company is considering the possibility of raising Rs 100 million by issuing debt, preference capital, and equity and retaining earnings. The book values and the market values of the issues are as follows:
(Rs in millions)
Book value Market value
Ordinary shares 30 60
Reserves 10 —
Preference shares 20 24
Debt 40 36
The following costs are expected to be associated with the above-mentioned issues of capital. (Assume a 35 per cent tax rate.)
(i) The firm can sell a 20-year Rs 1,000 face value debenture with a 16 per cent rate of interest. An underwriting fee of 2 per cent of the market price would be incurred to issue the debentures.
(ii) The 11 per cent Rs 100 face value preference issue fetch Rs 120 per share. However, the firm will have to pay Rs 7.25 per preference share as underwriting commission.
(iii) The firm’s ordinary share is currently selling for Rs 150. It is expected that the firm will pay a dividend of Rs 12 per share at the end of the next year, which is expected to grow at a rate of 7 per cent. The new ordinary shares can be sold at a price of Rs 145. The firm should also incur Rs 5 per share flotation cost.
Compute the weighted average cost of capital using (i) book value weights (ii) market value weights.