Question 3 OR (b)
WACC on book value and market value weights
9 marks
- Time to write
- About 18 minutes
- Topic
- Cost of capital
Question
Question 3 OR (b) · 9 marksThe capital structure of Vega Limited is given below
| Sources | Amount | Specific cost of capital |
|---|---|---|
| Equity Share capital (3,00,000 shares of ₹10 each) | ₹30,00,000 | 11% |
| Preference Share capital (75,000 shares of ₹10 each) | ₹7,50,000 | 8% |
| Retained earning | ₹15,00,000 | 11% |
| 7.5% Debentures of ₹1,000 each | ₹22,50,000 | 4.5% |
Currently the Debentures are being traded at 94%, while Preference shares at par and equity shares at ₹13 per share. Using book value weights and market weights, find out the weighted average 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
- find outFormula first, then the working, then the answer with its unit (₹, %, units).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Market values, with equity apportioned to retained earnings 2 marks 4 min
- 2 WACC on book value weights 3 marks 5 min
- 3 WACC on market value weights 4 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 18 minutes for 9 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.
The specific costs are given; only the weights differ.
Market values. Equity shares: 3,00,000 × ₹13 = ₹39,00,000. Retained earnings have no separate market value, so the equity market value is apportioned between share capital and retained earnings in the ratio of their book values, 30,00,000: 15,00,000 = 2: 1: equity share capital ₹26,00,000, retained earnings ₹13,00,000. Preference shares at par: ₹7,50,000. Debentures at 94%: ₹22,50,000 × 0.94 = ₹21,15,000.
| Source | Book value (₹) | Cost | Weighted cost (₹) |
|---|---|---|---|
| Equity share capital | 30,00,000 | 11% | 3,30,000 |
| Preference share capital | 7,50,000 | 8% | 60,000 |
| Retained earnings | 15,00,000 | 11% | 1,65,000 |
| 7.5% Debentures | 22,50,000 | 4.5% | 1,01,250 |
| Total | 75,00,000 | 6,56,250 |
WACC (book) = 6,56,250 ÷ 75,00,000 = 8.75%.
| Source | Market value (₹) | Cost | Weighted cost (₹) |
|---|---|---|---|
| Equity share capital | 26,00,000 | 11% | 2,86,000 |
| Preference share capital | 7,50,000 | 8% | 60,000 |
| Retained earnings | 13,00,000 | 11% | 1,43,000 |
| 7.5% Debentures | 21,15,000 | 4.5% | 95,175 |
| Total | 67,65,000 | 5,84,175 |
WACC (market) = 5,84,175 ÷ 67,65,000 = 8.64%.
The market-value WACC is lower because the equity, the costliest source, is worth less in the market (₹39,00,000) than its book value with retained earnings (₹45,00,000).
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Market values, with equity apportioned to retained earnings | 2 |
| 2 | WACC on book value weights | 3 |
| 3 | WACC on market value weights | 4 |
| Total | 9 |
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