The Cost of Capital

Servex Engineering Ltd (SEL) is considering a major expansion program requiring an investment of Rs 80 lakhs. Before proceeding with the expansion, the companys CEO Mr Virat wants to estimate the cost of capital. For this purpose, he summoned his three managers - Bhumra, Pandya and Pant. As per Bhumra, the companys expected net income this year is Rs 5 lakhs, its established dividend pay-out ratio is 35%, tax rate is 30%, and the expected earnings and dividends are likely to grow at 7%. SEL paid a dividend of Rs 2.6 per share last year and its stock is currently selling for Rs 50 per share. Based on this information, Bhumra suggested to opt for Discounted Cash Flow (DCF) approach with an optimal capital structure as shown below:

Particulars	Amount
Ordinary shares (88,000 shares)	44
12% Preference shares	12
10% Bond ( Par value Rs 100)	24
Total	80

Pandya had a different opinion from Bhumra. He argued that CAPM (Capital Asset Pricing Model) approach is superior to DCF approach, and hence SEL could adopt CAPM approach. For this purpose, he gathered the following information: SELs beta is 0.9, the yield on G-Sec bonds is 5% and the market risk premium is expected to be 7%. Pandya was also of the opinion that based on the prevalent market conditions, the optimal capital structure should comprise more equity and less of debt: 20% debt, 15% preferred stock and 65% common equity. Mr Virat asked Pant who had been a silent spectator throughout the meeting, for his opinion. Pant agreed that both the afore- mentioned approaches were good, but he suggested that they should also consider the Bond-yield risk premium approach, with a risk premium of 4.5% and an optimal capital structure as suggested by Pandya.

SEL had good access to the capital market and could raise capital in the following ways: New preferred stock with a dividend of Rs 12 could be sold in the market at a price of Rs 98. Also, debt could be raised at 10%.

Calculate

1. 1) WACC based on Bhumras suggestion

2. 2) WACC based on Pandyas suggestion

3. 3) WACC based on Pants suggestion

4. 4) If Mr Virat decided to give equal importance to all the three approaches, what would be

   the WACC for the expansion programme?

5. What is the cost of equity if a companys beta is 1.2, the yield on G-Sec bonds is 7% and the expected market return is 15%? a. 25% b. 16.6% c. 20% d. 15%