CA Inter P6 · Chapter 4
Cost of Capital MCQs with Answers
10 multiple-choice questions on Cost of Capital for CA Inter P6 Financial Management and Strategic Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Pragati Ltd issues 12% irredeemable debentures of ₹ 100 each at ₹ 95 (net of issue costs). The corporate tax rate is 30%. The after-tax cost of these debentures is:
- A) 12.63%
- B) 8.40%
- C) 8.84%
- D) 8.62%
Show answer & explanation
Answer: C) 8.84%
For irredeemable debt, Kd = I(1 - t) / NP = 12 x (1 - 0.30) / 95 = 8.40 / 95 = 8.84%. Using face value instead of net proceeds gives 8.40%. Ignoring tax gives 12.63%. The relevant base is the net amount actually raised, ₹ 95.
Question 2
A company issues 10% debentures of ₹ 1,000 each. Net proceeds per debenture are ₹ 940, and the debentures are redeemable at a 5% premium after 8 years. The tax rate is 25%. Using the approximation formula, the after-tax cost of debt is closest to:
- A) 8.51%
- B) 11.43%
- C) 8.92%
- D) 9.44%
Show answer & explanation
Answer: C) 8.92%
Redemption value RV = ₹ 1,050 and NP = ₹ 940. Kd = [I(1 - t) + (RV - NP)/n] / [(RV + NP)/2] = [100 x 0.75 + (1,050 - 940)/8] / [(1,050 + 940)/2] = (75 + 13.75) / 995 = 8.92%. Ignoring tax gives 11.43%. Dividing by NP alone gives 9.44%, and ignoring the redemption premium gives 8.51%.
Question 3
9% preference shares of ₹ 100 each are issued with net proceeds of ₹ 92 per share and are redeemable at par after 10 years. Using the approximation formula, the cost of preference capital is:
- A) 9.78%
- B) 9.00%
- C) 10.65%
- D) 10.21%
Show answer & explanation
Answer: D) 10.21%
Kp = [PD + (RV - NP)/n] / [(RV + NP)/2] = [9 + (100 - 92)/10] / [(100 + 92)/2] = 9.80 / 96 = 10.21%. No tax adjustment is made because preference dividend is not tax-deductible. The figure 9.78% would apply to irredeemable preference shares.
Question 4
The equity shares of Nirmal Ltd are quoted at ₹ 80. The company has just paid a dividend of ₹ 4 per share, and dividends are expected to grow at 6% per annum indefinitely. Using the dividend growth model, the cost of equity is:
- A) 11.0%
- B) 11.3%
- C) 6.0%
- D) 5.3%
Show answer & explanation
Answer: B) 11.3%
D1 = D0 x (1 + g) = 4 x 1.06 = ₹ 4.24. Ke = D1/P0 + g = 4.24/80 + 0.06 = 0.053 + 0.06 = 11.3%. Using D0 instead of D1 gives 11.0%. Leaving out the growth rate gives only the dividend yield of 5.3%.
Question 5
The risk-free rate is 6%, the expected market return is 13% and the beta of Tejas Ltd's equity shares is 1.3. Using CAPM, the cost of equity is:
- A) 15.1%
- B) 22.9%
- C) 9.1%
- D) 16.9%
Show answer & explanation
Answer: A) 15.1%
Ke = Rf + β(Rm - Rf) = 6% + 1.3 x (13% - 6%) = 6% + 9.1% = 15.1%. Multiplying beta by the full market return (16.9%), or adding Rf to that product (22.9%), ignores that beta applies only to the market risk premium. The figure 9.1% is the risk premium alone.
Question 6
The market price of an equity share is ₹ 60, the expected dividend next year (D1) is ₹ 3 and dividends are expected to grow at 7% per annum. A fresh issue of equity would involve flotation costs of 5% of the market price. The cost of retained earnings, ignoring personal taxes, is:
- A) 5.26%
- B) 12.00%
- C) 5.00%
- D) 12.26%
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Answer: B) 12.00%
Retained earnings involve no flotation cost, so Kr = D1/P0 + g = 3/60 + 0.07 = 0.05 + 0.07 = 12.00%. The figure 12.26% is the cost of new equity, which uses net proceeds of ₹ 57 (60 x 0.95). The figure 5% is only the dividend yield.
Question 7
The capital structure of Dhruv Ltd (book values) is: equity share capital ₹ 30 lakh (cost 15%), 12% preference share capital ₹ 10 lakh and 10% debentures ₹ 40 lakh. The tax rate is 30%. The weighted average cost of capital on book value weights is:
- A) 12.125%
- B) 10.175%
- C) 10.625%
- D) 11.33%
Show answer & explanation
Answer: C) 10.625%
Post-tax cost of debt = 10% x (1 - 0.30) = 7%. Preference capital costs 12% with no tax adjustment. WACC = (30 x 15 + 10 x 12 + 40 x 7) / 80 = (450 + 120 + 280) / 80 = 850 / 80 = 10.625%. Using pre-tax debt gives 12.125%, and applying a tax shield to preference dividend gives 10.175%.
Question 8
Kaveri Ltd has equity with a book value of ₹ 50 crore and a market value of ₹ 60 crore, and debentures with a book value of ₹ 50 crore and a market value of ₹ 40 crore. The cost of equity is 14%, the pre-tax cost of debt is 10% and the tax rate is 30%. The WACC using market value weights is:
- A) 11.20%
- B) 10.50%
- C) 9.80%
- D) 12.40%
Show answer & explanation
Answer: A) 11.20%
Post-tax Kd = 10% x 0.70 = 7%. Market weights: equity 60/100 = 0.6 and debt 40/100 = 0.4. WACC = 0.6 x 14% + 0.4 x 7% = 8.4% + 2.8% = 11.20%. Book value weights (0.5 each) give 10.50%, and using pre-tax debt gives 12.40%.
Question 9
Debt is usually the cheapest source of long-term finance for a profitable company. The most important reason is that:
- A) Debt does not have to be repaid at any time
- B) Debt holders have voting rights in general meetings
- C) Interest payments are at the discretion of the board of directors
- D) Interest is a tax-deductible expense and debt holders face lower risk than equity holders, so they accept a lower return
Show answer & explanation
Answer: D) Interest is a tax-deductible expense and debt holders face lower risk than equity holders, so they accept a lower return
Debt holders have a prior, contractual claim on income and assets, so they bear less risk and accept a lower return. Interest is also allowed as a deduction for tax, which reduces the effective cost further. Debt must be repaid, interest is a contractual obligation rather than discretionary, and debt holders do not normally vote.
Question 10
Jyoti Ltd has EPS of ₹ 10 and has just paid a dividend of ₹ 4 per share. It earns a return of 15% on retained earnings, and this retention policy is expected to continue. If the share price is ₹ 60, the cost of equity using the dividend growth model is closest to:
- A) 15.67%
- B) 12.67%
- C) 16.27%
- D) 13.07%
Show answer & explanation
Answer: C) 16.27%
Retention ratio b = 1 - 4/10 = 0.6, so g = b x r = 0.6 x 15% = 9%. D1 = 4 x 1.09 = ₹ 4.36. Ke = 4.36/60 + 0.09 = 7.27% + 9% = 16.27%. Using the payout ratio instead of the retention ratio to estimate growth (g = 6%) is a common error.