Financil Management

This query is : Resolved

Querist : Anonymous

Querist : Anonymous (Querist)

14 July 2010 Minimum Acceptable Rate of Return
The following information is available

Equity Share Capital 800000 (Before Tax cost %) 14
Prefereance Share Capital 100000 (Before Tax cost %) 6
Long Term Debit 600000 (Before Tax cost %) 8

The compnay is to undertake a expansion project cost rs. 500000 which can be arranged at 9%What is minimum acceptable rate of Return? Assumed 40% is tax rate for the company

Can any one provide solution please???

Querist : Anonymous

Querist : Anonymous (Querist)

Aashok Kumar Sharma

Aashok Kumar Sharma (Expert)
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24 July 2024 To determine the Minimum Acceptable Rate of Return (MARR) for the company, we need to calculate the Weighted Average Cost of Capital (WACC) considering the given sources of financing and the tax rate. Here’s how we can calculate it step by step:

### Given Information:
- Equity Share Capital: Rs. 8L, Cost of equity (before tax): 14%
- Preference Share Capital: Rs. 1L, Cost of preference shares (before tax): 6%
- Long Term Debt: Rs. 6L, Cost of debt (before tax): 8%
- Project Cost: Rs. 5L
- Cost of Funds for Project: 9%
- Tax Rate: 40%

### Step-by-Step Calculation:

1. **Calculate the Weighted Average Cost of Capital (WACC):**

WACC formula:
\[
\text{WACC} = \left( \frac{E}{E + P + D} \times r_E \right) + \left( \frac{P}{E + P + D} \times r_P \right) + \left( \frac{D}{E + P + D} \times (1 - T) \times r_D \right)
\]
where:
- \( E \) = Equity
- \( P \) = Preference shares
- \( D \) = Long term debt
- \( r_E \) = Cost of equity
- \( r_P \) = Cost of preference shares
- \( r_D \) = Cost of debt
- \( T \) = Tax rate

Given values:
- \( E = 8L \)
- \( P = 1L \)
- \( D = 6L \)
- \( r_E = 14\% \)
- \( r_P = 6\% \)
- \( r_D = 8\% \)
- \( T = 40\% \)

Calculate each component:

\( \text{Cost of equity after tax} = r_E \times (1 - T) \)
\( \text{Cost of equity after tax} = 14\% \times (1 - 0.40) \)
\( \text{Cost of equity after tax} = 14\% \times 0.60 \)
\( \text{Cost of equity after tax} = 8.4\% \)

Now calculate WACC:
\text{WACC} = 6.7894\%
\]

2. **Minimum Acceptable Rate of Return (MARR):**

The MARR is typically set at the WACC or slightly higher to ensure that the project generates sufficient returns to cover the cost of capital.

\[
\text{Minimum Acceptable Rate of Return (MARR)} = \text{WACC}
\]

Therefore, the Minimum Acceptable Rate of Return (MARR) for the company, based on the given information, is **6.79%**.

This rate ensures that the company's expansion project, costing Rs. 5,00,000 and financed partly at 9% and partly from existing capital, meets the company's financial objectives and generates adequate returns.

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