Exercise 4 The Kay Company has the following Capital structure as at 31st March, 2019.
Based on Book Value Based on Market Value % Costs
Debentures 300,000 330,000 7
Preference 100,000 110,000 9
Equity 1,500,000 1,700,000 15
Debt 200,000 180,000 10
Required:
Determine the Weighted Average cost of capital using:
a) Book Value weights
b) Market Value weights
c) What are the factors affecting Cost of Capital?

The Kay Company

Weighted Average Cost of Capital:

a) using the book value weights = 13.1%

b) using the market value weights = 13.2%

c) Some of the factors that affect the Cost of Capital include market opportunities, capital provider's preference, market risk, inflation, reserve policy, budget surplus and deficit, trade activity, foreign trade surpluses and deficits, country risk, and finally, but not the least important, exchange rate risk.

Explanation:

a) Data and Calculations:

Capital structure as at 31st March, 2019:

                                      Based on       Based on         % Costs

                                    Book Value     Market Value

Debentures                 300,000             330,000             7

Preference                   100,000               110,000             9

Equity                        1,500,000           1,700,000            15

Debt                            200,000              180,000            10

Total                         2,100,000          2,320,000

b) The WACC (Weighted Average Cost of Capital) is the cost of capital based on the relative weights of each capital class.

c) WACC based on the Book Value weights:

= 1,500,000/2,100,000 * 15% + 300,000/2,100,000 * 7% + 100,000/2,100,000 * 9% + 200,000/2,100,000 * 10%

= 0.107 + 0.01 + 0.004 + 0.01

= 0.131

= 13.1%

d) WACC based on the Market Value weights:

= 1,700,000/2,320,000 * 15% + 330,000/2,320,000 * 7% + 110,000/2,320,000 * 9% + 180,000/2,320,000 * 10%

= 0.11 + 0.01 + 0.004 + 0.008

= 0.132

= 13.2%

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