,000 its current share MP of Rs 100 Outstanding equity shares is 10,000. The Co. decided to raise an additional capital of RS 2,50,000 through issue of equity shares to the public. It is expected to pay 10% per share as flotation cost. Equity capital is issued at a discount rate of 10%, Per share. The co. is interested to pay a dividend of RS 8 per share. Calculate the Cost of equity
K = D/Np * 100 K = 8/ (100 -10-10) * 100 K = 10%
Earning Yield Method
Earning yield method equates the present value of expected future Earnings per share with the net proceeds
K = Earning per share/Net proceeds
Q. A firm
is considering an expenditure of RS 60 lakhs for expanding its operations. The relevant information is as follows: 10 lakhs 60 90 lakhs
Number of existing equity shares Market value of existing shares Net earnings
Compute the cost of existing share 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 Rs2 per share
Cost of equity share capital Ke = EPS/MP EPS = 90,00,000/10,00,000 = Rs 9 K = 9/60 * 100 = 15%
Cost of new equity capital:
K = EPS/ NP = 9/(52 -2 ) *100 = 18%
Limitation: 1. All earning are not distributed to the equity shareholders as dividend. 2. Earning per share may not be constant 3. Share price also does not remain constant
Q2. A firm is currently earning Rs 1,00,000 and its share is selling at MP of Rs 90. The firm has 10,000 shares outstanding and has no debt. Compute the cost of equity.
K = E/MP * 100
K = 10/90 = 11..11
C. Dividend yield plus growth in dividend method:
When dividend of the firm grow at constant rate and the dividend Payout ratio is constant. Ke =D1/NP + G Ke = D0(1+g)/NP + G Where, D1 = expected dividend per share at the end of the year D0 = Previous year’s dividend G = Rate of growth in dividend
Q. A co. plans to issue 1000 new shares of Rs 100 each at par. The flotation costs are expected to be 5% of share price. The co. 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.
Ke =D1/NP + G
K = {10/(100- 5) + 5%} K = 15.53%
Q. The shares of a company are selling at Rs 40 per share and it had paid a dividend of Rs 4 per share last year. The investor’s market expects a growth rate of 5% per Year. a. Compute the co’s equity cost of capital b. If the anticipated growth rate is 7% per annum, calculate the indicated market price per share.
K = D1 /MP + g D1 = D0(1+G)/ MP + G
= 4 (1.05)/40 + 5%
= 4.20/40 + 5% = 15.5% K = D/ MP + g 15.5% = 4(1.07)/ MP + 7% MP = 4.28/8.5% = Rs 50.35
Cost of Internal Equity: (Retained Earning) K = DIV1/P0 + G K = Expected dividend yield + Capital gain
Weighted Average Cost of Capital
Q1. A firm has the following capital structure as the latest statements shows:
Sources of Funds Debt Preferences Shares Equity Share Retained Earnings Total
Rs 30,00,000 10,00,000 20,00,000 40,00,000 100,00,000
After Tax Costs 4 85 115 10
Based on the book values compute the cost of capital
Source of weights Weights Debt Preferences Shares Equity Share Retained Earning .30 (30,00,000/100,00,000) .10 .20 .40
Specific Cost (%) .04 .08 .11 .10
Weighted Cost .012 .008 .022 .040
1.00
.082
Overall Cost of Capital (K0) = Total Weighted Cost * 100 .082 * 100 = 8.2 %
Factors Affecting WACC: 1. Controllable factors : (Internal Factor) Capital Structure policy Dividend Policy Investment Policy 2. Uncontrollable Factors: ( External Factor) Tax Rates Level of Interest Rates Market Risk premium
Q2. XYZ company supplied the following information and requested you to compute the cost of capital based on book values and market values.
Source of Finance Equity Capital Long term Debt
Book Value 10,00,000 8,00,000
Market Value 15,00,000 7,50,000
After Tax Cost (%) 12 7
Short term debt Total
2,00,000 20,00,000
2,00,000 24,50,000
4
Computation of cost of capital based on book value
Source of Finance Book of Value Equity Capital Long term debt Short Term debt Total 10,00,000 8,00,000 2,00,000 20,00,000
Weights .50 .40 .10 1.00
Specific cost .12 .07 .04
Weighted Cost .060 .028 .004 0.092
Cost of Capital = 0.092*100 = 9.2%
Cost of Capital Based on Market value weight
Source of Finance Equity Capital Long term debt Short Term debt Total
Book of Value 15,00,000 7,50,000 2,00,000 24,50,000
Weights .613 .307 .080 1.000
Specific cost .12 .07 .04
Weighted Cost .074 .022 .003 .099
Cost of Capital = 100 * 0.099 = 9.9%
Marginal Cost of Capital : Cost of additional Funds to be raised:
Q3. HLL has provided the following information and requested you to calculate a. WACC using book value weights b. Weighted marginal cost of capital
Source of Finance Equity Capital
Amount 14,00,000
Weights (5%) .452
After Tax Cost (%) 9
Preference Capital
Debentures
8,00,000
9,00,000
.258
.290
12
16
HLL wishes to raise an additional capital of Rs 12,00,000 for the expansion of the project. The details are as follows: Equity Capital Preference Capital Debentures Rs 6,00,000 Rs 3,00,000 Rs 3,00,000
Source of Finance
Amount
Weights (5%)
After Tax Cost (%)
Equity Capital
Preference Capital Debentures
Total
.50
.25 .25
.09
.12 .16
.045
.030 .040
.115
WACC = 0.115*100 = 11.5 %
Q A firm finances all its investments by 40% debt and 60% equity. the estimated required rate of return on equity is 20% after tax and that on debt is 8% after tax. The firm is considering an investment proposal costing Rs 40,000 with an expected return that will last forever. What amount must the proposal yield per year so that the MP of the share does not change? Show calculations to prove your point. The min overall required ROR is: Debt .40*.08 Equity .60*.20 Weighted average
= =
.032 .120 .152
Thus, the investment proposal must earn .152 * 40000 = Rs 6080 Per year.
Annual Return before taxes
Rs 6080
Less Interest .08*.40*40000
ROE
Rs 1280
4800
After tax rate of return on equity 4800/ (.60 * 40000) 4800 / 24000 = .20
Q. The servex co has the following capital structure on 30th June 2004:
(Rs’ 000) 4,000 1,000 3,000 8,000
Ordinary shares (2,00,000 shares) 10% preferences shares 14% debentures
The share of the co. sells for Rs 20. It is expected that co. will pay next Year a dividend of Rs 2 per share, which will grow at 7% forever. Assume a 50% tax rate. You are required: a. Compute a WACC based on existing capital structure b. Compute new WACC if the co. raises an additional RS 2,00000 debt by issuing 15% deb. This would result in increasing the expected Dividend to Rs 3 and leave the growth rate unchanged but the price of share will fall to 15 per share
WACC = Existing capital structure
Source of Finance Ordinary
After tax cost .17
Weights (5%) .500
weighted cost .0850
10% preference .10 14% Debenture .07 WACC
Cost of ordinary share is K = DIV/p + G K = 100/1000 K = 420(.50)/3000 =
.125 .375
.0125 .0262 .1237
2/20 + .07
= .17 = .10 =.07
WACC : Changed growth rate
Source of Finance Ordinary
Amount 4,000
After tax cost .27
Weights weighted cost .40 .108
10% preference 14% Debenture 15% debenture WACC
Cost of ordinary shares is K =
1,000 3,000 2,000
.10 .07 .075
.10 .30 .20
.010 .021 .015 .154
3/15 + .07
=
.27
Cost of 15% deb K = 300(.50)/2000 = .075
WACC : Changed growth rate Source of Finance Ordinary Amount After tax cost 4,000 .30 Weights .40 weighted cost .120
10% preference 14% Debenture 15% debenture WACC
1,000 3,000 2,000
.10 .07 .075
.10 .30 .20
.010 .021 .015 .166
Cost of ordinary share is: Ke = 3/15 + .10 = .30
No. Purpose
Formula
1
2 3
Before tax cost of debt
After tax Cost of debt Before tax cost of redeemable debt
K = I / NP
K = I (1 –t)/ NP K = {I + (RV – NP)/n}/ (RV + NP )/2
4
5 6 7.
After tax cost of redeemable debt
Cost of irredeemable preference Cost of redeemable preference Cost of equity Dividend yield Dividend yield plus growth in dividend Earning yield method Cost of retained earning WACC
K = {I(1-t) + (RV – NP)/n}/ (RV + NP )/2
K = D/NP K = {D + (MV –NP)/n}/(MV + NP)/2 Ke = D/NP Ke = D0(1+g)/NP + G K = EPS/Net proceeds
8. 9.
K = D/NP + G K = XW/W
doc_472792079.pptx