Page 114 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Illustration 23: (Instalment repayment): Hari Ram & Co. issued 14 per cent debentures aggregate Notes
at 2,00,000. The face value of debenture is 100. Issue cost is 5 per cent. The company has agreed
to repay the debenture in 5 equal instalment at par value. Instalment starts at the end of the year.
The company’s tax rate is 35 per cent. Compute cost of debenture.
Solution:
Sales proceeds = Face value – Flotation cost = 100 – 5 = 95
Instalment amount = Face value No. of installments = 100 ÷ 5 = 20.

Cash Outflow ( ) DF Factor PV of Cash Outflows ( )
Years
(NI + Instalment) 8% 13% 8% 13%
1 9.1 + 20 = 29.1 0.926 0.885 26.947 25.754
2 7.28 + 20 = 27.28 0.857 0.783 23.379 21.361
3 5.46 + 20 = 25.46 0.794 0.693 20.216 17.644
4 3.64 + 20 = 23.64 0.735 0.613 17.376 14.492
5 1.82 + 20 = 21.82 0.681 0.543 14.860 11.849
PV of cash out flows 102.778 91.230
PV of cash inflows 95.000 95.000
(+) 7.778 (-)3.770

 102.778 – 95 
K = 8%+   13 – 8 × 
d  102.778 – 91.1 

 7.778 
= 8%+  5× 11.678  

= 8% + 3.33 = 11.33 per cent

Self Assessment

Fill in the blanks:

10. Cost of debenture is equal to the……………., when debenture is issued at par and without
considering tax.
11. Cost of preference share is the ……………that equates the present value of cash inflows
with the present value of cash outflows.
12. Retention of earnings involves an …………….cost.

5.5 Weighted Average Cost of Capital (WACC)

A company has to employ a combination of creditors and fund owners. The composite cost of
capital lies between the least and most expensive funds. This approach enables the maximisation
of profits and the wealth of the equity shareholders by investing the funds in projects earning in
excess of the overall cost of capital.
The composite cost of capital implies an average of the costs of each of the source of funds
employed by the firm property, weighted by the proportion they hold in the firm’s capital
structure.

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