Question

Aries Limited wishes to raise additional Finance of Rs.100 lakhs. The additional capital will be used for starting of a new project. For the need for meetings Investment plan, it has 21 lakhs in the form of retained earnings is available for the investment purpose. The debt-equity mix is 30: 70 ratios the cost of debt up to 18 lacs is 10% before tax and beyond 18 lacks the cost of that the 16%. The Earning per share is Rs. 4:00 the dividend payout ratio is 50% of earnings. The expected growth rate in dividend is 10% the current market price per share is Rs.44.

The tax rate applicable is 33% p.a.

You are required to determine

A.    The pattern for raising the additional Finance.

B.     To determine the post-tax advantage, cost of additional debt

C.    To determine the cost of retained earnings and cost of equity

D.    And compute the overall Waited average cost of capital.

Answer 1

Part (A)

Total debt to be raised = Capital required x D / (D + E) = 100 x 30% / (30% + 70%) = 30 of which Rs. 18 lakhs will be debt @ 10% and balance 30 - 18 = Rs. 12 Lakhs will be debt @ 16%

Total equity to be raised = Capital required - debt raised = 100 - 30 = 70 of which 21 will come from retained earnings and ablance 70 - 21 = 49 will be fresh equity raised.

Hence, the pattern should be:

Source	Rs. Lakhs
Debt
10% Debt (D1)	18
16% Debt (D2)	12
Total Debt (D = D1 + D2)	30
Equity
Retained Earnings (E1)	21
Fresh Equity (E2)	49
Total Equity (E = E 1 + E2)	70

Part (B)

Wd1 = D1 / D = 18/30 = 0.6

Wd2 = D2/D = 12/30 = 0.4

Hence, average pre tax cost of debt = Wd1 x Kd1 + Wd2 x Kd2 = 0.6 x 10% + 0.4 x 16% = 12.40%

Hence, the post-tax advantage, cost of additional debt, Kd = Average pre tax cost x (1 - T) = 12.40% x (1 - 33%) = 8.31%

Part (C)

Cost of retained earnings, Kr = D0 x (1 + g) / P0 + g = 4 x 50% x (1 + 10%) / 44 + 10% = 15.00%

Since there is no flotation cost, hence cost of equity, Ke = Kr = 15.00%

Part (D)

Weighted average cost of capital = Wd x Kd + We x Ke = 30% x 8.31% + 70% x 15% = 12.99%