Page 70 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

Solution: Notes

D
K = × 100
p NP
24
K = × 100 = 12 per cent
p 200
Illustration 11: (with dividend tax): A company is planning to issue 14 per cent irredeemable
preference share at the face value of ` 250 per share, with an estimated flotation cost of 5%. What

is the cost of preference share with 10% dividend tax.
Solution:
D (1 Dt+ )
K = × 100
p NP
35 (1 0.10 )
+
=
= × 100 16.21 per cent
237.5
Illustration 12: Sai Ram & Co. is planning to issue 14 per cent perpetual preference shares, with
face value of ` 100 each. Floatation costs are estimated at 4 per cent on sales price. Compute
(a) cost of preference shares if they are issued at (i) face/par value, (ii) 10 per cent premium, and
(iii) 5 per cent discount, (b) compute cost of preference share in these situation assuming 5 per
cent dividend.

Solution:
Without dividend tax With dividend tax
(i) Issued at face value (i) Issued at face value
14 14 (1 0.05+ )
K = = 14.6 per cent K = = 15.4 per cent
p
p
−
(100 4) 96
(ii) Issued at 10% premium (ii) Issued at 10% premium
14 14 (1 0.05+ )
K = = 13.2 per cent K = = 13.9 per cent
p
p
−
(110 4) 106
(iii) Issued at 5% discount (iii) Issued at 5% discount
14 14 (1 0.05+ )
K = = 15.4 per cent K = = 16.2 per cent
p
p
−−
(100 5 3.8) 91.2
Cost of Redeemable Preference Shares

Shares that are issued for a specific maturity period or redeemable after a specifi c period are
known as redeemable preference shares. The explicit cost of redeemable preference shares is the
discount rate that equates the net proceeds of the sale of preference shares with the present value
of the future dividend and principle repayments. In other words, cost of preference share is the
discount rate that equates the present value of cash inflows (sale proceeds) with the present value

of cash outflows (dividend + principal repayment). Dividends will be paid at the end of each
year, but the principle amount will be repaid either in lump sum at the end of maturity period or
in installments (equal or unequal). If the principle amount is paid in installments, then the cash

outflow for each year equals to dividend plus part of principal amount. Cost of preference shares,
when the principal amount is repaid in one lumpsum amount:
d
D + ( f + + pr − pi )/N
K = m
p (RV + NP )/2

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