Question 3 OR (a)
Cost of capital at book and market proportions
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 3 OR (a) · 8 marks- TQ Corporation's book value capital structure is:
| Equity capital (10 million shares, each Rs.10 par) | Rs.100 million |
| 11 percent Preference capital (100,000 shares of Rs.100 par each) | Rs.10 million |
| Retained earnings | Rs.120 million |
| Debentures at 13.5 percent (500,000 debentures, each Rs.100 par) | Rs.50 million |
| Term loans at 12 percent | Rs.80 million |
| TOTAL | Rs.360 million |
The dividend per share expected next is Rs.1.50, and is expected to grow at the rate of 7 percent. Each share's market price is Rs.20.00. The Preference stock, redeemable after 10 years, now sells for Rs.75.00 per share. The Debentures, redeemable after 6 years, sell for Rs.80.00 per debenture. The company's tax rate is 50 percent. Using book value and market value proportions, calculate the 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
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Retained earnings take the cost of equity, and in market value weights are combined with equity at its market value (C2). The term loan is taken at book value; preference shares and debentures are redeemed at par (C1).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Specific costs 3 marks 5 min
- 2 WACC at book value proportions 2½ marks 4 min
- 3 WACC at market value proportions 2½ marks 4 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 16 minutes for 8 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 (tax 50%; preference shares and debentures redeemed at par; paper note)
- Equity: Ke = D1 ÷ P0 + g = 1.50 ÷ 20 + 7% = 14.50%; retained earnings take the same cost.
- 11% preference (redeemable in 10 years, price ₹75): Kp = [11 + (100 − 75) ÷ 10] ÷ [(100 + 75) ÷ 2] = 13.50 ÷ 87.50 = 15.43%.
- 13.5% debentures (redeemable in 6 years, price ₹80): Kd = [13.5 × 0.5 + (100 − 80) ÷ 6] ÷ [(100 + 80) ÷ 2] = (6.75 + 3.33) ÷ 90 = 11.20%.
- 12% term loans: 12% × (1 − 0.5) = 6%.
(i) Book value proportions (Rs. million)
| Source | Book value | Cost | Weighted cost |
|---|---|---|---|
| Equity capital | 100 | 14.50% | 14.5000 |
| 11% Preference capital | 10 | 15.43% | 1.5429 |
| Retained earnings | 120 | 14.50% | 17.4000 |
| 13.5% Debentures | 50 | 11.20% | 5.6019 |
| 12% Term loans | 80 | 6.00% | 4.8000 |
| Total | 360 | 43.8448 |
WACC (book) = 43.8448 ÷ 360 = 12.18%.
(ii) Market value proportions (Rs. million). Equity: 10 million shares × Rs. 20 = 200, covering share capital and retained earnings together (paper note); preference 0.1 million × Rs. 75 = 7.5; debentures 0.5 million × Rs. 80 = 40; term loans at book value, 80.
| Source | Market value | Cost | Weighted cost |
|---|---|---|---|
| Equity (including retained earnings) | 200 | 14.50% | 29.0000 |
| 11% Preference capital | 7.5 | 15.43% | 1.1571 |
| 13.5% Debentures | 40 | 11.20% | 4.4815 |
| 12% Term loans | 80 | 6.00% | 4.8000 |
| Total | 327.5 | 39.4386 |
WACC (market) = 39.4386 ÷ 327.5 = 12.04%.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Specific costs | 3 |
| 2 | WACC at book value proportions | 2.5 |
| 3 | WACC at market value proportions | 2.5 |
| Total | 8 |
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