Question 3 OR
WACC at book-value weights
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 3 OR · 15 marksDEF Ltd's book value capital structure is as below
| Rs in lakhs | |
|---|---|
| Equity capital (shares of Rs 10 each, fully paid at par) | 20 |
| Retained earnings | 10 |
| 12% preference capital (shares of Rs 100 each, fully paid at par) | 5 |
| 10% debentures (Rs 100 each) | 10 |
| 11% term loans | 5 |
The next dividend expected on the shares is Rs. 4 per share, and the expected growth rate of the dividend per share is 8%. Each share's market price is Rs. 40. The preference stock, redeemable after 10 years, currently 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 book value proportions, compute the 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
- computeFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Retained earnings take the cost of equity. The preference shares and debentures are redeemed at par (their face value, Rs 100).
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Cost of equity and of retained earnings 3 marks 5 min
- 2 Cost of redeemable preference capital 3 marks 5 min
- 3 Cost of redeemable debentures 3 marks 5 min
- 4 Cost of term loans 2 marks 4 min
- 5 Book-value weights and WACC 4 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 30 minutes for 15 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 = 4 ÷ 40 + 8% = 18%.
- Retained earnings: taken at the cost of equity, 18% (paper note). With book-value weights, retained profits are included in the book value of equity alongside the share capital.
- 12% redeemable preference capital (₹100 par, price ₹75, 10 years; no tax adjustment): Kpr = [12 + (100 − 75) ÷ 10] ÷ [(100 + 75) ÷ 2] = 14.50 ÷ 87.50 = 16.57%.
- 10% redeemable debentures (₹100 par, price ₹80, 6 years; interest tax-deductible): Kd = [10 × 0.60 + (100 − 80) ÷ 6] ÷ [(100 + 80) ÷ 2] = 9.333 ÷ 90 = 10.37%.
- 11% term loans: 11% × (1 − 0.40) = 6.60%.
| Source | Book value (₹ lakh) | Weight | After-tax cost | Weighted cost (%) |
|---|---|---|---|---|
| Equity capital | 20 | 0.40 | 18.00% | 7.20 |
| Retained earnings | 10 | 0.20 | 18.00% | 3.60 |
| 12% Preference capital | 5 | 0.10 | 16.57% | 1.66 |
| 10% Debentures | 10 | 0.20 | 10.37% | 2.07 |
| 11% Term loans | 5 | 0.10 | 6.60% | 0.66 |
| Total | 50 | 1.00 | 15.19 |
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Cost of equity and of retained earnings | 3 |
| 2 | Cost of redeemable preference capital | 3 |
| 3 | Cost of redeemable debentures | 3 |
| 4 | Cost of term loans | 2 |
| 5 | Book-value weights and WACC | 4 |
| Total | 15 |
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