Question

Renown Plc intends to initiate a vast expansion programme which will significantly impact the fundamental nature of the company. The programme will be completed over the forthcoming five year period. The following information has been extracted from the 31st January 2019 statements.

   £

            10% debentures                                     9,000

Share capital (£1 per share)              12,000

                            7% LT Debt             7,000

  Other Equity Items 16,000

The debt of the company is recorded at face value, but the debentures are currently transacting at a discount of 5% yielding 10.85% and the LT debt at a discount of 3% yielding 7.56%. The stock is currently trading at £2.80 cu dividend and is just a few days from ex rights date. The dividend to be paid is 15p per share. The market consensus is that dividends will increase by 6% per annum for the foreseeable future. The company’s tax rate is 20%. The current risk free rate is 2%, the return on the equity markets is 8% and the company's beta is 1.5.

Calculate companys book value WACC and market value WACC

Answer 1

Cost of different types of Capitals

After-tax cost of 10% debentures=Before-tax cost*(1-Tax rate)

ie. 10.85%*(1-20%)=

8.68%

After-tax cost of 7% LT Debt=Before-tax cost*(1-Tax rate)

ie.7.56%*(1-20%))=

6.05%

Cost of common shares

as per Dividend discount model

ke=(Next dividend/Current market price)+Growth rate

ie.(0.15/2.80)+6%=

11.36%

as per CAPM,

ke=RFR+(Beta*(Market return-RFR))

ie.2%+(1.5*(8%-2%))=

11.00%

We can assume the cost of equity as the average of that as per DDM & CAPM

ie.(11.36%+11%)/2=

11.18%

Type of capital	Book Values	Wt. to total	Cost	Wt.*Cost
10% debentures	9000	20.45%	8.68%	1.78%
7% debt	7000	15.91%	6.05%	0.96%
Share capital	28000	63.64%	11.18%	7.11%
Total book value	44000	100.00%		9.85%

So, Book value WACC= 9.85%

Now for market value WACC, we need market values of the three type of capitals.
Market value of 10% debentures= 9000*(1-5%)=
8550
Market Value ofLT debt=7000*(1-3%)=
6790
Market Value of equity=12000 shares*$ 2.80/share=
33600

Type of capital	Market Values	Wt. to total	Cost	Wt.*Cost
10% debentures	8550	17.47%	8.68%	1.52%
7% debt	6790	13.87%	6.05%	0.84%
Share capital	33600	68.66%	11.18%	7.68%
Total market value	48940	100.00%		10.03%

So,Market value WACC= 10.03%