ACCA FM Capital Structure & WACC: Examiner Evidence Guide

WACC calculations and gearing analysis account for 20–25% of ACCA FM marks. The SD25 examiner report on Meen Co reveals candidates still using coupon rates instead of IRR for cost of debt, book values instead of market values, and simple averages instead of weighted averages. This guide maps every WACC and capital structure error to examiner evidence from SD24, MJ25, and SD25 sittings.

Table of Contents

1. WACC Calculations: Examiner’s Common Errors

Examiner evidence (SD25, Meen Co): Common errors included using book values instead of market values, failing to weight costs correctly, and averaging costs rather than applying the WACC formula. Full marks were awarded where candidates clearly calculated market values first and then applied the formula correctly.

WACC = (E/V × Re) + (D/V × Rd × (1−T))

Where E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = pre-tax cost of debt, T = corporate tax rate.

The 5 WACC Errors the Examiner Flags

For accurate investment appraisal, WACC provides the discount rate — errors here cascade into wrong NPV answers.

2. Cost of Equity: DGM and CAPM

Dividend Growth Model (DGM)

Re = (D1 ÷ P0) + g

Examiner evidence (SD24): The most common errors involved not applying the growth rate to the current dividend (using D0 instead of D1) and incorrectly rearranging the formula.

Example: Current dividend $0.15, growth 2%, share price $1.20. Re = ($0.15 × 1.02) ÷ $1.20 + 0.02 = 14.75%.

Capital Asset Pricing Model (CAPM)

Re = Rf + β(Rm − Rf)

Where Rf = risk-free rate, β = beta (systematic risk measure), (Rm − Rf) = market risk premium.

Understanding CAPM is essential for valuation questions where you must estimate the required return for a specific company or project.

3. Cost of Debt: The IRR Method

Examiner evidence (SD25, Meen Co): Common errors included using the coupon rate (7%) as the cost of debt, failing to adjust interest for tax, using nominal instead of market values, and applying a perpetuity method to redeemable debt (for which no marks were available).

Redeemable Debt: IRR Approach

For bonds with a known redemption date, the cost of debt is the IRR of the after-tax cash flows.

1. Market price today = inflow at T0
2. Annual interest payments after tax = outflows at T1–Tn
3. Redemption value = outflow at Tn
4. Find the discount rate that gives NPV = 0 (use interpolation)

Irredeemable Debt

Kd = (Interest × (1−T)) ÷ Market Value

Only use the perpetuity approach for irredeemable (undated) debt. The SD25 examiner specifically noted that applying perpetuity to redeemable debt scored zero marks.

Preference Shares

Kp = Dividend ÷ Market Price

Preference dividends receive no tax relief — this is the key difference from debt. Candidates who apply (1−T) to preference shares lose marks.

4. Gearing: Market Value vs Book Value

Examiner evidence (MJ25): The most common errors for the calculation of gearing involved (1) using book values instead of market values, (2) applying the D/(D+E) formula instead of the D/E formula, and (3) the addition of reserves for the calculation of the market value of equity.

Gearing Formulas

Critical point: Market value of equity = Shares outstanding × Current share price. Do not add reserves to market value — the share price already reflects all value including retained earnings.

For MJ25 (LSL Co): Gearing = MV of debt $780m ($800m × 97/100) ÷ MV of equity $3,300m = 23%.

Interest Coverage

Interest Coverage = EBIT ÷ Interest Expense

Coverage above 5× is generally safe. Below 1.5× indicates financial distress risk. Effective working capital management can improve coverage by increasing operating cash flows.

5. Capital Structure Theories for the Exam

Examiner evidence (SD25): High-quality answers demonstrated a clear understanding of WACC as a weighted average of the costs of equity and debt and explained how gearing alters both component costs and overall firm value. Candidates were expected to engage with the Traditional view, Modigliani and Miller, and apply theory to the company scenario.

Theory Comparison Table

The examiner awards marks for applying theory to the specific company scenario, not for generic definitions. Link gearing changes to impact on WACC and firm value.

Beta and Gearing

Asset beta (ungeared): βa = βe ÷ [1 + (1−T) × (D/E)]

Re-levering: βe = βa × [1 + (1−T) × (D/E)]

Use asset betas when comparing companies with different gearing, or when estimating the cost of equity for a project with different risk characteristics.

6. Rights Issues and TERP

Rights issues are tested regularly. The examiner expects clean TERP calculations and understanding of dilution effects.

TERP Formula

TERP = (Current Market Value + Net Proceeds) ÷ (Current Shares + New Shares)

Example: 1,200m shares at $2.75, 1-for-6 rights at $2.20.

1. New shares: 1,200m ÷ 6 = 200m
2. Current value: 1,200m × $2.75 = $3,300m
3. Proceeds: 200m × $2.20 = $440m
4. TERP: $3,740m ÷ 1,400m = $2.67

After the rights issue, recalculate EPS with the new share base and use the P/E ratio to find the new market price — do not assume TERP is the new share price permanently.

7. Islamic Finance Instruments

Examiner evidence (MJ25, Cyprus Co): Candidates misidentified Mudaraba as debt finance. Understanding the equity vs debt nature of Islamic instruments is essential.

All Islamic instruments prohibit riba (interest), gharar (excessive uncertainty), and haram activities. The exam tests whether you can identify the correct instrument type and explain its structure.

8. Dividend Policy

Dividend Valuation Model

P0 = D1 ÷ (Re − g)

This links directly to cost of equity: if you know three variables, you can find the fourth. The examiner tests rearrangement of this formula regularly.

Theory Summary

• MM irrelevance — dividend policy does not affect value (perfect markets)
• Signalling — dividend changes communicate management’s confidence about future earnings
• Clientele effect — different investor groups prefer different payout levels
• Pecking order link — firms retain earnings first before seeking external finance

Share buybacks as an alternative to dividends: calculate the EPS impact using New EPS = Earnings ÷ (Original Shares − Repurchased Shares).

For comprehensive exam preparation strategy, see our FM exam tips guide. For all official ACCA technical articles, visit our FM technical articles page.

For study materials, consider BPP FM printed books or BPP ECR online classes.

FAQ: ACCA FM Capital Structure & WACC

For official ACCA FM guidance and practice questions, visit the ACCA FM resource page.