This question asked candidates to calculate the weighted average cost of capital of a company. Many answers gained very good marks here.

Some candidates wrongly used the average return on the market (11%) as the equity or market risk premium in calculating the cost of equity using the capital asset pricing model (CAPM). More common were errors in calculating the after-tax cost of debt of the 7% bond, including:

• taking incorrect values from the discount and annuity tables; 
• using nominal value as market value; 
• using market value as nominal value 
• calculating the after-tax interest payment with an incorrect corporation tax rate; 
• employing the before-tax interest payment in calculating the after-tax cost of debt; 
• making calculation errors when using the internal rate of return formula.

It should be mentioned that candidates, when calculating the after-tax cost of debt, should be seeking to make their answers reasonably accurate. Consequently, if the first estimate of the cost of debt produces a negative NPV when interpolating the internal rate of return, the second estimate of the cost of debt should be lower, as the first estimate was too high.

Choosing a higher rate rather than a lower rate indicates an intention to extrapolate rather than interpolate, and to seek inaccuracy rather than accuracy. Having a wide spread between the estimated costs of debt also increases inaccuracy, so choosing 1% and 20% indicates an unwillingness to think about what the value of the after-tax cost of debt might roughly be.

A bond approximation model (correctly used) can provide an initial estimate of the cost of debt as a guide to selecting discount rates for linear interpolation.