Totto Ltd. has following capital structure as on 31 st December 2023, which is considered to be optimum: (₹) 12% Debenture 4,50,000 10% Preference…

(a) (i) Calculation of after-tax cost of the followings: (a) New 14% Debentures (K d ) K d = I(1-t) / NP = 14(1-0.5) / 99 = 0.0707 or 7.07% New 12% Preference Shares (K p ) K p = PD / NP = 1.25 / 9.90 = 0.1263 or 12.63% Where, I = Interest t = Tax rate PD = Preference dividend NP = Net proceeds (b) Equity Shares (Retained Earnings) (K e ) K e = Expected dividend(D 1 ) / Current market price(P 0 ) + Growth rate(G) K e = (50% of 3.023) / 30.25 + 0.11* = 0.16 or 16% * Growth rate (on the basis of EPS) is calculated as below : EPS in current year - EPS in previous year / EPS in previous year = (3.023 - 2.723) / 2.723 = 0.11 (Students may verify the growth trend by applying the above formula to last three or four years. Growth Rate is rounded off) (ii) Calculation of marginal cost of capital (on the basis of existing capital structure): Source of capital Weight (a) After tax Cost of capital (%) (b) WACC (%) (a) x (b) 14% Debenture 0.15 7.07 1.0605 12% Preference shares 0.05 12.63 0.6315 Equity shares 0.80 16.00 12.800 Marginal cost of capital 14.492 (iii) The company can spend for capital investment before issuing new equity shares and without increasing its marginal cost of capital: Retained earnings can be available for capital investment = 50% of 2023 EPS × equity shares outstanding = 50% of 3.023 × 2,00,000 shares = 3,02,300 Since, marginal cost of capital is to be maintained at the current level i.e. 14.492%, the retained earnings should be equal to 80% of total additional capital for investment. Thus, investment before issuing equity = (₹ 3,02,300 / 80) × 100 = 3,77,875 The remaining capital of 75,575 i.e.3,77,875- 3,02,300 shall be financed by issuing 14% Debenture and 12% preference shares in the ratio of 3 : 1 respectively. (iv) If the company spends more than 3,77,875 as calculated in part (iii) above, it will have to issue new shares at 22 per share. The cost of new issue of equity shares will be: K e = Expected dividend(D 1 ) / Current market price(P 0 ) + Growth rate (g) = (50% of 3.023) / 22 + 0.11 = 0.1787 or 17.87% Calculation of marginal cost of capital (assuming the existing capital structure will be maintained): Source of capital Weight (a) Cost (%) (b) WACC (%) (a) x (b) 14% Debenture 0.15 7.07 1.0605 12% Preference shares 0.05 12.63 0.6315 Equity shares 0.80 17.87 14.296 Marginal cost of capital 15.988