Question 3 OR (b)

WACC on book value and market value weights

6 marks

Time to write: About 12 minutes
Topic: Cost of capital

Question

Question 3 OR (b) · 6 marks

The following is the capital structure of Dhara Ltd:

Equity share capital (₹10 each)	₹1,68,000
Reserves	₹72,000
10% preference share capital (₹100 each)	₹48,000
14% Debentures (₹100 each)	₹96,000

Further information:

The cost of equity capital is 15% while the cost of the reserves is 14% the cost of Equity capital.
The tax rate applicable is 33.5%
The average market prices are given below:

Equity shares ₹16

Preference shares is ₹70

Debentures ₹80

Using Book value weights and market value weights, calculate the Weighted Average Cost of Capital (WACC).

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

12 minfor 6 marks

Read from the question

calculateFormula first, then the working, then the answer with its unit (₹, %, units).

What the paper leaves open

"The cost of the reserves is 14% the cost of Equity capital" is garbled. It is read as a cost of reserves of 14%, which is also what "1% less than the cost of equity capital" would give.

Write it in this order

Read the data; note exactly what is asked 1 min
1 Specific costs, including after-tax cost of debt 1 mark 2 min
2 Market values, with equity apportioned to reserves 1 mark 2 min
3 WACC on book value weights 2 marks 3 min
4 WACC on market value weights 2 marks 3 min
Check: arithmetic, units (₹, %), final answer underlined 1 min

1234

Try it first. About 12 minutes for 6 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. The existing preference shares and debentures are costed on their current market prices, as the DU text does for debenture funds and ICAI for irredeemable preference shares. The same costs apply under both sets of weights.

Equity share capital: ke = 15%. Reserves: kr = 14% (paper note).
10% preference shares (₹100, price ₹70): kp = 10 ÷ 70 = 14.29%.
14% debentures (₹100, price ₹80): interest is tax deductible, so kd = 14 × (1 − 0.335) ÷ 80 = 9.31 ÷ 80 = 11.64%.

Market values. Equity shares: 16,800 shares × ₹16 = ₹2,68,800. Reserves have no separate market value, so the market value of the equity shares is apportioned between share capital and reserves in the ratio of their book values, 1,68,000: 72,000 = 7: 3: equity share capital ₹1,88,160, reserves ₹80,640. Preference shares: 480 × ₹70 = ₹33,600. Debentures: 960 × ₹80 = ₹76,800.

(a) Book value weights

Source	Book value (₹)	Cost	Weighted cost (₹)
Equity share capital	1,68,000	15.00%	25,200.00
Reserves	72,000	14.00%	10,080.00
10% preference share capital	48,000	14.29%	6,857.14
14% debentures	96,000	11.64%	11,172.00
Total	3,84,000		53,309.14

WACC (book) = 53,309.14 ÷ 3,84,000 = 13.88%.

(b) Market value weights

Source	Market value (₹)	Cost	Weighted cost (₹)
Equity share capital	1,88,160	15.00%	28,224.00
Reserves	80,640	14.00%	11,289.60
10% preference share capital	33,600	14.29%	4,800.00
14% debentures	76,800	11.64%	8,937.60
Total	3,79,200		53,251.20

WACC (market) = 53,251.20 ÷ 3,79,200 = 14.04%.

The market-value WACC is a little higher because equity, the costliest source, stands above its book value, while the preference shares and debentures stand below theirs. (If the preference shares and debentures were costed on par instead, at 10% and 9.31%, the WACC would be 12.77% on book and 13.19% on market weights.)

Where the 6 marks sit

#	Component	Marks
1	Specific costs, including after-tax cost of debt	1
2	Market values, with equity apportioned to reserves	1
3	WACC on book value weights	2
4	WACC on market value weights	2
	Total	6

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