Question 4
Market versus book value weights; WACC both ways
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 4 · 18.75 marksComment: "Market value weights are superior to book value weights"
MNO Ltd.'s capital structure is as below.
| Sources | Amount (Rs.) | Specific Cost of Capital |
|---|---|---|
| Equity Share Capital (6,00,000 equity shares of Rs. 10 each) | 60,00,000 | 10% |
| Preference Share Capital (1,80,000 shares of Rs. 10 each) | 18,00,000 | 8% |
| 10% Debentures of Rs. 1,000 each | 24,00,000 | 5% |
| Retained Earnings | 30,00,000 | 10% |
Presently, the debentures trade at 90%, the preference shares at par, with Rs. 15 per share for the equity shares. Find out the WACC on the basis of book value weights and of market value weights.
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
- Comment…Find…Two asks in one question: answer both.
- CommentA statement to judge: take a stand on it in your first line, and come back to it at the end.
- Find outFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks. The debentures' market value is 90% of face value; retained earnings have no market value of their own and are combined with equity at its market value (C2).
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Comment: merits of market weights 4 marks 7 min
- 2 Comment: limitations and conclusion 3.8 marks 7 min
- 3 WACC at book value weights 5 marks 9 min
- 4 WACC at market value weights 6 marks 11 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 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.
Comment: "Market value weights are superior to book value weights"
Largely true, with qualifications. The WACC is the average of the specific costs weighted by each source's proportion of the total; the weights can be book values or market values, and if they differ so does the WACC.
Why market value weights are considered superior
- They are more correct and represent the firm's actual capital structure; they reflect existing conditions and current prices of the securities.
- The market value represents the true value of the investors' holdings; the WACC is the return the firm must earn on its current market value to satisfy them.
- The specific costs (such as ke = D1 ÷ P0 + g) are themselves calculated from market prices, so market weights are consistent with them.
- Book values are historical: the book value of equity reflects neither current asset values nor future prospects.
Limitations of market value weights
- Market values fluctuate frequently and are hard to determine; some securities have no quoted price.
- Equity usually gets a greater weight (its market value is often well above book value), which raises the WACC.
- Retained earnings have no separate market value; the market value of equity covers both share capital and retained earnings.
Book value weights are readily available from the balance sheet, stable, and consistent with the target capital structures firms set in book terms. Conclusion: market value weights are theoretically superior; book value weights remain useful in practice.
WACC of MNO Ltd.
| Source | Book value (₹) | Cost | Weighted cost (₹) |
|---|---|---|---|
| Equity share capital | 60,00,000 | 10% | 6,00,000 |
| Preference share capital | 18,00,000 | 8% | 1,44,000 |
| 10% Debentures | 24,00,000 | 5% | 1,20,000 |
| Retained earnings | 30,00,000 | 10% | 3,00,000 |
| Total | 1,32,00,000 | 11,64,000 |
WACC (book) = 11,64,000 ÷ 1,32,00,000 = 8.82%.
(ii) Market value weights. Equity: 6,00,000 shares × ₹15 = ₹90,00,000, covering share capital and retained earnings together (paper note); both cost 10%, so combining them gives the same result as apportioning. Preference shares at par: ₹18,00,000. Debentures at 90%: ₹21,60,000.
| Source | Market value (₹) | Cost | Weighted cost (₹) |
|---|---|---|---|
| Equity (including retained earnings) | 90,00,000 | 10% | 9,00,000 |
| Preference share capital | 18,00,000 | 8% | 1,44,000 |
| 10% Debentures | 21,60,000 | 5% | 1,08,000 |
| Total | 1,29,60,000 | 11,52,000 |
WACC (market) = 11,52,000 ÷ 1,29,60,000 = 8.89%.
The market-weighted WACC is higher because equity, the most expensive source, has a larger weight at market values and the cheap debentures a smaller one.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Comment: merits of market weights | 4 |
| 2 | Comment: limitations and conclusion | 3.75 |
| 3 | WACC at book value weights | 5 |
| 4 | WACC at market value weights | 6 |
| Total | 18.75 |
Report a problemopens an email to admin@getkunji.com with the question IDFMP20-Q4already filled in.