Sagar Ltd. has been in IT business for six years and enjoys a favourable market reputation. Corporate tax is 30%. They anticipated that the demand for IT solutions would increase considerably since many foreign firms are

CS Professional · Financial, Treasury and Forex Management · PYQS · December 2015
Sagar Ltd. has been in IT business for six years and enjoys a favourable market reputation. Corporate tax is 30%. They anticipated that the demand for IT solutions would increase considerably since many foreign firms are setting-up their BPO centres in India. For an expansion project, they propose to invest ₹22 crore to be funded by new debt and equity on 50:50 basis. Enquiries with merchant bankers reveal that funds can be available at following rates: Debt Rate First 5 crore 10% Next 5 crore 12% All additional funds 15.72% Equity 12% Risk gradation by company 2% over cost of capital You are required to compute the appropriate risk adjusted discount rate.

Answer & Explanation:

Total funds required = ₹22 crores 50% is financed by debt. Therefore, ₹11 crore is financed by debt, out of which ₹5 crores is @ 10%, next ₹5 crores is @ 12% and remaining ₹1 crores @ 15.72%. Also remaining ₹11 crores is financed by equity @ 12% Therefore, K D1 = 10(1 - 0.30) = 7% K D2 = 12(1 - 0.30) = 8.4% K D3 = 15.72(1 - 0.30) = 11.004% Source Cost (X) Weight (W) (figure in ₹ crores) XW (figure in ₹ crores) Debt 1 (D1) 0.07 5 0.35 Debt 2 (D2) 0.084 5 0.42 Debt 3 (D3) 0.11004 1 0.11004 Equity 0.12 11 1.32 ΣW 22 ΣXW = 2.20004 K O = ΣXW / ΣW = 2.20004 / 22 = 10% Risk adjusted discount rate = 10% + 2% = 12%

Topics: Cost of Capital

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