Question 3 OR

WACC with flotation costs at book and market weights

15 marks

Time to write: About 30 minutes

From an older CBCS paper

Question

Question 3 OR · 15 marks

PQR Ltd.'s capital structure is as below:

9% Debentures (Rs. 100)	Rs. 3,30,000
11% Preference shares (Rs. 100)	Rs. 2,70,000
Equity shares (face value Rs. 10 per share)	Rs. 6,00,000

Further information:

The debentures are redeemable at par after 10 years, with a 20% floatation cost, and the market price per debenture is Rs. 105.

The preference shares are redeemable at par after 10 years, with a 30% floatation cost, and each sells in the market at Rs.106.
An Equity share has a floatation cost of Rs. 4, and a market price of Rs. 24 per share. Next year's dividend is expected to be Rs. 2 per share, with annual growth of 5%. The firm's practice is to pay out all its earnings as dividends.
The Corporate income tax rate is 35%.

Using (i) book value weights (ii) market value weights, calculate the weighted average cost of capital. 15

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

30 minfor 15 marks

Read from the question

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

What the paper leaves open

The floatation costs are taken as percentages of the market price, as printed (20% and 30%); the Hindi version prints 3% for the preference shares, and the answer shows that reading's figure too.
The debentures and preference shares are redeemable at par after 10 years.

Write it in this order

Read the data; note exactly what is asked 2 min
1 Cost of debentures 3 marks 5 min
2 Cost of preference shares 3 marks 5 min
3 Cost of equity 2 marks 4 min
4 WACC at book-value weights 3½ marks 6 min
5 WACC at market-value weights 3½ marks 6 min
Check: arithmetic, units (₹, %), final answer underlined 2 min

12345

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.

Specific costs (flotation costs taken as printed, as percentages of the market price; paper note)

9% debentures, redeemable at par after 10 years. Net proceeds = 105 × (1 − 20%) = ₹84; tax 35%: Kd = [9 × 0.65 + (100 − 84) ÷ 10] ÷ [(100 + 84) ÷ 2] = 7.45 ÷ 92 = 8.10%.
11% preference shares, redeemable at par after 10 years. Net proceeds = 106 × (1 − 30%) = ₹74.20; no tax adjustment: Kp = [11 + (100 − 74.20) ÷ 10] ÷ [(100 + 74.20) ÷ 2] = 13.58 ÷ 87.10 = 15.59%.
Equity, with flotation cost F: Ke = D1 ÷ (P0 − F) + g = 2 ÷ (24 − 4) + 5% = 15%. (All earnings are paid out, so no retained earnings enter the structure.)

(i) Book-value weights

Source	Book value (₹)	Cost	Book value × cost (₹)
9% Debentures	3,30,000	8.10%	26,722.83
11% Preference shares	2,70,000	15.59%	42,096.44
Equity shares	6,00,000	15.00%	90,000
Total	12,00,000		1,58,819.27

WACC (book) = 1,58,819.27 ÷ 12,00,000 = 13.23%.

(ii) Market-value weights. Market values: debentures 3,300 × ₹105; preference shares 2,700 × ₹106; equity 60,000 × ₹24; market value weights reflect current prices.

Source	Market value (₹)	Cost	Market value × cost (₹)
9% Debentures	3,46,500	8.10%	28,058.97
11% Preference shares	2,86,200	15.59%	44,622.23
Equity shares	14,40,000	15.00%	2,16,000
Total	20,72,700		2,88,681.20

WACC (market) = 2,88,681.20 ÷ 20,72,700 = 13.93%.

The other reading. The Hindi version prints a 3% flotation cost for the preference shares: net proceeds ₹102.82, Kp = 10.57%, and WACC 12.10% (book) and 13.23% (market).

Where the 15 marks sit

#	Component	Marks
1	Cost of debentures	3
2	Cost of preference shares	3
3	Cost of equity	2
4	WACC at book-value weights	3.5
5	WACC at market-value weights	3.5
	Total	15

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