Answer to Question #197495 in Finance for Kajal

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%.

Calculate

a. component cost of debt, preference shares and equity shares assuming that the company

does not issue any additional equity shares.

 

b. WACC.

Answer 1

a. Component cost of debt is:

$0.1×(1 - 0.25) = 0.075$ or 7.5%.

Cost of preference shares is:

$12/100 = 0.12$ or 12%.

and cost of equity shares is:

$Ke = 0.06 + 1.5×(0.15 - 0.06) = 0.195$ or 11.25%.

b. $WACC = 0.195×0.6 + 0.075×0.25 + 0.12×0.15 = 0.1538.$