Solution

Part (a)
As per prudential Regulations The borrowing capacity is worked out using
book values
Book Value of Equity
Dividend to be paid
Ex-Div Value of Equity
Debt to equity ratio
i.e.
Debt Equity Ratio

1,663
(225)
1,438
60%:40%
Rs 1.5 Debt to Re 1 Equity
1.50

Debt Capacity
Existing
Further borrowing Capacity

2,157
(526)
1,631

The company needs Rs 1,500 million for the project which can be
raised within the borrowing limits available as at the reporting date
without injecting any equity.
Part (b)
Weighted Average Cost of Capital
Market Value of Equity
Cost of Equity (ke)
Market value of Debt
Cost of Debt (before tax) (Kd)

Rs
Rs

WACC

18.22%

Market Value of Equity

Cum dividend Value
Dividend per share
Ex-Dividend Value

2,025
20%
515
15.40%

Per share
30
(3)
27

Cost of debt will be the irr incorporating the market values of debt
Interpolation
Yr

CF
1
2
3
4
5
6

(98)
7
7
7
7
7
107

Internal rate of Return (Kd)

Effective Annual Rate (Before Tax)

7.43%
15.40%

Market Returns (Rm)

At start of last yr
At end of last yr

15,530
18,325

Change

18.00%

Beta Debt
Since the bond is a corporate bond so its not risk free and risk of issued debt is
gauged in its beta
Premium for risk (as compared to Sovrn bonds)
Market premium for investing in market
Ratio of premiums (Beta Debt)
Cost of Equity
We know that

Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
and
Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
Beta Asset
Beta Debt

1.20
0.63

Debt
Equity
Beta Equity

515.48
2,025.00
1.3017

Working for Beta Equity

(Bd x after tax D / (E + After tax D)
{Beta Asset - (Bd x after tax D / (E + After tax D)}
{(E + After tax D)/E}
Beta Equity
Cost of Equity
Risk free rate on Gov Bonds
Market risk premium
Beta Equity
Cost of Equity

0.0951
1.1049
1.1782
1.3017

11%
7.0%
1.30
20.11%

Note
Company's existing WACC should be calculated using market values not the book
values. The suggested solution (previously available) was made using book values.
Part (a) of the question specifically referred the prudential regulations and hence it
was solved using book values. No such reference was made for part (b).
Furthermore, Calculation of WACC using book values will not produce any
meaningful information a compared to its calculation using market values.
Part (C)
Financing 100% through debt
Weighted Average Cost of Capital
Market Value of Equity ('E)
Cost of Equity (ke)
Market value of Debt (D)
Cost of Debt (before tax) (Kd)
WACC

Rs
Rs

2,025
21%
2,015
17.40%

Unchanged (no issuance

(Changed due to change
Changed due to issuance
Changed due to change i

16.50%

Beta Debt
Since the bond is a corporate bond so its not risk free and risk of issued debt is

gauged in its beta

Premium for risk (as compared to Sovrn bonds)
Market premium for investing in market
Ratio of premiums (Beta Debt)
Cost of Equity
We know that

Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
and
Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
Beta Asset
Beta Debt
Debt
Equity
Beta Equity

1.20
0.91
2,015.48
2,025.00
1.3989

Unchanged
Changed due to increase in Kd
Changed due to issuance of further deb
Unchanged
Changed due change in weight of Debt

Working for Beta Equity

(Bd x after tax D / (E + After tax D)
{Beta Asset - (Bd x after tax D / (E + After tax D)}
{(E + After tax D)/E}
Beta Equity
Cost of Equity
Risk free rate on Gov Bonds
Market risk premium
Beta Equity
Cost of Equity

0.3755
0.8245
1.6967
1.3989

11%
7.0%
1.40
20.79%

Financing 50% through debt and 50% through equity

Weighted Average Cost of Capital
Market Value of Equity ('E)
Cost of Equity (ke)

Rs

2,775 Changed (due to issuance

20% (Changed due to change

Market value of Debt (D)

Cost of Debt (before tax) (Kd)

Rs

1,265 Changed due to issuance

16.40% Changed due to change i

WACC

17.58%

Beta Debt
Since the bond is a corporate bond so its not risk free and risk of issued debt is
gauged in its beta
Premium for risk (as compared to Sovrn bonds)
Market premium for investing in market
Ratio of premiums (Beta Debt)
Cost of Equity
We know that

Beta Asset = {Be x E/(E + After tax D) + (Bd x after tax D / (E + After tax D)
and
Beta Equity = {Beta Asset - (Bd x after tax D / (E + After tax D)} x {(E + After tax D)/
Beta Asset
Beta Debt
Debt
Equity
Beta Equity

1.20
0.77
1,265.48
2,775.00
1.3367

Unchanged
Changed due to increase in Kd
Changed due to issuance of further deb
Unchanged
Changed due change in weight of Debt

Working for Beta Equity

(Bd x after tax D / (E + After tax D)
{Beta Asset - (Bd x after tax D / (E + After tax D)}
{(E + After tax D)/E}
Beta Equity
Cost of Equity
Risk free rate on Gov Bonds
Market risk premium
Beta Equity
Cost of Equity

11%
7.0%
1.34
20.36%

0.1867
1.0133
1.3192
1.3367

Evaluation
Profit before interest and tax
Finance cost
Profit before tax
Tax
Profit after tax

Existing
Option 1
532
857
(80)
(351)
452
506
(136)
(152)
316
354

Shares

82.50

82.50

EPS

3.835

4.296

18.22%

16.50%

WACC

out using

issued debt is

4.40%
7.00%
0.6290

After tax D)
x {(E + After tax D)/E}

ues not the book

using book values.
tions and hence it

duce any
et values.

hanged (no issuance of shares)

nged due to change in financial risk)
nged due to issuance of Debt
nged due to change in financial risk

issued debt is

6.40%
7.00%
0.9145

After tax D)
x {(E + After tax D)/E}

ncrease in Kd
suance of further debt

nge in weight of Debt in capital structure

nged (due to issuance of shares)

nged due to change in financial risk)

nged due to issuance of Debt

nged due to change in financial risk

issued debt is

5.40%
7.00%
0.7717

After tax D)
x {(E + After tax D)/E}

ncrease in Kd
suance of further debt

nge in weight of Debt in capital structure

Option 2
857
(208)
649
(195)
455
110
4.122
17.58%