Question

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.

Answer 1

First, we will calculate the cost of each capital.

1. Cost of Debt(K_d) = [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(K_t)

= I(1 - T)

= 11(1 - 0.30)

= 7.7%

3. Cost of Preference Shares(K_p)

= [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(K_e)

= (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%).