Question

Cummins India Ltd has the following capital structure, which it considers optimal:

Debt 25%

Preference Shares 10%

Equity shares 65%

Total 100%

Applicable tax rate for the company is 25%. Risk free rate of return is 6%, average equity market investment has expected rate of return of 12%. The company’s beta is 1.10. Following terms would apply to new securities being issued as follows:

1. New preference can be issued at a face value of Rs. 100 per share, dividend and cost of issuance will be Rs. 10 per share and Rs. 2 per share respectively.

2. Debt will bear an interest rate of 9%

Answer 1

a. Component cost of debt is:

$Rd = 0.09×(1 - 0.25) = 0.0675.$

Cost of preference shares is:

$Rp = (10 + 2)/100 = 0.12.$

Cost of equity is:

$Re = 0.06 + 1.1×(0.12 - 0.06) = 0.126.$

b. $WACC = 0.0675×0.25 + 0.12×0.1 + 0.126×0.65 = 0.1108.$