To compute the Weighted Average Cost of Capital (WACC) for ABC Company, we need to calculate the cost of debt, cost of equity, and the proportion of debt and equity in the company's capital structure. The WACC formula is given by:

$WACC = \left( \frac{D}{D + E} \times r_d \times (1 - T) \right) + \left( \frac{E}{D + E} \times r_e \right)$

Where:

• $D$ = Total debt
• $E$ = Total equity
• $r_d$ = Cost of debt
• $T$ = Corporate tax rate
• $r_e$ = Cost of equity

Step 1: Determine the amount of debt and equity

From the question, the Debt-Equity ratio is 3:2 and the company needs Rs. 40 lakh.

Let $D$ be the debt and $E$ be the equity. The sum of debt and equity equals Rs. 40 lakh:

$D + E = 40 \text{ lakh}$

Given the debt-equity ratio of 3:2:

$\frac{D}{E} = \frac{3}{2}$

From this, we can express $D$ in terms of $E$:

$D = \frac{3}{2}E$

Substituting into the equation $D + E = 40$:

$\frac{3}{2}E + E = 40$

$\frac{5}{2}E = 40$

$E = \frac{40 \times 2}{5} = 16 \text{ lakh}$

Thus, $E = 16 \text{ lakh}$ and $D = 40 - 16 = 24 \text{ lakh}$.

Step 2: Calculate the cost of debt ( $r_d$ )

The company pays interest of:

• 12% on the first Rs. 4 lakh of debt
• 12.5% on the remaining Rs. 20 lakh of debt (since the total debt is Rs. 24 lakh)

So, the total interest paid on the debt is:

$\text{Interest on first Rs. 4 lakh} = 4 \times \frac{12}{100} = 0.48 \text{ lakh}$ $\text{Interest on remaining Rs. 20 lakh} = 20 \times \frac{12.5}{100} = 2.5 \text{ lakh}$

Total interest expense = Rs. $0.48 + 2.5 = 2.98 \text{ lakh}$

The average cost of debt before tax is:

$r_d = \frac{2.98}{24} = 12.42\%$

The cost of debt after tax is:

$r_d \times (1 - T) = 12.42\% \times (1 - 0.30) = 8.694\%$

Step 3: Calculate the cost of equity ( $r_e$ )

The cost of equity can be calculated using the Dividend Discount Model (DDM):

$r_e = \frac{D_1}{P_0} + g$

Where:

• $D_1$ = Dividend per share next year
• $P_0$ = Market price per share
• $g$ = Growth rate of dividends

Given:

• EPS = Rs. 20
• Dividend payout ratio = 60%, so Dividend per share $D_0 = 20 \times 60\% = 12$ Rs.
• Growth rate $g = 5\%$
• Market price $P_0 = 90$
• Dividend per share next year $D_1 = D_0 \times (1 + g) = 12 \times 1.05 = 12.6$

Therefore, the cost of equity is:

$r_e = \frac{12.6}{90} + 0.05 = 0.14 = 14\%$

Step 4: Compute WACC

Now, we can compute the WACC using the formula:

$WACC = \left( \frac{D}{D + E} \times r_d \times (1 - T) \right) + \left( \frac{E}{D + E} \times r_e \right)$

Substituting the values:

$WACC = \left( \frac{24}{40} \times 8.694\% \right) + \left( \frac{16}{40} \times 14\% \right)$

$WACC = 5.2164\% + 5.6\% = 10.8164\%$

Thus, the Weighted Average Cost of Capital (WACC) is approximately 10.82%.

Do you want more details or have any questions?

Here are 5 follow-up questions for deeper understanding:

1. How does the change in the dividend payout ratio affect the cost of equity?
2. What would be the impact on WACC if the interest rate on debt increased?
3. How would a change in the market price per share influence the cost of equity?
4. How does the tax shield affect the overall cost of debt in WACC?
5. What is the significance of using the WACC in evaluating a company's financial decisions?

Tip: It's important to regularly review and update WACC calculations as market conditions, tax rates, and capital structures change over time.