Answer to Question #188517 in Finance for Sanskriti

Question #188517

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%


A) component cost of debt, preference shares and equity shares assuming that the company does not issue any additional equity shares. 


Expert's answer

a) Cost of Debt is given to be 10%

By issuing Preference shares, CP India Ltd can raise a net amount of Rs.100 -Rs.4 = Rs.96 and pay a dividend of Rs.8 annually

So, cost of preference shares to the company = Rs,8/Rs,96 = 0.0833 or 8.33%

Cost of equity (from CAPM) =risk free rate + beta × (Average equity return - risk free rate)

= 6%+1.10×(15%-6%)


b) WACC = weight of debt× cost of debt× (1-tax rate) + Weight of preference shares × cost of preference shares + weight of equity × cost of equity


=0.1443 or 14.43%

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