Test 2: Cost of Capital: answer key

Question 1 · 2 marks · Cost of Capital · medium

Scenario. Zenith Power Systems Ltd. is an established manufacturer of industrial energy-storage equipment. The company plans to expand its manufacturing capacity and is evaluating different preference share structures to finance the expansion. The finance director has advised that the company must consider issue expenses, redemption obligations and the non-deductibility of preference dividends before selecting an instrument. Existing capital structure (₹ crore): Equity share capital: ₹80 crore. Retained earnings: ₹20 crore. 12% irredeemable preference share capital: ₹25 crore. 10% debentures: ₹35 crore. 10% term loans: ₹20 crore. Total capital: ₹180 crore. Proposed preference share issues (per share): Series P: 12% irredeemable preference shares, face value ₹100, issue price ₹98, flotation expenses ₹2. Series Q: 10% redeemable preference shares, face value ₹100, issue price ₹97, flotation expenses ₹2, redemption at ₹110 after 5 years. Series R: 11% redeemable preference shares, face value ₹100, issue price ₹102, flotation expenses ₹2, redemption at par after 5 years. Additional financial information: Forecast EBIT: ₹24 crore. Annual interest on existing debt: ₹5.50 crore. Corporate income-tax rate: 25%. Equity beta: 1.15. Risk-free rate: 6%; expected market return: 13%. Proposed expansion investment: ₹50 crore. Expected annual CFAT from expansion: ₹14 crore for 5 years. Working capital cycle: Raw material holding 35 days, work-in-progress 20 days, receivables 45 days and supplier credit 30 days. Net operating cycle: 70 days. The company has sufficient taxable profits. The management confirms that preference dividends are distributions from post-tax profits and are not allowable deductions in computing corporate income-tax. The company also distinguishes the cost of preference capital from the tax consequences arising to individual investors. All proposed preference issues are assumed to carry annual dividend payments without additional issue-related tax obligations.

Zenith Power Systems Ltd. proposes to issue Series P irredeemable preference shares. Calculate the cost of preference share capital (Kp) after considering the flotation expenses.

1. 12.50% (correct answer)
2. 12.00%
3. 9.00%
4. 12.24%

Answer: A — 12.50%

Explanation. Annual preference dividend (PD) = 12% of ₹100 = ₹12. Net proceeds (NP) = Issue price − Flotation expenses = ₹98 − ₹2 = ₹96. Since the preference shares are irredeemable, Kp = PD/NP = ₹12/₹96 × 100 = 12.50%. Option b ignores the flotation expense and option c incorrectly applies the corporate tax shield to preference dividend. The face value determines the dividend, whereas net proceeds determine the issuer's cost.

Where it goes wrong. Using the face value or gross issue price as the denominator instead of net proceeds after flotation costs.

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

Question 2 · 2 marks · Cost of Capital · hard

Calculate the approximate cost of Series Q redeemable preference shares using the ICAI approximation formula. Consider the redemption premium and all flotation expenses.

1. 12.68% (correct answer)
2. 14.63%
3. 15.79%
4. 11.71%

Answer: A — 12.68%

Explanation. Annual preference dividend = ₹100 × 10% = ₹10. Net proceeds = ₹97 − ₹2 = ₹95. Redemption value = ₹110 and remaining life = 5 years. Kp = [PD + (RV − NP)/n] ÷ [(RV + NP)/2] = [10 + (110 − 95)/5] ÷ [(110 + 95)/2] = 13 ÷ 102.50 = 12.68%.

Where it goes wrong. Confusing Series Q with another preference issue and selecting a cost calculated using different issue particulars.

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

Question 3 · 2 marks · Cost of Capital · hard

The finance director is evaluating Series R against Series Q. Calculate the reduction in approximate cost of preference capital achieved by selecting Series R rather than Series Q.

1. 2.50 percentage points
2. 3.00 percentage points
3. 1.68 percentage points (correct answer)
4. 4.25 percentage points

Answer: C — 1.68 percentage points

Explanation. For Series R, NP = ₹102 − ₹2 = ₹100, PD = ₹11 and RV = ₹100. Therefore Kp = [11 + (100 − 100)/5]/[(100 + 100)/2] = 11/100 = 11.00%. For Series Q, Kp = [10 + (110 − 95)/5]/[(110 + 95)/2] = 13/102.5 = 12.68%. Reduction = 12.68% − 11.00% = 1.68 percentage points. The comparison must use calculated costs, not merely compare the stated dividend rates.

Where it goes wrong. Comparing stated dividend percentages instead of calculating the effective cost after flotation expenses and redemption.

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

Question 4 · 2 marks · Cost of Capital · medium

Zenith's existing preference share capital of ₹25 crore carries a 12% dividend. An analyst incorrectly deducts the resulting preference dividend from taxable profits while calculating corporate tax. By how much would the company's annual tax liability be understated?

1. Nil
2. ₹3.00 crore
3. ₹1.375 crore
4. ₹0.75 crore (correct answer)

Answer: D — ₹0.75 crore

Explanation. Annual preference dividend = ₹25 crore × 12% = ₹3 crore. Preference dividend is an appropriation of profit after tax and is not deductible in computing taxable income. The incorrect tax deduction would generate an artificial tax saving of ₹3 crore × 25% = ₹0.75 crore. Therefore, the analyst would understate corporate tax liability by ₹0.75 crore. Actual interest of ₹5.50 crore on debt is deductible, but preference dividend is not.

Where it goes wrong. Treating preference dividend as an allowable business expense and incorrectly extending the debt-interest tax shield to preference capital.

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

Question 5 · 2 marks · Cost of Capital · medium

Scenario. Aditya Automotive Ltd. manufactures precision components for electric vehicles and is preparing to finance a new automated assembly facility. The company is considering irredeemable and redeemable preference capital and has requested an assessment of the economic cost of each alternative. Its finance team must distinguish the company's cost of raising preference capital from the personal taxation of investors receiving preference dividends. Existing capital structure (₹ crore): Equity share capital: ₹100 crore. Retained earnings: ₹15 crore. 12% preference share capital: ₹20 crore. 10% debentures: ₹45 crore. Term loans: ₹15 crore. Total capital: ₹195 crore. Proposed preference issues (per share): Series M: 13% irredeemable preference shares, face value ₹100, issue price ₹104, flotation expenses ₹3. Series N: 12% redeemable preference shares, face value ₹100, issue price ₹98, flotation expenses ₹3, redemption at ₹110 after 5 years. Series O: 11% redeemable preference shares, face value ₹100, issue price ₹102, flotation expenses ₹2, redemption at par after 5 years. Additional financial information: Forecast EBIT: ₹32 crore. Annual interest on existing borrowings: ₹5.50 crore. Corporate income-tax rate: 25%. Equity beta: 1.25. Risk-free rate: 6%; market return: 13.5%. Automation project investment: ₹40 crore. Expected annual CFAT: ₹8 crore for 6 years. Working capital cycle: Raw material holding 50 days, work-in-progress 15 days, receivables 40 days and supplier credit 35 days. Net operating cycle: 70 days. All new preference shares are fully underwritten and the stated flotation expenses are borne by the company. The resident individual investors subscribing to Series M are assumed to pay personal income-tax at a marginal rate of 30%. For dividends distributed on or after 1 April 2020, the company follows the applicable post-DDT regime. No company-level Dividend Distribution Tax is assumed. The management requires the preference capital cost to be calculated without applying a corporate interest tax shield to preference dividends.

Calculate the cost of Series M irredeemable preference shares issued by Aditya Automotive Ltd. after considering the flotation expenses.

1. 12.87% (correct answer)
2. 12.50%
3. 9.65%
4. 13.00%

Answer: A — 12.87%

Explanation. Annual preference dividend = 13% × ₹100 = ₹13. The company receives an issue price of ₹104 but incurs flotation expenses of ₹3. Hence, NP = ₹104 − ₹3 = ₹101. Cost of irredeemable preference capital = PD/NP × 100 = ₹13/₹101 × 100 = 12.8713%, approximately 12.87%. Option b ignores the flotation expense, while option c incorrectly reduces the preference dividend by corporate tax.

Where it goes wrong. Applying the dividend rate directly to face value or issue price without adjusting for flotation expenses.

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

Question 6 · 2 marks · Cost of Capital · hard

Using the approximation method, determine the cost of Series N redeemable preference shares, including redemption premium and flotation expenses.

1. 12.68%
2. 14.63% (correct answer)
3. 12.00%
4. 16.00%

Answer: B — 14.63%

Explanation. PD = ₹100 × 12% = ₹12. NP = ₹98 − ₹3 = ₹95. RV = ₹110 and n = 5 years. Kp = [12 + (110 − 95)/5]/[(110 + 95)/2] = [12 + 3]/102.50 = ₹15/₹102.50 = 14.6341%, or approximately 14.63%. Preference dividend is not tax-deductible, so the corporate tax rate of 25% is not applied. Ignoring flotation cost or redemption premium gives an incorrect answer.

Where it goes wrong. Applying the tax adjustment to preference dividend or ignoring the premium payable on redemption.

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

Question 7 · 2 marks · Cost of Capital · hard

Series O has a different redemption structure from Series N. Determine the reduction in approximate cost of preference capital if Aditya Automotive Ltd. selects Series O rather than Series N.

1. 2.13 percentage points
2. 3.00 percentage points
3. 3.63 percentage points (correct answer)
4. 4.50 percentage points

Answer: C — 3.63 percentage points

Explanation. For Series O, NP = ₹102 − ₹2 = ₹100; annual dividend = ₹11 and RV = ₹100. Hence Kp = [11 + (100 − 100)/5]/100 = 11.00%. Series N has NP of ₹95, PD of ₹12 and RV of ₹110. Its Kp = 15/102.5 = 14.63%. The reduction = 14.63% − 11.00% = 3.63 percentage points. Redemption at par and the higher net proceeds make Series O comparatively economical.

Where it goes wrong. Comparing coupon rates without considering the redemption premium, issue premium and flotation cost.

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

Question 8 · 2 marks · Cost of Capital · medium

An individual investor subscribing to 100 Series M preference shares pays ₹104 per share. The annual dividend is ₹13 per share and the investor's assumed marginal income-tax rate is 30%. Calculate the investor's annual post-tax yield and the company's cost of raising this capital, respectively.

1. 12.87%; 12.50%
2. 9.10%; 9.65%
3. 12.50%; 8.75%
4. 8.75%; 12.87% (correct answer)

Answer: D — 8.75%; 12.87%

Explanation. Investor's gross dividend = ₹13 per share. After personal tax of 30%, net dividend = ₹13 × 70% = ₹9.10. Investor's post-tax yield = ₹9.10/₹104 × 100 = 8.75%. For the company, NP = ₹104 − ₹3 flotation cost = ₹101. Company Kp = ₹13/₹101 × 100 = 12.87%. Personal taxation affects the investor's net receipt, not the company's gross preference dividend obligation or its calculation of Kp.

Where it goes wrong. Confusing the investor's after-tax yield with the issuing company's cost of preference capital.

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

Question 9 · 2 marks · Cost of Capital · medium

Scenario. A company issues 15% irredeemable preference shares of face value ₹100 each at ₹96. The flotation expense is ₹1 per share. Determine the cost of preference capital.

A company issues 15% irredeemable preference shares of face value ₹100 each at ₹96. The flotation expense is ₹1 per share. Determine the cost of preference capital.

1. 15.79% (correct answer)
2. 15.00%
3. 11.25%
4. 15.63%

Answer: A — 15.79%

Explanation. Annual preference dividend = 15% × ₹100 = ₹15. Net proceeds = ₹96 − ₹1 = ₹95. Since these shares are irredeemable, Kp = PD/NP × 100 = ₹15/₹95 × 100 = 15.7895%, approximately 15.79%. Option b uses an incorrect net proceeds amount of ₹100, while option c incorrectly applies a 25% tax adjustment to the preference dividend. Option d ignores flotation expenses.

Where it goes wrong. Using issue price rather than net proceeds or incorrectly treating preference dividend as tax-deductible.

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

Question 10 · 2 marks · Cost of Capital · hard

Scenario. A company issues 14% redeemable preference shares of face value ₹100 at ₹96. Flotation expenses are ₹4 per share. The shares will be redeemed at ₹120 after 4 years. Calculate the approximate Kp.

A company issues 14% redeemable preference shares of face value ₹100 at ₹96. Flotation expenses are ₹4 per share. The shares will be redeemed at ₹120 after 4 years. Calculate the approximate Kp.

1. 16.67%
2. 19.81% (correct answer)
3. 19.44%
4. 15.85%

Answer: B — 19.81%

Explanation. PD = 14% × ₹100 = ₹14. NP = ₹96 − ₹4 = ₹92. RV = ₹120 and n = 4 years. Kp = [14 + (120 − 92)/4]/[(120 + 92)/2] = [14 + 7]/106 = 21/106 × 100 = 19.8113%, or 19.81%. Option a incorrectly uses par redemption. Option c ignores flotation costs, while option d incorrectly applies corporate tax to preference dividends.

Where it goes wrong. Ignoring flotation expenses or using the face value rather than the actual redemption value in the approximation formula.

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

Question 11 · 2 marks · Cost of Capital · hard

Scenario. A company issues 12% redeemable preference shares at ₹105 per share. Flotation expenses are ₹2 per share. The face value is ₹100 and the shares will be redeemed at ₹95 after 4 years. Compute the approximate cost of preference capital.

A company issues 12% redeemable preference shares at ₹105 per share. Flotation expenses are ₹2 per share. The face value is ₹100 and the shares will be redeemed at ₹95 after 4 years. Compute the approximate cost of preference capital.

1. 12.12%
2. 10.00%
3. 10.10% (correct answer)
4. 9.09%

Answer: C — 10.10%

Explanation. Annual dividend = 12% × ₹100 = ₹12. Net proceeds = ₹105 − ₹2 = ₹103. The company incurs a redemption loss of ₹8, so the annual adjustment is (₹95 − ₹103)/4 = −₹2. Average value = (₹95 + ₹103)/2 = ₹99. Therefore Kp = (₹12 − ₹2)/₹99 × 100 = 10.10%. The negative adjustment is essential because the company receives more than it repays at maturity.

Where it goes wrong. Adding a redemption loss adjustment instead of subtracting it, or confusing the issue premium with the redemption premium.

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

Question 12 · 2 marks · Cost of Capital · hard

Scenario. A company issues 50,000 10% irredeemable preference shares of ₹100 each at ₹98 per share. Flotation expenses amount to 1.5% of face value. Calculate the overall cost of preference capital for the issue.

A company issues 50,000 10% irredeemable preference shares of ₹100 each at ₹98 per share. Flotation expenses amount to 1.5% of face value. Calculate the overall cost of preference capital for the issue.

1. 10.00%
2. 10.10%
3. 9.65%
4. 10.36% (correct answer)

Answer: D — 10.36%

Explanation. Annual dividend per share = ₹10. Total annual dividend = 50,000 × ₹10 = ₹5,00,000. Flotation cost per share = 1.5% × ₹100 = ₹1.50. Net proceeds per share = ₹98 − ₹1.50 = ₹96.50. Aggregate net proceeds = 50,000 × ₹96.50 = ₹48,25,000. Therefore Kp = ₹5,00,000/₹48,25,000 × 100 = 10.36%. The calculation must deduct flotation expenses before determining the overall cost.

Where it goes wrong. Calculating preference dividend on issue price or deducting flotation expenses twice when calculating aggregate net proceeds.

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

Question 13 · 2 marks · Cost of Capital · hard

Scenario. A company issues 10% irredeemable preference shares of ₹100 each in two tranches: 20,000 shares at ₹96 and 30,000 shares at ₹102. Aggregate flotation expenses for the entire issue amount to ₹1,50,000. Calculate the cost of preference capital.

A company issues 10% irredeemable preference shares of ₹100 each in two tranches: 20,000 shares at ₹96 and 30,000 shares at ₹102. Aggregate flotation expenses for the entire issue amount to ₹1,50,000. Calculate the cost of preference capital.

1. 10.35% (correct answer)
2. 10.04%
3. 10.62%
4. 9.65%

Answer: A — 10.35%

Explanation. Gross proceeds of first tranche = 20,000 × ₹96 = ₹19,20,000. Gross proceeds of second tranche = 30,000 × ₹102 = ₹30,60,000. Total gross proceeds = ₹49,80,000. Net proceeds = ₹49,80,000 − ₹1,50,000 = ₹48,30,000. Annual preference dividend = 50,000 × ₹10 = ₹5,00,000. Kp = ₹5,00,000/₹48,30,000 × 100 = 10.35%. The separate issue prices must be applied to their respective quantities before deducting aggregate flotation expenses.

Where it goes wrong. Using a simple average of the two issue prices rather than calculating aggregate proceeds using the number of shares issued in each tranche.

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

Question 14 · 2 marks · Cost of Capital · hard

Scenario. A company has issued 10% redeemable preference shares of face value ₹100 at ₹98 with flotation expenses of ₹2 per share. These shares are redeemable at ₹110. If the redemption period is extended from 4 years to 7 years, what is the reduction in approximate Kp?

A company has issued 10% redeemable preference shares of face value ₹100 at ₹98 with flotation expenses of ₹2 per share. These shares are redeemable at ₹110. If the redemption period is extended from 4 years to 7 years, what is the reduction in approximate Kp?

1. 0.73 percentage point
2. 1.46 percentage points (correct answer)
3. 2.00 percentage points
4. 3.10 percentage points

Answer: B — 1.46 percentage points

Explanation. NP = ₹98 − ₹2 = ₹96. PD = ₹10 and RV = ₹110. Denominator = (₹110 + ₹96)/2 = ₹103. For 4 years, Kp = [10 + (14/4)]/103 × 100 = 13.11%. For 7 years, Kp = [10 + (14/7)]/103 × 100 = 11.65%. Reduction = 13.11% − 11.65% = 1.46 percentage points. A longer redemption period spreads the redemption premium over more years, reducing the annualised approximation adjustment.

Where it goes wrong. Using the same annual redemption adjustment regardless of the remaining life of the preference shares.

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

Question 15 · 2 marks · Cost of Capital · hard

Scenario. A company has existing 10% redeemable preference shares of face value ₹100. The current market price is ₹82 and the remaining redemption period is 4 years. They will be redeemed at par. Calculate the current cost of preference capital using the approximation formula.

A company has existing 10% redeemable preference shares of face value ₹100. The current market price is ₹82 and the remaining redemption period is 4 years. They will be redeemed at par. Calculate the current cost of preference capital using the approximation formula.

1. 12.20%
2. 14.29%
3. 15.93% (correct answer)
4. 16.67%

Answer: C — 15.93%

Explanation. For existing preference shares, the current market price is used as NP. Thus NP = ₹82, RV = ₹100, PD = ₹10 and n = 4. Annual redemption adjustment = (₹100 − ₹82)/4 = ₹4.50. Average value = (₹100 + ₹82)/2 = ₹91. Therefore Kp = (₹10 + ₹4.50)/₹91 × 100 = 15.9341%, approximately 15.93%. The calculation reflects the current cost of existing capital rather than the original issue cost.

Where it goes wrong. Using original issue proceeds or face value instead of the current market price when estimating the cost of existing redeemable preference shares.

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

Question 16 · 2 marks · Cost of Capital · hard

Scenario. A company has the following market-value capital structure: equity ₹70 lakh, debt ₹20 lakh and preference shares ₹10 lakh. Cost of equity is 16%, debt carries a pre-tax interest rate of 10%, and corporate tax is 30%. The preference shares carry a 12% dividend and are issued at ₹98 with flotation expenses of ₹2 per share. Calculate WACC.

A company has the following market-value capital structure: equity ₹70 lakh, debt ₹20 lakh and preference shares ₹10 lakh. Cost of equity is 16%, debt carries a pre-tax interest rate of 10%, and corporate tax is 30%. The preference shares carry a 12% dividend and are issued at ₹98 with flotation expenses of ₹2 per share. Calculate WACC.

1. 13.00%
2. 13.50%
3. 12.75%
4. 13.85% (correct answer)

Answer: D — 13.85%

Explanation. Cost of preference capital = ₹12/(₹98 − ₹2) × 100 = 12.50%. After-tax debt cost = 10% × 0.70 = 7%. Market-value weights are 70%, 20% and 10%, respectively. WACC = (70% × 16%) + (20% × 7%) + (10% × 12.50%) = 11.20% + 1.40% + 1.25% = 13.85%. Preference dividends receive no tax shield. Only debt interest is adjusted for corporate tax.

Where it goes wrong. Applying the debt tax adjustment to preference dividends or using book-value instead of the specified market-value weights.

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

Question 17 · 2 marks · Cost of Capital · medium

Scenario. A company issues 12% irredeemable preference shares of face value ₹100 at ₹96. Flotation expenses are ₹2 per share. Dividends are distributed under the post-1 April 2020 tax regime. A resident investor's marginal tax rate is 25%. Calculate the company's Kp and the investor's post-tax yield, respectively.

A company issues 12% irredeemable preference shares of face value ₹100 at ₹96. Flotation expenses are ₹2 per share. Dividends are distributed under the post-1 April 2020 tax regime. A resident investor's marginal tax rate is 25%. Calculate the company's Kp and the investor's post-tax yield, respectively.

1. 12.77%; 9.38% (correct answer)
2. 12.50%; 9.38%
3. 9.57%; 12.50%
4. 12.77%; 12.77%

Answer: A — 12.77%; 9.38%

Explanation. Company net proceeds = ₹96 − ₹2 = ₹94. Its annual dividend is ₹12, so company Kp = ₹12/₹94 × 100 = 12.77%. The investor pays ₹96 and receives a gross dividend of ₹12. After personal tax of 25%, net dividend = ₹12 × 75% = ₹9. Investor's post-tax yield = ₹9/₹96 × 100 = 9.375%, or 9.38%. The company's flotation expenses affect its cost, while the investor's personal tax affects only the investor's net return.

Where it goes wrong. Using the investor's personal tax rate to reduce the company's preference dividend or using company net proceeds as the investor's purchase price.

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

Question 18 · 2 marks · Cost of Capital · hard

Scenario. An individual investor purchases a preference share for ₹80 and requires an annual post-personal-tax return of 9%. The investor's marginal tax rate is 25%. The issuing company incurs flotation expenses of ₹2 per share and receives ₹80 as the issue price. If the face value is ₹100, determine the minimum annual preference dividend and the company's resulting cost of preference capital.

An individual investor purchases a preference share for ₹80 and requires an annual post-personal-tax return of 9%. The investor's marginal tax rate is 25%. The issuing company incurs flotation expenses of ₹2 per share and receives ₹80 as the issue price. If the face value is ₹100, determine the minimum annual preference dividend and the company's resulting cost of preference capital.

1. ₹7.20 and 9.23%
2. ₹9.60 and 12.31% (correct answer)
3. ₹9.60 and 12.00%
4. ₹12.80 and 16.41%

Answer: B — ₹9.60 and 12.31%

Explanation. Required net dividend = ₹80 × 9% = ₹7.20. Since 25% is payable as personal tax, gross dividend required = ₹7.20/(1 − 0.25) = ₹9.60. Company net proceeds = ₹80 − ₹2 = ₹78. Therefore company Kp = ₹9.60/₹78 × 100 = 12.3077%, approximately 12.31%. The investor's target is a post-tax yield, so the dividend must be grossed up before calculating the issuer's cost.

Where it goes wrong. Failing to gross up the investor's required return for personal taxation or ignoring flotation expenses when determining the company's net proceeds.

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

Question 19 · 2 marks · Cost of Capital · hard

Scenario. A company has issued 1,00,000 irredeemable 12% preference shares of face value ₹100 each at ₹98 with flotation expenses of ₹2 per share. An internal report prepared for the financial year 2026-27 incorrectly adds 15% Dividend Distribution Tax (DDT) to the company's dividend outflow. Resident shareholders are assumed to pay personal income-tax at 20%. Under the applicable post-DDT regime, determine the correct annual company cash outflow, aggregate post-tax dividend receipt of shareholders and company Kp.

A company has issued 1,00,000 irredeemable 12% preference shares of face value ₹100 each at ₹98 with flotation expenses of ₹2 per share. An internal report prepared for the financial year 2026-27 incorrectly adds 15% Dividend Distribution Tax (DDT) to the company's dividend outflow. Resident shareholders are assumed to pay personal income-tax at 20%. Under the applicable post-DDT regime, determine the correct annual company cash outflow, aggregate post-tax dividend receipt of shareholders and company Kp.

1. ₹13.80 lakh; ₹12.00 lakh; 14.38%
2. ₹12.00 lakh; ₹12.00 lakh; 12.50%
3. ₹12.00 lakh; ₹9.60 lakh; 12.50% (correct answer)
4. ₹9.60 lakh; ₹8.16 lakh; 10.00%

Answer: C — ₹12.00 lakh; ₹9.60 lakh; 12.50%

Explanation. Annual preference dividend = 1,00,000 × ₹12 = ₹12,00,000. Company-level DDT is not payable on dividends distributed on or after 1 April 2020; such dividends are taxable in shareholders' hands. Thus, company cash outflow remains ₹12 lakh. Shareholders' aggregate post-tax receipt = ₹12 lakh × 80% = ₹9.60 lakh. Net proceeds per share = ₹98 − ₹2 = ₹96; company Kp = ₹12/₹96 × 100 = 12.50%. The additional DDT in the old report overstates company cost.

Where it goes wrong. Continuing to add historical company-level DDT to current preference dividend payments or confusing shareholder income-tax with the issuing company's tax liability.

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

Question 20 · 2 marks · Cost of Capital · hard

Scenario. A company is deciding between issuing 14% redeemable preference shares of face value ₹100 at net proceeds of ₹95, redeemable at ₹110 after 5 years, and raising debt at 12% pre-tax interest. Corporate tax is 30%. Using the approximation method for preference capital, by how many percentage points is preference capital costlier than the after-tax cost of debt?

A company is deciding between issuing 14% redeemable preference shares of face value ₹100 at net proceeds of ₹95, redeemable at ₹110 after 5 years, and raising debt at 12% pre-tax interest. Corporate tax is 30%. Using the approximation method for preference capital, by how many percentage points is preference capital costlier than the after-tax cost of debt?

1. 5.00 percentage points
2. 7.50 percentage points
3. 16.59 percentage points
4. 8.19 percentage points (correct answer)

Answer: D — 8.19 percentage points

Explanation. Preference dividend = ₹100 × 14% = ₹14. Kp = [14 + (110 − 95)/5]/[(110 + 95)/2] = 17/102.50 × 100 = 16.5854%, or 16.59%. After-tax debt cost = 12% × (1 − 0.30) = 8.40%. Difference = 16.59% − 8.40% = 8.19 percentage points. Preference dividends are not tax-deductible, whereas the company's debt interest qualifies for the tax shield.

Where it goes wrong. Applying the corporate tax shield to preference dividends or comparing preference capital cost with the pre-tax rather than after-tax cost of debt.

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