Test 7: answer key

Question 1 · 2 marks · Cost of Capital · medium

Scenario. Radiant Solar Ltd follows a target capital structure of debt 40 percent, preference capital 10 percent and equity 50 percent. It has retained earnings of ₹24 lakh available for the current financing programme. The after-tax cost of debt is 6.0 percent, the cost of preference capital is 11.0 percent, the cost of retained earnings is 13.5 percent and the cost of fresh equity after flotation expenses is 15.5 percent. The company is evaluating the weighted marginal cost of capital at different financing levels.

What is the break-point in the total financing schedule at which Radiant Solar Ltd exhausts its retained earnings of ₹24 lakh, given the 50 percent equity weight?

1. ₹36 lakh
2. ₹48 lakh (correct answer)
3. ₹60 lakh
4. ₹72 lakh

Answer: B — ₹48 lakh

Working. Break-point = Retained earnings available / Equity weight = ₹24,00,000 / 0.50 = ₹48,00,000.

Explanation. The break-point is the total financing amount that can be raised before the equity component changes from retained earnings to fresh equity. It equals retained earnings divided by the equity weight. ₹24 lakh divided by 0.50 gives ₹48 lakh. Therefore option b is correct. Options a, c and d incorrectly divide by other weights or use an incorrect financing total.

Where it goes wrong. Students may divide retained earnings by the debt or preference weight instead of the equity weight.

Authority. Chapter 4: Cost of Capital - Weighted Average Cost of Capital and Marginal Cost of Capital

Question 2 · 2 marks · Cost of Capital · medium

What is the weighted marginal cost of capital for the first ₹48 lakh of financing, using retained earnings as the equity component?

1. 9.85 percent
2. 10.05 percent
3. 10.15 percent
4. 10.25 percent (correct answer)

Answer: D — 10.25 percent

Working. WMCC = 0.40 × 6.0 + 0.10 × 11.0 + 0.50 × 13.5 = 2.40 + 1.10 + 6.75 = 10.25 percent.

Explanation. The weighted marginal cost for the first ₹48 lakh uses 40 percent debt at 6 percent, 10 percent preference at 11 percent and 50 percent retained earnings at 13.5 percent. The weighted total is 10.25 percent. Option d is correct. Options a, b and c arise from arithmetic errors or from using fresh equity cost before the break-point.

Where it goes wrong. Using the fresh equity cost of 15.5 percent before the retained earnings break-point overstates the initial marginal cost.

Authority. Chapter 4: Cost of Capital - Weighted Average Cost of Capital and Marginal Cost of Capital

Question 3 · 2 marks · Cost of Capital · medium

What is the weighted marginal cost of capital for financing beyond ₹48 lakh, assuming the debt and preference costs remain unchanged and fresh equity cost is 15.5 percent?

1. 11.25 percent (correct answer)
2. 10.85 percent
3. 11.65 percent
4. 12.05 percent

Answer: A — 11.25 percent

Working. WMCC after break-point = 0.40 × 6.0 + 0.10 × 11.0 + 0.50 × 15.5 = 2.40 + 1.10 + 7.75 = 11.25 percent.

Explanation. After the break-point, the equity weight is financed by fresh equity at 15.5 percent. The weighted marginal cost is 0.40 × 6.0 plus 0.10 × 11.0 plus 0.50 × 15.5, which equals 11.25 percent. Option a is correct. Options b, c and d result from using retained earnings cost or from calculation errors.

Where it goes wrong. Continuing to use retained earnings cost after the break-point ignores the flotation cost of fresh equity.

Authority. Chapter 4: Cost of Capital - Weighted Average Cost of Capital and Marginal Cost of Capital

Question 4 · 2 marks · Investment Decisions - Capital Budgeting · medium

Scenario. Shivalik Heavy Engineering is evaluating replacement of a five-year-old machine. The old machine cost ₹20,00,000 and is depreciated on a straight-line basis over ten years to zero book value. It can be sold today for ₹8,00,000. The new machine costs ₹30,00,000, has a five-year life, a salvage value of ₹2,00,000 and is depreciated on a straight-line basis to its salvage value. The new machine is expected to increase annual contribution by ₹8,00,000 and reduce annual cash operating costs by ₹3,00,000. The tax rate is 30 percent and the cost of capital is 12 percent. PVAF at 12 percent for five years is 3.605 and PVIF at 12 percent for five years is 0.567.

What is the tax effect of selling the old machine today for ₹8,00,000 when its book value is ₹10,00,000 and the tax rate is 30 percent?

1. Tax payable of ₹60,000
2. No tax effect
3. Tax shield of ₹60,000 (correct answer)
4. Tax shield of ₹2,00,000

Answer: C — Tax shield of ₹60,000

Working. Book value = ₹20,00,000 − five years × ₹2,00,000 = ₹10,00,000. Loss = ₹10,00,000 − ₹8,00,000 = ₹2,00,000. Tax shield = ₹2,00,000 × 30 percent = ₹60,000.

Explanation. The old machine has a book value of ₹10,00,000 and is sold for ₹8,00,000. The loss on sale is ₹2,00,000. At a 30 percent tax rate, the loss saves tax of ₹60,000. This is a tax shield and is treated as a cash inflow in the initial outlay. Option c is correct. Option a treats the shield as tax payable, option b ignores the loss and option d wrongly applies the tax rate to the full loss amount without using 30 percent.

Where it goes wrong. Applying the tax rate to the sale value instead of the loss on sale gives an incorrect tax effect.

Authority. Chapter 7: Investment Decisions - Estimation of Project Cash Flows and Replacement Decisions

Question 5 · 2 marks · Investment Decisions - Capital Budgeting · hard

What is the incremental annual operating cash flow after tax from replacing the old machine with the new machine?

1. ₹7.70 lakh
2. ₹8.30 lakh
3. ₹8.60 lakh
4. ₹8.78 lakh (correct answer)

Answer: D — ₹8.78 lakh

Working. New depreciation = ₹30,00,000 − ₹2,00,000 divided by 5 = ₹5,60,000. Old depreciation = ₹2,00,000. Incremental depreciation = ₹3,60,000. Incremental EBDT = ₹8,00,000 + ₹3,00,000 = ₹11,00,000. PBT = ₹11,00,000 − ₹3,60,000 = ₹7,40,000. Tax = ₹2,22,000. PAT = ₹5,18,000. OCF = ₹5,18,000 + ₹3,60,000 = ₹8,78,000.

Explanation. Incremental earnings before depreciation and tax are ₹11,00,000. Incremental depreciation is new depreciation of ₹5,60,000 less old depreciation of ₹2,00,000, which equals ₹3,60,000. Incremental profit before tax is ₹7,40,000. Tax at 30 percent is ₹2,22,000. Profit after tax is ₹5,18,000. Adding back incremental depreciation of ₹3,60,000 gives ₹8,78,000. Option d is correct. Options a, b and c arise from incorrect depreciation or tax adjustments.

Where it goes wrong. Using only the new machine depreciation and ignoring the old machine depreciation overstates the incremental tax shield.

Authority. Chapter 7: Investment Decisions - Estimation of Project Cash Flows and Replacement Decisions

Question 6 · 2 marks · Investment Decisions - Capital Budgeting · hard

What is the net present value of the replacement decision?

1. ₹11.39 lakh (correct answer)
2. ₹9.85 lakh
3. ₹10.12 lakh
4. ₹12.40 lakh

Answer: A — ₹11.39 lakh

Working. Initial outlay = ₹30,00,000 − ₹8,00,000 − ₹60,000 = ₹21,40,000. PV of OCF = ₹8,78,000 × 3.605 = ₹31,65,190. PV of salvage = ₹2,00,000 × 0.567 = ₹1,13,400. Total PV = ₹32,78,590. NPV = ₹32,78,590 − ₹21,40,000 = ₹11,38,590.

Explanation. The initial outlay is the new machine cost of ₹30,00,000 less the old machine sale proceeds of ₹8,00,000 and the tax shield of ₹60,000, giving ₹21,40,000. The present value of annual operating cash flows is ₹8,78,000 × 3.605, which is ₹31,65,190. The present value of salvage is ₹2,00,000 × 0.567, which is ₹1,13,400. Total present value is ₹32,78,590. NPV is ₹32,78,590 − ₹21,40,000 = ₹11,38,590, approximately ₹11.39 lakh. Option a is correct. Options b, c and d arise from omitting the tax shield, using incorrect depreciation or ignoring salvage.

Where it goes wrong. Omitting the tax shield on the loss on sale of the old machine understates the initial outlay and gives an incorrect NPV.

Authority. Chapter 7: Investment Decisions - Estimation of Project Cash Flows and Replacement Decisions

Question 7 · 2 marks · Cost of Capital · hard

Scenario. Radiant Power Ltd issued 10,000 9 percent redeemable preference shares of face value ₹100 each at ₹95 per share. Flotation expenses are 2 percent of the issue price. The shares are redeemable after five years at ₹105 per share. The company is examining the cost of preference capital and the tax treatment of preference dividend under the current Indian tax framework.

What is the approximate cost of redeemable preference capital using the approximation method?

1. 10.85 percent
2. 11.49 percent (correct answer)
3. 12.10 percent
4. 13.05 percent

Answer: B — 11.49 percent

Working. NP = ₹95 − 2 percent of ₹95 = ₹93.10. Kp = [₹9 + (₹105 − ₹93.10) divided by 5] divided by [(₹105 + ₹93.10) divided by 2] = ₹11.38 divided by ₹99.05 = 11.49 percent.

Explanation. Net proceeds are issue price ₹95 less flotation of 2 percent of issue price, which is ₹1.90, giving ₹93.10. Annual preference dividend is ₹9. Redemption value is ₹105. Using the approximation formula, the numerator is ₹9 plus ₹11.90 divided by 5, which equals ₹11.38. The denominator is the average of ₹105 and ₹93.10, which is ₹99.05. The cost is 11.38 divided by 99.05, which is 11.49 percent. Option b is correct. Options a, c and d arise from using issue price, face value or redemption value incorrectly.

Where it goes wrong. Using the face value ₹100 instead of net proceeds ₹93.10 as the denominator base overstates or understates the cost.

Authority. Chapter 4: Cost of Capital - Cost of Preference Share Capital

Question 8 · 1 marks · Cost of Capital · medium

Which statement is correct for the cost of preference capital under the current Indian tax framework?

1. Preference dividend is tax deductible and reduces cost by the tax rate
2. Dividend distribution tax is added to the cost of preference capital
3. Preference dividend is not tax deductible and current Indian tax law does not levy dividend distribution tax at the company level (correct answer)
4. Dividend distribution tax is deductible in computing the cost of preference capital

Answer: C — Preference dividend is not tax deductible and current Indian tax law does not levy dividend distribution tax at the company level

Working. No tax adjustment is made to preference dividend for the cost of preference capital. Taxability, if any, arises in the hands of the recipient under the applicable regime.

Explanation. Preference dividend is an appropriation of profit and is not allowed as a tax-deductible expense. Under the current Indian tax framework, dividend distribution tax is not levied at the company level. Therefore the cost of preference capital is not adjusted for tax in the manner of debt. Option c is correct. Options a, b and d incorrectly assume tax deductibility or levy of dividend distribution tax at the company level.

Where it goes wrong. Applying the debt tax shield to preference dividend is a conceptual error because preference dividend is not tax deductible.

Authority. Chapter 4: Cost of Capital - Cost of Preference Share Capital