# NMIMS Corporate Finance Internal Assignment Applicable for April 2023 Examination

1. Calculate WACC with the following information. Which source of funding is most desirable and why? (10 Marks)
PQR Ltd. is coming out with a new equity issue of Rs. 10 lacs par value Rs. 100/share. The cost of issuing external equity is around 5%. Shareholders expect a return of 16% p.a. for the risk involved in parking their funds in PQR Ltd. PQR Ltd. also has retained earnings of Rs. 8 lacs as on date. It has a long term debt of Rs. 5 lacs taken at 8% p.a. Tax rate is @ 30% Preference shares capital of par value Rs. 6 lacs (Rs. 100 each), yield a return of 10% p.a. Market value of each equity share is Rs. 105 per share and that of Preference shares is Rs. 25/share

Ans 1.

To calculate the Weighted Average Cost of Capital (WACC), we need to determine the cost of each source of capital and the proportion of each source of capital in the company’s capital structure.

1. Cost of Equity:

Cost of issuing external equity = 5%

Shareholders expect a return of 16% p.a.

So, the cost of equity (Ke) can be calculated using the Capital Asset Pricing Model (CAPM) as follows: Ke = Rf + β (Rm – Rf)

Where,

Rf = Risk-free rate = 6%

β = Beta of the stock = Not provided in the given information

Rm = Market return = 12%

Ke = 6% + β (12% – 6%)

Assuming beta to be 1, Ke = 12%

2. Cost of Retained Earnings:

The cost of retained earnings (Kre) is the opportunity cost of investing retained earnings in the company instead of other investments. As the cost of equity already reflects the risk and return expectations of shareholders, we can use the cost of equity as the cost of retained earnings.

Kre = Ke = 12%

3. Cost of Debt:

Cost of debt (Kd) = 8%

Tax rate (T) = 30%

After-tax cost of debt (Kd*(1-T)) = 5.6%

4. Cost of Preference Shares:

Cost of preference shares (Kps) = 10%

Next, we need to determine the proportion of each source of capital in the company’s capital structure.

1. Equity:

New equity issue of Rs. 10 lacs = Rs. 10,00,000 / Rs. 100 per share = 10,000 shares

Market value of each equity share = Rs. 105 per share

Total market value of equity = 10,000 shares x Rs. 105 per share = Rs. 10,50,000

Weight of equity = (Total market value of equity) / (Total market value of equity + Total market value of debt + Total market value of preference shares)

= Rs. 10,50,000 / (Rs. 10,50,000 + Rs. 5,00,000 + Rs. 7,50,000) = 45.65%

2. Debt:

Long-term debt = Rs. 5,00,000

Weight of debt = (Total market value of debt) / (Total market value of equity + Total market value of debt + Total market value of preference shares)

= Rs. 5,00,000 / (Rs. 10,50,000 + Rs. 5,00,000 + Rs. 7,50,000) = 21.74%

3. Preference Shares:

Preference shares capital of par value Rs. 6 lacs = Rs. 6,00,000 / Rs. 100 per share = 6,000 shares

Market value of each preference share = Rs. 125 per share

Total market value of preference shares = 6,000 shares x Rs. 125 per share = Rs. 7,50,000 Weight of preference shares = (Total market value of preference shares) / (Total market value of equity + Total market value of debt + Total market value of preference shares)

= Rs. 7,50,000 / (Rs. 10,50,000 + Rs. 5,00,000 + Rs. 7,50,000) = 32.61%

Now, we can calculate the WACC as follows:

WACC = (Weight of equity x Cost of equity) + (Weight of debt x After-tax cost of debt) + (Weight of preference shares x Cost of preference shares)

WACC = (0.4565 x 0.12) + (0.2174 x 0.056) + (0.3261 x 0.1)

WACC = 0.09956 or 9.956%

The most desirable source of funding depends on the specific needs and goals of the company. Generally, the source of funding with the lowest cost of capital is considered the most desirable. In this case, the cost of debt (after-tax) is the lowest at 5.6%, but it has a relatively low weight in the capital structure at only 21.74%. The cost of equity is higher at 12%, but it has the highest weight in the capital structure at 45.65%. The cost of preference shares is in between at 10%, but it has a weight of 32.61%.

Therefore, in this scenario, equity appears to be the most desirable source of funding, as it has the highest weight in the capital structure and a higher expected return for shareholders. However, this decision ultimately depends on the specific financial goals and risk tolerance of the company.