Q. Compute the new WACC if the company raises an additional 40 Lakh debt by issuing 13% debentures. This would result in increasing the expected dividend to Rs. 3.60 and leave the growth rate unchanged but the price of the equity share will fall to Rs. 24.
To compute the new Weighted Average Cost of Capital (WACC) for ABC Ltd. after it raises an additional Rs. 40 lakh in debt through the issuance of 13% debentures, we need to first understand how the capital structure and the cost of capital components will be affected by this new financing decision. The company’s decision to issue more debt will alter the proportions of debt, equity, and preference share capital in the company’s overall financing mix. Additionally, the change in the equity price and the increased dividend will affect the cost of equity, as well as the overall financial risk and expected returns for all stakeholders.
Let us break down the calculations and analysis step by step, and examine the impact of this decision on the WACC, considering all the relevant factors. We will calculate the new cost of equity, the cost of debt (with the new debt issuance), and finally compute the revised WACC.
1. Capital
Structure Before and After the New Debt Issuance
Current Capital Structure (Before the Debt
Issuance)
As of March 31,
2024, the capital structure of ABC Ltd. is as follows:
- Equity Share Capital: Rs.
60,00,000 (with 2,00,000 shares at Rs. 30 per share).
- Preference Share
Capital: Rs. 10,00,000 (10% preference
shares).
- Debenture Capital: Rs. 30,00,000
(12% debentures).
- Total Capital: Rs.
100,00,000.
The proportion of
each source of capital is:
- Equity:
or 60%.
- Preference Share
Capital:
or 10%.
- Debt:
or 30%.
Capital
Structure After Raising Additional Debt
ABC Ltd. plans to
raise an additional Rs. 40 lakh by issuing 13% debentures. This will result in
a new total debt value of:
The total capital
of the company will now be:
The new
proportions of capital will be:
- Equity: Rs.
60,00,000 (unchanged),
- Preference Share Capital: Rs.
10,00,000 (unchanged),
- Debt: Rs.
70,00,000 (new total debt).
The new capital
structure proportions are:
- Equity:
or 42.86%.
- Preference Shares:
or 7.14%.
- Debt:
or 50%.
Thus, with the new
debt issuance, the proportion of debt increases from 30% to 50%, while the
equity proportion decreases from 60% to 42.86%. This change in the capital
structure indicates a more leveraged position for the company, which could
increase financial risk but also improve the potential return on equity if the
company utilizes the debt efficiently.
2. Impact
on Cost of Debt
ABC Ltd. plans to
raise Rs. 40 lakh by issuing 13% debentures. The new debt will have a cost of
13%, which is higher than the previous cost of 12% on the existing debentures.
The company’s overall cost of debt will now depend on the weighted average cost
of both existing and new debt.
Cost
of Debt (Before the New Debt Issuance)
Before the new
debt issuance, the company had Rs. 30 lakh worth of 12% debentures. The cost of
debt was:
After-Tax
Cost of Debt (Before New Debt Issuance)
The after-tax cost
of debt is calculated as:
Where is the tax rate (40%).
\text{After-tax
Cost of Debt} = 0.12 \times (1 - 0.40) = 0.12 \times 0.60 = 0.072 \quad
\text{or 7.2%}.
Cost
of Debt (After the New Debt Issuance)
The new debt
raised through the issuance of 13% debentures will increase the cost of debt.
The overall cost of debt will now be a weighted average of the existing 12%
debt and the new 13% debt. To compute this, we need to calculate the weighted
average cost of both debt components.
Substituting the
values:
After-Tax
Cost of Debt (After the New Debt Issuance)
Now, we calculate
the after-tax cost of debt based on the new weighted average cost of debt of
12.57%:
\text{After-tax
Cost of Debt} = 0.1257 \times (1 - 0.40) = 0.1257 \times 0.60 = 0.0754 \quad
\text{or 7.54%}.
Thus, after the
new debt issuance, the after-tax cost of debt increases slightly to 7.54%, up
from 7.2% before the new debt.
3. Impact
on Cost of Equity
The issuance of
additional debt and the subsequent changes in the company’s financial structure
will likely affect the risk perceived by equity investors, and consequently,
the cost of equity. Additionally, the expected dividend per share increases
from Rs. 3.00 to Rs. 3.60, which indicates a higher dividend payout to equity
shareholders, but the price of the equity share falls from Rs. 30 to Rs. 24.
This change in the price of equity shares will impact the cost of
equity, which is calculated using the Dividend Discount Model
(DDM).
Cost
of Equity (Before the New Debt Issuance)
The cost of equity
before the debt issuance, using the DDM formula, was:
Where:
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