Financial ManagementSubjectiveQuestion 5541 of 217
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Question 2 (a) Capital structure of B Ltd. for year ended 31st March, 2025: Equity share capital @₹10 each = ₹14,00,000 10% Preference share capital @₹1,000 each = ₹10,00,000 Debenture @₹100 each = ₹9,60,000 Bank Loan = ₹6,40,000 Risk-free rate = 14%, Market rate = 19%, Beta = 1.20 10% Preference shares redeemable at ₹1,065.40 after 3 years. Interest on bank loan = 1.30 times interest on debentures. Debentures redeemable at par after 5 years. Flotation cost = ₹4 per debenture. Tax rate = 30%. Cost of capital = 14%. Calculate: (i) Cost of Equity, (ii) Cost of Preference Share (YTM method), (iii) Post-tax cost of debenture (approximation method), (iv) Interest rate of bank loan. (1+2+3+2 = 8 Marks) (b) H Ltd.: EPS = ₹3.00, ROI = 20%, Cost of equity = 15%. As per Walter's Model, what is the maximum and minimum price of share? (2 Marks)

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Detailed Solution & Explanation

## Part (a): Cost of Capital — B Ltd.

**Total Capital:**
| Source | Amount (₹) | Weight |
|---|---|---|
| Equity Share Capital | 14,00,000 | 0.35 |
| Preference Share Capital | 10,00,000 | 0.25 |
| Debentures | 9,60,000 | 0.24 |
| Bank Loan | 6,40,000 | 0.16 |
| **Total** | **40,00,000** | **1.00** |

---

**(i) Cost of Equity (Ke) — CAPM**

\K_e = R_f + \\beta(R_m - R_f) \
\Ke=14K_e = 14\\% + 1.20 \\times (19\\% - 14\\%) = 14\\% + 6\\% = \\boxed{20\\%} \

---

**(ii) Cost of Preference Shares (YTM / IRR Method)**

Face Value = ₹1,000, Annual Dividend = 10% × 1,000 = ₹100, Redeemable at ₹1,065.40 after 3 years.

Current Market Price = ₹1,000 (assumed at par/issue price).

Calculate NPV at 10% and 14%:

| Year | Cash Flow (₹) | PVF @ 10% | PV @ 10% (₹) | PVF @ 14% | PV @ 14% (₹) |
|---|---|---|---|---|---|
| 0 | (1,000) | 1 | (1,000) | 1 | (1,000) |
| 1–3 (Dividend) | 100 | 2.487 | 248.70 | 2.322 | 232.20 |
| 3 (Redemption) | 1,065.40 | 0.751 | 800.12 | 0.675 | 719.14 |
| **NPV** | | | **+48.82** | | **−48.66** |

\textIRR=10\\text{IRR} = 10\\% + \\frac{48.82}{48.82 + 48.66} \\times (14\\% - 10\\%) \
\=10= 10\\% + \\frac{48.82}{97.48} \\times 4\\% = 10\\% + 2\\% = \\boxed{12\\%} \

**Cost of Preference Shares (Kp) = 12%**

---

**(iii) Post-Tax Cost of Debentures (Approximation Method)**

NP (Net Proceeds) = ₹100 − ₹4 (flotation) = ₹96; RV = ₹100; n = 5 years.

Let interest rate on debentures = X, so annual interest = 100X.
Interest on bank loan = 1.3X (pre-tax).

Using WACC = 14% to find X:

\\\text{Kd} = \\frac{I(1-t) + \\frac{RV - NP}{n}}{\\frac{RV + NP}{2}} = \\frac{100X(0.7) + \\frac{4}{5}}{\\frac{196}{2}} = \\frac{70X + 0.8}{98} \

\\\text{Kd(Bank Loan)} = 1.3X \\times (1 - 0.3) = 0.91X \

Setting up WACC equation:
\0.14 = 0.35(0.20) + 0.25(0.12) + 0.24 \\times \\frac{70X + 0.8}{98} + 0.16 \\times 0.91X \
\0.14 = 0.07 + 0.03 + \\frac{16.8X + 0.192}{98} + 0.1456X \
\0.04 = \\frac{16.8X + 0.192}{98} + 0.1456X \
\0.04 \\times 98 = 16.8X + 0.192 + 14.2688X \
\3.92 - 0.192 = 31.0688X \
\3.728=31.0688XRightarrowX=0.12textor123.728 = 31.0688X \\Rightarrow X = 0.12 \\text{ or } 12\\% \

So, interest rate on debentures = **12%**.

\K_d = \\frac{12(1 - 0.3) + \\frac{4}{5}}{\\frac{196}{2}} = \\frac{8.4 + 0.8}{98} = \\frac{9.2}{98} = \\boxed{9.39\\%} \

**Post-tax cost of debentures ≈ 9.39%**

---

**(iv) Interest Rate of Bank Loan**

\textInterestrateonbankloan=1.3timesX=1.3times12\\text{Interest rate on bank loan} = 1.3 \\times X = 1.3 \\times 12\\% = \\boxed{15.60\\%} \

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## Part (b): Walter's Model — H Ltd.

**Given:** EPS (E) = ₹3, r = 20%, Ke = 15%

Since **r (20%) > Ke (15%)**, the firm is a **growth firm**. As per Walter's Model, value is maximised by retaining all earnings (D = 0) and minimised by distributing all earnings (D = E).

**Walter's Formula:**
\P = \\frac{D + \\frac{r}{K_e}(E - D)}{K_e} \

**(i) Maximum Price — when D = 0 (full retention):**
\P_{max} = \\frac{0 + \\frac{0.20}{0.15}(3 - 0)}{0.15} = \\frac{\\frac{0.20}{0.15} \\times 3}{0.15} = \\frac{4}{0.15} = \\boxed{₹26.67} \

**(ii) Minimum Price — when D = E = ₹3 (full distribution):**
\P_{min} = \\frac{3 + \\frac{0.20}{0.15}(3 - 3)}{0.15} = \\frac{3}{0.15} = \\boxed{₹20} \

**Maximum Price = ₹26.67 | Minimum Price = ₹20**

Key Concepts to Understand

Debentures

Long-term debt instruments issued by a company to the public for raising loan capital, carrying a fixed rate of interest (coupon rate) payable regardless of profit. Debenture holders are creditors, not owners, of the company.

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