International Cost of Capital - Assignment Example

Introduction Weighted average of cost of capital is also called as the discount rate. This discount rate is used to discount the cash flows which are associated with a capital budgeting project. Before going to use an illustrative example to calculate weighted average of cost of capital, it is highly important to comprehensively understand the basic components of cost of capital. This understanding would be highly essential and helpful while doing a computational work with the help and use of the weighted average of cost of capital. With the help of weighted average of cost of capital, companies become in a position to determine an appropriate equity and debt policy that could ensure the future growth and sustainability. Question1. Provide an illustrative example of WACC calculation using a FTSE100 company. Answer: The components of weighted average of cost of capital come from the equity side of the statement of financial position, which is commonly understood and known as balance sheet-common shares, preferred shares and debt, long term liability are the components of capital. Any change in the shape of increase in assets of the balance sheet would require increasing at least any one of components of the capital account. In order to increase the liability side of the balance sheet, the cost of these components is called as component based cost of capital. Numerous causes require to occur or to increase the cost of capital. First, the need of long term investment and long term financing requires a company to determine and decide an appropriate way of arranging finance. Either willingly or unwillingly, the company has to evaluate all possible and available means that can be used for the purpose of satisfying their long term business investment needs. Some companies use and issue preferred shares for the purpose of raising finance. If company choose this way of financing, it has to give a certain amount of preferred dividends to those preferred shareholders to whom the company has issued preferred shares. On the other hand, debt can also be another source that can be used for the purpose of raising capital. There are different types of debt; for instance debentures is one of them. After issuing debentures, the company is required to pay a certain amount of interest as a cost of capital. On the whole, these both means have some sort of similarities and some sort of dissimilarities. Preferred shares are mostly placed with the ordinary shares, on the other hand, the debentures and other forms of long term liabilities are incorporated in the long term liability section of the statement of financial position. Following is the standard computational method of weighted average of cost of capital: WACC = Ke [(market value of equity/A)] + kd [(1-t) (market value of debt/A)]. Where; WACC= weighted average of cost of capital Ke= cost of equity A=market value of equity + market value of debt Kd= cost of debt Cost of equity (Ke) is the required return on the ordinary shares. Most of the time, it is this feature that is pretty difficult to estimate. Cost of equity can be determined by two ways: dividend growth model and capital asset pricing model (CAPM). The dividend growth model uses the following formula: P0 = D1/ (Re-g) Here, P0 is the current stock price or stock price in the period of 0. D1 is the amount of dividend in the next period or next year. Re is the cost of equity. G is the dividend growth rate. For ke the equation would become Re= D1/ P0+ g The capital asset pricing model (CAPM) helps with the following equation to determine the cost of equity: Re= Rf+ b(Rm - Rf) Here, Rf= the risk free rate. B= beta value Rm= market return Capital asset pricing model was determined and defined and published its derivation by William Sharpe in the year of 1986 (Megginson, 1996). There are numerous assumptions on which capital asset pricing model is based on. For instance, capital asset pricing model assumes that investors hold diversified range of portfolios (Head, 2008). Example: Computation of weighted average of cost of capital Calculate the WACC for Hobble, if the Market Value is equivalent to £10 per share and there were 1500,000 ordinary shares. There was a dividend just paid out equivalent to that expressed in the accounts. Dividends are expected to grow at its current rate of 25% to perpetuity. Debt costs are $200,000 of the Hobble Ltd. The Hobble Ltd has $0.2 dividend per share. Tax rate is 30%. Solution: WACC = ke [(market value of equity/A)] + kd [(1-t) (market value of debt/A)]. (Where A=market value of equity + market value of debt) Market value of total equity = $12*1500 shares; = $18000. Ke = [$0.2 / $10] + 25% Ke = 27% Kd (1-t) = 30% Where A = $18000+$200 A = $18200 WACC = 27% ($18000/$18200) + 30% ($200/$18200) WACC = 27.03% The figures are in $000. Calculation of WACC of FTSE-100 company: Vodafone Vodafone is the world’s leading and largest multi-national telecommunication corporation. Following is the WACC calculation of this company. (All the following figures are in UK pound) Market value of equity= 7,822(m) Market value of debt= 28,632(m) Share price= 181 Dividend= 5.65 pence per share Tax rate= 28% Perpetuity= 45% Solution: WACC = ke [(market value of equity/A)] + kd [(1-t) (market value of debt/A)]. (Where A=market value of equity + market value of debt) A= 7,822+28,632=36,632 Ke= 5.65/181+45% Ke= 45.031% WACC= 45.031%( 7,822/36,632) + 28%(28,632/36,632) =31.5% Weighted average of cost of capital of Vodafone is 31.5% (Above financial data is taken from the financial statements of Vodafone). Question 2.Critically analyse the uses and problems of WACC in making business investment decisions? Answer Uses of weighted average of cost of capital Weighted average of cost of capital is defined as an average cost of finance. This means a company is required to pay a certain amount of interest with a routine period of time as a cost of capital. Different amount of interests are paid on different sources. Weighted average of cost of capital represents a total amount of interests that is to be paid by the company to the lenders. With the availability of total amount of interest payable at one particular time would help company to understand and determine the appropriate current and future investment decisions. For many companies, weighted average of cost of capital tends to be a larger amount that to be paid at one time. Since the element of opportunity cost is involved in paying the interest amount, it is highly vital to carefully and properly evaluate the subsequent and future consequences of interest amount. Additionally, weighted average of cost of capital takes into consideration of all the relevant elements that directly influence on the capital structure of company. By accounting for the relevant factors, the company by using the tool of weighted average of cost of capital becomes in a position to properly and relevantly obtain the actual cost of finance. Also, weighted average of cost of capital has a capacity to appraise of some of probable and possible investments. Sometimes, some companies are given a set of different investment projects. In these investment projects, some require a considerable amount of investment and some require a less amount of investment. Aggregately, each project tends to be having different amount of risks and returns. On the face of it, to identify and highlight the most profitable investment does not remain a simple and easy choice as the amount of risk cannot be estimated or evaluated easily. Here, in order to determine the most profitable investment project among different investment projects, the weighted average of cost of capital can be used to evaluate and determine the most profitable investment project. By using the tool of weighted average of cost of capital, company would become in a better position to determine its future course of action for the purpose of investing in any of the lucrative investment projects. Furthermore, weighted average of cost of capital is used to represent averagely the cost of capital. For instance, it is vitally significant that how a company raises its amount of capital and how it uses or invest them are two separate financial activities. As raising capital and investing capital defines to be distinct and different financial activities, many companies have separate and different departments for each of the financial activity. The finance department is given and authorised to raise the capital and it is also made responsible for keeping costs lower. And in some of companies, an investment department is established to ensure the efficient and lucrative long term investments of the available and given amount of finance. The above given example of two departments is clearly highlighting the significance and use of weighted average of cost of capital in their respective use for the purpose of attaining departmental objectives. Problems of weighted average of cost of capital Capital asset pricing model is based on some unrealistic assumptions. For example, one assumption is that investors hold diversified portfolios. But in the real world, that is not always the case. Some investors do not hold diversified portfolios. As a result, computing cost of equity with the help of capital asset price model may not be truly and properly representing the market situation. Without any doubt, capital asset pricing model would create a limitation for weighted average of cost of capital. And the use of weighted average of cost of capital may not providing the required level of help while using it for the purpose of evaluating different investment projects, and on the basis of provided outcomes, making some business investment decisions. Question.3 specifically analyse the use of WACC in the context of an international firm. Answer: An international firm requires ensuring some factors for using the weighted average of cost of capital: 1) the availability of capital, 2) diversified cash flows, 3) foreign exchange risk, and 4) the expectations of international portfolio investors (Eiteman & Stonehill, 2010). The availability of capital requires some attention from the international firm. In some countries, the international firms have to face the problem of illiquid capital markets. Under this situation, the international firms cannot rely on any other option except for internally generated funds and bank borrowing. The international firms find themselves financially in better condition in comparison with the local firms as far as the risk reduction is concerned. Since the international firms enjoy internationally diversified cash flows, they have stronger financial position to considerably and substantially support their higher debt ratios. Since returns do not tend to be perfectly correlated between and among states, and using diversified cash flows internationally, the international firms might be able to achieve the same type of decrease in the cash flow diversity as international investors receive from diversifying their holding of securities ((Eiteman & Stonehill,2010). The expectations of international portfolio investors can easily be understandable. Understanding the expectations of international portfolio investors does not seem to pose any big challenge. The previous 30 years have developed considerable norms which find their presence in the expectations of international portfolio investors. They expect nothing new or nothing extra but what is globally expected from a firm’s debt ratio and aggregate structures of finances. Up to 60% debt ratios tend to receive an international acceptability ((Eiteman & Stonehill, 2010). Higher to this figure of 60% may not be able to obtain and retain the required level of recognition internationally. Conclusion Many companies sufficiently depend on the use of weighted average of cost of capital. Due to its aggregate representation of total cost of capital, companies use it for the purpose of knowing their current level of paying a cost of capital. With the help of weighted average of cost of capital, different projects can be evaluated and the most appropriate and lucrative profit would be ranked and selected with the help of weighted average of cost of capital. Since these are the most important benefits involving the use of weighted average of cost of capital for the international firms, large and big corporations prefer the use of weighted average of cost of capital. References 1. Megginson WL 1996, ‘Corporate Finance Theory’, Addison-Wesley, p10. 2. Head, T2008, ‘CAPM: Theory, Advantages and Disadvantages’, ACCA Student Accountant Magazine, pp. 50-53. 3. Eiteman, DK, Stonehill, AI, & Moffett, MH 2010,’ Multinational business finance’ 12th ed., Boston: Prentice Hall. 4. Financial information of Vodafone, 2010, [Available at: http://www.vodafone.com/content/annualreport/annual_report10/financials/note6.html] [Accessed on: 9 March, 2011]  Read More