Question 3 OR (c)
WACC, and the cost of redeemable preference shares
9 marks
- Time to write
- About 18 minutes
- Topic
- Cost of capital
Question
Question 3 OR (c) · 9 marksSagar Limited's capital structure is as follows:
| Particulars | Rs. |
|---|---|
| Equity share capital (2,40,000 shares) | 60,00,000 |
| 6% Preference shares | 12,00,000 |
| 8% Debentures | 36,00,000 |
| 1,08,00,000 |
The company's equity share has a market price of Rs. 200. The company is expected to pay a dividend of Rs. 2 per share at the close of the current year, growing at 8 percent for ever. The tax rate is 30 percent. Compute a weighted average cost of capital on the existing capital structure. Also find out what the cost of preference share capital is if the preference shares are to be redeemed after 15 years at a 10% premium.
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
- Compute…Find…Two asks in one question: answer both.
- ComputeFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The weighted average cost of capital is read as using the preference shares as given in the structure; the cost of the preference shares if redeemable after 15 years is then found separately, as the last sentence asks.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Specific costs 2 marks 4 min
- 2 WACC on the existing structure 4 marks 7 min
- 3 Cost of redeemable preference shares 3 marks 5 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.
- Equity: ke = D1 ÷ P0 + g = 2 ÷ 200 + 8% = 1% + 8% = 9%.
- 6% preference shares (as given in the structure, paper note): kp = 6%.
- 8% debentures: kd = 8% × (1 − 0.30) = 5.6%, interest being tax deductible.
Weighted average cost of capital (book values of the existing structure)
| Source | Amount (₹) | Cost | Weighted cost (₹) |
|---|---|---|---|
| Equity share capital | 60,00,000 | 9% | 5,40,000 |
| 6% Preference shares | 12,00,000 | 6% | 72,000 |
| 8% Debentures | 36,00,000 | 5.6% | 2,01,600 |
| Total | 1,08,00,000 | 8,13,600 |
WACC = 8,13,600 ÷ 1,08,00,000 = 7.53%.
Cost of the preference shares if redeemable after 15 years at a 10% premium. Taking a share of ₹100 issued at par (no issue costs given), the dividend is ₹6, the redemption value ₹110 and n = 15:
kpr = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2] = [6 + (110 − 100) ÷ 15] ÷ [(110 + 100) ÷ 2] = 6.667 ÷ 105 = 6.35%.
The redemption premium raises the cost above the 6% dividend rate.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Specific costs | 2 |
| 2 | WACC on the existing structure | 4 |
| 3 | Cost of redeemable preference shares | 3 |
| Total | 9 |
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