Question

1 (a) Surya Industries Ltd. has raised funds through issue of 10,000 debentures of Rs. 150 each at a discount of Rs. 10 per debenture with 10 years maturity. The coupon rate is 16%. The floatation cost is Rs. 5 per debenture. The debentures are redeemable with a 10% premium. The corporate taxation rate is 40%. Calculate the cost of debentures.
(b) The current market price of an equity share of Rs. 10 is Rs. 20. The current dividend per share is 20%. The dividends are expected to grow at a rate of 5%. Calculate the cost of equity based on dividend growth model.

Answer 1

Answer to 1(a):

Cost of Debentures (Kd) = [ I (1-t) + (RP - IP) / n ] / [(RP + IP) / 2]
where, IP is issue price less floation cost

RP is redemption price

I is coupon amount

t is tax rate

n is years to maturity.

Thus, putting the values in above formula, we get:

= [24 (1-0.4) + (165-135) / 10] / (165+135)/2

= 11.6%

Answer to 1(b):

Cost of equity as per dividend growth model is given by:

= D1 / P0 + G

where, D1 is dividend next year

P0 is current market price

G is divided growth rate

Hence, Cost of equity = (10*20% + 5%) / 20 + 5%
= 2.1 / 20 + 0.05

= 15.50%