Question Three (a) the requirement here was to calculate the market value after-tax weighted average cost of capital (WACC) of a company, explaining any assumptions made. Answers were of variable quality and although some answers gained full marks, some answers gained very little credit.

Most answers were able to apply correctly the capital asset pricing model (CAPM) in calculating the cost of equity, although some answers made arithmetic errors.

Fewer answers were able to calculate correctly the cost of the preference shares and some answers chose to use the dividend percentage relative to nominal as the cost of capital, or to assume a value for the cost of capital. Some answers mistakenly calculated the after-tax cost of the preference shares. As preference shares pay a dividend, which is a distribution of after-tax profit, they are not tax-efficient.

The calculation of the after-tax cost of debt of the convertible bonds needed the current market value of the bond, the after-tax interest payment on the bond and the conversion value of the bond. While some candidates calculated all three values correctly and went on to use linear interpolation to calculate the after-tax cost of debt, other candidates made errors with some or all of these values.

A common error was to mix bond-related values (such as the $4.90 after-tax interest payment) with total debt-related values (such as the $21 million market value of the bond issue), producing some very high values in the linear interpolation calculation. Some candidates were unable to calculate the future share price as part of the conversion value calculation.

Most candidates were able to calculate a WACC value, although some omitted the cost of preference shares from the calculation.

An important point to consider was whether the overdraft should be included in the WACC calculation. After all, the overdraft was bigger in size than the preference share issue. Some answers considered this point and made an assumption about whether or not to include the overdraft.

Question Three (b) the requirement here was to discuss why market value WACC was preferred to book value WACC when making investment decisions. Many answers were not of a high standard and tried to make some general points about market efficiency or about the window-dressing of financial statements.

The important point here is that the weightings used in the WACC calculation need to reflect the relative importance of the different sources of finance used by a company if the WACC is to be used in investment appraisal. The market value of equity is usually much higher than its book value, so using book value weighting would underestimate the contribution of the cost of equity to WACC and therefore underestimate WACC itself, leading to sub-optimal investment decisions.