Cost of Capital Financial and Strategic Management MCQ

After the date of maturity, the investment is redeemed at current NAV and the maturity proceeds are paid back to the investors. Short-term debt funds primarily invest in debt instruments with shorter maturity or duration. These primarily consist of debt and money market instruments and government securities.

The company is expected to declare a dividend of Rs. 10 at the end of the current year, with an expected growth rate of 10%. Equation 5.12 can be interpreted as that the cost of equity share capital ke is the present dividend yield plusthe growth rate, g. ABC Ltd. issues 15% Preference shares of the face value of ` 100 each at a flotation cost of 4%. Find out the cost of capital of preference share if the preference shares are irredeemable, and if the preference shares are redeemable after 10 years at a premium of 10%. The concept of cost of capital is an important and fundamental concept of theory of financial management.

Brent crude futures dropped 1.1% to $71.57 a barrel and US West Texas Intermediate crude fell 1.5% to $67.60. Both Brent and WTI have declined more than 10% since the start of the week. Investors are looking to see how the European Central Bank will respond after it announced it would raise rates for the seventh consecutive time. Simple interest differs from compound interest mainly in terms of charging interest on the accumulated funds that are done in compounding and are ignored in simple interest calculation. C) As interest on debenture and loans is an allowable deductible expenditure for arriving at taxable income, the real cost to the company will be interest charges less tax benefit . The higher the financial leverage, the higher is the probability of bankruptcy.

Rather, the market value of a firm is solely dependent on the operating profits of the company. It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.

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Find out the cost of equity capital given that the earnings are expected to remain same for coming years. However, there is one source of funds which does not involve any payment or flow i.e., the retained earnings of the firm. The profits earned by the firm but not distributed among the equity shareholders are ploughed back and reinvested within the firm. These profits gradually result in a substantial source of funds to the firm. Had these profits been distributed to equity shareholders, they could have invested these funds elsewhere and would have earned some return.

Therefore, the cost of capital of the firm is not same for different types of securities. The firm has to offer different returns to the investors depending upon the risk of the security. Importantly, both cost of debt and equity should be forward wanting, and mirror the expectations of danger and return in the future. This means, for instance, that the previous value of debt just isn’t a great indicator of the particular ahead trying cost of debt. Calculating the entire value of debt is a key variable for investors who’re evaluating an organization’s monetary health.

The merchant banker has suggested that an under pricing of Rupee 1 is necessary in pricing the new issue besides involving a cost of 50 paise per share on miscellaneous expenses. Find out the cost of existing equity shares as well as the new equity given that the dividend rate and growth rate are not expected to change. Hence, the price for debt is crucial because it offers an opportunity to a company to save its tax. Suppose a company named AIM Marketing has taken a loan for business expansion of $500,000 on the price of curiosity of eight%, tax fee relevant was 30%, here we’ve to calculate after-tax cost of debt. Once price of debt and cost of equity have been decided, their mix, the weighted average cost of capital , may be calculated.

Related Terms

If, however, you are the living on-the-edge type, then six months’ salary might suffice. Cost of capital helps to evaluate the financial performance of the firm. Capital structure is the mix or proportion of the different kinds of short-term securities. Capital budget decision largely depends on the cost of capital of each source. Students should practice Cost of Capital – CS Executive Financial and Strategic Management MCQ Questions with Answers based on the latest syllabus.

This is because including debt increases the default danger – and thus the rate of interest that the corporate should pay in order to borrow money. By using too much debt in its capital structure, this increased default threat can also drive up the costs for different sources as properly. So, the price of debt has a serious element tax price and curiosity expense. Once the price of debt is calculated then one can consider mortgage by evaluating business earnings that loan has generated and price of debt. This cost of debt offers curiosity expense which afterward helps in taxation that might be a tax deduction. The paper shows that a agency’s implied price-of-capital is a function of its industry membership, B/M ratio, forecasted long-term development rate, and the dispersion in analyst earnings forecasts.

Cost of Equity Share Capital

Roughly the amount that gives you the confidence to combat emergencies in your household should be enough. Those in their 20s and 30s might need more, so garner funds for about six months’ expenses, whereas those nearing retirement might not need much as they would have built up their reserves. The amount you save for an emergency depends ultimately on what makes you comfortable. It is given in the problem that the expected dividend per share in next year is 50% of the 2019 EPS.

In the event of pre-payment, a penalty and interest are charged from the borrower to avoid the loss of regular income considering the time value of money. Pieces of paper (sometimes referred to as “instruments”) that represent financial value. Issuing bonds and other kinds of debt instruments to finance agency activities in service to the public.

• In the present chapter, an attempt has been made towards the determination and measurement of this discount rate i.e., the cost of capital besides analyzing other related aspects.
• Fund Feature Suitability Liquid Funds Low duration funds, with portfolio maturity of less than 91 days.
• Ask a CFO or an academic in finance and you would get a different answer.
• Interval funds are typically debt oriented products , but may invest in equities as well as per the scheme’s investment objective and asset allocation specified in the Scheme Information Document.

There are no sources of finance like Preference Share Capital and Retained Earning. The main problem in applying this equation and Equation 5.14 is that it is difficult, if not impossible to estimate value of Pni.e., the expected market price at the end of year n. The cost of equity capital in the case may be ascertained by using the Equation 5.11. In order to avoid the cumbersome procedure of trial and error to find out the value of kd in Equation 5.3, Equation 5.4 may be used to give an approximation to after tax cost of capital of debt. Interval funds are typically debt oriented products , but may invest in equities as well as per the scheme’s investment objective and asset allocation specified in the Scheme Information Document.

Tax Saving

Of course, in an imperfect and illiquid market like India, this might not happen to the entire extent. Moreover, if some bonds held by your debt fund are upgraded, their prices would rise, leading to a drop in yields. Even Gilt Funds that are advertised as the safest available investments, can witness sharp fluctuations in their NAVs. That’s because prices of government securities are a function of various economic factors, including interest rates, macroeconomic data and liquidity in the banking system.

If its cost of debt is same as its rate of interest price is 40%, the distinction between a hundred% and forty% is 60%, and 60% of the 5% is 3%. The after-tax cost of debt is the interest paid on debt much less any income tax savings as a result of deductible curiosity expenses. To calculate the after-tax price of debt, subtract an organization’s efficient tax rate from 1, and multiply the difference by its price of debt. The company’s marginal tax rate just isn’t used, rather, the company’s state and the federal tax price are added collectively to establish its efficient tax rate.

https://1investing.in/ funds are ideal for investors who want regular income, but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. To put it into perspective, if a company takes a loan of Rs. 1,00,000 with a 10% interest rate, then the cost of capital is 10% for the loan. Debt payments are tax-deductible in nature, and businesses take into account the corporate taxes when calculating a debt capital’s real cost.

If tax information is given, it recommends that with an increase in debt financing WACC reduces and value of the firm will start increasing. In case of Net Income Approach, with increase in debt proportion, the total market value of the company increases and cost of capital decreases. Reason for this conclusion is that assumption of NI approach that irrespective ofdebt financingin capital structure, cost of equity will remain same. Further, cost of debt is always lower than cost of equity, so with increase in debt finance WACC reduces and value of firm increase. This approach was suggested by Durand and he was in favour of financial leverage decision.

The implication of this assumption is that every firm has a particular level of business risk as determined by the present composition of its fixed and variable costs. The minimum rate of return that a firm must earn in order to satisfy the expectations of its investor is the cost of capital of the firm. Finally, much of the return on equity is tied up in stock appreciation, which requires an organization to develop revenue, revenue and money flow. An investor sometimes needs no less than a ten% return due to these dangers, whereas debt can usually be found at a decrease rate. A company’s cost of debt is the effective interest rate a company pays on its debt obligations, including bonds, mortgages, and any other forms of debt the company may have. Because interest expense is deductible, it’s generally more useful to determine a company’s after-tax cost of debt.

If the firm is using IRR technique, then the cut-off rate should also be taken on an after-tax basis. As discussed in the following sections, it is only the debt financing for which the tax adjustment to cost of capital is required. The reason being that interest on bonds and debentures is tax deductible.

A good alternative to savings bank account; potential to offer higher post-tax returns. Ultra short-Term Bond Funds Low duration funds, with portfolio maturity of less than a year. Ideal for parking short-term surplus money; also offer slightly better returns than liquid funds. Short-Term Income Funds Medium duration funds where portfolio maturity ranges from one year – three years. Investors with a horizon greater than one year can benefit from these funds in a rising interest rate scenario. Fixed Maturity Plans Passively managed close-ended funds, where investments are held to maturity.

In case of irredeemable preference shares, the dividend at the fixed rate will be payable to the preference shareholder perpetually. The cost of capital of the irredeemable preference shares can be calculated with the help of Equation 5.6. The opportunity cost of the investors depends upon the nature and type of security being offered by the firm.

• To calculate the cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year.
• The Net Income Approach suggests that with the increase in leverage , the WACC decreases and the value of firm increases.
• So in order to really get the most out of debt funds, it is essential that you match your investment horizon with the average maturity of the scheme.
• Along with investing, making the money available at a time when your child needs it is equally important.
• However, holding them for more than their average maturity may not get you the optimal results.There can be various types of debt funds based on the average maturity of the instruments invested in.

The expected dividend per share in next year is 5096 of the 2019 EPS. C) The entire share capital of a company consist of 1,00,000 equity share of Rs. 100 each. The company wants to raise additional funds of Rs. 25,00,000 by issuing new shares.

This return payable to investor is therefore, the minimum return the proposal must earn otherwise, the firm need not take up the proposal. A) A weighted average cost of capital based on existing capital structure. B) The new weighted average cost of capital if the company raises an additional Rs. 20,00,000 debt by issuing 10 per cent debentures. The would result in increasing the expected dividend to Rs. 3 and leave the growth rate unchanged but the price of share will fall to Rs. 15 per share.

As a compensation of investing in the highly leveraged company, the shareholders expect higher return resulting in higher cost of equity capital. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate which has no relation to debt-equity ratio.

The Modigliani and Miller Approach indicates that the value of a leveraged firm is the same as the value of an unleveraged firm if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm. There is no flotation cost, no transaction cost and corporate dividend tax.