TUTORIAL COST OF CAPITAL

Q1. The Servex Company has the following capital

structure
Ordinary Shares (2,00,000 shares)
40,00000
10% Preference Share
10,00000
14% Debentures
30,00000
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% forever.
Assume a 50% tax rate.
1. Compute weighted average cost of capital based
on the existing capital structure.
2. Compute the new weighted average cost of
capital it the company raises an additional of Rs
20,00000 by issuing 15% debenture. This would
result in increasing the expected dividend to Rs 3
and leave the growth rate unchanged, but the
price of the share will fall to Rs 15 per share.
Q2. The Kay company has the following capital structure
at 31 March 2003 which is considered to be optimum.
14% Debentures
3,00,000
11% Preference Share
1,00,000
Equity (1,00,000 Shares)
16,00,000
The company shares has a current market price of Rs
23.60 per share. The expected dividend per share
next year is 50% of the 2003 EPS. The following EPS
figure for the company during the preceding ten
years. The past trends are expected to continue
Year

94

95

96

97

98

99

00

01

02

03

EPS

1.10

1.21

1.33

1.46

1.61

2.2

2.15

2.16

The company can issue 16% new debentures. The

companys debentures are currently selling at Rs 96.
The new preference issue can be sold at net price of
Rs 9.20, paying a dividend of Rs 1.1 per share. The
companys marginal tax rate is 50%.
a) Calculate the after-tax cost (i) of new debt, (ii) of
new preference capital and (iii) of ordinary equity,
assuming new equity comes from retained
earnings.
b) Find the marginal cost of capital, assuming no new
ordinary shares are sold.
c) How much can be spent for capital investments
before new ordinary shares must be sold? Assume
that retained earnings available for next years
investment are 50% of 2003 earnings.
d) What is the marginal cost of capital (cost of funds
raised in excess of the amount calculated in part
(c) if the firm can sell new ordinary shares to net
Rs 20 a share? The cost of debt and of preference
capital is constant.

TUTORIAL COST OF CAPITAL

Q1. The Servex Company has the following capital
structure
Ordinary Shares (2,00,000 shares)
40,00000
10% Preference Share
10,00000
14% Debentures
30,00000
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% forever.
Assume a 50% tax rate.
1. Compute weighted average cost of capital based
on the existing capital structure.
2. Compute the new weighted average cost of
capital it the company raises an additional of Rs
20,00000 by issuing 15% debenture. This would
result in increasing the expected dividend to Rs 3
and leave the growth rate unchanged, but the
price of the share will fall to Rs 15 per share.
Q2. The Kay company has the following capital structure
at 31 March 2003 which is considered to be optimum.
14% Debentures
3,00,000
11% Preference Share
1,00,000
Equity (1,00,000 Shares)
16,00,000
The company shares has a current market price of Rs
23.60 per share. The expected dividend per share
next year is 50% of the 2003 EPS. The following EPS
figure for the company during the preceding ten
years. The past trends are expected to continue
Year

94

95

96

97

98

99

00

01

02

03

EPS

1.10

1.21

1.33

1.46

1.61

2.2

2.15

2.16

The company can issue 16% new debentures. The

companys debentures are currently selling at Rs 96.
The new preference issue can be sold at net price of
Rs 9.20, paying a dividend of Rs 1.1 per share. The
companys marginal tax rate is 50%.
a) Calculate the after-tax cost (i) of new debt, (ii) of
new preference capital and (iii) of ordinary equity,
assuming new equity comes from retained
earnings.
b) Find the marginal cost of capital, assuming no new
ordinary shares are sold.
c) How much can be spent for capital investments
before new ordinary shares must be sold? Assume
that retained earnings available for next years
investment are 50% of 2003 earnings.
d) What is the marginal cost of capital (cost of funds
raised in excess of the amount calculated in part
(c) if the firm can sell new ordinary shares to net
Rs 20 a share? The cost of debt and of preference
capital is constant.