Cost-of-capital-solved-problems compress Rushi Ahuja 1 SOLVED PROBLEMS COST OF CAPITAL Problem 1

The preference dividend is payable as an appropriation of profit unlike interest on debentures which is a charge against profits. ABC Ltd. issues 12.5% debentures of face value of ` 100 each, redeemable at the end of 7 years. The debentures are issued at a discount of 5% and the flotation cost is estimated to be 1%.

Find out the cost of capital of equity shares given that the present market value of the share is ` 168. The fixed rate of dividend on preference shares is the starting point for calculation of cost of capital of preference share capital. Conceptually, the preference shares may either be redeemable or irredeemable, the cost of capital may also be ascertained accordingly. If its tax price is 40%, the distinction between a hundred% and forty% is 60%, and 60% of the 5% is 3%. The after-tax cost of debt is the interest paid on debt much less any income tax savings as a result of deductible curiosity expenses. To calculate the after-tax price of debt, subtract an organization’s efficient tax rate from 1, and multiply the difference by its price of debt.

A Businessman’s Guide to Working Capital Loans

When a company wants to expand, it can borrow money by issuing bonds at different rates and then selling them to the public. As bonds ensure payment of fixed interest rates along with the principal amount to the lenders, it can be said that they work the way loans do. There are various types of bonds, having different features and characteristics. For example, Government bonds, Institutional bonds, Corporate Bonds, and Municipal Bonds. The company is expected to declare a dividend of Rs. 10 at the end of the current year, with an expected growth rate of 10%. Calculating Cost of Equity involves use of models like Capital Asset Pricing Model .

It is already discussed in Chapter 3 that the cash flows relevant for capital budgeting decisions are taken on an after-tax basis. These cash flows are then discounted at the cost of capital to find out their present value. It should be noted that this cost of capital which is used to discount the cash flows (after-tax) should also be after-tax only. If the firm is using IRR technique, then the cut-off rate should also be taken on an after-tax basis.

A. Specific Capital Cost Computation

Dividend decision A financial manager takes decision in three broad areas, viz, investment, financing and dividend, for maximising shareholders’ wealth. Wealth maximisation is possible with increase in price of shares. A good dividend policy will enhance the market value of shares thus, meeting the objective of wealth maximisation. It also influences the financing decision of the firm, since the firm will not require funds to the extent of re-invested retained earnings.

However, the same is not the case with dividends paid on equity. In other words, the actual cost of debt is less than the nominal cost of debt due to tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress, i.e., the cost of bankruptcy, exceeds the value of the tax benefits. Thus, the increased debts, until a given threshold value, will add value to a company.

Income Tax Filing

Means the borrowed funds of a company that need to be repaid in the future or later. This form of capital growth denotes what the company raises as a loan, whether short-term or long-term, like overdrafts, machinery loans, etc. Debt on the other hand while being cheaper, results in a liability or obligation that must be serviced. This introduces cash flow risks independent of the business’s degree of success, or in other words you pay it back whether the business does well or not. It is possible to find out the cost of equity capital by using the mechanism of risk-return trade off as given by the Capital Assets Pricing Model .

Strategies to Manage Returns Debt funds manage returns by varying the maturity profile or credit rating of their bond portfolios. Funds with higher exposure to long term debt can make strong capital gains when rates are falling, but could generate massive losses when rates are going up. In contrast, funds that invest mainly in short-term securities like money market debt or treasury bills have stable NAVs, but do not benefit from capital gains.

Thus, there is an opportunity cost involved in the firms retaining the earnings and an estimation of this cost can be taken up as a measure of cost of capital of retained earnings, kᵣ. So, the cost of capital is same at 15.63% as it was when the preference shares were treated as irredeemable. However, if the preference shares are redeemable at par i.e., ` 100, then kₚ comes to 15.83%. This increase in cost of capital from 15.63% to 15.83% arises because of premium of ` 4 payable at the time of redemption.

If a firm’s operating risk is lower, its capacity to use debt is higher and vice-versa. Dividend decision It relates to decision regarding distribution of dividend. The decision taken is as to how much dividend is to be retained in business and how much should be distributed to shareholders, after taking into account various factors affecting it. When a firm is able to borrow at a lower rate, ft increases the capacity to employ higher debt and can increase the debt component in the capital structure.

A) Determine the weighted average cost of capital of the company. It had been paying dividends at a consistent rate of 20% per annum. B) What difference will it make if the current price of the Rs. 100 share is Rs. 160? C) Determine the effect of Income Tax on the cost of capital under both premises (Tax rate 40%). The cost of retained earnings must be considered as the opportunity cost of the foregone dividends. From the point of view of equity shareholders, any earning retained by the firm could have been profitably invested by the equity shareholders themselves, had these been distributed to them.

Balance of Payment

The Cost of Capital becomes a ‘Hurdle Rate’ for the business, which means that you would not accept any proposal that does not provide a return higher than this rate. The other primary use of Cost of Capital is in helping measure business performance in a more objective and thorough manner. For example, if you measure business performance by say margins analysis, it would not show how well you are using your capital. Alternatively, even a comparative measure like Return on Equity or Return on Capital will not provide a measure of whether the rate you are earning is adequate. How much of each component should be used depends on the riskiness of the business and availability of funding, besides the relevance of each type. Broadly, Equity is less risky with respect to cash flow commitments but is much more expensive compared to Debt.

When you borrow money from a financial institution, you are obligated to pay them back the principal amount along with a pre-decided interest. They do not have a say cost of debt example in how you run your business, unlike venture capitalists. Therefore, you retain the ownership of your company and are free to make decisions at your discretion.

When an accounting system is introduced, the process becomes even more manageable. You can easily handle tasks like projecting cash flow or estimating costs, and you can set realistic goals for your business. Budgeting for a business is a large task, which is why you might need assistance.

Selecting the best debt fund will depend on your investment horizon. If you want to invest for 1 day to up to a month then opt for Overnight Funds or Liquid Funds. And if the investment horizon is between 1 year and 3 years, you can go for Corporate Bond Funds, Banking & PSU Bond Funds, or Short Duration Bond Funds. It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC.

WACC = 11 OR 11%

In addition, the dividend expected on the equity share at the end of the year is Rs. 2 and the earnings are expected to increase by 7% p. The firm has a policy of paying all its earnings in the form of dividends. A) A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share of Rs. 10 each. Find out the cost of preference share capital when it is issued at 10% premium, and 10% discount.

• However, the IRR or Investor rate of return is the premium on the investment that makes the investor risk justifiable.
• E) Trading / Trading in “Options” based on recommendations from unauthorised / unregistered investment advisors and influencers.
• Measurement of Overall Cost of Capital It is also called as weighted average cost of capital and composite cost of capital.
• When a company increases debt, the financial risk faced by the equity shareholders increases and then EPS starts decreasing with inclusion of debt beyond a certain point.
• Because of tax benefits on debt issuance, will probably be cheaper to problem debt quite than new fairness .

Cost of debt is one part of a company’s capital structure, which additionally contains the price of fairness. With a debt component in the total capital, shareholders are likely to have the benefit of a higher rate of return on the share capital. This is because debt/loan carry a fixed charge and the amount of interest paid is deductible from the earnings before tax payment. The benefit to the shareholders will be realised only if the average rate of return on total capital invested is more than the rate of interest payable on loan/debt.

The IL&FS downgrade and resulting value erosion for some debt funds have made it clear that even liquid funds are not exempt from the consequence of credit default. The corporate tax rate is 55% and the expected growth in equity dividend is 8% per year. The expected dividend at the end of the current financial year is Rs. 11 per share. Assume that the company is satisfied with its present capital structure and intends to maintain it.