Problem.No.

(a)X Ltd. issues Rs.50,000 8% debentures at par. The tax rate applicable to the company is 50%. Compute the
cost of debt capital.

(b)Y Ltd. issues Rs.50,000 8% debentures at a premium of 10%. The tax rate applicable to the company is
60%. Compute cost of debt capital.

(c)A Ltd. issues Rs.50,000 8% debentures at a discount of 5%. The tax rate is 50%. Compute the cost of debt
capital.

(d)B Ltd. issues Rs.1,00,000 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate
applicable is 60%. Compute cost of debt-capital.

Problem.No.2

A company issues Rs.10,00,000 10% redeemable debentures at a discount of 5%. The costs of
floatation amount to Rs.30,000. The debentures are redeemable after 5 years. Calculate before-tax and after-
tax cost of debt assuming a tax rate of 50%.

Problem.No.3

A 5-year Rs.100 debenture of a firm can be sold for a net price of Rs.96.50. The coupon rate of interest is 14
percent per annum, and the debenture will be redeemed at 5 percent premium on maturity. The firm’s tax rate is
40 percent. Compute the after tax-cost of debentures.

COST OF EXISTING DEBT:

If a firm wants to compute the current cost of its existing debt, the current market yield of the debt
should be taken into consideration.

Problem.No.4

A firm has 10% debentures of Rs.100 each outstanding on January 1, 1994 to be redeemed on December 31,
2000 and the new debentures could be issued at a net realizable price of Rs.90 in the beginning of 1996,
compute the current cost of existing debt.

COST OF PREFERENCE CAPITAL

D
K p
=
P

Where K p = Cost of preference capital

D = Annual preference dividend

P = Preference share capital (proceeds)

Further, if preference shares are issued at premium or discount or when cost of flotation are incurred to issue
preference shares, the nominal or par value of preference share capital has to be adjusted to find out the net
proceeds from the issue of preference shares. In such a case, the cost of preference capital can be computed
with the following formula:

1
 D
K p
=
NP

It may be noted that as dividends are not allowed to be deducted in computation of tax, no adjustment is
required for taxes. Sometimes redeemable preference shares are issued which can be redeemed or cancelled on
maturity date. The cost of redeemable preference share capital can be calculated as:

MV  NP
D
K pr  n
1
( MV  NP)
2

Where,

K pr = Cost of redeemable preference shares

D =Annual preference dividend

MV = Maturity value of preference shares

NP = Net proceeds of preference shares

Problem.No.5

A company raised preference share capital of Rs.100,000 by issue of 10% preference shares of Rs.10 each.
Calculate the cost of preference capital when they are issued (i) at 10% premium, and (ii) at 10% discount.

Problem.No.6

A company issues 10,000 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 (a) at par, (b) at a premium of 10% and (c) at a
discount of 5%.

Problem.No.7

A company issues 1,000 7% preference shares of Rs.100 each at a premium of 10% redeemable after 5 years at
par. Compute the cost of preference capital.

COST OF EQUITY SHARE CAPITAL

A)Dividend Yield Method Or Dividend/Price Ratio Method:

According to this method, the cost of equity capital is the ‘discount rate that equates the present value of
expected future dividends per share with the net proceeds (for current market price) of a share’.

D D
Ke = or
NP MP

Where, Ke = Cost of equity capital

D = Expected dividend per share

NP = Net proceeds per share

2
 MP = Market price per share

The basic assumptions underlying this method are that the investors give prime importance to dividends and
risk in the firm remains unchanged. The dividend price ratio method does not seem to consider the growth in dividend,

 It does not consider future earnings or retained earnings and

 It does not take into account the capital gains.
This method of computing cost of equity capital is suitable only when the company has stable earnings and stable
dividend policy over a period of time.

Problem.No.8

A company issues 1000 equity shares of Rs.100 each at a premium of 10%. The company has been paying 20% dividend
to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of
equity capital. Will it make any difference if the market price of equity share is Rs.160?

B)Dividend Yield Plus Growth In Dividend Method:

When the dividends of the firm are expected to grow at a constant rate and the dividend-pay-out ratio is
constant this method may be used to compute the cost of equity capital. According to this method the cost of equity
capital is based on the dividends and the growth rate.

D1 D (1  g )
Ke = G = 0 G
NP NP

Where, Ke = Cost of equity capital

D1 = Expected dividend per shares at the end of the year

NP = Net proceeds per share

G = Rate of growth in dividends

D0 = Previous year’s dividend.

Further, in case cost of existing equity share capital is to be calculated, the NP should be changed with MP (Market price
per share) in the above equation.

D1
Ke = G
MP

Problem.No.9

a)A company plans to issue 1000 new shares of Rs.100 each at par. The floatation costs are expected to be 5% of the
share price. The company 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.

b)If the current market price of an equity share is Rs.150, calculate the cost of existing equity share capital.

3
Problem.No.10

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 percent per year.

a)Compute the company’s equity cost of capital;

b)If the anticipated growth rate is 7 percent per annum, calculate the indicated market price per share.

Earning Yield Method:

According to this method, the cost of equity capital is the discount rate that equates the present value of
expected future earnings per share with the net proceeds (or, current market price of a share. Symbolically:

Earnings per share

Ke = ----------------------------

Net proceeds

EPS

NP

Where, the cost of existing capital is to be calculated:

Earnings per share

Ke = ------------------------------

Market price per share

EPS

MP

This method of computing cost of equity capital may be employed in the following cases:

 When the earnings per share are expected to remain constant

 When the dividend pay-out-ratio is 100 percent or when the retention ratio is zero, i.e., all the available profits
are distributed as dividends.
 When a firm is expected to earn an amount on new equity shares capital, which is equal to the current rate of
earnings.
 The market price of the share is influenced only by earnings per share.

Problem.No.11

A firm is considering an expenditure of Rs.60 lakhs for expanding its operations. The relevant information is as
follows:

Rs.

Number of existing equity shares 10 lakhs

4
Market value of existing share 60

Net earnings 90 lakhs

Compute the cost of existing equity 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 Rs.2 per share.

COST OF RETAINED EARNINGS

It is sometime argued that retained earnings do not involve any cost because a firm is not required to pay
dividends on retained earnings. However, the shareholders expect a return on retained profits. Retained earnings
accrue to a firm only because of some sacrifice made by the shareholders in not receiving the dividends out of the
available profits.

The cost of retained earnings may be considered as the rate which the existing shareholder can obtain by
investing the after-tax dividends in alternative opportunity of equal qualities. It is, thus, the opportunity cost of
dividends forgone by the shareholders. Cost of retained earnings can be computed with the help of following formula:

Kr D
= G
NP

Where, Kr = Cost of equity capital

D = Expected dividend

NP = Net proceeds of share issue

G = Rate of growth

Further, the shareholders usually cannot obtain the entire amount of retained profits by way of dividends even
if there is 100 percent pay out ratio. It is so because the shareholders are required to pay tax on their dividend income.
So, some adjustment has to be made for tax. However, tax adjustment in determining the cost of retained earnings is a
difficult problem because all shareholders do not fall under the same tax bracket. Moreover, if the shareholders wish to
invest their after –tax dividends income in alternative securities, they may have to incur some costs of purchasing the
securities, such as brokerage.

Hence the effective rate of return realized by the shareholders from the new investment will be somewhat
lesser than their present return from the firm. to make adjustment in the cost of retained earnings for tax and costs of
purchasing new securities, the following formula is adopted:

Kr D 
=  G  x (1-t) x (1-b)
 NP 

or, Kr = Ke (1-t) (1-b)

Where,

Kr = cost of retained earnings

D = Expected dividend

5
 NP = Net proceeds of share issue

G = Rate of growth

t = tax rate

b = cost of purchasing new securities or brokerage costs.’

Ke = Rate of return available to shareholders.

Problem.No.12

A firm’s K (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that
2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is
the cost of retained earnings?

Computation of Weighted Average Cost of capital

Problem.No.13

A firm has the following capital structure and after-tax costs for the different sources of funds used:

Amount Proportion After-tax cost

Sources of funds
Rs. % %
Debt 15,00,000 25 5
Preference shares 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained earnings 15,00,000 25 11
Total
60,00,000 100
You are required to compute the weighted average cost of capital.

Problem.No.14

A firm has the following capital structure and after-tax costs for the different sources of funds used:

Amount Proportion After-tax cost

Sources of funds
Rs. % %
Debt 15,00,000 25 5
Preference shares 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained earnings 15,00,000 25 11
Total
60,00,000 100
If the firm has 18,000 equity shares of Rs.100 each outstanding and the current market price is Rs.300 per share,
calculate the market value weighted average cost of capital assuming that the market values and book values of the
debt and preference capital are same.