Question 4
Cost of capital in capital budgeting; WACC at market-value weights
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 4 · 18.75 marksQ4. How is the cost of capital relevant to capital budgeting decisions? Also discuss the factors that affect the cost of capital.
A company's capital structure is as follows:
| Particulars | Book Value | Market Value |
|---|---|---|
| Equity Capital(36,000 shares of Rs. 10 each) | 3,60,000 | 5,76,000 |
| Preference capital (720 shares of Rs. 100 each carrying 12% dividend) | 72,000 | 84,000 |
| Reserves and Surplus | 1,80,000 | - |
| Debentures (2400 debentures of Rs. 100 each carrying 12% interest) | 2,40,000 | 2,28,000 |
| 8,52,000 | 8,88,000 |
The dividend per share is expected to be Rs. 1.50, and it is expected to grow at a rate of 8 per cent for ever. The preference shares are redeemable at par after 5 years, while the debentures are redeemable at par after 6 years. The company's tax rate is 50 per cent.
Using market value weights, you are required to compute the WACC (weighted average cost of capital).
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
- How…?Discuss…Two asks in one question: answer both.
- computeFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
- Reserves and surplus have no market value given; the market value weights use the market values printed.
- No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Relevance of the cost of capital to capital budgeting 4 marks 7 min
- 2 Factors affecting the cost of capital 4 marks 7 min
- 3 Costs of equity, preference shares and debentures 6 marks 11 min
- 4 Market-value weights and WACC 4.8 marks 9 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 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.
Part 1: relevance of the cost of capital to capital budgeting. The cost of capital is the minimum rate of return a firm must earn on its funds to satisfy the expectations of its suppliers of funds. If a project's return exceeds the cost of capital, the difference adds to the shareholders' wealth, so the cost of capital is the yardstick in capital budgeting (and also in deciding the capital structure):
- it is the discount rate for NPV (accept if NPV > 0) and the profitability index;
- it is the cut-off rate against which IRR is compared (accept if IRR > cost of capital);
- it ranks projects and so guides the allocation of scarce funds to those that create value.
Factors affecting the cost of capital. It depends on the risk-free rate of interest and on a risk premium that reflects the risk of the investment and of the firm: general economic conditions (interest rates, inflation), market conditions (marketability of the securities), the firm's business risk (operating decisions) and financial risk (its debt), the amount of finance needed, the tax rate (which lowers the cost of debt), and the firm's dividend and capital structure policies.
Part 2: WACC at market-value weights.
- Equity: price = 5,76,000 ÷ 36,000 = ₹16; Ke = D1 ÷ P0 + g = 1.50 ÷ 16 + 8% = 17.375%.
- 12% preference shares, redeemable at par after 5 years, price 84,000 ÷ 720 = ₹116.67 (no tax adjustment): Kp = [12 + (100 − 116.67) ÷ 5] ÷ [(100 + 116.67) ÷ 2] = 8.667 ÷ 108.33 = 8.00%.
- 12% debentures, redeemable at par after 6 years, price 2,28,000 ÷ 2,400 = ₹95; tax 50%: Kd = [12 × 0.50 + (100 − 95) ÷ 6] ÷ [(100 + 95) ÷ 2] = 6.833 ÷ 97.5 = 7.01%.
Reserves have no market value given; the printed market values are used as the weights (paper note); with market-value weights, retained profits are in effect part of the equity's value.
| Source | Market value (₹) | Cost | Market value × cost (₹) |
|---|---|---|---|
| Equity capital | 5,76,000 | 17.375% | 1,00,080 |
| Preference capital | 84,000 | 8.00% | 6,720 |
| Debentures | 2,28,000 | 7.01% | 15,979.49 |
| Total | 8,88,000 | 1,22,779.49 |
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Relevance of the cost of capital to capital budgeting | 4 |
| 2 | Factors affecting the cost of capital | 4 |
| 3 | Costs of equity, preference shares and debentures | 6 |
| 4 | Market-value weights and WACC | 4.75 |
| Total | 18.75 |
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