Question 2
Weighted average cost of capital at market-value weights
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 2 · 15 marksKaveri Foods Limited's capital structure is as follows:
| Sources | Book Value (₹) | Market Value (₹) |
|---|---|---|
| Equity Capital (30000 shares of ₹10 each) | 300000 | 540000 |
| 13% Preference Capital (600 Shares of ₹100 each) | 60000 | 54000 |
| Retained earnings | 180000 | -------- |
| 12% Debentures (1800 debentures of ₹100 each) | 180000 | 174000 |
| 720000 | 768000 |
The dividend per share is expected to be ₹1.40, and to grow at a rate of 8% for ever, The preference shares are redeemable at par after 5 years, while the debentures are redeemable at par after 6 years. The tax rate is 30%.
You are required, using market value as weights, to compute the weighted average cost of capital of the existing capital structure.
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 have no market value given; the market value weights use the market values printed, and the cost of retained earnings is not separately weighted.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Cost of equity by the growth model 3 marks 5 min
- 2 Cost of redeemable preference shares 3 marks 5 min
- 3 After-tax cost of redeemable debentures 4 marks 7 min
- 4 Market-value weights, treatment of retained earnings 2 marks 4 min
- 5 WACC 3 marks 5 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 (growth model). Ke = D1 ÷ P0 + g. Market price per share = 5,40,000 ÷ 30,000 = ₹18. Ke = 1.40 ÷ 18 + 0.08 = 0.0778 + 0.08 = 15.78%.
- 13% redeemable preference shares. Kpr = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2], with no tax adjustment because preference dividend is not tax-deductible. Market price = 54,000 ÷ 600 = ₹90; redeemable at ₹100 after 5 years. Kpr = [13 + (100 − 90) ÷ 5] ÷ [(100 + 90) ÷ 2] = 15 ÷ 95 = 15.79%.
- 12% redeemable debentures. Kd = [I(1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2], interest being tax-deductible. Market price = 1,74,000 ÷ 1,800 = ₹96.67; redeemable at ₹100 after 6 years. Kd = [12 × 0.70 + (100 − 96.67) ÷ 6] ÷ [(100 + 96.67) ÷ 2] = 8.956 ÷ 98.33 = 9.11%.
Weights. Market-value weights are used, as the question asks. There is no separate market value for retained earnings: the market value of the equity shares represents both the paid-up capital and the retained earnings. So the equity weight is the shares' market value of ₹5,40,000 (paper note). Splitting it between share capital and retained earnings in the ratio of their book values would change nothing here, because with no flotation cost both carry the same cost, 15.78%.
| Source | Market value (₹) | Weight | After-tax cost | Market value × cost (₹) |
|---|---|---|---|---|
| Equity shares (incl. retained earnings) | 5,40,000 | 0.7031 | 15.78% | 85,200 |
| 13% Preference shares | 54,000 | 0.0703 | 15.79% | 8,526.32 |
| 12% Debentures | 1,74,000 | 0.2266 | 9.11% | 15,846.78 |
| Total | 7,68,000 | 1.0000 | 1,09,573.10 |
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Cost of equity by the growth model | 3 |
| 2 | Cost of redeemable preference shares | 3 |
| 3 | After-tax cost of redeemable debentures | 4 |
| 4 | Market-value weights, treatment of retained earnings | 2 |
| 5 | WACC | 3 |
| Total | 15 |
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