Question 18.8: A US MNC has its subsidiary in India. The subsidiary has iss......
A US MNC has its subsidiary in India. The subsidiary has issued 12 per cent preference shares of the face value of Rs 100, to be redeemed at year-end 8. Flotation costs are expected to be 4 per cent; these costs can be amortised for tax purposes during the 8 years at a uniform rate. The corporate tax rate is 35 per cent. Determine the cost of preference shares from the perspective of the subsidiary.
\, Rs 96 = \sum\limits_{t=1}^{8}{\frac{Rs\>11.825^*}{(1+k_p)^t}+\frac{\mathrm{Rs \>100}}{(1+k_p)^8} }
Accordingly, k_p = Rs 96 = \sum\limits_{t=1}^{8}{\frac{Rs\>11.825}{(1+k_p)^t}+\frac{\mathrm{Rs \>100}}{(1+k_p)^8} }
\, Given the rate of preference dividend of 12 per cent and based on the reasoning provided for determining k_d, the value of k_p is likely to be between 12 and 13 per cent.
k_p = 12% + \left\lgroup\frac{\mathrm{Rs \>98.79\, −\, Rs\> 96 = Rs\> 2.79}}{\mathrm{Rs \>98.79\, −\, Rs\> 94.35 = Rs \>4.44}} \right\rgroup = 12% + 0.63% = 12.63 per cent.
\, Example 18.8 shows the computation of k_p when the foreign subsidiary raises funds in the currency of the country (in the present context India) where it is located and payment of dividends as well as of principal repayments are to be made in Indian rupees.
\, In the event of a British subsidiary either raising preference share capital abroad or k_p is to be measured from the perspective of the US parent company, additional calculations in terms of adjustment for foreign exchange variations are required to determine the cost of preference shares; the treatment is akin to cost of debt. Consider Example 18.9.
* Determination of cash outflows during years 1–8:
| Rs 12.00 | Dividend payment |
| 0.175
|
Less tax advantage on flotation cost of Rs 4/8 years = Re 0.5 @ 35% |
| 11.825 | Effective dividend paid/cash outflows |
Determination of PV at 12 per cent and 13 per cent
| Total\>PV\>at | PV\>factor\>at | Effective\>cash\>outflows \qquad\qquad\qquad\quad |
Year \qquad\qquad\qquad\quad\quad |
||
| 13% | 12% | 13% | 12% | ||
| Rs 56.75 | Rs 58.75 | 4.799 | 4.968 | Rs 11.825 | 1 – 8 |
| 37.60
|
40.04
|
0.376 | 0.404 | 100.00 | 8 |
| 94.35 | 98.79 | Total present value | |||