Question 2 (b)
WACC at market-value weights with new-issue costs
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 2 (b) · 11 marksUsing Market Value Weights, calculate the weighted average cost of capital (ko) from the information below, provided by RST Ltd. RST Ltd.'s present book value capital structure is:
| (Amount in ₹) | |
|---|---|
| Debentures (₹ 100 per debenture) | 12,00,000 |
| Preference Shares (₹ 100 per share) | 6,00,000 |
| Equity Shares (₹ 10 per share) | 24,00,000 |
| Retained Earnings | 6,00,000 |
| 48,00,000 |
Each of these securities is traded in the capital markets, at these recent prices: debentures @ ₹ 110, preference shares @ ₹ 120 and equity shares @ ₹ 22. The external financing opportunities anticipated are:
₹ 100 per debentures, redeemable at par: maturity 20-year, coupon rate 8%, floating costs 4%, sale price ₹ 100.
₹ 100 preference shares, redeemable at par: maturity 15-year, dividend rate 10%, floating costs 5%, sale price ₹ 100.
Equity shares: floating costs ₹ 2 per share, sale price ₹ 22.
Further, the dividend expected on the equity shares at the year end is ₹ 2 per share; dividends are anticipated to grow at a rate of 5%, and the company's practice is to pay all its earnings as dividends. The corporate tax rate is 30%. 11
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Market value weights use the market prices given; retained earnings have no market value of their own and are combined with equity at the equity's market value (C2). The cost of each source is taken from the new-issue terms given, the debentures and preference shares as redeemable at par.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Cost of debentures 2 marks 4 min
- 2 Cost of preference shares 2 marks 4 min
- 3 Costs of equity and retained earnings 2 marks 4 min
- 4 Market values and the split of the equity's value 2 marks 3 min
- 5 WACC 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Specific costs (from the new-issue terms, paper note)
- Debentures (8%, 20 years, redeemable at par; net proceeds 100 − 4% = ₹96): Kd = [8 × (1 − 0.30) + (100 − 96) ÷ 20] ÷ [(100 + 96) ÷ 2] = (5.60 + 0.20) ÷ 98 = 5.92%.
- Preference shares (10%, 15 years, redeemable at par; net proceeds 100 − 5% = ₹95; no tax adjustment): Kp = [10 + (100 − 95) ÷ 15] ÷ [(100 + 95) ÷ 2] = 10.333 ÷ 97.5 = 10.60%.
- Equity (new issue), with flotation cost F: Ke = D1 ÷ (P0 − F) + g = 2 ÷ (22 − 2) + 5% = 15%.
- Retained earnings (no flotation cost): Kr = D1 ÷ P0 + g = 2 ÷ 22 + 5% = 14.09%.
Market values. Debentures 12,000 × ₹110 = ₹13,20,000; preference shares 6,000 × ₹120 = ₹7,20,000; equity shares 2,40,000 × ₹22 = ₹52,80,000. There is no separate market value for retained earnings: the equity's market value is split between share capital and retained earnings in the ratio of their book values, 24: 6.
| Split of the equity's market value | ₹ |
|---|---|
| Equity share capital (24/30) | 42,24,000 |
| Retained earnings (6/30) | 10,56,000 |
| Market value of equity shares | 52,80,000 |
WACC (ko) at market-value weights
| Source | Market value (₹) | Cost | Market value × cost (₹) |
|---|---|---|---|
| Debentures | 13,20,000 | 5.92% | 78,122.45 |
| Preference shares | 7,20,000 | 10.60% | 76,307.69 |
| Equity share capital | 42,24,000 | 15.00% | 6,33,600 |
| Retained earnings | 10,56,000 | 14.09% | 1,48,800 |
| Total | 73,20,000 | 9,36,830.14 |
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Cost of debentures | 2 |
| 2 | Cost of preference shares | 2 |
| 3 | Costs of equity and retained earnings | 2 |
| 4 | Market values and the split of the equity's value | 2 |
| 5 | WACC | 3 |
| Total | 11 |
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