Question

1. KU Avocado industry is planning to raise funds for an expansion of mango juice production and in preparation for this the company has decided to calculate its weighted average cost of capital. KU Co has the following capital structure:

Equity	($ in millions)
Ordinary Shares	200
Reserves	650
Non-current liabilities
Loan notes	200
Total	1050

The ordinary shares of KU Co have a nominal value of 50 cents per share and are currently trading on the stock market on an ex dividend basis at 5.85 per share. KU Co has an equity beta of 1.15. The loan notes have a nominal value of 100 and are currently trading on the stock market on an ex interest basis at 103.50 per loan. The interest on the loan notes is 6% per year before tax and they will be redeemed in six years’ time at 6% premium to their nominal value. The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. KU Co pays corporation tax at annual rate of 25% per year. Calculate the market value weighted average cost of capital and the book value weighted average cost of capital and comment briefly on any difference between the two values.

Answer 1

Below are the screenshot of the excel formulas used and the outputs got.

As we can see WACC in case of Market Value Weights is considerably higher at 10.39% while for book value weights it is lower at 9.70%.

This can be explained as using book value weights, debt proportion in total capital employed turned out to be very high which helped reducing the overall cost of capital. This is because cost of debt is lower as compared to cost of equity. Thus having higher proportion of debt would help in reduction of WACC. The higher debt in book value is due to the fact that Book Value of Equity haven't clearly defined its true worth. While Book Value of Debt was very much closer to its market worth. So, using market weights give true picture of WACC of a firm.