Cost of Capital Cost by lanyuehua


									                               Cost of Capital
        Cost of capital is one of the most important concepts in business finance. Capital,
specially long terms are collected from different sources like – debenture (debt), equity
loan, preferred stock, common equity, and retained earnings are known as capital
components. Cost of capital means minimum expected rate of return of total capital
amount of which are collected from different sources. Cost of equity/preferred/debenture
which depends on the expected return of the suppliers.
        IM Pandey Says, “The cost of capital to a firm is the minimum return which the
suppliers of capital require. In other words, it is a price of obtaining capital; it is a
compensation for time and risk.”
        Cost of capital is those expected dividend rate, less of which they are not
interested to invest. Again, the capitals which are collected through seeing debenture on
loan, cost of the capital is the expected rate of interest of which they are not interested to
purchase debenture or giving loan, i.e. from the view point of investors, minimum
expected rates of returns at which they are interested to supply capital. Average cost of all
sources is called cost of capital.

Opportunity Cost: If an investor invests in any project, he /she has to sacrifice the other
alternative options, expected return of that best alternative options is called “Opportunity
Marginal Cost: Cost of new or extra investment. To expand a business extra capital is to
be collected. The cost of that extra capital is called Marginal cost.
Problem No: 1 Calculate the weighted cost of capital from the following information:
      a. Market value of the debt capital Tk 5,00,000.
      b. Market value of preferred capital Tk 4,00,000.
      c. Market value of the equity capital Tk 6,00,000.
      d. Interest rate for debt capital is 12% (Before Tax)
      e. Income tax is 48%
      f. Dividend per share Tk 15 per share.
      g. Market price of each equity share is Tk 110.
      h. Market price of each preferred share is Tk 95.
      i. Growth rate is 8%.

Problem No: 2 Calculate the weighted cost of capital from the following information:
        a. Market value of debt capital Tk 9,00,000.
        b. Market value of preferred capital Tk 8,00,000
        c. Market value of equity capital Tk 10,00,000.
        d. Interest rate for debt capital is 14% (before tax)
        e. Income Tax 40%
        f. Dividend per share is Tk 15 per share.
        g. Market price of each equity share is Tk 125.
        h. Market price of each preferred share is Tk 90.
        i. Growth rate is 7%.
Problem No: 3 A firm’s after tax cost of capital of the specific sources of capital is as
     SL                 Sources                       Amount              Cost %
     01          Equity Share Capital                 2,00,000              50%
     02        Preference Share Capital               1,00,000              25%
     03            Retained Earnings                    60,000              15%
     04            Long Term Debt                       40,000              10%
                                    Total             4,00,000
        Calculate the weighted average cost of capital.

Problem No: 4 The following is the capital structure of the ABC Co Ltd.
             Sl               Particulars (Sources)                      Tk
           01     Equity capital (@ Tk 10 each)                          5,00,000
           02     Preference Share Capital ( @ Tk 10 each)               3,00,000
           03     Retained Earnings                                      5,00,000
           04     Debentures                                             3,00,000
           05     Trade Credit                                           2,00,000
           06     Short Term Note                                        2,00,000
        The firm acquired trade credit is on 2/10, net 30 terms and it does not enjoy the
benefit of discount. The cost of short term before tax is 6%. The cost of equity share
capital and preference share capital is 8% and 10 % respectively. The cost of retained
earnings is 9.8%.The interest rate of debenture is 7.6%. If the marginal tax rate of the
firm is 30%, what is the weighted average cost of capital?
Problem No:5 The shares of a company are selling at Tk 20 per share. The firm had paid
Tk 2 per share dividend last year. The estimated growth of the company is approximately
5% per year.
Required: 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% and ii. Falls to 3%
c) Determine the market price of the co. shares assuming the growth rate of 20%. Are you
satisfied with your calculations?

Problem No: 6 Mr. Powlo Ltd has the following information:
                                        Balance Sheet
                                  as At 31st December 2010
    Capital and Liabilities            Tk            Properties & Assets          Tk
4,000 common share @ Tk            4,00,000     Fixed Assets                  10,00,000
100 each (Book Value)                           (-)Depreciation               2,50,000
Retained Earnings                  2,00,000                                    7,50,000
1000, 6% savings preference        1,00,000     Current Assets                 7,50,000
share @ Tk 100 each (Book
2,000, 9.5% savings                2,00,000
preference share @ Tk 100
(Book Value)
100 & 7% Debenture @ 1000 1,00,000
(Book Value)
Current Liabilities                5,00,000
Total                              15,00,000                                  15,00,000
 Additional Information:
1. Average Market Price
         i. Common share @ Tk 125 per share
         ii.6% savings preference share @ Tk 65 per share
         iii. 9.5% savings preference share @ 102 per share
         iv. 7% Debenture @ Tk 90 per share
2. Initial dividend of common share @ Tk 18 per share.
3. Growth rate of common share 8%.
4. Company’s tax rate 50%
5. Shareholder’s personal tax 20%.
                 Calculate weighted average cost of capital.

Problem No: 7
A company was recently formed to manufacture a new product; it has the following
capital structure---
                     SL             Particulars                    Total Tk
             01         10% Debenture                        Tk 16,00,000
             02         8% Preferred Stock                       12,00,000
             03         Common Stock (40,000 Shares)             10,00,000
        The company’s common stock sells for Tk 25 per share and is expected to pay a
Tk 2 Dividend this year which will grow @ 20% for the foreseeable future. The company
has a marginal tax rate of 50%.
        (a). Compute a weighted average cost of capital of the company.
        (b). Assume that the investment bankers for the company informed that it could
raise an additional tk 1 million in debt by means of a 15 % mortgage debenture. This sale
would result increasing the expected dividend is to Tk 2.50 and leave the growth rate
unaffected but the added risk would cause the price of the stock to fall to Tk 20 per share.
What would be the new weighted average cost of capital?
        (c) Assume that an addition on Tk 1 million in mortgage debenture could be sold
to yield 20%. This would cause the price of the common stock to drop to Tk 15 yet to
increase the dividend to Tk 3 and the growth rate is 25%. What would be the impact upon
the cost of capital of the company?

Problem No 8:
As a financial analyst of a large electronics company, you are required to determine the
weighted average cost of capital of the company using (i) book value we weights and (ii)
Market value weights. The following information is available for your proposal (i.e)
consideration). The Company’s present book value capital structure is:

       SL                          Particulars                              Tk
     01          Debentures (Tk 100 per debenture)                   8,00,000
     02          Preference Share( Tk 100 per share)                 2,00,000
     03          Equity Shares (Tk 10 per share)                    10,00,000
                                        Total                       20,00,000
          All these sucurities are traded in the capital markets. Recent prices are
         SL                      Particulars                                Tk
       01        Debentures                                     Tk 110 per Debenture
       02        Preference Shares (Tk 100 per share)           Tk 120 per Share
       03        Equity Shares                                  Tk 10 per Share
          Anticipated external financing opportunities are:
(i)       Tk 100 per debenture redeemable at per 10 year maturity, 13% coupon rate, 4%
flotation costs, sales price Tk 100.
\(ii). Tk 100 preference share redeemable at par, 10 year maturity, 14% dividend rate, 5%
flotation costs, sales price Tk 100.
(iii). Equity shares Tk 2 per share flotation costs, sales price Tk 22.
          In addition, the dividend expected on the equity share at the end of the year is Tk
2 per share. the anticipated growth rate in dividends is 7% and the firm has the practice of
paying all its earnings in the from of dividends. The Corporate tax rate is 50%.
                                       Extra Problems

Problem No: If a company is able to sell a new issue of 15 years debt with a 6%
interest and realize net proceeds of Tk 1000 for each Tk 1000 face value fund would be
6% and the income tax rate is 50% . Calculate the cost of capital

Problem No: If a firms sells an issue of Tk 100 per value preferred stock with a Tk 6
dividend and rates Tk 96 a share underwriting commission. Calculate cost of preferred

Problem No: Current dividend is Tk 6 per share, current market price Tk 150 per share,
dividend per share is expected to increase at about 2% per year. Compute cost of equity
         Problem No: ABC Co employs four types of capital common stock, preferred
stock, debt and Retained earnings and their values are Tk 30,000; Tk 10,000 and Tk
20,000 and Tk 40,000 respectively. The proportions of each of them to total capital are
                        30% for Common Stock
                        10% for Preferred Stock
                        20% for Debt Stock
                        40% for Retained Earnings.
After tax costs are----
                        Common Stock –2.5%
                        Preferred Stock—6%
                        Debt Stock—10.5%
                        Retained Stock—10%
Calculate weighted average cost of capital.

Problem No: Compute the average cost of capital for XYZ Corporation from the
following data. Market value of the company’s common stock is estimated at Tk 45,000.
Market value of its interest bearing debt is estimated at Tk 30,000 and the average before
tax yield on these liabilities is 6% per year.
Assume that the company is currently paying a dividend of Tk 8 per share and that the
stock selling at a price of Tk 100. The rate of growth of the dividend is projected to be
2 % per year and tax rate is 52%.

Problem No: Calculate the weighted cost of capital from the following information:
      Market value of the Debt Capital—TK 5,00,000
      Market value of the Equity Capital—Tk 6,00,000
      Interest rate for Debt Capital—12%
      Income Tax rate ---48%
      Dividend per share is Tk 15 per year
      Market price of each equity share Tk 110
      Market price of each preferred share Tk 95.
      Growth Rate is 8%

Problem No: Cost of short Term loans------.05
            Cost of Long Term loans------.06
            Cost of common Stock loans--.01
                                            Book Value   Market Value
Current Liabilities (Non interest bearing)  10,000       10,000
Short Term Loan (Interest Bearing)          5,000        5,000
Accumulated Depreciation                    50,000       Not applicable
Long Term Debt                              20,000       20,000
Common Stock                                25,000       75,000
Tax rate is 40%
               Compute average cost of capital.

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