Problems in Cost of Capital

1. A company has on its books the following amounts in the Capital

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Types of Capital Book Value Market value Specific Cost
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15 % Debt (Irredeemable) 4,00,000 3,80,000 15 %
12 % Preference Shares 1,00, 000 1,10,000 12 %
Equity 6, 00, 000 20 %
Retained Earnings 2, 00,000 12,00,000
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13,00,000 16,90,000
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Assume tax rate = 35 %

Compute the overall cost of capital of the firm by using book value weights and market
value weights.

2. From the following capital structure of XYZ Ltd, determine appropriate weighted
average cost of capital

Equity shares (1,00,000) Rs 38,00,000

Preference shares 8,00,000
Debentures 50,00,000
Bank loan 18,00,000

Additional information
1.Cost of equity is 20 %
2.Dividend indicated on preference shares is 12 %
3.Pre tax cost of debentures is 11 %
4. Interest on bank loan is 12 %
5. Corporate tax rate is 35 %
6. Market value of equity shares = Rs 50,00, 000
7. Market value of preference shares = Rs 8, 50,000

3. Multimedia network has the following book value capital structure

Equity capital (10 million shares, Rs 10 par) Rs 100 million

Preference capital, 11 percent
(100,000 shares, Rs 100 par) Rs 10 million
Retained Earnings Rs 129 million
13.5 % (500,000 debentures, Rs 100 par) Rs 50 million
Terms loans 12 % Rs 80 million
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Rs 369 million

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The next expected dividend per share is Rs 1.50. The dividend per share is expected to
grow at the rate of 7 %. The market price per share is Rs 20.00. Preference stock
redeemable after 10 years is currently selling for Rs 75.00 per share. Debentures,
redeemable after 6 years, are selling for Rs 80.00 per debenture. The tax rate for the
company is 50 %.

Calculate the overall cost of capital using market value weights.

4.The following information is available from the balance sheet of a company.

Equity share Capital (20,000 shares of Rs 10 each) Rs 2,00,000

Retained Earnings 1,30,000
8 % Debentures 1,70,000

The rate of tax for the company is 35 %. Current level of equity dividend is 12 percent.
Dividend is expected to grow @ 5 %. Determine the overall cost of capital

5. You are analyzing the beta for Hewlett Packard and have broken down the company
into four broad business groups, with market values and betas for each group.
Market Value of
Business Group Beta
Equity
Mainframes $ 2.0 billion 1.10
Personal
$ 2.0 billion 1.50
Computers
Software $ 1.0 billion 2.00
Printers $ 3.0 billion 1.00
a. Estimate the beta for Hewlett Packard as a company.
b. If the treasury bond rate is 7.5%, estimate the cost of equity for Hewlett Packard.
Estimate the cost of equity for each division. Assume the market return is 14 %.
6. You have collected returns on AnaDone Corporation (AD Corp.), a large diversified
manufacturing firm, and the NYSE index for five years:
Year AD Corp NYSE
2002 10% 5%
2003 5% 15%
2004 -5% 8%
2005 20% 12%
2006 -5% -5%
a. Estimate the beta of the company
b. If you bought stock in AD Corp. today how much would you expect to make as
a return over the next year? [The six-month T.Bill rate is 6%]

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 c. Looking back over the last five years, how would you evaluate AD's
performance relative to the market? (The risk free rate during the period was also
6% on an annual basis)
d. Assume now that you are an undiversified investor and that you have all of
your money invested in AD Corporation. What would be a good measure of the
risk that you are taking on?

7. Bombay Chemicals Ltd wishes to raise additional finance of Rs 10 lakh for meeting its
investment plans. It has Rs 2,10,000 in the form of retained earnings available for
investment purposes. The following are the further details. 5 marks

1.Debt equity mix 30: 70

2.Cost of debt: upto Rs 1,80,000, 10 % (before tax)
Beyond Rs 1,80,000, 12 % (before tax)
3.Earnings per share Rs 4
4.Dividend pay out, 50 % of earnings
5.Expected growth rate in dividend. 10 %
6.Current market price per share Rs 44
7.Tax rate 35 %

You are required

a. To determine the pattern for raising the additional finance, assuming the firm
intends to maintain existing debt/equity mix.
b.To determine the post tax average cost of additional debt
c. To determine the cost of retained earnings and cost of equity
d. Compute the overall weighted average after tax cost of additional finance.

8. Suppose you are an investor having a portfolio of Rs 13, 00,000. Your portfolio
consists of 4 stocks with the following investments and betas:
Stock Investment (Rs) Beta
Aravind mills 4,00,000 1.50
Suzlon Energy ltd 6,00,000 0.50
Patni Computers 1,00,000 1.25
PVR cinemas 2,00,000 0.75

If the market required rate of return is 14 percent and the risk free rate is 6 percent, What
is the fund required rate of return?

Stock Investment Proportion Beta Total Beta

Aravind 4,00,000
Mills
Suzlon 6,00,000
Patni 1,00,000
PVR 2,00,000
Total 13,00,000

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9. HAL has the following capital structure
Ordinary shares (200,000 shares) 4,000
10 % preference shares 1,000
14 % debentures 3,000
8,000
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The share of the company sells for Rs 20.it is expected that company will pay next year a
dividend of Rs 2 per share, which will grow at 7 percent forever. Assume a 50 percent tax
rate. You are required to compute the weighted average cost of capital based on the
existing capital structure.

10. Securities X and Y have the following characteristics

Security X Security Y
Return % Probability Return % Probability
30 0.10 -20 0.05
20 0.20 10 0.25
10 0.40 20 0.30
5 0.20 30 0.30
-10 0.10 40 0.10

You are required to calculate the expected return and standard deviation of return and
coefficient of variation for each security. Which security would you select for investment
and why?

11. The returns of the share of Pidilite industries and the Sensex for the past five years are
given below.

Sensex (%) Pidilite ( %)

- 12.5 - 5.1 %
1.7 6.7
7.2 7.1
11.5 18.9
6.3 11.9

What is Pidilite’s Beta?

12. Royal Paints Limited is an all equity firm without any debt. It has a beta of 1.21. the
current risk free rate is 8.5 % and the historical market premium is 9.5 %. Royal is
considering a project that is expected to generate a return of 20 %. Assuming that the
project has the same risk as the firm, Should the firm accept the project?
13. You have a portfolio of the following four shares.

Share Beta Investment

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GAC 0.80 1,00,000
KOEL 1.25 1,00,000
KBL 1.12 75,000
KPCL 0.60 1,25,000

What is the expected rate of return on your portfolio if the risk –free rate of return is 9
percent and the expected market rate of return is 16 percent ?

14.The shares of a chemical company are selling at Rs 20 per share. The firm had paid
dividend @ Rs 2 per share last year. The estimated growth of the company is
approximately 5 per cent per year.
a. Determine the cost of equity capital of the company
b. Determine the estimated market price of the equity shares if the anticipated
growth rate of the firm (i) rises to 8 %, falls to 3 %.

15. From the following information supplied to you, determine the appropriate weighted
average cost of capital, relevant for evaluating long term investment projects of the
company.

Cost of equity 12 percent

After tax cost of long term debt 7 percent
After tax cost of short term loans 4 percent

Source Book value Market value

Equity Rs 5,00,000 Rs 7,50,000

Long term debt 4,00,000 3,75,000
Short term debt 1,00,000 1,00,000
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10,00,000 12,25,000
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