L5 FINANCIAL MANAGEMENT

CALCULATION OF WACC

Question 1.
There are a number of problems that will be encountered when trying to calculate a
WACC for a company.

 How do we find the cost of equity? There are two alternatives – the dividend
growth model and the CAPM – both of which have potential drawbacks.
 How do we find the cost of debt? Companies have many forms of debt, and
company accounts do not always give the appropriate interest that they are
paying, for example to their bank. In addition, the maturity date of the debt
may not be specified, or it may have split redemption dates.
 The market values of debt and equity may be hard to find. For example, some
forms of debt may be tradable, but may not have a continuously trading
market, whereas other forms of debt may not be traded.
 Some debt instruments, for example convertibles and floating rate debt, are
rather complex and it may not be possible to find their cost or market value.
 Should short–term debt be included in the WACC calculation or is it a working
capital issue?
 Company balance sheets may further be complicated by the use of non–
sterling debt or currency and interest rate swaps.

Question 2.

(a) To calculate the cost of debt of an irredeemable bond we divide the coupon
payment by the market value. To then state after tax, we must deduct the
appropriate tax rate hence:

10/90 = 0.111 x 0.72 = 0.08. The after-tax cost of debt for this bond is = 8%

(b) Here we need to use the redeemable bond approximation model:

I + ((P - MV)/n) = 8 + ((100 - 102)/6) = 7.67 = 7.6%

(P + 0.6 x (MV - P)) (100 + 0.6 x (102 - 100)) 101.2

After tax at 28% = 7.6% x 0.72 = 5.47%

Question 3.

(a) Cum dividend share price = 280p

Ex-div share price = 280 - 15 = 265p

Ke = Do. ( 1 + g ) + g = 15.(1 + 0.12) + 0.12 =

18.3%
Po 265

(b) With a nominal value of £1 and a dividend of 6% the annual dividend is 6p. To
calculate the financing cost of the preference share we simply divide the
dividend by the market price hence: 6/103 = 0.058 so 5.8%

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LECTURE 6
 L5 FINANCIAL MANAGEMENT
CALCULATION OF WACC

Question 4.
Cost of equity using the dividend growth model
Ke = ((7  (1 + 0.08))/49) + 0.08 = 0.23, so 23%

Cost of preference shares

Kp = Dp/Po = (0.075  50)/32 = 0.0117, so 12%

Cost of iredeemable bonds

Kd = I/Po = (0.1  100)/92 = 0.109, so 11%

Weighting could be done using book values but a market based weighting is
preferable when market values are available.
Market value
£
Equity = 1,000,000  0.49 = 490,000
Preference shares = 250,000  0.32 = 80,000
Bonds = 100,000  0.92 = 92,000
662,000

WACC = [(23  490) + (12  80) + (11  (1 – 0.30)  92)]/662 = 19.5%

Question 5.
Ordinary shares (Ke):

Estimate for g:
21
√
4

g = 14 - 1 = 10.7%

Ke = 21 x (1 + 0.107) + 0.107 = 15.7%

466

Preference shares (Kps):

Kps = 8/ 67 = 11.9%

Redeemable bonds (Kd):

Kd = I + ((P - MV)/ n) = 6 + ((100 - 92)/ 6) = 7.33 = 7.7%

P + [0.6 x (MV - P)] 100 + [0.6 x (92 - 100)] 95.2

After tax Kd = 7.7 x (1 - 0.31) = 5.3%

Irredeemable bonds (Kdir):

Kdir = 100 x (8/ 82) = 9.8%
After tax Kdir = 9.8 x (1 - 0.31) = 6.7%

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LECTURE 6
 L5 FINANCIAL MANAGEMENT
CALCULATION OF WACC

Market values £000

Equity 200 x £4.66 = 932
Preference 800 x £0.67 = 536
Redeemable bonds 500 x 0.92 = 460
Irredeemable bonds 400 x 0.82 = 328
2,256

WACC calculation:-
WACC = [(15.7 x 932) + (11.9 x 536) + (5.3 x 460) + (6.7 x 328)]/ 2,256 = 11.4%

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LECTURE 6
 L5 FINANCIAL MANAGEMENT
CALCULATION OF WACC

Phase Test Preparation:

Q1. B (2) is correct

This statement is the only true one. Finance raised in other currencies needs to be
converted into the home-country currency when calculating the weights. Equally,
WACC is a dynamic concept which means it needs to be re-calculated on a frequent
basis, making statement (3) also incorrect.

Q2. E Share options

These should be left out of the WACC calculations as they are not a source of
finance until they are exercised by the holder. Usually overdraft would be left out but
if it is being used on an on-going basis, it is classified as a long-term source of
finance.

Q3. A (1) is correct

Here statement 2 is incorrect as the marginal cost of capital can be either above or
below the WACC. For statement 3, the reverse is likely to be true – book values give
a higher weighting to cheaper debt finance, reducing the WACC.

Q4. D Fixed charge security is where debt is secured against a pool of assets
Firstly, we need to calculate the ex-div share price = £2.78 – 18p = £2.60. Then:
Ke = 18(1 + 0.076)/260 + 0.076 = 0.15 or 15%

Q5. A Convertible debt has a higher cost f capital than ordinary shares
This statement is untrue. Although convertibles may way convert and end up as
equity, they will spend part of their life as debt with a debt-related cost. Hence
making them cheaper than equity finance.

Q6. D 11%
If we assume that the securities are issued at par, we need the discount rate that will
equate with this. The securities will convert as £6 x 20 > £100.

Try 10%: (2.487 x £5) + (0.751 x £120) = £102.56. Too high so:
Try: 11% (2.444 x £5) + (0.731 x £120) = £102.56 £99.94  £100 so D is correct

Q7. A 5, 1, 2, 3, 4
Secured bonds will be the cheapest. Ordinary shares will be the most expensive.
This means the answer has to be A.

Q8. D 15.7%
Here: Ke = 25.(1.1)/325 + 0.1 = 18.5%
Kd = 8/86 = 9.3%
MV of Bonds = £5m x 0.86 = £4.3m
MV of Equity = 3m x £3.25 = £9.75m
WACC = (18.5% x 9.75/14.05) (9.3% x 4.3/14.05) = 12.8% + 2.9% = 15.7%

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LECTURE 6