## Question

# Suman Joshi, Managing Director of Omega Textiles, was reviewing two very different investment proposals. The first one is for expanding the capacity in the main

Suman Joshi, Managing Director of Omega Textiles, was reviewing two very different investment proposals.

The first one is for expanding the capacity in the main line of business and the second one is for

diversifying into a new line of business.

Suman Joshi asks for your help in estimating Omega's weighted average cost of capital which he

believes is relevant for evaluating the expansion proposal. He also wants you to estimate the hurdle rate

for the new line of business. To enable you to carry out your task, he has provided the following data.

The latest balance sheet of Omega is given below

Omega's target capital structure has 50 percent equity, 10 percent preference, and 40 percent

debt

Omega has Rs.100 par, 10 percent coupon, annual payment, noncallable debentures with 8 years

to maturity. These debentures are selling currently at Rs.112.

Omega has Rs. 100 par, 9 percent, annual dividend, preference shares with a residual maturity

of 5 years. The market price of these preference shares is Rs. 106.

Omega's equity stock is currently selling at Rs. 80 per share. Its last dividend was Rs.2.80 and

the dividend per share is expected to grow at a rate of 10 percent in future.

Omega's equity beta is 1.1, the risk-free rate is 7 percent, and the market risk premium is estimated

to be 7 percent.

Omega's tax rate is 30 percent.

The new business that Omega is considering has different financial characteristics than Omega's

existing business. Firms engaged purely in such business have, on average, the following characteristics:

(i) Their capital structure has debt and equity in equal proportions, (ii) Their cost of

debt is 11 percent, (iii) Their equity beta is 1.5.

questions

(a) What sources of capital would you consider relevant for calculating the weighted average cost

of capital?

(b) What is Omega's post-tax cost of debt?

(c) What is Omega's cost of preference?

(d) What is Omega's estimated cost of equity using the dividend discount model?

(e) What is Omega's estimated cost of equity using the capital asset pricing model?

(f) What is Omega's weighted average cost of capital using CAPM for the cost of equity.

(g) What would be your estimate for the cost of capital for the new business?

(h) What is the difference between company cost of capital and project cost of capital?

## Rs.in million Liabilities Assets Equity capital 350 Fixed assets Preference capital 100 Investments 700 100 Reserves and surplus 200 Current assets, loans and advances 400 Debentures 450 Current liabilities & provisions 100 1200 1200

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