Fianancial Management & international finance
Illustration 1 : Cost of Irredeemable Debtntures :
Borrower Ltd. issued 10,000, 10% Debentures of Rs. 100 each on 1st April. The cost of issue was
Rs. 25,000. The Company’s tax rate is 35%. Determine the cost of debentures if they were issued
(a) at par (b) at a premium of 10% and (c) at a discount of 10%
Solution :
Particulars Par Premium Discount
Gross Proceeds 10,000×100=10,00,000 10,000×110=11,00,000 10,000×90=9,00,000
Less : Cost of Issue 25,000 25,000 25,000
Net Proceeds 9,75,000 10,75,000 8,75,000
Interest at 10% 1,00,000 1,00,000 1,00,000
Less : Tax at 35% 35,000 35,000 35,000
Net Outflow 65,000 65,000 65,000
Kd = Interest (after tax)
Net Proceeds 6.67% 6.05% 7.43%
Illustration 2 : Cost of Redeemable Debentures
Indebted Ltd issued 10,000, 10% Debentures of Rs. 100 each, redeemable in 10 years time at
10% premium. the cost of issue was Rs. 25,000. The Company’s Income Tax Rate is 35%.
Determine the cost of debentures if they were issued (a) at par (b) at a premium of 10% and (c)
at a discount of 10%.
Solution :
Particulars Par Premium Discount
1. Gross Proceeds 10,000×100 10,000×110 10,000×90 =
10,00,000 11,00,000 9,00,000
2. Cost of Issue 25,000 25,000 25,000
3. Net Proceeds (1–2) 9,75,000 10,75,000 8,75,000
4. Redemption Value (Face Value+10% premium) 11,00,000 11,00,000 11,00,000
5. Average Liability (RV+NP) ÷ (2=(4+3) ÷ 2 10,37,500 10,87,500 9,87,500
6. Premium on Redemption = RV – NP 1,25,000 25,000 2,25,000
7. Avg Premium on Redemption p.a.=(6)÷10 yrs. 12,500 2,500 22,500
8. Interest payable at 10% of Face Value 1,00,000 1,00,000 1,00,000
9. After Tax Interest at 65% (Since Tax=35%) 65,000 65,000 65,000
10. Average Annual Payout = (7+9) 77,500 67,500 87,500
11. Average Liability
Interest (after tax) Avg Premium on Red
Kd
+
= 7.47% 6.21% 8.86%
Note : Cost of Debt will not be equal to the Interest Rate on Debt. This is due to the following
reasons—
(d) Tax-Saving Effect :
(e) Issue at Premium/Discount :
(f) Expenses of Issue and difference between Face Value and Net Proceeds;
(g) Redemption at premium and additional amount payable.
Illustration 3 : Alternative Modes of Debt
Company is considering raising funds of about Rs. 100 Lakhs by one of two alternative methods,
viz. 14% Substitutional Term Loan and 13% Non-Convertible Debentures. The term loan option
would attract no major accidental cost. The Debentures would be issued at a discount of 2.5%
and would involve cost of issue Rs. 1 lakh. Advice the company as to the better option based
on effective cost of capital. Assume a tax rate of 50%.
Solution : (information in Rs. Lakhs)
Mode Term Loan Debentures
Gross Realisation 100.00 100×97.5%=97.50
Less : Cost of Issue – 1.00
Net Proceeds 100.00 96.50
Interest Payale at 14% and 13% of Face Value 14.00 13.00
Interest × After tax rate=Annual Payout 7.00 6.50
Effective Kd Interest (after tax)/ Net Proceeds 7% 6.74%
Ranking II I
Note : Based on Effective Kd, Debentures can be preferred. But net realisation is only Rs. 96.5
Lakhs. If fund requirement of Rs. 100 Lakhs is considered as the base, the Face Value of
Debentures to be issued. [Rs. 100 Lakhs (Net Proceeds) 1 Rs. 1 Lakh (Cost of Issue)] + 97.5%
(issured at a discount). Hence, Face Value of Debentures issued Rs. 103.59 Lakhs approximately.
Effective Cost of Debentures in that case = 6.73%.
Illustration 4 : Cost of Irredeemable Preference Shares
Preferred Ltd issued 30,000, 15% Preference Shares of Rs. 100 each. The cost of issue was Rs.
30,000. Determine the cost of Preference Capital is shares are issued (a) at par (b) at a premium
of 10% and (c) at a discount of 10%.
Solution :
Particular Par Premium Discount
Gross Proceeds 30,000×100 = 30,00,000 30,000 × 110 = 33,00,000 30,000×90 = 27,00,000
Less : Cost of Issue 30,000 30,000 30,000
Net Proceeds 29,70,000 32,70,000 26,70,000
Preference Dividend 15% 4,50,000 4,50,000 4,50,000
Net Proceeds
Pr eference Dividend
Kp = 15.15% 13.76% 16.85%
Illustragion 5 : Cost of Redeemable Preference Shares.
Preferential Ltd. issued 30,000, 15% Preference Shares of Rs. 100 each, redeemable at 10%
premium after 20 years. Issue Management Expenses were Rs. 30,000. Find out of Preference
Capital if sahres are issued (a) at par (b) at a premium of 10% and (c) at a discount of 10%.
Solution :
Particulars Par Premium Discount
1. Gross Proceeds (30,000 Shares × Issue Price) 30,00,000 33,00,000 27,00,000
2. Cost of Issue 30,000 30,000 30,000
3. Net Proceeds = (1–2) 29,70,000 32,70,000 26,70,000
4. Redemption Value (Face Value+10% premium) 33,00,000 33,00,000 33,00,000
5. Average Liability (RV+NP) ÷ 2 = (4+3) ÷ 2 31,35,000 32,85,000 29,85,000
6. Premium on Redemption = RV – NP 3,30,000 30,000 6,30,000
7. Avg Premium on Redemption p.a. ÷ 20 yrs. 16,500 1,500 31,500
8. Dividend at 15% of Face Value 4,50,000 4,50,000 4,50,000
9. Average Annual Payout = (7+8) 4,66,500 4,51,500 4,81,500
10. KP = 9 : 5 14.88% 13.74% 16.13%
Illustration 6 : Cost of Equity — Dividend Price Approach
Dividend–Payers Ltd has a stable income and stable dividend policy. The average annual
dividend payout is Rs. 27 per share (Face Value = Rs. 100). You are required to find out –
(h) Cost of Equity Capital if Market Price in Year 1 is Rs. 150.
(i) Expected Market Price in Year 2 if cost of equity is expected to rise to 20%
(j) Dividend Payout in Year 2 if the Company were to have an expected market price of
Rs. 160 per share, at the existing cost of equity.
Solution :
1. Ke = %
Rs.
Rs.
Market Pr ice per Share
Dividend per Share
= = 18
150
27
2. Ke = %
MPS
Rs.
Market Pr ice per Share
Dividend per Share
20
27 = = .On substitution, MPS=Rs. 27÷20%= Rs. 135
3. Ke = %
Rs.
DPS
Market Pr ice per Share
Dividend per Share
18
160
= = . On substitution, DPS=Rs.160×18%= Rs. 28.80.
Illustration 7 : Cost of Equity — E/P Approach
Easy–Earnes Ltd has a uniform income that accrues in a four-year business cycle. It has an
average EPS of Rs. 25 (per share of Rs. 100) over its business cycle. You are required to find out–
1. Cos of Equity Capital if Market Price in Year 1 is Rs. 150.
2. Expected Market Price in Year 2 if cost of Equity is expected to rise to 18%
3. EPS in Year 2 if the Company were to have an expected Market Price of Rs. 160 per share,
at the existing cost Equity.
Solution :
1. Ke = 16.67%
.150
. 25 = =
Rs
Rs
Market Price per Share
Earning per Share
2. Ke = 18%
. 25 = =
MPS
Rs
Market Price per Share
Earning per Share
. On substitution, MPS=Rs.25÷18%= Rs. 138.89
Note : Earnings accrue evenly and hence EPS is uniform at Rs. 25 per share.
3. Ke = 16.67%
.160
= =
Rs
DPS
MarketPrice per Share
Earning per Share
. On substitution, DPS=Rs.160×16.67%
= Rs. 26.67
Illustration 8 : Computation of EPS, Cost of Equity and Cost of Debt
The following is an extract from the Financial Statements of KPN Ltd. (in Rs. Lakhs)
Operating Profit 105
Less :Interest on Debentures 33
Net Operating Income before Tax 72
Less :Income tax 36
Net Profit after Tax 36
Equity Share Capital (Shares of Rs. 10 each) 200
Reserves and Surplus 100
15% Non-Convertible Debentures (of Rs. 100 each) 220
Total 520
Market Price per Equity Share is Rs. 12 and per Debeuture is Rs. 93.75
What is the Earning per Share?
What is the percentage cost of capital to the Company for the Debenture Funds and the Equity?
Solution :
S = Rs. 1.80.
20
Rs . 36 Lakhs
.
= =
No of Equity Shares Lakhs Shares
Earning After Tax
S = Rs. 15%.
Rs. 12.00
. 1.80
Market per Share
Earning per Share = = Rs
Fianancial Management & international finance 81
Cost of Debt Kd may be computed as under—
Particulars Book Value Market Value
Cost Rs. 33.00 Lakhs Rs. 33.00 Lakhs
Invest after tax of 50% Rs. 16.50 Lakhs Rs. 16.50 Lakhs
Share of Debentures Rs. 220.00 Lakhs (220/100×93.75)=
Rs. 206.25 Lakhs
Kd=After Tax Interest ÷ Value of Deb. 7.5% 8%
Illustration 9 : Cost of Equity — Growth Approach
Optimistic Ltd has an EPS of Rs. 90 per Share. Its Dividend Payout Ratio is 40%. Its Earnings
and Dividends are expected to grow at 5% per annum. Find out the cost of Equity Capital if its
Market Price is Rs. 360 per share.
Futuristic Ltd pays a Dividend of Rs. 2 per share. Its shares are quoted at Rs. 40 presently and
investors expect a growth rate of 10% per annum. Calculate—
(i) Cost of Equity Capital
(ii) Expected Market Price per share if anticipated growth rate is 11%.
(iii) Market price if dividend is Rs. 2, cost of capital is 16% and growth rate is 10%.
Solution :
Optimistic Ltd.
i) Ke = %
Rs.
Rs. 90 40%
g (Growth Rate)
Market Price per Share
Dividend per Share
5
360
+
×
+ = = .1+.05 = 15%
Futuristic Ltd.
Ke = %
Rs. 40
Rs. 2
g (Growth)
Market Priece per Share
Dividend per Share
+ = +10 = 5%+10% = 15%.
ii) Ke = g.
Market Priece per Share
Dividend per Share + It is given that Ke = 15% = %
MPS
Rs.
11
2 +
On transposing, we have,
MPS
Rs. 2
=15%–11%=4%. So, MPS = Rs. 2 ÷ 4% = Rs. 50 per Share.
iii) Ke = g.
Market Price per Share
Dividend per Share + It is given that Ke = 16% = %
MPS
Rs.
10
2 +
On transposing, we have, % % %.
MPS
Rs.
16 10 6
2 = − = So, MPS = Rs. 2 ÷ 6%=Rs. 33 per Share.
Illustration 10 : Valuation of Equity Share — Present Value of Future Dividend Flows
D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth rate is
likely to be 10% for the third and fourth year. After that, the growth rate is expected to stabilise
at 8% per annum. If the last dividend was Rs. 1.50 per Share and the Investor’s required rate of
return is 16%, determine the current value of Equity Share of the Comapny.
The P.V. factors at 16% are —
Year 1 2 3 4
P V factor 0.862 0.743 0.641 0.552
Solution :
Value of Equity Share = Present Value of all dividend flows.
Year Dividend Discount Rate PV of Dividend
1 Rs. 1.50 + 12% = Rs. 1.68 0.862 Rs. 1.4482
2 Rs. 1.68 + 12% = Rs. 1.88 0.743 Rs. 1.3968
3 Rs. 1.88 + 10% = Rs. 2.07 0.641 Rs. 1.3269
4 Rs. 2.07 + 10% = Rs. 2.27 0.552 Rs. 1.2530
5 onwards See Note below = Rs. 30.65 0.552 Rs. 16.9160
Total Current Value of Equity Share of the Comapny Rs. 22.3409
Note : Computation of Perpetual Dividend received after 4th year i.e. at 8% per annum
Total Dividend (k g)
D ( g)
−
× 1+
( . . )
. ( . )
0 16 0 08
2 27 1 0 08
−
× +
= Rs. 30.645
Where D = Dividend; g = Growth Rate and K = Cost of Equity Capial
Illustration 11 : Computation of WACC
(d) The Capital Structure of All-Good Ltd is — Equity Capital Rs. 5 Lakhs; Reserves and
Surplus Rs. 2 Lakhs and Debentures Rs. 3 Lakhs. The Cost of Capital before Tax are – (a)
Equity – 18% and (b) Debentures – 10%. You are required to compute the Weighted
Cost of Capital, assuming a tax rate of 35%.
(e) From the following information, compute WACC of Super-Good Ltd. (Assume
Tax = 35%)
Debt to Total Funds : 2:5
Preference Capital to Equity Capital : 1:1
Preference Dividend Rate : 15%
Interest on Debentures : Rs. 20000 for half-year.
EBIT at 30% of Capital Employed : Rs. 3 Lakhs
Cost of Equity Capital is 24%.
(f) Backwaork Ltd has a Debt Equity Ratio of 2:1 and a WACC of 12%. Its Debentures bear
interest of 15%. Find out the cost of Equity Capital. (Assume Tax = 35%)
Solution: (a) WACC of All Good Ltd
Component Amount % Indivitual Cost in % WACC
Debetures 3,00,000 30% Kd= Interest ×(100%- Tax Rate) 1.95
=10% × (100% - 35%) = 6.5%
Equity 5,00,000 50% Ke = 18% 9.00%
Reserves 2,00,000 20% Kr= Ke= 18% 3.60%
Total 10,00,000 Ko = 14.55%
Note : Reserve are taken at same rate as Equity.
(b) Super Good Ltd.
EBIT at 30% of Capital Employed = Rs. 3 Lakhs,Capital Employed =Rs.3Lakhs/30%=Rs10,00,000.
Debt to Total Funds = 2:5. Hence, Debt = 2/5th of Rs.10,00,000 =Rs.4,00,000
Shareholders’ Funds = balance 3/5th of Rs. 10,00,000 =Rs.6,00,000
Preference to Equity Capital = 1:1 (i.e.equal). The total of both = Rs.6,00,000
So, Preference Capital = Equity Capital = 1/2 of Rs. 6,00,000 =Rs.3,00,000 each.
Interest on Debt = Rs.20,000 × 2 =Rs.40,000. Hence Interest Rate
= Rs.40,000 / Rs.4,00,000 = 10% .
WACC is computed as under—
Component Amount % Indivitual Cost in % WACC%
Debt 4,00,000 40% Kd = Interest × (100% - Tax Rate) 2.60%
=10%×(100% - 35%) = 6.5%
Preference 3,00,000 30% Kp = 15% 4.50%
Equity 3,00,000 30% Ke = 24% 7.20%
Total 10,00,000 Ko = 14.30%
(c) Computation of Cost of Equity of Backwork Component
Component % Indivitual Cost in % Wacc%
Debt 2/3rd Kd = Interest × (100% - Tax Rate) 9.75%×2/3rd=6.50%
=15%× (100% -35%) = 9.75%
Equity 1/3rd Ke = 5.50 ÷ 1/3rd = 16.50% 12%-6.5%=5.50%
(final balancing figure) (bal.figure)
Total Ko = (given)12.00%
Illustration 12 : WACC - Book Value & Market Value Proportions - with / without
tax-RTP.
The following information has been extracted from the Balance Sheet of ABC Ltd.as on
31st March -
Component of capital Equity Share Capital 12% Debentures 18%Term Loan Total
Amount Rs. In Lakhs 400 400 1,200 2,000
1. Determine the WACC of the Company. It had been paying dividends at a consistent rate of
20% per annum.
2. What difference will it make if the current price of the Rs.100 share is Rs.160?
3. Determine the effect of Income Tax on WACC under both the above situations. (Tax Rate =
40%).
Solution:
1. Computation of WACC (based on Book Value Proportions and ignoring Tax)
Component(a) Proportion(b) Indivitual Cost (c) Wacc (d) = (b) × (c)
Equity Share Capital 4/20 Ke=20% (Dividend Approach) 4.00%
12% Debentures 4/20 Kd= 12% 2.40%
18% Term Loan 12/20 Kd= 18% 10.80%
WACC = Ko = 17.20%
Note: 1. Ke = Dividend per Share Equals Market Price per share = Rs.20.
2. Book Value Proportions have been considered in Column (b) above.
2. (a) Computation of WACC (based on Book Value Proportions and ignoring tax)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Share Capital 4/20 Ke = 20÷160 = 12.50% 3.57%
12% Debentures 4/20 Kd = 12% 2.40%
18% Term Loan 12/20 Kd = 18% 10.80%
Total Rs. 2,240 Lakhs WACC = K0 = 15.70%
2. (b) Computation of WACC (based on Market Value Proportions and ignoring tax)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Capital Rs. 640 Lakhs 64/224 Ke = 20÷160 = 12.50% 3.57%
12% Debentures Rs. 400 Lakhs 40/224 Kd = 12% 2.14%
18% Term Loan Rs. 1,200 Lakhs 120/224 Kd = 18% 9.64%
Total Rs. 2,240 Lakhs WACC = K0 = 15.35%
Fianancial Management & international finance 85
3. Effect of Tax Rate of 35% on WACC
(a) Computation of WACC with tax (Situation 1 above based on Book Value Proportions)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Share Capital 4/20 Ke = 20% 4.00%
12% Debentures 4/20 Kd = 12%×60% = 7.20% 1.44%
18% Term Loan 12/20 Kd = 18%×60% = 10.80% 6.48%
WACC = K0 = 11.92%
The WACC has reduced from 17.20% to 11.92%, due to tax saving effect.
(b) Computation of WACC with tax (Situation 2 (a) above based on Book Value Proportions)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Share Capital 4/20 Ke = 20 ÷160 = 12.50% 2.50%
12% Debentures 4/20 Kd = 12%×60% = 7.20% 1.44%
18% Term Loan 12/20 Kd = 18%×60% = 10.80% 6.48%
WACC = K0 = 10.42%3
The WACC has reduced from 15.70% to 10.42, due to tax saving effect.
(c) Computation of WACC with tax (Situation 2(b) above based on Book Value Proportions
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Capital Rs. 640 Lakhs 64/224 Ke = 20÷160 = 12.50% 3.57%
12% Debentures Rs. 400 Lakhs 40/224 Kd = 12%×60% = 7.20% 1.29%
18% Term Loan Rs. 1,200 Lakhs 120/224 Kd = 18%×60% = 10.80% 5.780%
Total Rs. 2,240 Lakhs WACC = K0 = 10.64%
The WACC has reduced from 15.35% to 10.64%, due to tax saving effect.
Illusatration 13 : WACC – Financing Decision of Projects
Z Co. has a capital structure of 30% debt and 70% equity. The company is considering various
investment proposals costing less than Rs. 30 Lakhs. The company does not want to distrub its
present capital structue. The cost raising the debt and equity are as follows :
Project Cost Cost of Debt Cost of Equity
Above Rs. 5 Lakhs 9% 13%
Above Rs. 5 Lakhs and upto Rs. 20 Lakhs 10% 14%
Above Rs. 20 Lakhs and upto Rs. 40 Lakhs 11% 15%
Above Rs. 40 Lakhs and upto Rs. 1 Crore 12% 15.55%
Assuming the tax rate is 50%, compute the cost of two projects A and B, whose fund requirements
are Rs. 8 Lakhs and Rs. 22 Lakhs respectively. If the project are expected to yield after tax
return of 11%, determine under what conditions if would be acceptable.
Solution :
Particulars Kd (Debt)% Ke (Equity) % WACC = K0
% of Debt and Equity 30% 70%
Upto 5 Lakhs 9×50% = 4.5% 13% 4.5×30%+13×70% = 10.45%
Lakhs to 20 Lakhs 10×50% = 5.0% 14% 5.0×30%+14×70% = 11.30%
Lakhs to 40 Lakhs 11×50% = 5.5% 15% 5.5×30%+15×70% = 12.15%
Lakhs to 1 Crore 12×50% = 6.0% 15.55% 6.0×30%+15.55×70% = 12.69%
Project Investment WACC Return Decision
A Rs. 8.00 Lakhs 11.3% (5L to 20L) 11% ROI <>
B Rs. 22.00 Lakhs 12.15% (20L to 40L) 11% ROI <>
Decision : If ROI 11%, Project is acceptable only if
(a) Project Ivestment is less than Rs. 5 Lakhs.
(b) Fractional Investment is possible on a divisible project — Investment is less than Rs. 5 Lakhs.
Illustration 14 : Financing Decision and EPS Maximisation
A Company requires Rs. 15 Lakhs for the installation of a new unit, which would yield an
annual EBIT of Rs. 2,50,000. The Company’s objective is to maximise EPS. It is considering the
possibility of Issuing Equity Shares plus raising a debt of Rs. 3,00,000, Rs. 6,00,000 and
Rs. 9,00,000. The current Market Price per Share is Rs. 50 which is expected to drop to Rs. 40 per
share if the market borrowings were to exceed Rs. 7,00,000., The cost of borrowing are indicated
as follows :
Level of Borrowing Upto Rs. 2,00,000,Rs. 2,00,000 to Rs. 6,00,000,Rs. 6,00,000 to Rs. 9,00,000,
Cost of Borrowing 12% p.a. ,15% p.a. ,17% p.a.
Assuming a tax rate of 50%, work out the EPS and the scheme, which you would recommended
to the Company.
Solution : Statement showing EPS under the different schemes
Particulars Scheme I Scheme II Scheme III
Capital Required 15,00,000 15,00,000 15,00,000
Less : Debt Content 3,00,000 6,00,000 9,00,000
Balance Equity Capital required 12,00,000 9,00,000 6,00,000
Market Price per Share Rs. 50 Rs. 50 Rs. 40
Number of Equity Shares to be 24,000 18,000 15,000
issued (Equity Capital MPS)
Fianancial Management & international finance 87
Profitability Statement
EBIT 2,50,000 2,50,000 2,50,000
Less : Interest on Debt First Rs. 2,00,000 at 12% 24,000 24,000 24,000
Next Rs. 4,00,000 at 15% 15,000 60,000 60,000
Balance at 17% 51,000
Total Interest 39,000 84,000 1,35,000
EBIT 2,11,000 1,66,000 1,15,000
Less : Tax at 50% 1,05,500 83,000 57,500
EAT 1,05,500 83,000 57,500
Earnings Per Share (EPS)=EAT÷No. of Shares 4.40% 4.61% 3.83%
Average Interest Rate = Total Interest÷Debt 12% 14% 15%
ROCE=EBIT÷Capital Employed 16.67% 16.67% 16.67%
Conclusion : EPS is maximum under Scheme II and is hence preferable.
Leverage Effect : Use of Debt Funds and Financial Leverage will have a favourable effect only
if ROCE > Interest rate. ROCE is 16.67% and hence upto 15% interest rate, i.e. Scheme II, use of
debt will have favourable impact on EPS and ROE. However, when interest rate is higher at
17%, financial leverage will have negative impact and hence EPS falls from Rs. 4.61 to Rs. 3.83.
Illustration 15 : Funding Pattern — EPS Maxisation
The following figures are made available to you —
Particulars Rs.
Net Profits for the year 18,00,000
Less : Interest on Secured Debentures at 15% p.a.
(Debentures were issued 3 months after commencement
of the year) 1,12,500
PBT 16,87,500
Less : Tax at 35% and Dividend Distribution Tax 8,43,750
PAT 8,43,750
Number of Equity Shares of Rs. 10 each 1,00,000
Market Quotation of Equity Shares Rs. 109.70 per share
The Company has accumulated revenue reserves of Rs. 12 Lakhs. It is examining a project
requiring Rs. 10 Lakhs Investment, which will earn at the same rate as the funds already
employed.
You are informed that a Debt-Equity Ratio (Debt÷[Debt+Equity]) above 60% will cause the PE
ratio to come down by 25%. The interest rate on additional borrowals (above the present Secured
Debentures) will cost the Company 300 basic points more than their current borrowal on Secured
Debentures. You are required to compute the probable price of the Equity Shares if the additional
investment were to be raised by way of — (a) Loans or (b) Equity.
Solution : 1. Computation of Capital Employed and Debt–Equity Ratio
Particulars Present Loan Option Equity Option
Debt [1,12,500×12/9 ÷ 15% Rs. 10,00,000 + Rs. 10,00,000 (as per present situation)
= Rs. 10,00,000 = Rs. 20,00,000 Rs. 10,00,000
Equity Capital 1,00,000 Shares×Rs 10 = (as present) Rs. 10,00,000 (See Note) 10,91,160
Rs. 10,00,000
Reserves (given) Rs. 12,00,000 (given) Rs. 12,00,000 Rs. 12,00,000+Rs. 9,08,840
= Rs. 21,08,840
Total Funds
Employed Rs. 32,00,000 Rs. 42,00,000 Rs. 42,00,000
Debt Equity
Ratio 10÷32 = 31.25% 20÷42 = 47.62% 10÷42 = 23.81%
Present Market Value per Share = Rs. 109.70. Hence, additional funds of Rs. 10,00,000 will be
raised by issue of shares at an issue price of Rs. 109.70 per Share.
Number of Equity Sharess to be issued = Rs. 10,00,000 ÷Rs. 109.70 per Share = 9,116 Shares of
Rs. 10 each, issued at a premium of (Rs. 109.70–Rs. 10.00) Rs. 99.70 per Share.
Hence Additional Equity Share Capital = Rs. 91,160 and Additional Reserves i.e. Securities
Premium = Rs. 9,08,840 (9,116 Shares × Rs. 99.70 approx.)
2. Computation of Profits and EPS
Less : Present EBIT = Rs. 18,00,000 for Capital Employed of Rs. 32,00,000.
So, Return on Capital Empolyed = Rs. 18,00,000 ÷ Rs. 32,00,000 = 56.25%.
Revised EBIT after introducing additional funds = Rs. 42,00,000×56.25% = Rs. 23,62,500.
Particulars Present Loan Option Equity Option
EBIT at 56.25% 18,00,000 23,62,500 23,62,500
Less : Interest next year - Deb. 1,12,500 1,50,000 1,50,000
Loans — 10,00,000 × 18% — 1,80,000 —
EBIT 16,87,500 20,32,500 22,12,500
Less : Tax at 35% 5,90,625 7,11,375 7,74,375
EAT 10,96,875 13,21,125 14,38,125
Number of Equity Shares (given) = 1,00,000 1,00,000 1,09,116
EPS 10.97 13.21 13.18
PE Ratio = MPS ÷ EPS 109.70 ÷ 10.97 = 10 10 10
Hence, Market Price Rs. 109.70 Rs. 132.10 Rs. 131.80
Note :
For interest calculation purposes, 100 basic point = 1% interest. Hence, 300 basic points means
3%. So, Interest Rate on additional borrowings is 15% +3% = 18%.
Corporate Income Tax at 35% only is relevant. Dividend Distribution Tax is irrelevant for
computing EPS, since dividend distribution is only an appropriation of profits.
Fianancial Management & international finance 89
Since Debt-Equity Ratio has not increased beyond 60%, PE Ratio will not be affected and will
remain the same at 10, in all situations.
Illustration 16 : Funding Pattern — EPS Maximisation
Company earns a profit of Rs. 3,00,000 per annum after meeting its interest liability of Rs.
1,20,000 on its 12% debentures. The tax rate is 50%. The number of Equity Shares of Rs. 10 each
are 80,000 and the retained earnings amount to Rs. 12,00,000.
The Company proposes to take up an expansion scheme for which a sum of Rs. 4,00,000 is
required. It is anticipated that after expansion, the Company will be able to achieve the same
return on investment as at present. The funds required for expansion can be raised either
through debt at the rate of 12% or through the issue of Equity shares at par.
Required : 1. Compute the EPS if additional funds were raised by way of — (a) Debt;
(b) Equity Shares.
2. Advise the Company as to which source of finance is preferable.
Solution : 1. Computation of Capital Employed
Particulars Present Loan Option Equity Option
EBIT at 14% 4,20,000 4,76,000 4,76,000
Less : Interest on Loans 1,20,000 1,68,000 1,20,000
EBIT 3,00,000 3,08,000 3,56,000
Less : Tax at 50% 1,50,000 1,54,000 1,78,000
EAT 1,50,000 1,54,000 1,78,000
Number of Equity Shares (given)=80,000 80,000 1,20,000
EPS = EAT÷No. of ES 1.875 1.925 1.483
Conclusion : EPS is maximum under Debt Funding Option and is hence preferable.
Leverage Effect : Use of Debt Funds and Financial Leverage willhave a favourable effect only
if ROCE > Interest rate. ROCE is 14% and Interest Rate is 12%. So, use of debt will have
favourable impact on EPS and ROE. This is called at “Trading on Equity” or “Gearing” Effect.
Illustration 17 : WACC and Marginal WACC Computation
XYZ Ltd. (in 40% Tax bracket) has the following book value capital structure —
Equity Capital (in shares of rs. 10 each, fully paid-up at par) Rs. 15 Crores
11% Prefernece Capital (in shares of Rs. 100 each, fully paid-up at par) Rs. 1 Crore
Retained Earnings Rs. 20 Crores
13.5% Debentures (of Rs. 100 each) Rs. 10 Crores
15% Term Loans Rs. 12.5 Crores
The next expected dividend on Equity Shares is Rs. 3.60 per share. Dividends are expected
to grow at 7% and the Market price per share is Rs. 40.
Preference Stock, redeemable after ten years, is currently selling at Rs. 75 per share.
Debentures, redeemable after 6 years, are selling at Rs. 80 per debenture.
Required :
1. Compute the present WACC using (a) Book Value Proportions and (b) Market Value
Proportions.
2. Compute the wighted Marginal Cost of Capital if the Company raises Rs. 10 Crores next
year, given the following information—
The amount will be raised by equity and debt in equal proportions.
The Company expects to retain Rs. 1.5 Crores earnings next year.
The additional issue of Equity Shares will result in the net price per share being
fixed at Rs. 32.
The Debt capital raised by way to Term Loans will cost 15% for the first Rs. 2.5 Crores
and 16% for the next Rs. 2.5 Crores.
Solution :
1. Computation of Cost of Equity under Dividend Approach
Present Cos of Equity under Dividend Approach :
Ke = Market Pr ice per Share
Dividend per Share
+ g (Growth Rate) = 40 00
3 60
Rs. .
Rs. .
+ 7% = 9%+7% = 16.00%.
Revised Cost of Equity under Dividend Approach :
Ke = Market Pr ice per Share
Dividend per Share
+ g (Growth Rate) = 32 00
3 60
Rs. .
Rs. .
+ 7% = 11.25%+7% = 18.25%.
2. Computation of Cost of Preference Share Capital
(RV Net Proceeds) 2
Preference Dividend (RV Net Proceeds) N
+ ÷
+ − ÷
. %.
[ ]
[ ( ) ]
= 15 43
+ ÷
= + − ÷
100 70 2
11 100 75 10
3. Computation of Cost of Debt
Present Costs of Debentures
(RV Net Proceeds) 2
Preference Dividend (RV Net Proceeds) N
+ ÷
+ − ÷
. %.
[ ]
[ . % ( ) ]
= 12 70
+ ÷
= × + − ÷
100 80 2
13 5 60 100 80 6
Present Cost of Term Loans = Kd = Interest (100%—Tax Rate) = 15% × (100%–40%) = 9.00%.
Cost of Additional Debt for first Rs. 2.50 Crores=Interest (100%–Tax Rate) = 15%×60%= 9.00%
Cos fo Additional Debt for next Rs. 2.50 Crores=Interest (100%–Tax Rate)=16%×60%=9.60%.
4. Computation of Present WACC base on Book Value Proportions
Particulars Amount Proportion Individual Cost WACC
Equity Capital Rs. 15 Crores 15/58.5 WN 1 = 16.00% 4.10%
Preference Capital Rs. 1 Crore 1/58.5 WN 2 = 15.43% 0.26%
Earnings Rs. 20 Crores 20/58.5 WN 1 = 16.00% 5.47%
Debentures Rs. 10 Crores 10/58.5 WN 3 = 12.70% 2.17%
Loans Rs. 12.5 Crores 12.5/58.5 WN 3 = 9.00% 1.92%
Total Rs. 58.5 Crores 100% K0=13.92%
Fianancial Management & international finance 91
5. Computation of Present WACC base on Market Value Proportions
Particulars Amount Proportion Individual Cost WACC
Equity Capital Rs. 60 Corres 60/81.25 WN 1 = 16.00% 11.82%
Preference Capital Rs. 0.7 Crore 0.75/81.25 WN 2 = 15.43% 0.14%
Retained Earnings Included in Market Value of Equity Share Capital, hence note
applicable
Debentures Rs. 8 Crores 8/81.25 WN 3 = 12.70% 1.25%
Loans Rs. 12.5 Crores 12.5/81.25 WN 4 = 9.00% 1.38%
Total Rs. 81.25 Crores 100% K0 = 14.59%
6. Computation of Marginal Cost of Capital
Marginal Cost of Capital is computed in different segments as under —
For the first Rs. 1.5 Crores of Equity and Debt each — since retained earnings are Rs. 1.5
Cores.
For the next Rs. 1 Crores of Debt and Equity each — since cost of debt changes beyond Rs. 2.5
Crores debt.
For the balance Rs. 2.5 Crores of Debt and Equity each.
Particulars Debt Equity Total Individual Cost Marginal WACC
First Rs. 1.5 Rs. 1.5 Rs.1.5 Rs. 3 WN 2 : Kd = 9.00% (9.00%×50%)+(16.00%×50%)
Crores Crores Crores Crores WN 1 : Kd = 16.00% = 12.50%
Next Rs. 1.5 Rs. 1 Rs.1 Rs. 2 WN 3 : Kd = 9.60% (9.00%×50%)+(18.25%×50%)
Crores Crores Crores Crores WN 1 : Kd = 18.25% = 13.63%
Balance Rs. 2.5 Rs. 2.5 Rs. 2.5 WN 3 : Kd = 9.60% (9.00%×50%)+(18.25%×50%)
Amonnt Crores Crores Crores WN 1 : Kd = 18.25% = 13.93%
Illustration 18: Coputation of Cost of Debt, Equity and WACC
The R & G Co. has following capital structure at 31st March 2009, which is considered to be
optimum -
Particulars Amount(in Rs.)
13% Debentures 3,60,000
11% Preference share Capital 1,20,000
Equity Share Capital (2,00,000 Shares) 19,20,000
The Company’s Share has a current Market Price of Rs.27.75 per Share. The expected Dividend
per Share in the next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows.
The past trends are expected to continue -
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS(Rs.) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can Issue 14 percent New Debenture. The Company’s Debenture is currently
selling at Rs.98. The New Preference Issue can be sold at a net price of Rs.9.80, paying a dividend
of Rs.1.20 per share. The Company’s marginal tax rate is 50%.
1. Calculate the After Tax Cost (a) of new Debt and new Preference Share Capital, (b) of
ordinary Equity, assuming new Equity comes from Retained Earnings.
2. Calculate the Marginal Cost of Capital.
3. How much can be spent for Capital Investment before new ordinary share must be
sold?Assuming that retained earning available for next year’s Investment are 50% of 2004
earnings.
4. What will be Marginal Cost of Capital(cost of fund raised in excess of the amount calculated
in part (3) if the Company can sell new ordinary shares to net Rs.20 per share? The cost of
Debt and of Preference Capital Is constant.
Solution :
1. Computation of Cost of Additional Capital (component wise)
1. (a) After Tax Cost of New Debt =
Net Proceeds of Issue
Interest× Tax Rate
105 54
14 50
.
= × % = 6.63%
(Note 1)
1. (a) After Tax Cost of New =
Net Proceeds of Issue
Preference Dividend
9 80
1 20
Rs. .
Rs. . = = 12.24%
Preference Share Capital
1. (b) After Tax Cost of Ordinary (DPS + MPS) + g %
.
( . %)
12
27 75
2 773 50 = × + = 17.00%
Equity (Note 2)
Note 1 : Since Current 13% Debenture is selling at Rs.98 (Rs. 100 presuned as Par Value), the
Company can sell 14% New Debentures at (14%× 98) ÷ 13% = Rs.105.54
approximately.Alternatively, Kd can also be computed as (Rs. 14 × 50%) ÷ Rs.98 = 7.14%.
Note 2 : For computing “g” i.e. Growth Rate under Realised Yield Method, the past avarage
Growth Rate is at 12%, in the following manner-
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
** (Rs.) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
Additioanl — 0.120 0.134 0.151 0.169 0.188 0.212 0.237 0.265 0.297
*
Increase — 12.00% 11.96% 12.04% 12.03% 11.94% 12.03% 12.01% 11.99% 12.00%
Note: % Increase in EPS = Additional EPS ÷ Previous Year EPS e.g. 0.120 ÷ 1.00 etc.
Marginal Cost of Capital : Since the present Capital Structure is optium the additional funds
will be raised in the same ratio in order to maintain the capital structure. Hence, Marginal Cost
of Capital is 15.20% , computed as under :
Fianancial Management & international finance 93
Component Amount % Individual WACC
Debt 3,60,000 15% Kd = 6.63% 0.99%
Preference Capital 1,20,000 5% Kp = 12.24% 0.61%
Equity Capital 19,20,000 80% Ke = 17.00% 13.60%
Total 24,00,000 100% WACC = K0 = 15.20%
Note : When Kd is taken at 7.14%, Ko will be 15.28% .
Retained Earnings available for further investments = 50% of 2004 EPS
= 50%×Rs.2.773×2,00,000 Shares
= Rs.2,77,300
Hence, amount to be spent before selling new ordinary shares = Rs.2,77,300.
Since Equity is 80% of the total funds employed, the total capital before issuing fresh
equity shares = Rs.2,77,300 ÷ 80% = Rs.3,46,625.
Computation of Revised Marginal Cost of Capital if Equity Issue is made at Rs.20 per share
Revised Cost of Ordinary Equity =(DPS ÷ MPS) +g
20 00
2 773 50 12
.
( . × %) + %
= =18.30%
if MPS (i.e. Issue Price) = Rs.20
Component Amount % Individual WACC
Debt 3,60,000 15% Kd = 6.63% 0.99%
Preference Capital 1,20,000 5% Kp = 12.24% 0.61%
Equity Capital 19,20,000 80% Ke = 18.93% 15.15%
Total 24,00,000 100% WACC = K0 = 16.75%
Note : When Kd is taken at 7.14%, Revised Ko will be 16.82%.
Illustration 19 : Computation of Marginal WACC - Redeemable PSC and Debt .
BC Limited has the following book value capital structure -
Equity Share Capital (150 million shares Rs.10 par) Rs.1,500 million
Reserves & Surplus Rs.2,250 million
0.5% Preference Share Capital (1 million shares Rs.100 par) Rs.100 million
0.5% Debentures (1.5 million debentures Rs.1000 par) Rs.1,500 million
0.5% Term Loans from Financial Institutions Rs. 500 million
The debentures of ABC Limited are redeemable after three years and are quoting at Rs.981.05
per debenture. The applicable income tax rate for the company is 35%.
The current Market Price per Equity Share is Rs. 60. The prevailing default risk free interest
rate on 10 year GOI Treasury Bonds is 5.5%. The avarage market risk premium is 8%. The beta
of the company is 1.1875.
The Preferred Stock of the Company is redeemable after 5 years and is currently selling at
Rs.98.15 per Preference Share.
1. Calculate the weighted cost of capital of the company using market value weights.
2. Define the marginal cost of capital schdule for the firm if it raises Rs. 750 million for a
new project. The firm plans to have a target debt to value ratio of 20%. The beta of the
new project is 1.4375. The debt capital will be raised through term loans. It will carry an
interest rate of 9.5% for the first Rs.100 million and 10% for the next Rs.50 million.
Solution :
1.Ke (Cost of Equity Capital) = Risk Free Rate + Risk Premium
= Risk Free Rate + (Average Market Risk Premium×Beta)
= 5.5% + (8% × 1.1875) = 5.5%+ 9.5% = 15.00%
2.Kp(Cost of Preference Share Capital)is computed using two alternative approaches as
under -
(a) Irredeemable Preference Capital:
Kp=Preference Dividend÷Market value of Preference Share Capital=10.5÷98.15=10.70% .
(b) Redeemable Preference Capital :
1 2 3 4 1 5
10 5
1
10 5
1
10 5
1
10 5
1
10 5
98 5
( YTM)
.
( YTM)
.
( YTM)
.
( YTM)
.
( YTM)
.
. %
+
+
+
+
+
+
+
+
+
=
Where YTM = Yield to Maturity. On solving, we get YTM=11% (approximately).
So, Kp = 11%.
3.Kd (Cost of Debentures) is computed using two alternative approaches as under -
(a) Irredeemable Debt (Check)
Kd (for Debentures) MarketValueof Debt
= [Interest × (100%−Tax rate)]
. %
.
, . % ( % %)
6 29
1471 575
1 500 9 5 100 35 = × × − =
(b) Redeemable Debt :
1 2 1 3
95
1
95
1
95
981 05
( YTM) ( YTM) ( YTM)
. %
+
+
+
+
+
=
Where YTM = Yield to Maturity. On solving,we get YTM = 10%(approximately).
So,Kd= YTM × (100% - TAX Rate) = 10%× 65% = 6.5%.
4. Kd (Cost of Term Loans) is computed as under —
Kd (for Term Loans) Market Value Debt
= [Interest ×(100 − Tax rate]
. %
. % ( % %)
= × × − = 5 525
500
1500 8 5 100 35
5. (a) Computation of Individual Cost of Capital and WACC
Type of Capital Market Value in Rs. millions Ratio Indl. Cost WACC
Equity Share Capital 150×60 = 9000.000 81.30% 15.00% 12.20%
Reserver & Surplus Included in Market Value of Equity Share Capital, hence note applicable
10.5% Preference 1×98.15 = 98.150 0.89% 10.70% 0.09%
Share Capital
9.5% Debentures 1.5×981.05 = 1471.575 13.30% 6.29% 0.84%
15% Term Loan from Given 500.000 4.51% 5.53% 0.25%
Total 11069.725 100% 13.38%
5. (b) Computation of Individual Cost of Capital and WACC (using YTM calculations)
Type of Capital Market Value in Rs. millions Ratio Indl. Cost WACC
Equity Share Capital 150×60 = 9000.000 81.30% 15.00% 12.20%
Reserver & Surplus Included in Market Value of Equity Share Capital, hence note applicable
10.5% Preference 1×98.15 = 98.150 0.89% 10.00% 0.09%
Share Capital
9.5% Debentures 1.5×981.05 = 1471.575 13.30% 6.50% 0.86%
15% Term Loan from Given 500.000 4.51% 5.53% 0.25%
Total 11069.725 100% 13.40%
6. Marginal WACC : Total Amount to be raised = Rs.750 million, of which debt should be 20%
i.e. Rs.150 millions and equity 80%, being Rs.600 millions. Since cost of debt changes after
Rs.100 millions, the Marginal WACC is computed in the following segments -
Particulars Debt Equity Individual Cost Marginal WACC
First Rs. 500 100 400 Kd = 9.5%×(100%–35%) = 6.175% K0 = (6.175%×20%) +
millions millions millions Ke = 5.5%×(8%–1.4375) = 17% (17%×80%) = 12.365%
First Rs. 250 50 200 Kd = 10%×(100%–35%) = 6.5% K0 = (6.5%×20%) +
millions millions millions Ke = 5.5%×(8%–1.4375) = 17% (17%×80%) = 14.9%
Illustration 20 : Computation of WACC
JKL Ltd has the following book - value capital structure as on 31st March -
Equity Share Capital (2,00,000 Shares) Rs. 40,00,000
11.5% Preference Shares Rs. 10,00,000
10% Debentures Rs. 30,00,000
Total Rs. 80,00,000
The Equity Shares of the Company sell for Rs.20. It is expected that the Company will pay a
dividend of Rs.2 per share next year, this dividend is expected to grow at 5% p.a. forever.
Assume 35% corporate tax rate.
1. Compute the Company’s WACC based on the existing Capital Structure.
2. Compute the new WACC if the Company raises an additional Rs.20 Lakhs debt by issuing
12% debentures. This would result in increasing the expected Equity dividend to Rs. 2.40
and leave the growth rate unchanged, but the price of equity share will fall to Rs.16 per
share.
3. Comment on the use of weights in the computation of WACC.
Solution :
1. Ke g
Market Price per Share
Dividend per Share
+ %
Rs. .
Rs. .
5
20 00
2 00
= + = 10% + 5% = 15%.
2. Kd Net Proceeds of Issue 30,000,000 6.50%
3. Kp Preference Dividend Rs. 1,15,000 11.50%
Net Proceeds of Issue Rs. 10,00,000
4. Computation of WACC under present capital structure:
Particulars Amount % Individual Cost WACC
Debt 30,00,000 37.50% Kd = 6.50% 2.544%
Preference Capital 10,00,000 12.50% Kp = 11.50% 1.44%
Equity Capital 40,00,000 50.00% Ke = 15.00% 7.50%
Total 80,00,000 100% WACC = K0 = 11.38%
5. Computation of WACC under present capital structure:
Component Amount % Individual Cost WACC
Present Debt 30,00,000 30% Kd = 6.50% 1.95%
New Debt at 12% 20,00,000 20% Kd = 7.80% 1.56%
Preference Capital 10,00,000 10% Kp = 11.50% 1.15%
Equity Capital 40,00,000 40% Ke = 20.00% 8.00%
Total 1,00,00,000 100% WACC = K0 = 12.66%
Revised Ke = g
Market Price per Share
Dividend per Share
+ %
Rs. .
Rs. .
5
16 00
2 40 = + = 15% = 15%+5% = 20.00%.
6.Use of Weights: Market Value weights may be preferred to Book Value weights since they
represent the Company’s true corporate facet. In the evalution of a Company’s performance,
Cash Flows are preferred to more Book Profits; also Market Value Balance Sheet is analysed in
depth rather than the Book Value Balance Sheet.
Illustration 21 : Computation of Cost of Equity using Beta
You are analysing the beta for ABC Computers Ltd. and have dividend the Company into four
broad business groups, with market values and betas for each group.
Fianancial Management & international finance 97
Business Group Market value of Equity Unleveraged beta
Main frames Rs.100 billion 1.10
Personal Computers Rs.100 billion 1.50
Software Rs.50 billion 2.00
Printers Rs.150 billion 1.00
ABC Computers Ltd. had Rs.50 billion in debt outstanding.
Required :
1. Estimate the beta for ABC Computers Ltd. as a Company. Is this beta going to be equal to
the beta estimated by regressing past returns on ABC Computers stock against a market
index. Why or Why not?
2. If the treasury bond rate is 7.5% estimate the cost of equity of ABC Computers Ltd. Estimate
the cost of equity for each division. Which cost of equity would you use to value the printer
division? The average market risk premium is 8.5%.
Solution :
1. Computation of Company Bets:
Group Market value Proportion Unleveraged beta Product beta
Mainframe Rs. 100 billion 25% 1.10 0.275
Presonal Computer Rs. 100 billion 25% 1.50 0.375
Software Rs. 50 billion 12.5% 2.00 0.250
Printers Rs. 150 billion 37.5% 1.00 0.375
Total Rs. 400 billion 100% Unleveraged beta of portfolio 1.275
Note : Beta measures the volatility of ABC Computers’ stock returns against a broad-based
market portfolio. In the above case, the beta is calculated for four business groups in a computer
segment and not a broad-based market portfolio. Hence, beta calculations will not be the same,
as such.
Beta of the Leveraged Firm B(L) =Beta of Unleveraged FirmB(U)×[(Equity+ Debt)÷Equity]
= 1.275 × [(400 + 50) ÷ 400]
= 1.434
Market Index Relationship : This leveraged Beta of 1.434 will be equal to the Beta estimated
by regressing returns on ABC Computers stock against a market index. The reasoning is as
under-
1. The Beta of a security is a measure of return for the systematic risk of that security, relative
to the market i.e. its Systematic Risk.
2. A portfolio generally consists of a well - diversified set of securities.
3. The Systematic Risk cannot be diversified away, and hence, the Beta of a portfolio is the
value - weighted beta of the securities constituting the portfolio.
4. The Beta of a portfolio depicts the systematic Risk (i.e. Non-Diversifiable Risk) of the
portfolio itself.
3. Cost of Equity for ABC Computers = Return of Risk Free Securities +
(Market Risk premium × Beta)
= 7.50% + (8.50% × 1.434) = 19.69%
4. Cost of Equity for each Division
Division Cost of Equity for each Division =
Return of Risk Free Securities + (Market Risk premium × Beta)
Mainframe = 7.50% + (8.50% × 1.10) = 16.85%
Personal Computer = 7.50% + (8.50% × 1.50) = 20.25%
Software = 7.50% + (8.50% × 1.10) = 24.50%
Printers = 7.50% + (8.50% × 1.00) = 16.00%
For valuing Printer Division, Ke of 16% would be used.
Illustration 22 : Leverage and Beta Analysis
The following summarises the percentage changes in operating income, percentage changes in
revenues and the betas fo four pharmaceutical firms.
Firm Change in Revenue Change in Operating Income Beta
PQR Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WYZ Ltd. 21% 40% 1.40
Required :
1. Calculate the Degree of Operating Leverage for each of these firms.
2. Use the Operating Leverage to explain why these firms have different beta.
Firm Change in Change in Degree of Operating Leveratge Beta
Revenue Operating Income
(1) (2) (3) (4) = (3) + (2) (5)(given)
PQR Ltd. 27% 25% 0.926 1.00
RST Ltd. 25% 23% 1.28 1.15
TUV Ltd. 23% 36% 1.57 1.30
WXY Ltd. 21% 40% 1.905 1.40
Inference :
1. DOL of WXY Ltd. is the highest of all firms. High DOl reflects high operating risk, which
means WXY Ltd. has the maximum operating risk. Also PQR Ltd. is exposed to minimum
operating risk, when compared to other forms.
2. Beta is the measure of volatility of risk of a security against the market risk. Both Operating
Leverage and Beta reveals the measure of risk. Since the Operating Leverage is different
for each firm, the beta would also be different. Therefore, High DOL = High Risk = High
Beta.
Illustration 23 : Net Income Approach – Valuation of Firm
The following data arelates to four Firms—
Firm A B C D
EBIT in Rs. 2,00,000 3,00,000 5,00,000 6,00,000
Interst in Rs. 20,000 60,000 2,00,000 2,40,000
Equity Capitalization Rate 12% 16% 15% 18%
Assuming that there are no taxes and rate of debt is 10%, determine the value of each firm
using the Net Income approach. Also determine the Overall Cost of Capital of each firm.
Solution :
Firm A B C D
EBIT 2,00,000 3,00,000 5,00,000 6,00,000
Less : Interest 20,000 60,000 2,00,000 2,40,000
EBT = Net Income 1,80,000 2,40,000 3,00,000 3,60,000
Ke (given) 12% 16% 15% 18%
Value of Equity (E)=Net Income ÷Ke 15,00,000 15,00,000 20,00,000 20,00,000
Value of Debt (D)=Interest ÷ Kd of 10% 2,00,000 6,00,000 20,00,000 24,00,000
Value of Firm (V) = (E+D) 17,00,000 21,00,000 40,00,000 44,00,000
K0 = WACC = EBIT÷V 11.76% 14.29% 12.5% 13.64%
Under NI Approach, increase in Debt content implies leads to increase in value of Firm &
decrease in WACC.
Illustration 24 : NOI & M&M Approach
ABC Ltd adopts constant WACC approach and believes that its cost of debt and overall cost of
capital is at 9% and 12% respectively. If the ratio of the market value of debt to the market
value of equity is 0.8, what rate of return do Equity Shareholders earn? Assume that there are
no taxes.
Solution:
Constant WACC implies the use of NOI or M&M Approach. Under M&M Approach,
Ke = Ko+Risk Premium.
So, Ke = K0 + (K0 + Kd) Equity
Debt
On substitution, we have, Ke = 12%+(12%-9%)×80% = 14.4%
Alternatively, Ke can be obtained as balancing figure as under --
(Note : Debt : Equity = 0.8 = 4 : 5)
Component % Individual Cost in % WACC %
Debt 4/9th Kd = 9.00% 9.00% × 4/9th = 4.00%
Equity 5/9th Ke = 8.00 ÷ 5/9th = 14.00% 12% – 4% = 8.00%
(final balancing figure) (balance figure)
Illustration 25 : Traditional Theory - Optium Cost of Capital
TT Ltd has a PBIT of Rs.3 Lakhs. Presently the company is financed by equity capital of
Rs. 20 Lakhs with Equity Capitalization Rate of 16%. It is contemplating to redeem a part of its
Capital by introducing Debt Financing. It has two options—to raise debt to the tune of 30% or
50% of the total funds.
It is expected that for debt financing upto 30% will cost 10% Equity Capitalization Rate will
rise to 17%. However, if the Firm opts for 50% debt, it will cost 12% and Equity Shareholders
expectation will be 20%.
From the above, compute the Overall Cost of Capital of the different options and comment
thereon.
Solution :
Plan 0% Debt 30% Debt 50% Debt
Debt Nil Rs. 6,00,000 Rs. 10,00,000
Equity Capital (bal. figure) Rs. 20,00,000 Rs. 14,00,000 Rs. 10,00,000
Total Assets Rs. 20,00,000 Rs. 20,00,000 Rs. 20,00,000
EBIT Rs. 3,00,000 Rs. 3,00,000 Rs. 3,00,000
Less : Interest — Rs. 60,000 Rs. 1,20,000
PBT Rs. 3,00,000 Rs. 2,40,000 Rs. 1,80,000
Ke 16% 17% 20%
Value of Equity (E) = EBT ÷ Ke Rs. 18,75,000 Rs. 14,12,000 Rs. 9,00,00
Add : Value of Debt (D) — Rs. 6,00,000 Rs. 10,00,000
Value of Firm = V = (E+D) Rs. 18,75,000 Rs. 20,12,000 Rs. 19,00,000
WACC = Ke = EBIT+V 16.00% 14.91% 15.78%
Inference : Traditional Theory lays down that as debt content increases, rate of interest on debt
increases & Equity Shareholders expectations also arise. Hence Value of Firm & WACC will be
affected. By suitably altering Debt content the firm should achive maximum Firm Value &
minimum WACC.
Illustration 26 : M&M Approach - Value of Levered & Unlevered Firm - Computing WACC
Companies Uma and Lata are identical in every respect except that the former does not use
debt in its capital structure, while the latter employs Rs.6 Lakh of 15% Debt. Assuming that, (a)
all the M&M assumptions are met, (b) the corporate tax rate is 35%, (c) the EBIT is Rs.2,00,000
and (d) the equity capitalization of the unlevered Company is 20%. What will be the value of
the firms - Uma and Lata? Also, determine the weighted Average Cost of Capital for both the
firms.
Fianancial Management & international finance 101
Solution :
CostofEquityKe
[PBIT( % TaxRate)]
ValueofUnleveredFirm ValueofEquityonly
−
= = 100
%
, , %
20
2 00 000× 65
= Rs. 6,50,000
Value of Levered Firm = Value of Unlevered Firm + (Value of Debt × Tax Rate)
= Rs.6,50,000 + (Rs.6,00,000×35%) = Rs.8,60,000.
Particulars (Unlevered) (Levered)
Uma Lata
EBIT 2,00,000 2,00,000
Less : Interest on Debt (Rs. 6,00,000×15%) — 90,000
EBIT 2,00,000 1,10,000
Less : Tax at 35% 70,000 38,500
EAT 1,30,000 71,500
Value of Firm (V) (as computed above) 6,50,000 8,60,000
Less : Value of Debt (D) Nil 6,00,000
Value of Equity (E) = (V) – (D) 6,50,000 2,60,000
Cost of Equity = EAT ÷ Value of Equity 20% 27.5%
Cost of Debt Nil 15%×65% = 9.75%
WACC =
V
E
K
V
D
Kd e × + × 20% 9.75%×(60/86)=6.80%
+ 27.5%×(26/86)=8.31%
WACC = 15.11%
Illustration 27 : Traditional and M&M Approach
A Company estimates its Cost of Debt and Cost of Equity for different debt - equity mix, as
under.
% of Debt 0% 20% 40% 60% 80% 90%
Cost of Debt — 10% 10% 12% 14% 16%
Cost of Equity 18% 19% 21% 25% 32% 40%
1. Compute the Overall Cost of Capital and Optimal Debt - Equity Mix under the Traditional
Theory.
2. Consider the Cost of Debt at different debt - equity mix as given above. If M&M Approach
were to hold good, what will be the cost of Equity Capital at different debt - equity mix?
What will be the Risk Premium?
Solution : 1. Computation of Ko at different Debt - Equity Mix (Traditional Theory)
Situation % of Debt and Kd % of Equity and Ke WACC i.e. K0
I 0% Nil 100% 18% (0×NIl) + (100% × 18%) = 18.0%
II 20% 10% 80% 19% (20%×10%) + (80% × 19%) = 17.2%
III 40% 10% 60% 21% (40%×10%) + (60% × 21%) = 16.6%
IV 60% 12% 40% 25% (60×12%) + (40% × 25%) = 17.2%
V 80% 14% 20% 32% (80%×14%) + (20% × 32%) = 17.6%
VI 90% 16% 10% 40% (90×16%) + (10% × 40%) = 18.4%
From the above, the optimal debt equity mix is 40% Debt and 60% Equity, relating to least
WACC of 16.6%.
2. Computation of Cost of Equity under M&M Approach
Under M&M approach, WACC = Ke at 0% Debt: Since WACC is constant, WACC at 0% Debt
(i.e. 100% Equity) should be the same as WACC at any other percentage of debt. Hence WACC
= Ke when the Firm is financed purely by Equity. So, WACC of a Firm equals the Capitalization
Rate of pure equity stream of its class of risk. In the above case,WACC = Ke at 0% Debt = 18%.
So, Ke = K0 + (K0 + Kd) Equity
Debt
Situation Debt : Equity K0 (Constant) Kd Ke=Ko+(K0–Kd)×D/E Risk Premium =
Ke–K0
I Nil 18% Nil 18%+(18%–0%)×0 = 18.00% Nil
II 20 : 80 18% 10% 18%+(18%–10%)×2/8=20.00% 2.00
III 40 : 60 18% 10% 18%+(18%–10%)×2/8=20.00% 5.33%
IV 60 : 40 18% 12% 18%+(18%–10%)×4/6=27.00% 9.00%
V 80 : 20 18% 14% 18%+(18%–14%)×8/28=34.00% 16.00%
VI 90 : 10 18% 16% 18%+(18%–16%)×9/1=36.00% 18.00%
Illustration 28 : Rights Share Valuation
Pioneer Ltd. has issued 15,000 Equity Shares of Rs.10 each. The current Market Price per Share
is Rs.37. The Company has a plan to make a rights issue of one new equity share at a price of
Rs.25 for every five shares held. You are required to -
1. Calculate the Theoretical Post-Rights Price per Share.
2. Calculate the Theoretical Value of the Rights alone.
3. Show the effect of the rights issue on the wealth of a shareholders who has 1,000 shares
assuming he sells the entire rights;and
4. Show the effect if the same Shareholders does not take any action ignores the issue.
Fianancial Management & international finance 103
Solution :
1. Theoretical Post Rights Price per share
TotalNumberof Shares
(OldNumberof Shares×OldMarketPr ice) + (RightShares×NewPr ice)
=
=[(5×Rs.37)+(1×Rs.25)]÷(5+1) = Rs.210 ÷ 6 = Rs.35.
2.Theoretical Value of Rights=Post Rights Price per Share - Cost of Rights Share= 35-25=Rs.10.
3.Value of Shares :
Before Rights Issue After Rights Issue
1,000 Shares at Rs. 37 Rs. 37,000 1,000 Shares at Rs 35 Rs. 35,000
Sales of Rights Nil Sale of Rights 1,000/5×Rs. 10 Rs. 2,000
Total Rs. 37,000 Total Rs. 37,000
If the Shareholders ignores the issue, there is a loss due to dimunition in value to the extent of
Rs.2,000.
Illustration 29 : EBIT-EPS Indifference Point
Calculate the level of EBIT at which the EPS indifference point between the following financing
alternatives will occur-
1. Equity share Capital of Rs.6,00,000 and 12% Debentures Rs.4,00,000 [or]
2. Equity Share Capital of Rs.4,00,000, 14% Preference Share Capital of Rs.2,00,000 and 12%
Debentures of Rs.4,00,000.
Assume that Corporate Tax rate is 35% and par value of Equity Share is Rs.10 in each case.
Solution : Let the PBIT at the indifference point level be Rs.X
Particulars Alternative 1 Alternative 2
EBIT X X
Less : Interest 48,000 48,000
EBIT X–48,000 X–48,000
Less : Tax at 35% 0.35X—16,800 0.35X—16,800
EAT 0.65X—31,200 0.65X—31,200
Less : Preference Dividend Nil 28,000
Residual Earnings available 0.65X—31,200 0.65X—59,200
Number of Equity Shares 60,000 40,000
Earnings per Share (EPS) 60 000
0 65 31 200
,
. X − ,
40 000
0 65 59 200
,
. X − ,
For indifference between the above alternatives,EPS should be equal.
40 000
0 65 59 200
60 000
0 65 31 200
,
. X ,
,
. X ,
Hence,we have
− = −
On Cross Multiplication, 1.30X - 62,400 = 1.95X - 1,77,600.
0.65X = 1,15,200 or X = PBIT = Rs. 1,77,231.
Illustration 30 : Financial BEP, EBIT EPS Indifference Point and Interpretation
ABC Ltd. wants to raise Rs.5,00,000 as additional capital. It has two mutually exclusive
alternative financial plans. The current EBIT is Rs.17,00,000 which is likely to remain unchanged.
The relevant Information is -
Present Capital Structure: 3,00,000 Equity shares of Rs.10 each and 10% Bonds
of Rs.20,00,000
Tax Rate: 50%
Current EBIT: Rs.17,00,000
Current EPS: Rs.2.50
Current Market Price: Rs.25 per share
Financial Plan I: 20,000 Equity Shares at Rs.25 per share.
Financial Plan II: 12% Debentures of Rs.5,00,000.
What is the indifference level of EBIT? Identify the financial break-even levels and plot the
EBIT-EPS lines on graph paper. Which alternative financial plan is better?
Solution :
1. Computation of EBIT - EPS Indifference Point
Particulars Financial Plan I Financial Plan II
Owner’s Funds (3,00,000×10+20,000×25)= 3,00,000×10=Rs.30,00,000
Rs.35,00,000
Borrowed Funds (given) Rs.20,00,000 20,00,000+5,00,000=Rs.25,00,000
Total Capital Employed Rs.55,00,000 Rs.55,00,000
Particulars Financial Plan I Financial Plan II
EBIT (let it be Rs. X X X
Less: Interest 20,00,000×10%=Rs.2,00,000 (20,00,000×10%+5,00,000×12%)=
Rs. 2,60,000
EBT X—2,00,000 X—2,60,000
Less: Tax at 50% ½X–1,00,000 ½X–1,30,000
EAT ½X–1,00,000 ½X–1,30,000
Number of Equity Shares 3,00,000+20,000=3,20,000 (given) 3,00,000
EPS [½X–1,00,000]÷3,20,000 [½X–1,30,000]÷3,00,000
For indifference between the above alternatives, EPS should be equal.
Hence, we have 3 20 000
1 00 000
, ,
[½X − , , ]
= 3 00 000
1 30 000
, ,
[½X − , , ]
On Cross Multiplication, 15X - 30 Lakhs = 16X - 41.6 Lakhs; or X = 11.6 Lakhs
Fianancial Management & international finance 105
Hence EBIT should be Rs.11.60 Lakhs and at that level, EPS will be Rs.1.50 under both
alternatives.
2.Computation of Financial Break-Even Point
The Financial BEP for the two plans are --
Plan I EBIT = Rs.2,00,000(i.e. 10% interest on Rs.20,00,000)
Plan II EBIT = Rs.2,60,000(i.e. 10% interest on Rs.20,00,000 and 12% interest on Rs.5,00,000)
3.Graphical Depiction of Indifference Point and Financial BEP
2.00
2.00
1.50
1.00
0.50
0
Plan II
Plan II BEP
Plan I BEP
Plan I
Indifference Point of EPS
4.00 6.00 8.00 10.00 12.00
EBIT (in Rs. Lakhs)
4. Interpretation of Graph:
(a) The horizontal intercepts identify the Financial Break Even levels of EBIT for each plan.
(b) The point at which EPS lines of both plans interest is called Indifference Point. Its
horizontal intercept gives the level of EBIT at that point. The vertical intercept gives the
value of EPS at that point.
(c) Below the indifference point, one plan will have EPS over the other. Above that point,
automatically the other plan will have higher EPS over the former. This is interpreted as
under--
Interpretation of the Indifference Point
Situation Option Reason
EBIT below
Idifference Point
When rate of earnings and operating profits
(EBIT) are low, more interest and debt burden
is not advisable. A high DOL should be
properly managed by low Financial Leverage.
EBIT equal
Idifference Point
Any alternative can be
chosen.
Same EPS due to indifference point.
EBIT above
Idifference Point
Option with higher
debt (Interest Burden)
When EBIT is high, financial leverage works
abourable the EPS is maximised. Low DOL
should be coupled with high DFL, to maximize
gain go Equity Shareholders.
Option with lower debt
(Interest Burden)
Conclusion : In the given case Indifference Point of EBIT = Rs.11.60 Lakhs but the current EBIT
is Rs.17 lakhs. The new EBIT after employing additional capital of Rs.5 Lakhs will be (17/
50×55)=Rs.18.70 Lakhs. Since this is above the indifference point of Rs. 11.60 Lakhs, the option
with the higher debt burden should chosen. Hence, the firm should prefer Plan II for financing.
Note : As an exercise, students may recalculate the EPS for both plans with EBIT of Rs.18.70
Lakhs, EPS will be Rs.2.61 and Rs.2.68 respectively. Hence Plan II is better on account of higher
EPS.
Illustration 31 : EVA using Cost of Capital
Consider a firm that has existing assets in which it has capital invested of Rs.100 Crores. The
after tax operating Income on assets-in-place is Rs.15 Crore. The return on capital of 15% is
expected to be sustained it perpetuity, and Company has a Cost of Capital of 10%. Estimate
the present value of Economic Values Added (EVA) to the firm from its assets - in - Place.
Solution :
Operating Profit after Tax = Rs.15 Crores
Less: Capital Employed×WACC = 100×10% = Rs.10 Crores
Economic Value Added(EVA) = Rs.5 Crores
Since this EVA is sustained till perpetuity,
Present value of EVA = EVA ÷ Cost of Capital=Rs.15 Crores÷10%=Rs.150 Crores.
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