Caselet - Iv

CASELET - IV

ABOUT CASE The case is about Omega textiles in which the managing director is in dilemma whether to expand the original business or to diversify into new line of business.  The cost of capital for each case is to be calculated now and the best option is to be selected. 

methodology 

Cost of capital

 Cost

of equity under capital asset method and dividend discount method  Cost of debt (post tax)  Cost of preference  Retained earnings  Weighted average of capital using capital asset method

IMPORTANCE  Useful

role to play in deciding the finance plan or capital structure of the firm.  Useful for proper analysis of capital expenditure decisions.  Contributes towards the achievement of the objective of maximization of the shareholders wealth.

analysis SOURCES OF CAPITAL RELEVANT FOR CALCULATING WACC:Ø Equity capital Ø Preference capital Ø Debentures Ø Retained earnings





POST TAX COST OF DEBT Interst rate = 10  RV = 100/ NP = 112/ maturity period = 8 yrs 

  

Cost of debt = 0.0801 = 8.01%

COST OF PREFERNCE Dp - Share Dividend = 9  RV- Redemtion value = 100/ NP – Amt realised on debt issue = 112/ n – Maturity period = 5 yrs 

  

Cost of prefernce = 0.0757 = 7.57%

ESTIMATED COST OF EQUITY Ke = D1 + g  Po  D1 – Dividend = 3.08  Po – Current market price = 80/ g - growth rate = 10%  Ke = 13.85% 

COST OF EQUITY ( capital asset model) Ri = Rf + ( Rm – Rf ) β  Ri – Rate of return required  Rf – Risk free rate of return = 0.07  Rm – Rate of return on market = 0.07  β - Beta of security = 1.1 

 

Cost of equity = 0.07 = 7%

RETAINED EARNINGS: Kr = Ke  Kr = 7% 



WEIGHTED AVG COST OF CAPITAL Source  Equity

Amt(mill) Ki Wi 350 0.07 0.318  Preference 100 0.0757 0.09  Retained 200 0.07 0.181  Earnings  Debentures 450 0.080 0.409  1100  Cost of capital = 7.43% 



WiKi 0.0222 0.0068 0.0126 0.0327 0.0743

NEW BUSINESS characteristics EQUITY: Ri = Rf + (Rm –Rf)β  Rf = 0.07  Rm = 0.07  β = 1.5  Equity = 0.07  DEBT : 11% 

COST OF CAPITAL FOR NEW BUSINESS Cost of capital : Wo= (Ke x We) + (Kd x Wd )  Ke – Cost of equity = 0.07  We – Weightage of equity = 0.5  Kd– Cost of debt = 0.11  Wd – Weightage of debt = 0.5  Cost of capital for new business = 9% 

CONCLUSION 

Since the cost of capital for the expansion of business is less than the cost of capital for diversification of business it would be better for the Omega textiles to opt the option of expansion of business than for the diversification.