3) - WEIGHTED AVERAGE COST OF CAPITAL (WACC)

COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Sources of Finance Total Market Value Individual Overall Cost of Capital (%)
(Weight) Costs (%)
Equity
Ordinary shares No. of shares x current market price ex-div Ve Ke [Ve ÷ (Ve + Vp + Vd)] x Ke =x
Long term Debts:
Preference shares No. of preference shares x current market price ex-div Vp Kp [Ve ÷ (Ve + Vp + Vd)] x Kp =x
Irredeemable Debentures No. of irredeemable debentures x current market price ex-interest Vd Kd (1 – T) [Ve ÷ (Ve + Vp + Vd)] x Kd(1 – T) = x
Redeemable Debentures No. of redeemable debentures x current market price ex-interest Vd Kd (1 – T) [Ve ÷ (Ve + Vp + Vd)] x Kd(1 – T) = x
Convertible Debentures No. of convertible debentures x current market price ex-interest Vd Kd (1 – T) [Ve ÷ (Ve + Vp + Vd)] x Kd(1 – T) = x
Bank loan Book value = Market value Vd Kd (1 – T) [Ve ÷ (Ve + Vp + Vd)] x Kd(1 – T) = x
Ve + Vp + Vd WACC (%) =x
COST OF EQUITY

DIVIDEND VALUATION CAPITAL ASSET PRICIING MODEL MM PROPOSITION II

MODEL (DVM) (CAPM)

Without Growth Ke = RF +βe (RM – RF) KeG = KeU + ( KeU - Kd) Vd(1 – T)
Where Ve
Ke = D Ke = Cost of equity Where
MV ex-div RF = Risk free rate KeG = Cost of Equity of geared Co.
RM = Market rate of return Keu = Cost of Equity of geared Co
Where βe= Beta (Measure of Systematic Risk) T = Tax rate
Ke = Cost of equity Vd = Market Value of debt
D = Constant dividend paid from Ve = Market Value of equity
year 1 to infinity DIVERSIFICATION Kd = Debt is risk free so here RISK FREE RATE will
EXPANSION
MV = MV of shares (ex-div) Share price (cum div) (New Industry) be taken as pre- tax cost of debt.
Less: Dividend announced but not paid
yet
With Growth Use existing Equity ()
Beta (βe) of own
i. Un-gear proxy βe at proxy Co. D/E ratio to calculate βa.
company ii. Re-gear βa at overall D/E ratio of company to calculate project specific βe.
Ke = Do (1 + g) +g RETENTION MODEL
MV ex-div Note: If project specific D/E ratio is not given then current D/E ratio will be maintained.
Where
Ke = Cost of equity
Do = Most recent dividend paid or just to be paid g = b x re
MV = Market value of Shares (ex-div)
D1=Do (1+g) = Dividend expected in one year’s time
g = Constant growth rate where:
re = ROE
b = Retention Ratio (OR)
HISTORICAL BASIS
b = ( 1 – Dividend Payout Ratio) (OR)
b = (1 – [DPS/EPS])
1÷n Exam Notes
g= Recent Dividend -1 If question is silent then
Earliest Dividend ROE = Profit after tax – Pref. Div.  Share price will be assumed as ex – div.
Book value of Equity  Expansion of existing operations will be assumed
where: Where  Capital structure of project will be same to existing capital structure of Co.
n = number of times dividend is changed. Equity = Share Capital + Reserves  β will be assumed as equity Beta (βe)
 βd will be assumed zer

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 1

 COST OF DEBT AFTER TAX

TRADED DEBT NON - TRADED DEBT

(Fixed Rate Debts) (Floating Rate Debt)

Bank
Irredeemable
Loan
Preference Redeemable Convertible
Debt Shares Debt Debt

Kd(1-T) IRR of after tax Cash IRR of after tax Cash Flows After-tax Cost of debt
= Amount of interest (1 – t) Flows (See next page) = Rate of interest (1 – t)
Market value (See next page)
where
Amount of interest
= (Nominal Value x Coupon %)
T = tax rate

Irredeemable preference shares Exam Notes

Note: If question is
silent, then Nominal i. If question is silent, then cost of debt will be assumed as pre – tax cost of
value of debt Kp= Amount of Pref. Dividend debt and (1 – T) will be used to convert into Post tax cost of debt.
instrument will be Market Value of Preference Share Redeemable preference shares ii. If no information is given regarding cost of bank loan then, cost of debt will be
equal to Rs. 100. taken as market rate of a similar bank loan or Cost of debenture or bonds.
where IRR of Cash Flows
Amount of Preference dividend
(Nominal Value x Dividend %)

Assumed Assumed Rate

Rate (Select high rate if first NPV is positive)
After tax Cost of Redeemable Debt IRR of Cash Flows after tax
Years Description Cash PV Factor PV PV Factor PV
Flow 5% 10%

0 (Market price of bond) (x) 1.00 (x) 1.00 (x)

1–5 Amount of Interest (1 – T) x 4.329 x 3.791 x

(Nominal Value x Coupon rate)

5 Redemption Value X 0.784 X 0.621 X

NPV = x NPV = (x)

NPVL
IRR = L+ x (H-L)
NPVL - NPVH

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 2

After tax cost of Convertible Debt
Step 1: Comparison
Redemption value = Rs. 100 /bond or given at premium
Conversion Value = Current share price x (1 + share price growth rate)n x No. of shares received against cancellation of one debenture Select the higher of redemption value and
conversion value
Assumed Rate Assumed Rate
(Select high rate if first NPV is positive)
Step 2:
IRR of Cash Flows after tax
Years Description Cash PV Factor PV PV Factor PV
Flow 5% 10%

0 (Market price of bond) (x) 1.00 (x) 1.00 (x)

1–5 Amount of Interest (1 – T) x 4.329 x 3.791 x
(Nominal Value x Coupon rate)

5 Conversion value or Redemption value (higher) X 0.784 X 0.621 X

NPV = x NPV = (x)

NPVL
IRR = L+ x (H-L)
NPVL - NPVH

MODIGILANI AND MILLER’S CAPITAL STRUCTURE THEORY

MM Theory (Without Tax) MM Theory (With Tax)

Formula Description Formula Description

MV g = MV u Market value of geared company will be equal to Market value MV g = MV u + Dt Market value of geared company will be higher than
of ungeared company. Market value of ungeared company.
WACC g = WACC u WACC of geared company will be similar to WACC of ungeared
company. WACC g = WACC u x ( 1 – Vd x T ) WACC of geared company will be lower than WACC of
Cost of equity of geared company will be higher than cost of Ve + Vd similar ungeared company.
Keg = Keu + (Keu – Kd) Vd
equity of ungeared company due to higher financial risk faced
Ve
by shareholders. Cost of equity of geared company will be higher than
Keg = Keu + (Keu – Kd) Vd (1 – T)
cost of equity of ungeared company due to higher
Ve
financial risk faced by shareholders.

ABDUL AZEEM – SKANS CA FINAL COMPENDIUM Page 3