Test 4: Cost of Capital: answer key

Question 1 · 2 marks · Cost of Capital · medium

Scenario. Bharat Renewables Ltd. manufactures solar modules and grid-scale energy storage systems. The company is planning a new manufacturing facility and its finance committee is reviewing the overall cost of capital before approving the investment. The finance director has requested both book-value and market-value WACC calculations because the share price has appreciated considerably over the last three years. Existing capital structure (₹ lakh): Paid-up equity share capital: ₹30 lakh, comprising 3,00,000 shares of ₹10 each. Retained earnings: ₹10 lakh. Preference share capital: ₹20 lakh. 10% debentures: ₹40 lakh. Total book capital: ₹100 lakh. Market information: Current equity share price: ₹40 per share. Preference shares: Market value ₹22 lakh. Debentures: Market value ₹36 lakh. Component costs supplied by the finance department: Cost of equity (Ke): 16%. Cost of retained earnings (Kr): 14%. Cost of preference shares (Kp): 12%. After-tax cost of debt (Kd): 7%. Additional operating information: Forecast EBIT: ₹32 lakh. Annual debenture interest: ₹4 lakh. Corporate tax rate: 30%. Equity beta: 1.25. Risk-free return: 6%; expected market return: 14%. Expected next-year dividend: ₹3.20 per share; dividend growth: 6%. The expansion requires an initial investment of ₹45 lakh. The expected annual CFAT is ₹13.5 lakh for five years, and the project-specific appraisal has estimated an IRR of 13.00%. The working capital cycle comprises raw-material holding of 40 days, work-in-progress of 15 days, receivables of 45 days and supplier credit of 30 days, resulting in a net operating cycle of 70 days. The finance director instructs that, under market-value weighting, the total market value of equity must be apportioned between paid-up equity share capital and retained earnings using their respective book values. Retained earnings must not be added separately to the total equity market value.

Calculate the Weighted Average Cost of Capital (WACC) of Bharat Renewables Ltd. using book-value weights and the component costs supplied in the scenario.

1. 11.40% (correct answer)
2. 12.00%
3. 13.35%
4. 10.80%

Answer: A — 11.40%

Explanation. Total book capital = ₹100 lakh. The respective weights are equity 30%, retained earnings 10%, preference shares 20% and debt 40%. WACC = (30% × 16%) + (10% × 14%) + (20% × 12%) + (40% × 7%). Therefore, WACC = 4.80% + 1.40% + 2.40% + 2.80% = 11.40%. The component debt cost is already after tax. Using the market values instead of the specified book values would produce a different result.

Where it goes wrong. Using market-value weights when the question expressly requires book-value weights, or applying the corporate tax rate to the already calculated after-tax debt cost.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 2 · 2 marks · Cost of Capital · hard

Determine the WACC of Bharat Renewables Ltd. using market-value weights. The market value of paid-up equity and retained earnings must be apportioned in the ratio of their respective book values.

1. 11.40%
2. 13.35% (correct answer)
3. 14.10%
4. 12.75%

Answer: B — 13.35%

Explanation. Market value of equity = 3,00,000 shares × ₹40 = ₹120 lakh. Paid-up equity and retained earnings have book values of ₹30 lakh and ₹10 lakh, giving a 3:1 ratio. Accordingly, their market values are ₹90 lakh and ₹30 lakh. Total market capital = 90 + 30 + 22 + 36 = ₹178 lakh. Weighted cost = (90×16 + 30×14 + 22×12 + 36×7)/178 = 2,376/178 = 13.35%.

Where it goes wrong. Adding retained earnings separately to the total equity market value instead of proportionately allocating the existing equity market value.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 3 · 2 marks · Cost of Capital · medium

What is the market-value allocation attributable to retained earnings in Bharat Renewables Ltd., applying the ICAI method of apportioning total equity market value?

1. ₹20 lakh
2. ₹25 lakh
3. ₹30 lakh (correct answer)
4. ₹40 lakh

Answer: C — ₹30 lakh

Explanation. Total equity market value = 3,00,000 shares × ₹40 = ₹120 lakh. The book value of paid-up equity is ₹30 lakh and retained earnings are ₹10 lakh. Therefore, the allocation ratio is 30:10, or 3:1. The retained earnings allocation is ₹120 lakh × 1/4 = ₹30 lakh. The paid-up equity allocation is ₹90 lakh. Retained earnings do not have an independent market quotation; they are incorporated in the overall market value of equity.

Where it goes wrong. Treating the book value of retained earnings as their market value or allocating the entire equity market value to paid-up share capital.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 4 · 2 marks · Cost of Capital · medium

The proposed expansion project has an estimated IRR of 13.00%. Based on the market-value WACC computed for Bharat Renewables Ltd., determine the appropriate investment decision.

1. Accept, because IRR exceeds book-value WACC.
2. Accept, because IRR exceeds the after-tax cost of debt.
3. Accept, because the project generates positive annual CFAT.
4. Reject, because IRR is below market-value WACC. (correct answer)

Answer: D — Reject, because IRR is below market-value WACC.

Explanation. The relevant market-value WACC is 13.35%, as calculated using the company's market-value capital proportions and individual component costs. The project's estimated IRR is 13.00%. Since IRR of 13.00% is lower than the required return of 13.35%, the project does not meet the investment cut-off rate and should be rejected. Positive annual cash flow alone does not establish value creation; the return must exceed the relevant cost of capital.

Where it goes wrong. Accepting a project merely because it generates positive cash flows or comparing IRR with the cost of debt instead of the overall cost of capital.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 5 · 2 marks · Cost of Capital · hard

Scenario. Zenith Power Systems Ltd. is a manufacturer of industrial electrical equipment and renewable-energy control systems. It plans to raise additional capital for capacity expansion and has asked its finance team to prepare a marginal cost of capital schedule. The company intends to maintain a constant financing mix for all incremental funds, but the specific costs of debt and equity will increase after defined funding limits are exhausted. Existing financial position (₹ lakh): Equity share capital: ₹100 lakh. Retained earnings: ₹30 lakh. Preference share capital: ₹20 lakh. Existing debentures: ₹75 lakh. Total book capital: ₹225 lakh. Operating and risk information: Forecast EBIT: ₹45 lakh. Existing annual debt interest: ₹7.50 lakh. Corporate tax rate: 25%. Debt coupon rate on existing debentures: 10%. Equity beta: 1.00. Risk-free return: 6%; expected market return: 14%. Proposed incremental financing pattern: Debt: 30% of each additional rupee raised. Preference capital: 10% of each additional rupee raised. Equity: 60% of each additional rupee raised. Marginal component costs: Debt up to an aggregate additional debt raising of ₹12 lakh: 8% before tax. Debt raised beyond ₹12 lakh: 12% before tax. Preference capital: 12%, remaining constant. Retained earnings: 14%, with ₹15 lakh available for reinvestment. New equity shares, after retained earnings are exhausted: 17%. The company has sufficient taxable profits to use the interest tax shield. The proposed expansion projects have different investment requirements and estimated returns. One additional project requires ₹8 lakh and is expected to generate annual CFAT of approximately ₹2 lakh for six years, with no terminal value. The project-specific IRR is approximately 13.00%. The plant has a raw-material holding period of 50 days, work-in-progress of 20 days, receivables of 40 days and supplier credit of 35 days, resulting in a 75-day net operating cycle. The company has already committed to raising the first ₹25 lakh under its expansion programme. Management requires the marginal cost schedule to reflect the exhaustion of retained earnings and the higher borrowing rate separately.

Calculate the first break-point in Zenith Power Systems Ltd.'s marginal cost of capital schedule arising from the exhaustion of retained earnings.

1. ₹25 lakh (correct answer)
2. ₹30 lakh
3. ₹40 lakh
4. ₹50 lakh

Answer: A — ₹25 lakh

Explanation. Retained earnings available for reinvestment = ₹15 lakh. Equity represents 60% of the company's marginal financing mix. The total amount of capital that can be raised before retained earnings are exhausted is therefore ₹15 lakh/60% = ₹25 lakh. Beyond this point, the company must use external equity, carrying a higher component cost of 17% instead of 14%. The break-point is determined by dividing the source-specific limit by that source's intended financing proportion.

Where it goes wrong. Treating ₹15 lakh as the total funding break-point instead of adjusting it for the 60% equity proportion.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 6 · 2 marks · Cost of Capital · hard

Determine the marginal WACC applicable when Zenith Power Systems Ltd. raises total additional capital exceeding ₹25 lakh but not exceeding ₹40 lakh.

1. 11.40%
2. 13.20% (correct answer)
3. 14.10%
4. 12.00%

Answer: B — 13.20%

Explanation. The retained earnings break-point is ₹25 lakh, while the debt break-point is ₹40 lakh. In the ₹25–₹40 lakh interval, external equity is required, but debt remains within its lower-cost slab. After-tax debt cost = 8% × (1 − 25%) = 6%. Marginal WACC = (30%×6%) + (10%×12%) + (60%×17%) = 1.80% + 1.20% + 10.20% = 13.20%.

Where it goes wrong. Applying the higher debt cost before the debt break-point or continuing to use retained earnings after their available amount has been exhausted.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 7 · 2 marks · Cost of Capital · hard

Calculate the marginal cost of capital applicable when Zenith Power Systems Ltd. raises total additional capital beyond ₹40 lakh.

1. 13.20%
2. 12.60%
3. 14.10% (correct answer)
4. 15.00%

Answer: C — 14.10%

Explanation. The debt break-point occurs when debt of ₹12 lakh has been raised. Since debt represents 30% of total financing, the corresponding total capital break-point is ₹12 lakh/30% = ₹40 lakh. Above ₹40 lakh, the after-tax debt cost is 12% × 0.75 = 9%, and external equity costs 17%. Therefore MCC = (30%×9%) + (10%×12%) + (60%×17%) = 2.70% + 1.20% + 10.20% = 14.10%.

Where it goes wrong. Continuing to use the lower 6% after-tax debt cost after exceeding the specified debt financing limit.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 8 · 2 marks · Cost of Capital · hard

Zenith Power Systems Ltd. has already committed to raising ₹25 lakh. It now considers an additional indivisible project requiring ₹8 lakh with an estimated IRR of 13%. Using the appropriate marginal cost of capital, determine whether the additional project should be accepted.

1. Accept, because the marginal cost is 11.40%.
2. Accept, because the IRR equals the existing debt coupon rate.
3. Accept, because annual CFAT is positive.
4. Reject, because the project's IRR is below the applicable marginal cost. (correct answer)

Answer: D — Reject, because the project's IRR is below the applicable marginal cost.

Explanation. The initial ₹25 lakh has exhausted the available retained earnings. The additional ₹8 lakh takes total capital raised to ₹33 lakh, which falls in the ₹25–₹40 lakh interval. The applicable marginal WACC is 13.20%. Project IRR is only 13.00%. Since 13.00% is below 13.20%, the project should be rejected. The decision must use the marginal cost applicable to the additional funding, rather than the historical average cost of existing capital.

Where it goes wrong. Using the first marginal-cost slab for an investment that takes total capital raised beyond the retained earnings break-point.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 9 · 2 marks · Cost of Capital · medium

Scenario. A company has the following book-value capital structure: equity share capital ₹40 lakh, retained earnings ₹10 lakh, preference capital ₹20 lakh and debt ₹30 lakh. The respective component costs are 17%, 15%, 12% and 7%. Calculate the WACC using book-value weights.

A company has the following book-value capital structure: equity share capital ₹40 lakh, retained earnings ₹10 lakh, preference capital ₹20 lakh and debt ₹30 lakh. The respective component costs are 17%, 15%, 12% and 7%. Calculate the WACC using book-value weights.

1. 12.80% (correct answer)
2. 13.45%
3. 14.00%
4. 11.90%

Answer: A — 12.80%

Explanation. Total book capital = ₹100 lakh. WACC = (40%×17%) + (10%×15%) + (20%×12%) + (30%×7%). Individual contributions are 6.80%, 1.50%, 2.40% and 2.10%, respectively. Total WACC = 12.80%. The cost of each source must be multiplied by its own proportion of total capital. A simple average of the four component costs would ignore the different capital proportions.

Where it goes wrong. Calculating a simple arithmetic average of the component costs instead of their weighted average.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 10 · 2 marks · Cost of Capital · hard

Scenario. The book values of paid-up equity share capital and retained earnings are ₹24 lakh and ₹16 lakh, respectively. The total market value of equity shares is ₹150 lakh. Preference capital and debt have market values of ₹30 lakh and ₹20 lakh, respectively. If Ke = 18%, Kr = 15%, Kp = 12% and after-tax Kd = 7%, calculate WACC using market-value weights.

The book values of paid-up equity share capital and retained earnings are ₹24 lakh and ₹16 lakh, respectively. The total market value of equity shares is ₹150 lakh. Preference capital and debt have market values of ₹30 lakh and ₹20 lakh, respectively. If Ke = 18%, Kr = 15%, Kp = 12% and after-tax Kd = 7%, calculate WACC using market-value weights.

1. 14.50%
2. 15.10% (correct answer)
3. 16.00%
4. 13.80%

Answer: B — 15.10%

Explanation. The book-value ratio of paid-up equity to retained earnings is 24:16, or 3:2. Allocate the ₹150 lakh equity market value accordingly: paid-up equity = ₹90 lakh and retained earnings = ₹60 lakh. Total market capital = ₹200 lakh. WACC = (90×18 + 60×15 + 30×12 + 20×7)/200 = 3,020/200 = 15.10%. The retained earnings market value is included within the allocated equity market value, not added separately.

Where it goes wrong. Applying the book-value amounts directly as market-value weights or double-counting retained earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 11 · 2 marks · Cost of Capital · hard

Scenario. A company has paid-up equity share capital of ₹36 lakh and retained earnings of ₹24 lakh. The total market value of equity shares is ₹250 lakh. Determine the market value attributable to retained earnings under the prescribed proportional allocation method.

A company has paid-up equity share capital of ₹36 lakh and retained earnings of ₹24 lakh. The total market value of equity shares is ₹250 lakh. Determine the market value attributable to retained earnings under the prescribed proportional allocation method.

1. ₹75 lakh
2. ₹90 lakh
3. ₹100 lakh (correct answer)
4. ₹150 lakh

Answer: C — ₹100 lakh

Explanation. The book-value ratio is paid-up equity ₹36 lakh to retained earnings ₹24 lakh, or 3:2. Total ratio parts = 5. Retained earnings represent 2/5 of the book-value equity structure. Therefore, their allocated market value = ₹250 lakh × 2/5 = ₹100 lakh. Paid-up equity receives the balance of ₹150 lakh. The allocation is necessary because the market quotation reflects the combined value of paid-up capital and accumulated retained earnings.

Where it goes wrong. Assuming that the entire market value belongs to paid-up equity share capital or using the book value of retained earnings directly.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 12 · 2 marks · Cost of Capital · medium

Scenario. A company has equity and debt representing 50% each of its book capital. Their market-value proportions are 75% equity and 25% debt. Cost of equity is 18%, pre-tax cost of debt is 11%, and corporate tax is 20%. Calculate the market-value WACC.

A company has equity and debt representing 50% each of its book capital. Their market-value proportions are 75% equity and 25% debt. Cost of equity is 18%, pre-tax cost of debt is 11%, and corporate tax is 20%. Calculate the market-value WACC.

1. 13.40%
2. 14.50%
3. 16.00%
4. 15.70% (correct answer)

Answer: D — 15.70%

Explanation. After-tax cost of debt = 11% × (1 − 20%) = 8.80%. The specified market-value weights are 75% equity and 25% debt. WACC = (75%×18%) + (25%×8.80%) = 13.50% + 2.20% = 15.70%. Using equal book-value weights would produce a different result and would not reflect the market-value financing proportions required in the question.

Where it goes wrong. Using equal book-value weights instead of the specified market-value proportions or failing to adjust debt cost for corporate tax.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 13 · 2 marks · Cost of Capital · hard

Scenario. A company intends to finance additional capital using 60% equity, 25% debt and 15% preference shares. Retained earnings available for reinvestment are ₹18 lakh. Determine the capital-raising break-point at which external equity becomes necessary.

A company intends to finance additional capital using 60% equity, 25% debt and 15% preference shares. Retained earnings available for reinvestment are ₹18 lakh. Determine the capital-raising break-point at which external equity becomes necessary.

1. ₹30 lakh (correct answer)
2. ₹18 lakh
3. ₹45 lakh
4. ₹36 lakh

Answer: A — ₹30 lakh

Explanation. Retained earnings available = ₹18 lakh. Equity represents 60% of the company's incremental financing. Thus, the maximum total funds that can be raised before exhausting retained earnings = ₹18 lakh/0.60 = ₹30 lakh. Beyond this amount, external equity must be issued. The break-point represents total capital raised, not merely the amount of retained earnings available. Debt and preference proportions do not enter this specific calculation.

Where it goes wrong. Confusing the amount of available retained earnings with the total capital break-point.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 14 · 2 marks · Cost of Capital · hard

Scenario. A company follows a financing pattern of 40% debt and 60% equity. Its lower-cost debt facility is available up to ₹16 lakh of debt. Calculate the total funds that can be raised before the marginal cost of debt increases.

A company follows a financing pattern of 40% debt and 60% equity. Its lower-cost debt facility is available up to ₹16 lakh of debt. Calculate the total funds that can be raised before the marginal cost of debt increases.

1. ₹16 lakh
2. ₹40 lakh (correct answer)
3. ₹32 lakh
4. ₹48 lakh

Answer: B — ₹40 lakh

Explanation. Debt represents 40% of every additional rupee of capital. The lower-cost debt capacity is ₹16 lakh. Hence, total funding at which this facility becomes exhausted = ₹16 lakh/40% = ₹40 lakh. Any additional capital raised beyond ₹40 lakh will contain debt costing at the higher rate. The break-point must be determined from the proportion of debt in the target financing structure, not by adding debt and equity amounts incorrectly.

Where it goes wrong. Using ₹16 lakh directly as the total funding break-point rather than dividing by the debt financing proportion.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 15 · 2 marks · Cost of Capital · medium

Scenario. A company plans to raise additional funds in the following proportions: debt 40%, preference shares 10% and retained earnings 50%. The pre-tax cost of debt is 12%, corporate tax is 25%, cost of preference capital is 13% and cost of retained earnings is 16%. Calculate the marginal cost of capital.

A company plans to raise additional funds in the following proportions: debt 40%, preference shares 10% and retained earnings 50%. The pre-tax cost of debt is 12%, corporate tax is 25%, cost of preference capital is 13% and cost of retained earnings is 16%. Calculate the marginal cost of capital.

1. 14.10%
2. 13.50%
3. 12.90% (correct answer)
4. 11.70%

Answer: C — 12.90%

Explanation. After-tax debt cost = 12% × (1 − 25%) = 9%. The marginal cost of capital is the weighted cost of the intended financing mix. Therefore, MCC = (40%×9%) + (10%×13%) + (50%×16%) = 3.60% + 1.30% + 8.00% = 12.90%. Debt receives the corporate tax adjustment, while preference dividends and retained earnings are not reduced by the debt tax shield.

Where it goes wrong. Applying the corporate tax adjustment to all components or using an unweighted average of the three financing costs.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 16 · 2 marks · Cost of Capital · hard

Scenario. A company raises additional funds using 30% debt, 10% preference capital and 60% equity. Debt has a pre-tax cost of 12%, corporate tax is 25%, preference capital costs 12%, and retained earnings are exhausted. New equity carries a cost of 18%. Calculate the new marginal WACC.

A company raises additional funds using 30% debt, 10% preference capital and 60% equity. Debt has a pre-tax cost of 12%, corporate tax is 25%, preference capital costs 12%, and retained earnings are exhausted. New equity carries a cost of 18%. Calculate the new marginal WACC.

1. 13.20%
2. 14.10%
3. 15.00%
4. 14.70% (correct answer)

Answer: D — 14.70%

Explanation. After-tax debt cost = 12% × 75% = 9%. Preference cost = 12%, and new equity cost = 18%. Since retained earnings are exhausted, the external equity cost must be used. MCC = (30%×9%) + (10%×12%) + (60%×18%) = 2.70% + 1.20% + 10.80% = 14.70%. Continuing to use the lower retained earnings cost would understate the marginal financing cost.

Where it goes wrong. Using the cost of retained earnings after the internal equity funding limit has been exhausted.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 17 · 2 marks · Cost of Capital · hard

Scenario. A company intends to maintain a marginal financing mix of 25% debt, 15% preference shares and 60% equity. Corporate tax is 25%. The pre-tax debt cost is 8% on the first ₹10 lakh of debt raised and 12% thereafter. Preference cost is 12%. Retained earnings cost is 14%, with ₹12 lakh available; external equity costs 17%. Calculate the marginal cost of capital applicable when total capital raised exceeds ₹40 lakh.

A company intends to maintain a marginal financing mix of 25% debt, 15% preference shares and 60% equity. Corporate tax is 25%. The pre-tax debt cost is 8% on the first ₹10 lakh of debt raised and 12% thereafter. Preference cost is 12%. Retained earnings cost is 14%, with ₹12 lakh available; external equity costs 17%. Calculate the marginal cost of capital applicable when total capital raised exceeds ₹40 lakh.

1. 14.25% (correct answer)
2. 13.50%
3. 11.70%
4. 15.00%

Answer: A — 14.25%

Explanation. The debt break-point is ₹10 lakh/25% = ₹40 lakh. The retained earnings break-point is ₹12 lakh/60% = ₹20 lakh. Beyond ₹40 lakh, external equity and higher-cost debt both apply. After-tax debt cost = 12% × 75% = 9%. MCC = (25%×9%) + (15%×12%) + (60%×17%) = 2.25% + 1.80% + 10.20% = 14.25%. Both break-points must be considered before selecting the relevant component costs.

Where it goes wrong. Recognising only one break-point and continuing to use either the cheaper debt or retained earnings cost beyond its available limit.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 18 · 2 marks · Cost of Capital · hard

Scenario. Using the marginal financing schedule in the previous question, a company has already raised ₹25 lakh and proposes another investment requiring ₹5 lakh. The project's estimated IRR is 13.20%. Determine the applicable cut-off rate and investment decision.

Using the marginal financing schedule in the previous question, a company has already raised ₹25 lakh and proposes another investment requiring ₹5 lakh. The project's estimated IRR is 13.20%. Determine the applicable cut-off rate and investment decision.

1. 11.70%; Accept
2. 13.50%; Reject (correct answer)
3. 14.25%; Reject
4. 12.00%; Accept

Answer: B — 13.50%; Reject

Explanation. The retained earnings break-point is ₹20 lakh and the debt break-point is ₹40 lakh. Raising ₹25 lakh plus the additional ₹5 lakh results in total capital of ₹30 lakh, which remains within the ₹20–₹40 lakh interval. Therefore the applicable MCC is 13.50%. The project's IRR of 13.20% is below this cut-off rate, so the project should be rejected. The higher 14.25% rate applies only after total capital exceeds ₹40 lakh.

Where it goes wrong. Using the first marginal-cost slab despite the exhaustion of retained earnings, or applying the higher debt cost before the debt break-point.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 19 · 2 marks · Cost of Capital · hard

Scenario. A company has paid-up equity share capital of ₹20 lakh and retained earnings of ₹10 lakh. The total market value of equity is ₹90 lakh. Preference capital has a market value of ₹10 lakh and debt has a market value of ₹20 lakh. Component costs are Ke 18%, Kr 15%, Kp 12% and after-tax Kd 7%. Calculate WACC using market-value weights.

A company has paid-up equity share capital of ₹20 lakh and retained earnings of ₹10 lakh. The total market value of equity is ₹90 lakh. Preference capital has a market value of ₹10 lakh and debt has a market value of ₹20 lakh. Component costs are Ke 18%, Kr 15%, Kp 12% and after-tax Kd 7%. Calculate WACC using market-value weights.

1. 13.80%
2. 15.50%
3. 14.92% (correct answer)
4. 16.00%

Answer: C — 14.92%

Explanation. Paid-up equity and retained earnings have a book-value ratio of ₹20 lakh:₹10 lakh, or 2:1. Allocate the ₹90 lakh market equity value as ₹60 lakh and ₹30 lakh respectively. Total market capital = ₹90 + ₹10 + ₹20 = ₹120 lakh. WACC = (60×18 + 30×15 + 10×12 + 20×7)/120 = 1,790/120 = 14.92%. Retained earnings must be allocated within the equity market value.

Where it goes wrong. Adding retained earnings separately to market equity value or assigning the entire equity market value to paid-up share capital.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital

Question 20 · 2 marks · Cost of Capital · hard

Scenario. A company has the following marginal cost of capital schedule: 11.70% up to ₹20 lakh, 13.50% for capital exceeding ₹20 lakh up to ₹40 lakh, and 14.25% beyond ₹40 lakh. Three mutually independent investment proposals are available: Project A requires ₹15 lakh and has an IRR of 15%; Project B requires ₹20 lakh and has an IRR of 13.80%; Project C requires ₹10 lakh and has an IRR of 13%. Projects must be considered in descending order of IRR. Which combination should be accepted?

A company has the following marginal cost of capital schedule: 11.70% up to ₹20 lakh, 13.50% for capital exceeding ₹20 lakh up to ₹40 lakh, and 14.25% beyond ₹40 lakh. Three mutually independent investment proposals are available: Project A requires ₹15 lakh and has an IRR of 15%; Project B requires ₹20 lakh and has an IRR of 13.80%; Project C requires ₹10 lakh and has an IRR of 13%. Projects must be considered in descending order of IRR. Which combination should be accepted?

1. Projects A and C only
2. Project A only
3. Projects A, B and C
4. Projects A and B only (correct answer)

Answer: D — Projects A and B only

Explanation. Project A ranks first. Its ₹15 lakh requirement falls within the first ₹20 lakh slab, where MCC is 11.70%; its 15% IRR exceeds the cut-off, so accept it. Project B raises cumulative funding to ₹35 lakh. The relevant MCC slabs are 11.70% for the first ₹5 lakh of B and 13.50% for the remaining ₹15 lakh; its 13.80% IRR exceeds both, so accept it. Project C would take funding beyond ₹40 lakh, where MCC is 14.25%; its 13% IRR is insufficient, so reject it.

Where it goes wrong. Ranking projects incorrectly, ignoring cumulative capital raised, or accepting a lower-IRR project without comparing it with the marginal cost applicable to its funding requirement.

Authority. ICAI SM: Financial Management and Strategic Management, Cost of Capital