Mahakali Agro Company was recently formed to manufacture a new product. The company has the following capital structure : : 9% Debentures Rs. 6 million 10% Preferred Stock 2 million Common Stock 8…

Solution to Question on Cost of Capital (MGT215, TU Board 2082)

1. Cost of Debt After Tax (2 marks)

The cost of debt is the interest rate paid on debentures, adjusted for taxes. The formula is:

$$\text{Cost of Debt (after tax)}=\text{Interest Rate}\times (1-\text{Tax Rate})$$

Given:

• Debenture interest rate (k_d) = 9% = 0.09
• Tax rate (T) = 40% = 0.40

$$\text{Cost of Debt (after tax)}=9\%\times (1-0.40)=9\%\times 0.60=5.4\%$$

Final Answer: The cost of debt after tax is 5.4%.

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2. Cost of Preferred Stock (2 marks)

The cost of preferred stock is calculated using the formula:

\text{Cost of Preferred Stock (k_p)} = \frac{\text{Annual Dividend}}{\text{Market Price per Share}}

Given:

• Preferred stock dividend rate = 10% of face value (Rs. 100 per share)
• Market price per share = Rs. 100 (assuming face value = market value unless stated otherwise)
• Total preferred stock = Rs. 2 million

$$\text{Annual dividend per share}=10\%\times 100=\text{Rs. 10}$$

$$k_p=\frac{10}{100}=10\%$$

Final Answer: The cost of preferred stock is 10%.

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3. Cost of Common Equity (3 marks)

The cost of common equity can be calculated using the Dividend Discount Model (DDM) since dividends are expected to grow at a constant rate forever. The formula is:

$$k_e=\frac{D_1}{P_0}+g$$

Where:

• $D_1$ = Expected dividend next year
• $P_0$ = Current market price per share
• $g$ = Constant growth rate

Given:

• Current dividend (D₀) = Rs. 15
• Growth rate (g) = 8% = 0.08
• Market price (P₀) = Rs. 300

$$D_1=D_0\times (1+g)=15\times 1.08=\text{Rs. 16.2}$$

$$k_e=\frac{16.2}{300}+0.08=0.054+0.08=13.4\%$$

Final Answer: The cost of common equity is 13.4%.

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4. Weighted Average Cost of Capital (WACC) (3 marks)

WACC is calculated using the formula:

$$\text{WACC}=\left(\frac{E}{V}\times k_e\right)+\left(\frac{D}{V}\times k_d\right)+\left(\frac{P}{V}\times k_p\right)$$

Where:

• $E$ = Market value of equity
• $D$ = Market value of debt
• $P$ = Market value of preferred stock
• $V=E+D+P$ = Total capital
• $k_e,k_d,k_p$ = Costs of equity, debt, and preferred stock

Given:

• Debt (D) = Rs. 6 million
• Preferred Stock (P) = Rs. 2 million
• Common Stock (E) = Rs. 8 million (market value = number of shares × price per share)

Assuming 8 million is the market value (not book value), we proceed:

$$V=6+2+8=\text{Rs. 16 million}$$

$$\text{Weights:}$$

• Weight of debt = $\frac{6}{16}=0.375$
• Weight of preferred stock = $\frac{2}{16}=0.125$
• Weight of equity = $\frac{8}{16}=0.5$

$$\text{WACC}=(0.5\times 13.4\%)+(0.375\times 5.4\%)+(0.125\times 10\%)$$

$$=(6.7\%)+(2.025\%)+(1.25\%)=9.975\%$$

Final Answer: The Weighted Average Cost of Capital (WACC) is 9.98%.

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Summary of Costs