Question 5 OR (b)
WACC at market-value proportions
10 marks
- Time to write
- About 20 minutes
From an older CBCS paper
Question
Question 5 OR (b) · 10 marksDEF ltd's book value capital structure is as below
| Rs. in lakhs | |
|---|---|
| Equity capital (shares of Rs 10 each, fully paid up at par) | 24 |
| Retained earnings | 10 |
| 12% preference capital (shares of Rs 100 each, fully paid up at par) | 6 |
| 10% debentures (of Rs 100 each) | 10 |
| 11% term loan | 6 |
The next dividend expected on the shares is Rs 3 per share, and it is expected to grow at a rate of 6%. Each share's market price is Rs 30. The preference stock, redeemable after 10 years, now sells at Rs. 75 per share. The debentures, redeemable after 6 years, sell at Rs. 80 per debenture. The company's income tax rate is 40%. Using market value proportions, compute the weighted average cost of capital. (5,10)
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
- computeFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Retained earnings take the cost of equity; market value weights put retained earnings with equity at the equity's market value (C2). The term loan has no market quote and is taken at book value. Preference shares and debentures are redeemed at par.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Cost of equity and retained earnings 2 marks 4 min
- 2 Costs of preference capital, debentures and term loan 3 marks 5 min
- 3 Market values 2 marks 4 min
- 4 WACC 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 20 minutes for 10 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.
- Equity: Ke = D1 ÷ P0 + g = 3 ÷ 30 + 6% = 16%. Retained earnings take the same cost (paper note).
- 12% preference capital, redeemable at par after 10 years, price ₹75, no tax adjustment: Kpr = [12 + (100 − 75) ÷ 10] ÷ [(100 + 75) ÷ 2] = 14.5 ÷ 87.5 = 16.57%.
- 10% debentures, redeemable at par after 6 years, price ₹80, interest tax-deductible: Kd = [10 × 0.60 + (100 − 80) ÷ 6] ÷ [(100 + 80) ÷ 2] = 9.333 ÷ 90 = 10.37%.
- 11% term loan: 11% × (1 − 0.40) = 6.60%.
Market values. Equity: 2,40,000 shares × ₹30 = ₹72,00,000. Retained earnings have no market value of their own: the equity's market value represents both the share capital and the retained earnings, and both cost 16% (paper note). Preference shares 6,000 × ₹75 = ₹4,50,000; debentures 10,000 × ₹80 = ₹8,00,000; the term loan, with no quote, at book value ₹6,00,000.
WACC at market-value proportions
| Source | Market value (₹) | Cost | Market value × cost (₹) |
|---|---|---|---|
| Equity shares and retained earnings | 72,00,000 | 16.00% | 11,52,000 |
| 12% Preference capital | 4,50,000 | 16.57% | 74,571.43 |
| 10% Debentures | 8,00,000 | 10.37% | 82,962.96 |
| 11% Term loan (book value) | 6,00,000 | 6.60% | 39,600 |
| Total | 90,50,000 | 13,49,134.39 |
Where the 10 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Cost of equity and retained earnings | 2 |
| 2 | Costs of preference capital, debentures and term loan | 3 |
| 3 | Market values | 2 |
| 4 | WACC | 3 |
| Total | 10 |
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