In: Accounting
Queen limited has an investment proposal which is expected to yield a return of 12%. The CEO is contemplating whether to go ahead with the proposal or not. Following is the capital structure of the firm as per book value weights. Equity capital - 1.5 crore shares of Rs. 10 each 12% preference capital, 1 lakh shares of Rs. 100 each, 11% term loan of Rs. 12.5 crore, 11.5% debentures - 10 lakh debentures of Rs. 100 each and retained earnings of Rs. 20 crore. The company is expected to declare equity dividend at the rate of 36% next year. The company is growing at the rate of 7% pa and is currently quoted at Rs. 40 per share. Debentures were issued 4 years ago for a tenure of 10 years and are currently trading at a rate of Rs. 80. Preference shares redeemable in next 10 years are trading at Rs. 75 per share. The income tax rate is 30%.
Advise the CEO if the investment proposal should be undertaken.
First, we will calculate the cost of each capital.
1. Cost of Debt(Kd) = [I(1-T) + (RV-NP)/n] / [(RV+NP)/2]
=[11.5(1-0.30) + (100-80)/6] / [(100+80)/2]
=(8.05 + 3.33)/90
= 0.1264 or 12.64%
2. Cost of term loan(Kt)
= I(1 - T)
= 11(1 - 0.30)
= 7.7%
3. Cost of Preference Shares(Kp)
= [PD + (RV - NP)/n] / [(RV+NP)/2]
=[12 + (100 - 75)/2] / (100+75)/2]
=24.5/87.5
=0.28 or 28%
4. Cost of equity(Ke)
= (D1/P0) + G
= (3.6/40) + 0.07
= 0.16 or 16%
Calculation of Weighted Average Cost of Capital
Source of Capital | Capital Structure | Weight | After-Tax Cost | WACC(%) |
Equity Shares | 15,00,00,000 | 0.26 | 16 | 4.16 |
Retained Earnings | 20,00,00,000 | 0.34 | 16 | 5.44 |
Term Loan | 12,50,00,000 | 0.21 | 7.7 | 1.617 |
Debentures | 10,00,00,000 | 0.17 | 12.64 | 2.149 |
Preference Shares | 1,00,00,000 | 0.02 | 28 | 0.56 |
58,50,00,000 | 1.00 | 13.926 |
This investment proposal should not be taken as cost of capital(i.e. 13.926%) is more than return(i.e. 12%).