Cost of Capital and Capital Structure of a Firm and Cost of Capital - Case Study Example

Cost of capital and capital structure of a firm and cost of capital Case study of ABU DHABI NATIONAL ENERGY COMPANY Table of Contents Cost of capital and capital structure of a firm and cost of capital 1 Table of Contents 2 Abstract 4 Introduction 4 Cost of capital and capital structure of a firm hypotheses 5 Trade-off hypothesis 5 Other hypotheses of cost of capital and capital structure of a firm 6 Pecking-order hypothesis 7 Cost of capital 8 Beta (β) 8 Issues with the Cost of Capital 11 Past and future financial performance 11 METHODS OF FINANCIAL STATEMENT ANALYSIS 11 Horizontal analysis 12 Advantages and Disadvantages of Horizontal Analysis 12 Vertical Analysis 12 Advantages and Disadvantages of Vertical Analysis 12 Income statement 13 Statement of financial position 13 Applying the outcomes from the previous articles to the selected company 14 ABU DHABI NATIONAL ENERGY COMPANY 14 Income statement 14 Statement of financial position 15 Leverage Analysis 16 Conclusion 18 Bibliography 19 Abstract The research focus on examining the funding verdict and the cost of capital and capital structure of a firm of water and sanitation firms as well relates the observed finding to the cost of capital and capital structure of a firm hypothesis. Big water and sanitation companies normally depict low debt as well as small water and sanitation firms depict high debt. It can be observed that the trade-off hypothesis of cost of capital and capital structure of a firm, the pecking-order model, the market timing hypothesis as well as other hypotheses cannot specifically explain the company’s cost of capital and capital structure of a firm, nevertheless, they might harmonize each other in explaining some trend of experiential performance. We recommend a number of advices for cost of capital and capital structure of a firm hypothesis as well as practice. Introduction The modern hypothesis of cost of capital and capital structure of a firm started with the well known Modigliani and millah proposition of 1958 that describes the situation of cost of capital and capital structure of a firm irrelevance. From that time, many hypotheses of cost of capital and capital structure of a firm was created inclusive of the trade-off hypothesis, the pecking-order model, agency hypothesis as well as life cycle hypothesis. Subsequent to much innovation, cost of capital and capital structure of a firm turns to be one of the very controversial matters in corporate finance. The issues being the big gap that exist between the hypotheses and practice. According to grahn and Harvey (2001), less than 49% of the hypothetical notions find support amongst the managers and also, there big dissimilarity in the examiners opinion. For instance, Leary and robber (2010) agreed that the trade-off hypothesis drives cost of capital and capital structure of a firm verdict whilst Myers (1999) claims that pecking-order model hypothesis drives the cost of capital and capital structure of a firm. There is also a difference amongst opinion concerning the way that prospect work on cost of capital and capital structure of a firm must assume. The asymmetric information hypothesis of cost of capital and capital structure of a firm is not encouraging; the flow of study linked to asymmetric information has progressing. Moreover, the financial crisis of 2008/09 depicted that company managers turns to be in deficiency of comprehending the duty of asymmetric information. The marketplace for mortgage-backed security that is believed to be the center of fiscal disaster entails asymmetric information flanked by investor and issues. Much scandal like the one of Bernie mad-off depicts the deepness of asymmetric information issues involving the company’s insider and investor in a company. Cost of capital and capital structure of a firm hypotheses Trade-off hypothesis Contrasting to dividend, interest on debt minimizes the company’s table income. Debt grows the likelihood of company being insolvent. Tradeoff hypothesis recommends that cost of capital and capital structure of a firm depict a tradeoff involving the duty advantage of the debt and the anticipated cost of insolvency. Miglo (2010) recommends a model in which the optimal debt level is provide as follows D= {TR/T+KK} Where R depicts the utmost earning, T is tax rate and K evaluates the cost of insolvency. If K is high, then the equilibrium level of D must be low. As anticipated insolvency cost grows, the benefit of employing the equity grows. The outcome depicts much interpretation. Big companies must have more debt since they are much diversified as well as depict a low default risk. The assets experience the high leverage unlike those with more intangible Asset like the research companies. Growth companies depict a tendency of losing more of their values unlike the non growing companies when they experience monetary pain. Hence, the hypothesis forecast a negative association between the leverage as well as growth (Aravossis, 2006). When T increase, the debt must as well increases since a high tax lead to great tax benefit with the use of debt capital. In this regards, company with high tax rate (T) must depict a high debt ratio unlike the companies with low tax rate. On the contrary, companies with non debt tax shield like the deprecation must be less susceptible to the use of debt capital unlike companies that do not have this tax shield. Where the tax rates grow overtimes, the debt ratio must as well grows. Debt ratio in nation where the debt depicts a high tax benefit must be high unlike debt ratio in nation whose debt depicts low tax advantage. As recommended in the above equation, where R grows, D must as well grows. In this regards, the more profitable company must depict more debt (Damodaran, 2010). The expected insolvency cost is low and the interest tax shield is more precious for lucrative company. Even though trade-off forecast that the minor tax advantage of liability must be same to the marginal anticipated insolvency cost. The theoretical proof is diverse. Some examiners explain that the latter is superior unlike the former since straight insolvency cost is small and the debt level is below the finest. The trade-off hypothesis of cost of capital and capital structure of a firm takes into consideration the tax and growth in risk from the debt Other hypotheses of cost of capital and capital structure of a firm Pecking-order hypothesis The main constituent of pecking-order model is asymmetric information between the company’s insiders as well as outsider. Information asymmetric information asymmetries exist in every component of corporate finance as well as intricate manager’s capacity to capitalize the company values. Managers of good standard companies experiencing challenges of directly persuasive shareholder concerning the true standards of their company more specifically where this relates to the future business performance. In this regards, an investor will try to integrate indirect proof in their appraisal of firm performance by examining the information that reveals actions inclusive of cost of capital and capital structure of a firm alternate. Equity is controlled by internal finance in pecking-order model. Low standard company employs the equity more than the internal finance to high standard companies consider internal funds as appropriate since shares issued by the company might just be disposed with discount due to imperfect information issues. The debt capital controls the equity. Debt differs from the lack of appraisal less than the equity. These similar holds where the company has existing assets. In this regards, pecking-order model turns to be good amongst the, internal funds as well as equity. Improved company will make use of internal funds to fund the capital investment. Since low standard company doesn’t make more profits as well as net profit as high standard company, they employ external sources, normally debt capital. This aids in explaining the above problem concerning the off-putting link between the debt and productivity. Furthermore, pecking-order model forecast that a high extent of asymmetric information minimizes the inducement to use Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity (Henderson, 2015). A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the cost of capital and capital structure of a firm may be affected. Cost of capital The cost of capital and capital structure of a firm is a mix of debt and equity that would lead to high value to the company and low cost on capital. The cost of capital and capital structure of a firm depicts the manner to which a firm funds its entire operations as well as growth with the use of diverse funding sources. The company share of short and long term debt is deeming in examining cost of capital and capital structure of a firm (Henderson, 2015). When individual refer to cost of capital and capital structure of a firm they are refereeing to company’s debt to equity ratio which provide awareness on the company’s current business situation. Company with high debt finance depicts a greater risk since the company is highly levered. The optimal cost of capital and capital structure of a firm is the ideal debt to equity ratio for the company that capitalize on its worth as well as reduces the cost of capital. In hypothesis, debt funding provides a low cost on capital as a result of tax advantage. Nenverthe3lses, it is on rare occasion that the optimal structure exists since a firm’s risk grows a debt increase. A healthy share of equity capital unlike the debt capital, in a firm’s cost of capital and capital structure of a firm is a sign of financial wellbeing. Beta (β) A Beta (β) appraises the riskiness of the stock in comparison with the market like the S&P 500. It is important to evaluate the volatility of the stock. In this regards, beta measures the market risk as whole whilst the standard deviation evaluate the risk for a specific stock. It is an evaluation of the dispersion of the data set from the mean in which, a wide dispersion from the mean would imply a high risk. Beta is evaluated by finding the slope of the linear trend line created by plotting the benchmark returns against the equity returns (James, 2015). Beta is similar to the slope of the trend and it might be depicted that Beta for TAQ to be 0,09 which less than one implying that the company stock is less volatile in the market and thus recommends investment in TAQA due to loss risk and guarantee investment in returns in this company. The capital asset pricing model (CAPM) is explained as a model that ascertains the risk premium of a security. The CAPM model discloses the returns that are similar to the risk realized under the circumstance that the capital market upholds the balances. The formula for calculating the cost of capital comprise if different working of cost of debt and cost of equity, which should combined to form weighted average cost of capital (WACC) to derive the cost of debt (KD), we multiply the interest cost of linked to debt by inverse of the tax rate percentage and divide the outcome by the value of debt existing. The amount of debt existing that is employed in the denominator must entail the transaction fees linked to the purchase of debt which will amortized as time goes by. The formulae for the cost of debt is worked out as follows (Interest Expense x (Net of tax) Value of Debt Cost of equity (Ke) doesn’t include the interest and is worked out as follows Interest Expense Amount of Preferred Stock Cost of capital= {3,940,000,000/ $108,767,000,000.00} =4% For Abu Dhabi National Energy Co Pjsc (TAQA), the cost of debt is worked at follows Kd={ 3,940,000,000(0.7)/ 105,928,000,000=3% The working for the cost of equity is dissimilar to diverse kind of workings. It comprise of three kind of return which are the risk free rate, rate of return and the return that is on the basis of risk of specific stock. The risk free rate is derived from the returns on government security. The rate of return is derived from industry (Palepu, 2007). The returns linked to risk is known as beta, it is normally worked out and published in many investment services for public listed companies. A bet of less than one depict that the level of rate of return risk that is low unlike the average whilst a beta of more than one implies a growth in risk in the rate of return. Provide these components, the formulae for the cost of equity is as follows. Risk-Free Return + (Beta x (Average Stock Return – Risk-Free Return)) WACC=Weight(Kd/value of the firm)+Weight(Ke)/value of the firm} Funding Type Funding Amount % Cost Dollar Cost Debt $105,928,000,000 3% $3,177,840,000 Preferred Stock $2,839,000,000 4% $113,560,000 Totals $108,767,000,000 7% $7,613,690,000 Based on the above workings, it can be observed that the company’s return of 12% is a marginal returns enhancement over the cost of capital of 7%. The implication is that a mix of debt and equity would lead to a low cost on capital and high value to the firm which is recommend for the business as explained by Modigliani and miller proposition. Issues with the Cost of Capital The value of the common stock employed in these workings is on the basis of the current market price of this item, instead of the price that was originally sold. In using the market rate, we will precisely establish the assumed rate of return that an investor anticipates, this is ideal to the sue of the book rate for either of the item, Because this solves the rate of return at the time when the shares are sold in the first place and provides no signs of the current market anticipations (Palepu, 2007). Past and future financial performance The financial statement analysis is an approach of examining and evaluating the firm’s accounting report to measure the past, present and future financial performance. The process of examining the financial statement permits for improved economic verdict making. The public listed firms are mandated by law to file the financial statement with the appropriate authorities. Companies are well obligated to provide financial statement in their annual report that they share with their shareholders (Robert Stine, 2013). As financial statement is prepared to comply with the requirements, there is need for analysis of the financial statement effectively so that the prospect profitability as well as cash flows might be anticipated. In this regards, the key aim of the financial statement assessment is to utilize the information concerning the past performance of the company to forecast the future financial situation. METHODS OF FINANCIAL STATEMENT ANALYSIS There two key approach to financial statement analysis; horizontal and vertical analysis. They are explained below. Horizontal analysis This is the comparison of the financial performance of a firm with past financial performance of a similar firm over a specified period. It might as well be on the basis of ratios derived from the financial information over the same time (Shi, 2001). The key aims are to depict if the numbers are high or ow as compared to the past records, which might be employed to research on the cause for concern. Advantages and Disadvantages of Horizontal Analysis When the assessment is performed for the entire financial statement at the same time. The effect of operational activities might be depicted on the firm’s financial situation at the time of review. Disadvantage The disadvantage of horizontal analysis is that the aggregated information is expressed in the financial statement and might have been changed as time goes by and as a result will lead to variation when the account balances are in comparison across periods. Vertical Analysis This analysis is undertaken on the financial statement for one time period only. Every item in the financial statement is depicted as a base value of another item in the financial statement. The analysis implies that each item on the income statement and the statement of financial position is expressed in percentage of gross dales whilst each item in the statement of financial position is expressed as a percentage of net assets held by the company. Advantages and Disadvantages of Vertical Analysis The vertical analysis just requires the financial statement for one period. It is important for the inter company or inter division comparison of performance since (Tessa Hebb, 2015), it can be observed a relative proportion of account balances given the size of the business or department. Disadvantage Since primary vertical analysis is limited to the sue of one period, it depict the disadvantage of losing on the comparison with timeframe to measure the performance This might be addressed by using it in line with the timeframe assessment, which depict what changes existed in the financial account over time lie the comparative analysis for the last four years. Income statement Income Statement (AED)   PERIOD ENDING December 31, 2014 December 31, 2015 Percentage Net Sales 27,325,000,000 19,344,000,000 40% COGS 23,324,000,000 16,513,000,000 35% GROSS PROFIT 4,001,000,000 2,831,000,000 6% Selling General and Administrative 5,852,000,000 5,311,000,000 11% Depreciation and Amortization (77,000,000) (79,000,000) 0% Total Other Income/Expenses Net 164,000,000 (79,000,000) 0% Interest Expense 0 3,940,000,000 8% Income Tax Expense 602,000,000 (1,299,000,000) -3% Net Income 60,589,000,000 47,781,000,000 100% Statement of financial position Balance Sheet (AED000)   PERIOD ENDING December 31, 2014 December 31, 2015  % Current Assets:       Cash 3,880,000,000 3,824,000,000 4% Account Receivable 5,157,000,000 5,069,000,000 5% Inventory 2,963,000,000 2,835,000,000 3% Total Current Assets 12,000,000,000 11,728,000,000 11% Non-Current Assets:     0% Machinery & Equipment 121,901,000,000 123,666,000,000 118% Accumulated Depreciation -42,077,000,000 -48,816,000,000 -47% Total Non-Current Assets 96,737,000,000 93,032,000,000 89% Total Assets 108,737,000,000 104,760,000,000 100% Liabilities       Accounts Payable 6,423,000,000 5,129,000,000 5% Total Current Liabilities 9,704,000,000 12,102,000,000 12% Non-Current Liabilities: 100,720,000,000 93,826,000,000 90% Long Term Debt 74,558,000,000 68,674,000,000 66% Total Non-Current Liabilities 100,720,000,000 93,826,000,000 90% Total Liabilities 110,424,000,000 105,928,000,000 101% Stockholders' Equity     0% Common stock and paid-in surplus 4,614,000,000 2,839,000,000 3% Retained Earnings -1,687,000,000 -4,007,000,000 -4% Total Stockholder Equity -1,687,000,000 -1,168,000,000 -1% Total Stockholder Equity and Total Liabilities 108,737,000,000 104,760,000,000 100% TRUE TRUE   Applying the outcomes from the previous articles to the selected company ABU DHABI NATIONAL ENERGY COMPANY TAQA is the leading Abu Dhabi’s flagship corporations and hence it is a significant role to play in aiding to deliver the economic plant for the emirates of Abu Dhabi. The follow is the income statement analysis of the company for the period ending 2014/15. Income statement Income Statement (AED) PERIOD ENDING December 31, 2014 December 31, 2015 Net Sales 27,325,000,000 19,344,000,000 COGS 23,324,000,000 16,513,000,000 Gross Profit 4,001,000,000 2,831,000,000 Selling General and Administrative 5,852,000,000 5,311,000,000 Depreciation and Amortization (77,000,000) (79,000,000) Operating Income / Profit (1,774,000,000) (2,401,000,000) Total Other Income/Expenses Net 164,000,000 4,007,000,000 Earnings Before Interest And Taxes (EBIT) (1,851,000,000) (2,480,000,000) Interest Expense 0 3,940,000,000 Income Before Tax (EBT)     Income Tax Expense 602,000,000 4,007,000,000 Net Income (1,687,000,000) (4,007,000,000) Dividends 0 173,290 Add To Retained Earnings -1,687,000,000 -4,007,173,290 Statement of financial position Balance Sheet (AED000) PERIOD ENDING December 31, 2015 December 31, 2016 Current Assets:     Cash 3,880,000,000 3,824,000,000 Account Receivable 5,157,000,000 5,069,000,000 Inventory 2,963,000,000 2,835,000,000 Total Current Assets 12,000,000,000 11,728,000,000 Non-Current Assets:     Machinery & Equipment 121,901,000,000 123,666,000,000 Accumulated Depreciation -42,077,000,000 -48,816,000,000 Total Non-Current Assets 79,824,000,000 74,850,000,000 Total Assets 108,737,000,000 104,760,000,000 Liabilities     Accounts Payable 6,423,000,000 5,129,000,000 Total Current Liabilities 9,704,000,000 12,102,000,000 Non-Current Liabilities: 100,720,000,000 93,826,000,000 Long Term Debt 74,558,000,000 68,674,000,000 Total Non-Current Liabilities 100,720,000,000 93,826,000,000 Total Liabilities 110,424,000,000 105,928,000,000 Stockholders' Equity     Common stock and paid-in surplus 4,614,000,000 2,839,000,000 Retained Earnings -1,687,000,000 -4,007,000,000 Total Stockholder Equity -1,687,000,000 -1,168,000,000 Total Stockholder Equity and Total Liabilities 108,737,000,000 104,760,000,000 TRUE TRUE     December 31, 2015 December 31, 2016 Current Ratio CA/CL 1.2366 0.9691 Quick Ratio (CA-INV)/CL 0.9313 0.7348 Cash Ratio Cash/CL 0.3998 0.3160 Leverage Analysis December 31, 2015 December 31, 2016 Total Liability = TL = D 110,424,000,000 105,928,000,000 Total Assets = TA = A 108,737,000,000 104,760,000,000 Total Equity = TE = E -1,687,000,000 -1,168,000,000 EBIT (1,851,000,000.00) (2,480,000,000.00) Interest $ - (3,940,000,000.00) December 31, 2015 December 31, 2016 Debt Ratio D/A 1.02 1.01 TL/E = D/E D/E -65.46 -90.69 Times Interest Earned EBIT/Interest 0 0.63 Cash Coverage Ratio EBDIT/Interest 0 0.61 December 31, 2016 ROA -0.076 -0.024 ROE 343% From the above financial statement analysis, it is evident that the company is improving in the year 2015 as compared to 2014. This is depicted by the growth in EBITDA and the retained earnings as well as growth in net asset and shareholders’ equity. From the financial statement analysis, it is evident that placing reliance eon past and current financial situation is important before investment decision as well as aid in examining the company’s current financial situation and predicting future trend since (William Petty, 2015), the company current and past trend depict a trend which is useful in predicting future business situation of the company as well s identifying the current problem that need to be solved in order to ensure that the company realize a an expansion in terms of profitability and business expansion in terms of assets base which will guarantee the company’s going concern assumption. Conclusion From the financial statement analysis of the company’s pastime current financial performance, it can be con concluded that TAQA is an ideal investment company that will guarantee high returns on investment at low cost on capital and consequently, the company’s going concern assumption is guaranteed. A risk adverse investor will therefore consider holding a diversified portfolio in order to minimize risk. From our calculation on the cost of capital, it is evident that the weighted average cost of capital depicts a high value and low cost of capital to the company which signifies an optimal capital mix for the company. The stock that is volatility is ideal for investment since, there is strong correlation between the standard deviation (Volatility) and the returns from investment. Bibliography Aravossis, K. (2006) Environmental Economics and Investment Assessment, Londion: Cingage Learning. Auditing Standard No. 12 (2013) Identifying and Assessing Risks, London. Damodaran, A. (2010) Applied Corporate Finance - Page 552, New York: Cingage Learning. Ehrhardt, M. (2008) Corporate Finance: A Focused Approach - Page 554, london: Cingage Learning. Ezzy, D. (2002) Qualitative Analysis: Practice and Innovation - Page 86, London: Springer. Henderson, S. (2015) Issues in Financial Accounting - Page 991, London: Cingage learning. James, W. (2015) Financial & Managerial Accounting - Page 992, London: John Wiley. Palepu, K. (2007) Business Analysis and Valuation: Ifrs Edition - Text Only - Page 11, New York. Robert Stine, ‎.F. (2013) Statistics for Business: Decision Making and Analysis, New York. Schuster, U.G.‎.N.&.‎. (2015) Investment Appraisal: Methods and Mode, New York: Cingage Learning. Shi, J. (2001) Handbook of Financial Analysis, Forecasting, and Modeling - Page 311, London. Tessa Hebb, ‎.P.H.‎.G.F.H. (2015) The Routledge Handbook of Responsible Investment. William Petty, ‎.T. (2015) Financial Management: Principles and Applications - Page 705, London: Springer. Read More