Test 1: Cost of Capital: answer key

Question 1 · 2 marks · Cost of Capital · medium

Scenario. Bharat Renewables Ltd. manufactures grid-scale battery modules and is evaluating a six-year expansion at its Gujarat plant. The finance committee is comparing debenture tranches because stated coupon rates alone do not capture the issuer’s financing cost. Unless otherwise stated, interest is paid annually, the company has sufficient taxable profits to use the interest deduction, and principal is not repaid before maturity. All debt figures below are per ₹1,000 face-value instrument; operating figures are in ₹ crore. Debt and operating information: Series A – irredeemable debentures; coupon 12%; issue price 96% of face value; underwriting, brokerage and legal expenses together ₹20 per debenture. Series B – redeemable debentures; coupon 10%; issue price 97.5% of face value; flotation cost ₹10 per debenture; redemption at ₹1,050 after 5 years. Series C – existing redeemable debentures; coupon 10%; current market price ₹920; redemption at ₹1,050 after 3 years. Book capital mix: equity ₹120 crore; retained earnings ₹30 crore; preference shares ₹20 crore; existing debt ₹50 crore. Forecast EBIT is ₹36 crore and the corporate tax rate is 30%. The company’s aggregate annual deductible interest on all existing funded facilities is ₹7 crore. Its equity beta is 1.20, the risk-free rate is 6% and the expected market return is 13.5%. The proposed expansion requires an initial outlay of ₹48 crore and is forecast to generate annual cash flow after tax (CFAT) of ₹10.5 crore for six years. Plant-level working-capital information shows raw-material holding of 40 days, work-in-progress of 20 days, receivables of 35 days and supplier credit of 20 days, resulting in a net operating cycle of 75 days. The committee asks the finance analyst to use net proceeds after all issue costs, apply the tax shield only to deductible interest unless a question expressly says otherwise, and use present-value interpolation for the YTM question. Do not treat coupon rate, after-tax cost and redemption yield as interchangeable.

For Series A, calculate the after-tax cost of irredeemable debt (Kd) per annum, using the issue price and all flotation expenses stated in the scenario.

1. 8.94% (correct answer)
2. 8.75%
3. 12.77%
4. 8.40%

Answer: A — 8.94%

Explanation. Issue price = ₹1,000 × 96% = ₹960. Net proceeds (NP) = ₹960 − ₹20 flotation cost = ₹940. Annual coupon = ₹1,000 × 12% = ₹120; after-tax interest = ₹120 × (1 − 0.30) = ₹84. As the debt is irredeemable, Kd = ₹84/₹940 × 100 = 8.936%, or 8.94%. The 8.75% distractor omits flotation cost, while 12.77% ignores the tax shield. The redemption adjustment is zero for this perpetual instrument.

Where it goes wrong. Using face value or gross issue proceeds instead of net proceeds after discount and flotation costs.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 2 · 2 marks · Cost of Capital · hard

For Series B, assume that only annual interest is tax-deductible. Using the approximation formula, determine the cost of redeemable debt (Kd).

1. 7.84%
2. 8.64% (correct answer)
3. 11.61%
4. 8.40%

Answer: B — 8.64%

Explanation. NP = ₹1,000 × 97.5% − ₹10 = ₹965; RV = ₹1,050; after-tax interest = ₹100 × 0.70 = ₹70. Annual redemption adjustment = (₹1,050 − ₹965)/5 = ₹17. Thus Kd = (₹70 + ₹17)/[(₹1,050 + ₹965)/2] = ₹87/₹1,007.50 = 8.635%, or 8.64%. A lower result uses par instead of the premium redemption value; the pre-tax result incorrectly leaves interest untaxed.

Where it goes wrong. Omitting the ₹10 flotation cost, using par rather than the ₹1,050 redemption value, or failing to apply the tax shield to interest.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 3 · 2 marks · Cost of Capital · hard

Estimate the YTM (cost of debt) of Series C by linear IRR interpolation. Use the following factors: at 8%, PVAF for 3 years = 2.577 and PVF for year 3 = 0.794; at 12%, PVAF = 2.402 and PVF = 0.712. The annual post-tax coupon is based on the stated tax rate.

1. 10.75%
2. 11.20%
3. 11.83% (correct answer)
4. 12.50%

Answer: C — 11.83%

Explanation. At 8%, PV of post-tax coupons = ₹70 × 2.577 = ₹180.39 and PV of redemption = ₹1,050 × 0.794 = ₹833.70; NPV = ₹94.09. At 12%, the corresponding values are ₹168.14 and ₹747.60; NPV = −₹4.26. Therefore YTM = 8% + [94.09/(94.09 + 4.26)] × 4% = 11.83%. The interpolation must use post-tax coupons and the full redemption amount; omitting either understates the yield.

Where it goes wrong. Using the stated coupon instead of post-tax interest, omitting the redemption cash flow, or interpolating with the wrong NPV signs.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 4 · 2 marks · Cost of Capital · medium

At the forecast EBIT of ₹36 crore, the company has aggregate annual deductible interest of ₹7 crore. What are the effective after-tax interest burden and the annual tax shield, respectively?

1. ₹7.00 crore and ₹2.10 crore
2. ₹4.90 crore and ₹7.00 crore
3. ₹2.10 crore and ₹4.90 crore
4. ₹4.90 crore and ₹2.10 crore (correct answer)

Answer: D — ₹4.90 crore and ₹2.10 crore

Explanation. PBT = ₹36 crore − ₹7 crore = ₹29 crore and tax at 30% is ₹8.70 crore, leaving PAT of ₹20.30 crore. The tax shield is deductible interest × tax rate = ₹7 crore × 30% = ₹2.10 crore. The effective after-tax interest burden is ₹7 crore − ₹2.10 crore = ₹4.90 crore. Gross interest is not the tax saving, and the tax on EBIT is not the incremental shield.

Where it goes wrong. Confusing gross interest expense with the tax saving, or treating the full interest amount as the after-tax burden.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 5 · 2 marks · Cost of Capital · hard

Scenario. Aditya Automotive Ltd. supplies electric-vehicle powertrain assemblies and is assessing an automated production line. The finance director has provided market-value capital data and asks the team to distinguish the tax treatment of interest from the treatment of issue discount and redemption premium. Coupons are annual; taxable profits are sufficient. Use market-value weights for WACC. Retained earnings of ₹15 crore are already represented within the quoted market value of equity and must not be added again as a separate weight. Capital and risk information (₹ crore unless stated): Equity shares – market value ₹90; equity beta 1.30. Preference shares – market value ₹9.5; face value ₹100 per share; annual dividend ₹12; current market price ₹95. Existing debt – market value ₹45; coupon rate 10%. Risk-free return is 6%, expected market return is 13%, and corporate tax is 25%. The company is also considering a new Series D debenture with face value ₹1,000, coupon 10%, issue price 96% of face value, flotation expenses of ₹15 per debenture and redemption at 108% after 4 years. For this issue, the problem expressly stipulates that both the issue discount and the redemption premium are tax-deductible, in addition to annual interest. The existing plant reports EBIT of ₹28 crore and annual interest charges of ₹5.6 crore before the expansion. Operations carry 60 days of raw materials, 20 days of work-in-progress, 45 days of receivables and 50 days of trade credit, creating a net operating cycle of 75 days. The automation project requires ₹32 crore immediately and is expected to generate annual operating CFAT of ₹9 crore for 5 years. An additional working-capital investment of ₹3 crore is recovered at the end of year 5; there is no other terminal value. For the project question, use the supplied five-year PV annuity factor of 3.554 and single-sum factor of 0.553 at the computed WACC (approximately 12.57%).

For Series D, calculate Kd using the approximation formula applicable where both issue discount and redemption premium are tax-deductible. The face value is ₹1,000 and the debt is redeemed after 4 years.

1. 9.91% (correct answer)
2. 10.74%
3. 9.56%
4. 13.21%

Answer: A — 9.91%

Explanation. Issue price = ₹1,000 × 96% = ₹960; NP = ₹960 − ₹15 = ₹945. RV = ₹1,080 and annual coupon I = ₹100. Because the question expressly makes both issue discount and redemption premium deductible, use Kd = [I + (RV − NP)/n] × (1 − t) ÷ [(RV + NP)/2]. This gives [100 + 135/4] × 0.75 ÷ 1,012.50 = 9.907%, or 9.91%. Applying tax only to coupon would produce the wrong method here.

Where it goes wrong. Applying the ordinary interest-only tax treatment even though the question expressly makes the issue discount and redemption premium tax-deductible.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 6 · 2 marks · Cost of Capital · hard

Compute the company’s WACC using the market values in the scenario. Retained earnings are already included in the market value of equity and must not be separately added. Use CAPM for equity and adjust debt cost for tax.

1. 12.10%
2. 12.57% (correct answer)
3. 13.20%
4. 14.05%

Answer: B — 12.57%

Explanation. CAPM cost of equity = 6% + 1.30 × (13% − 6%) = 15.10%. Cost of preference shares = ₹12/₹95 = 12.6316%; after-tax cost of debt = 10% × (1 − 25%) = 7.50%. Total market value = ₹90 + ₹9.5 + ₹45 = ₹144.5 crore. WACC = (90×15.10 + 9.5×12.6316 + 45×7.50)/144.5 = 12.57%. The retained earnings are embedded in equity market value and must not be double-counted.

Where it goes wrong. Using book-value weights, leaving debt before tax, or adding retained earnings again to the stated market value of equity.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 7 · 2 marks · Cost of Capital · hard

Using the computed WACC of approximately 12.57%, determine the NPV of the automation project. Annual CFAT is ₹9 crore for 5 years, the initial outlay is ₹32 crore, and ₹3 crore of working capital is recovered at the end of year 5. Use the supplied factors.

1. −₹0.01 crore
2. +₹2.99 crore
3. +₹1.65 crore (correct answer)
4. +₹33.65 crore

Answer: C — +₹1.65 crore

Explanation. PV of annual CFAT = ₹9 crore × 3.554 = ₹31.986 crore. PV of the year-5 working-capital recovery = ₹3 crore × 0.553 = ₹1.659 crore. Total present value of inflows = ₹33.645 crore; NPV = ₹33.645 crore − ₹32 crore = +₹1.645 crore. The project should be accepted because NPV is positive. Ignoring working-capital recovery gives an understated NPV; treating the ₹3 crore recovery as a year-0 inflow overstates it.

Where it goes wrong. Discounting only the operating CFAT and omitting the year-5 recovery of working capital, or treating that recovery as an immediate inflow.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 8 · 2 marks · Cost of Capital · medium

Before the expansion, the company reports EBIT of ₹28 crore and annual interest charges of ₹5.6 crore. Calculate its interest coverage ratio.

1. 4.00 times
2. 5.60 times
3. 0.20 times
4. 5.00 times (correct answer)

Answer: D — 5.00 times

Explanation. Interest coverage ratio = EBIT ÷ annual interest charges = ₹28 crore ÷ ₹5.6 crore = 5.00 times. This measures the number of times operating earnings cover the fixed interest burden. Dividing interest by EBIT gives 0.20 times, the reciprocal rather than the coverage ratio. Using profit after tax or deducting interest again from EBIT would also distort the numerator because EBIT is measured before interest and tax.

Where it goes wrong. Inverting the ratio or using earnings after interest and tax instead of EBIT.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 9 · 2 marks · Cost of Capital · medium

Scenario. A company has 14% irredeemable debentures of face value ₹1,000. Their current market price is ₹1,080 and the corporate tax rate is 30%. No issue expenses are relevant. What is the current after-tax cost of debt?

A company has 14% irredeemable debentures of face value ₹1,000. Their current market price is ₹1,080 and the corporate tax rate is 30%. No issue expenses are relevant. What is the current after-tax cost of debt?

1. 9.07% (correct answer)
2. 12.96%
3. 9.80%
4. 7.80%

Answer: A — 9.07%

Explanation. Annual interest = ₹1,000 × 14% = ₹140. After-tax interest = ₹140 × (1 − 30%) = ₹98. With irredeemable debt, there is no maturity repayment adjustment, so Kd = ₹98/₹1,080 × 100 = 9.074%, or 9.07%. The 12.96% distractor is the pre-tax yield; using face value rather than the current market price ignores the return investors require on the existing debt.

Where it goes wrong. Using face value rather than the current market price, or forgetting the tax shield on interest.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 10 · 2 marks · Cost of Capital · hard

Scenario. A company issues 12% redeemable debentures of face value ₹1,000 at ₹1,030 and incurs flotation costs of ₹20 per debenture. They are redeemable at ₹950 after 5 years. If only interest is tax-deductible and the tax rate is 30%, calculate Kd by the approximation method.

A company issues 12% redeemable debentures of face value ₹1,000 at ₹1,030 and incurs flotation costs of ₹20 per debenture. They are redeemable at ₹950 after 5 years. If only interest is tax-deductible and the tax rate is 30%, calculate Kd by the approximation method.

1. 6.12%
2. 7.35% (correct answer)
3. 8.57%
4. 11.02%

Answer: B — 7.35%

Explanation. NP = ₹1,030 − ₹20 = ₹1,010. Annual interest after tax = ₹120 × 0.70 = ₹84. Since only interest is tax-deductible, the redemption discount adjustment remains untaxed: (₹950 − ₹1,010)/5 = −₹12. Average value = (₹950 + ₹1,010)/2 = ₹980. Hence Kd = (₹84 − ₹12)/₹980 = 7.35%. Treating the redemption discount as a positive addition or applying the tax factor to it gives an incorrect result.

Where it goes wrong. Adding a redemption discount instead of subtracting it, or applying the tax factor to a non-deductible redemption adjustment.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 11 · 2 marks · Cost of Capital · hard

Scenario. A 9% debenture of face value ₹1,000 is issued for ₹960 with flotation cost of ₹15 and is redeemable at par after 4 years. Tax is 30%. Estimate Kd using YTM interpolation with these factors: at 7%, PVAF = 3.3872 and PVF = 0.7629; at 8%, PVAF = 3.3121 and PVF = 0.7350.

A 9% debenture of face value ₹1,000 is issued for ₹960 with flotation cost of ₹15 and is redeemable at par after 4 years. Tax is 30%. Estimate Kd using YTM interpolation with these factors: at 7%, PVAF = 3.3872 and PVF = 0.7629; at 8%, PVAF = 3.3121 and PVF = 0.7350.

1. 7.00%
2. 8.00%
3. 7.96% (correct answer)
4. 9.02%

Answer: C — 7.96%

Explanation. Net proceeds are ₹960 − ₹15 = ₹945. Annual post-tax interest is ₹90 × 0.70 = ₹63, with ₹1,000 redemption at year 4. At 7%, PV = ₹63×3.3872 + ₹1,000×0.7629 = ₹976.29, so NPV is +₹31.29. At 8%, PV = ₹63×3.3121 + ₹1,000×0.7350 = ₹943.66, so NPV is −₹1.34. IRR = 7% + [31.29/(31.29+1.34)]×1% = 7.96%.

Where it goes wrong. Using gross coupon interest or issue price without deducting flotation expenses when setting the initial cash flow.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 12 · 2 marks · Cost of Capital · hard

Scenario. A zero-coupon bond is issued for ₹3,000 and will be redeemed for ₹12,000 after 10 years. There is no tax and no periodic interest. What is the annual cost of debt (YTM)?

A zero-coupon bond is issued for ₹3,000 and will be redeemed for ₹12,000 after 10 years. There is no tax and no periodic interest. What is the annual cost of debt (YTM)?

1. 10.00%
2. 12.00%
3. 15.00%
4. 14.87% (correct answer)

Answer: D — 14.87%

Explanation. For a zero-coupon bond, there are no periodic interest payments; the only cash flows are ₹3,000 received now and ₹12,000 repaid after 10 years. Thus ₹12,000 = ₹3,000(1 + Kd)^10, so (1 + Kd)^10 = 4. Kd = 4^(1/10) − 1 = 14.8698%, approximately 14.87%. The shortcut redeemable-debt formula is unreliable for this large gap between NP and RV; compounding or YTM is appropriate.

Where it goes wrong. Applying the approximation formula despite a very large difference between net proceeds and redemption value.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 13 · 2 marks · Cost of Capital · medium

Scenario. A company issues 20,000 irredeemable 11% debentures of ₹100 each at a 3% discount. Underwriting commission is 1.5% of face value; total brokerage is ₹40,000 and legal expenses are ₹20,000. If tax is 30%, what is the after-tax Kd?

A company issues 20,000 irredeemable 11% debentures of ₹100 each at a 3% discount. Underwriting commission is 1.5% of face value; total brokerage is ₹40,000 and legal expenses are ₹20,000. If tax is 30%, what is the after-tax Kd?

1. 8.32% (correct answer)
2. 7.70%
3. 7.94%
4. 11.89%

Answer: A — 8.32%

Explanation. Issue proceeds per debenture = ₹100 − ₹3 discount = ₹97. Underwriting is 1.5% of ₹100 = ₹1.50; brokerage is ₹40,000/20,000 = ₹2; legal expense is ₹20,000/20,000 = ₹1. Therefore NP = ₹97 − ₹1.50 − ₹2 − ₹1 = ₹92.50. After-tax interest = ₹11 × 0.70 = ₹7.70, so Kd = ₹7.70/₹92.50 = 8.32%. Omitting either shared issue expense overstates NP and understates Kd.

Where it goes wrong. Failing to allocate total brokerage and legal expenses across the number of debentures before calculating net proceeds.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 14 · 2 marks · Cost of Capital · medium

Scenario. A company has irredeemable debt with face value and net proceeds of ₹1,000 per debenture and an annual coupon of 10%. If the tax rate falls from 30% to 20%, by how many percentage points does the after-tax Kd increase?

A company has irredeemable debt with face value and net proceeds of ₹1,000 per debenture and an annual coupon of 10%. If the tax rate falls from 30% to 20%, by how many percentage points does the after-tax Kd increase?

1. 0.50 percentage point
2. 1.00 percentage point (correct answer)
3. 2.00 percentage points
4. 3.00 percentage points

Answer: B — 1.00 percentage point

Explanation. At a 30% tax rate, after-tax interest on ₹1,000 face value is ₹100 × 0.70 = ₹70, giving Kd = 7.00%. At a 20% tax rate, after-tax interest becomes ₹100 × 0.80 = ₹80, giving Kd = 8.00%. The increase is 8.00% − 7.00% = 1.00 percentage point. The coupon has not changed; the increase arises solely because the tax shield is smaller. A 10% answer would confuse the pre-tax coupon with the after-tax cost.

Where it goes wrong. Treating the coupon rate as the after-tax cost, or applying the old tax rate after the change.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 15 · 2 marks · Cost of Capital · hard

Scenario. A company’s book values are equity ₹50 lakh and debt ₹50 lakh. Their market values are equity ₹80 lakh and debt ₹40 lakh. Cost of equity is 16%, debt coupon is 10% and tax is 30%. Calculate WACC using market-value weights.

A company’s book values are equity ₹50 lakh and debt ₹50 lakh. Their market values are equity ₹80 lakh and debt ₹40 lakh. Cost of equity is 16%, debt coupon is 10% and tax is 30%. Calculate WACC using market-value weights.

1. 11.50%
2. 12.00%
3. 13.00% (correct answer)
4. 14.00%

Answer: C — 13.00%

Explanation. After-tax debt cost = 10% × (1 − 30%) = 7%. Market-value weights are equity ₹80 lakh and debt ₹40 lakh, total ₹120 lakh. WACC = (80/120 × 16%) + (40/120 × 7%) = 10.6667% + 2.3333% = 13.00%. The 11.50% distractor is obtained from equal book-value weights of ₹50 lakh each; the question specifically requires market-value weights. The weight basis changes the hurdle rate.

Where it goes wrong. Using the book-value proportions even though the question expressly specifies market-value weights.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 16 · 2 marks · Cost of Capital · hard

Scenario. A company plans to raise additional capital using marginal weights of 60% debt carrying a 10% pre-tax cost and 40% equity carrying a 15% cost. Corporate tax is 30%. Calculate the marginal weighted average cost of capital.

A company plans to raise additional capital using marginal weights of 60% debt carrying a 10% pre-tax cost and 40% equity carrying a 15% cost. Corporate tax is 30%. Calculate the marginal weighted average cost of capital.

1. 9.00%
2. 11.00%
3. 12.00%
4. 10.20% (correct answer)

Answer: D — 10.20%

Explanation. Marginal weights are 60% debt and 40% equity. After-tax debt cost = 10% × (1 − 30%) = 7%. Marginal WACC = (60% × 7%) + (40% × 15%) = 4.20% + 6.00% = 10.20%. Using the gross 10% debt rate would ignore the tax shield; using the existing capital structure instead of the stated financing mix would calculate average rather than marginal cost.

Where it goes wrong. Using pre-tax debt cost or existing average capital weights instead of the specified marginal financing proportions.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 17 · 2 marks · Cost of Capital · hard

Scenario. A company is considering two financing plans for a project expected to earn EBIT of ₹20 lakh. Plan A uses ₹1 crore of equity divided into 10 lakh shares. Plan B uses ₹50 lakh of equity divided into 5 lakh shares and ₹50 lakh debt at 10% interest. Tax is 30%. Which plan gives the higher EPS and by how much?

A company is considering two financing plans for a project expected to earn EBIT of ₹20 lakh. Plan A uses ₹1 crore of equity divided into 10 lakh shares. Plan B uses ₹50 lakh of equity divided into 5 lakh shares and ₹50 lakh debt at 10% interest. Tax is 30%. Which plan gives the higher EPS and by how much?

1. Plan B by ₹0.70 per share (correct answer)
2. Plan A by ₹0.70 per share
3. Plan B by ₹0.35 per share
4. Both plans give equal EPS

Answer: A — Plan B by ₹0.70 per share

Explanation. Plan A has 10 lakh shares. PAT = ₹20 lakh × 0.70 = ₹14 lakh; EPS = ₹14 lakh/10 lakh = ₹1.40. Plan B has 5 lakh shares and ₹50 lakh debt; interest = ₹50 lakh × 10% = ₹5 lakh. PAT = (₹20 lakh − ₹5 lakh) × 0.70 = ₹10.50 lakh; EPS = ₹10.50 lakh/5 lakh = ₹2.10. Plan B exceeds Plan A by ₹0.70 per share. Comparing PAT alone misses the leverage effect on share count.

Where it goes wrong. Comparing profit after tax without dividing by the respective number of equity shares.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 18 · 2 marks · Cost of Capital · hard

Scenario. A project requires an initial investment of ₹15 lakh and generates operating CFAT of ₹6 lakh at each year-end for 3 years. It also releases ₹2 lakh of working capital at the end of year 3. At a 12% cost of capital, use discount factors 0.893, 0.797 and 0.712 for years 1, 2 and 3 respectively. What is the project NPV?

A project requires an initial investment of ₹15 lakh and generates operating CFAT of ₹6 lakh at each year-end for 3 years. It also releases ₹2 lakh of working capital at the end of year 3. At a 12% cost of capital, use discount factors 0.893, 0.797 and 0.712 for years 1, 2 and 3 respectively. What is the project NPV?

1. −₹0.59 lakh
2. +₹0.84 lakh (correct answer)
3. +₹2.26 lakh
4. +₹5.00 lakh

Answer: B — +₹0.84 lakh

Explanation. Discount each CFAT, not accounting profit: Year 1 PV = ₹6 lakh×0.893 = ₹5.358 lakh; Year 2 PV = ₹6 lakh×0.797 = ₹4.782 lakh; Year 3 operating CFAT PV = ₹6 lakh×0.712 = ₹4.272 lakh. Working-capital recovery PV = ₹2 lakh×0.712 = ₹1.424 lakh. Total PV = ₹15.836 lakh; NPV = ₹15.836 lakh − ₹15 lakh = +₹0.836 lakh. A positive NPV supports acceptance; omitting the recovery understates value.

Where it goes wrong. Discounting accounting profit instead of CFAT or omitting the terminal recovery of working capital.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 19 · 2 marks · Cost of Capital · hard

Scenario. A company can raise either (A) 10% irredeemable debt at ₹95 per ₹100 face value with flotation cost ₹2 per debenture, or (B) 9% redeemable debt issued at ₹100 less flotation cost ₹1 and redeemed at par after 5 years. Tax is 30%. Using the approximation formula, which source has the lower Kd and by how much?

A company can raise either (A) 10% irredeemable debt at ₹95 per ₹100 face value with flotation cost ₹2 per debenture, or (B) 9% redeemable debt issued at ₹100 less flotation cost ₹1 and redeemed at par after 5 years. Tax is 30%. Using the approximation formula, which source has the lower Kd and by how much?

1. A by 0.99 percentage point
2. B by 1.50 percentage points
3. B by 0.99 percentage point (correct answer)
4. Both have the same Kd

Answer: C — B by 0.99 percentage point

Explanation. Alternative A: NP = ₹95 − ₹2 = ₹93; Kd = ₹10×0.70/₹93 = 7.53%. Alternative B: NP = ₹100 − ₹1 = ₹99; after-tax interest = ₹9×0.70 = ₹6.30; annual redemption adjustment = (₹100−₹99)/5 = ₹0.20; average value = ₹99.50. Kd = ₹6.50/₹99.50 = 6.53%. B is cheaper by 7.53% − 6.53% = 0.99 percentage point. Comparing coupon rates alone would miss issue costs and maturity adjustment.

Where it goes wrong. Selecting the lower stated coupon without adjusting for tax, flotation costs and redemption proceeds.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 20 · 2 marks · Cost of Capital · hard

Scenario. A company issues 12% convertible debentures of face value ₹1,000 for ₹980 and incurs issue expenses of ₹20 per debenture. They mature in 4 years; holders may receive cash redemption of ₹1,050 or 20 equity shares. The expected share price at maturity is ₹60. If only interest is tax-deductible and tax is 30%, calculate Kd using the approximation method.

A company issues 12% convertible debentures of face value ₹1,000 for ₹980 and incurs issue expenses of ₹20 per debenture. They mature in 4 years; holders may receive cash redemption of ₹1,050 or 20 equity shares. The expected share price at maturity is ₹60. If only interest is tax-deductible and tax is 30%, calculate Kd using the approximation method.

1. 8.89%
2. 10.60%
3. 12.00%
4. 13.33% (correct answer)

Answer: D — 13.33%

Explanation. The conversion value is 20 shares × ₹60 = ₹1,200, which exceeds the ₹1,050 cash redemption; therefore RV = ₹1,200. NP = ₹980 − ₹20 = ₹960; post-tax interest = ₹120×0.70 = ₹84; annual principal/value adjustment = (₹1,200−₹960)/4 = ₹60. Average value = (₹1,200+₹960)/2 = ₹1,080. Kd = (₹84+₹60)/₹1,080 = 13.33%. Using cash redemption instead of the more valuable conversion alternative understates the cost.

Where it goes wrong. Using the cash redemption amount despite a higher expected conversion value, or forgetting to deduct flotation expenses.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital