The Cost of Finance - Case Study Example

Part 1: The cost of finance (20%) Cost of capital Cost of capital refers to the rate of return realizable by investing a given amount of money in different projects with similar risk levels. It is the imperative rate of return for persuading an investor to invest. In essence, cost of capital is the opportunity cost tied to a given investment (Han et.al 2013). The market is a significant determinant for an investment and it is a representation of the level of the investor(s) perceived risk. Generally, where various different investment options have equal risk levels, investors use rates of returns to choose the best investment options. Cost of capital is a significant player in business valuation. Since the expectations of an investor is that the investment’s growth will at least be equal to the cost of capital, fair values related to the cash flows of an investment can be calculated using the cost of capital as a discount rate (Lambert et.al 2012). Factors determining a firm’s cost of capital There are factors existing in a business environment that can lead to high or low weighted costs of capital for a given company, business or firm. This study identifies three main factors namely amount of financing, financing and operating decisions and market conditions Amount of financing The level of financing needed by a company to indulge in a given investment is a significant determinant of the cost of capital. The larger the financial requirements, there is a consequently increased weighted cost of capital (Oztekin & Flannery 2012). For example, issuance of more securities results to extra floatation costs for the company. Subsequently, with the management approaching large capital markets with respect to the size of the firm, there may be a resultant rise in the investors’ needed rate of return. The management is therefore required to prove that they can absorb such large amounts of capital into business as provided by the capital suppliers. Market conditions Purchase of a security with a notable risk level by an investor necessitates the need for the investment attractiveness hence creation of an additional returns’ opportunity. Basically, higher rates of returns are essential with increasing risk levels hence the risk premium. Increases in the required rates of returns result to a simultaneous increase in the cost of capital (Lambert et.al 2012). A readily marketable security with a stable price means that a company faces lower cost of capital while the investor requires lowers rates of returns. This is in contrast with securities that are not readily marketable; requiring the investor to have significantly high rates of return. Financing and operating decisions Returns’ variability, notably risk, is a function of decisions arising within a firm. Such decisional risks are either financial or business risks. Financial risks refer to the augmented variability of returns to common shareholders, resultant from financing using preferred shares or debt (Lambert et.al 2012). Business risk on the other hand is the variability of asset returns and is largely impacted by the decisions a firm makes regarding investment. Essentially, a firm’s costs of capital as well as the investors’ needed rate of return are directly proportional to the financial and business risks involved in an investment. Calculating WACC Step one: assigning costs to each component Cost of debt Kd = {int + (RV – SV)/N}(1 – t) (RV + SV)/2 Int = payable interest rate per annum which is £12 t = Innovate Plc. tax rate which is 25% or o.25 RV= redemption value of each debenture which is £110 SV= issue price per debenture less floatation price hence £100 N = the years it takes for the debentures to mature which is 5years Therefore, Kd = {12 + (110 – 100)/5}(1 - .25) (110 + 100)/2 {12 + 2}(.75) = 14.05% 105 Cost of equity Innovate Plc. Pays dividends of 50p per share. The ordinary shares have a market value of £4 and expected to grow at a rate of 5%. The cost of equity is thus calculated as follows; D1 = 50p × 1.05 = 52.5p P0 = 400p Ke = D1 + g = 52.5p + 5 = 18.13% P0 400p Cost of retained profit He cost of retained profits is the same as cost of equity hence Ke = Kr = 13.13% Step two: assigning weights Type of capital Amount £000’s weight 50p ordinary share 20,000 30.8 (20/65) Retained profit 35,000 53.8 (35/65) 12% redeemable debentures 10,000 15.4 (10/65) TOTAL 65,000 100 Step three: computing WACC Type of capital Amount £000’s weight After Tax Cost Weighted Cost 50p ordinary share 20,000 30.8 (20/65) 18.13 5.58 Retained profit 35,000 53.8 (35/65) 18.13 9.75 12% redeemable debentures 10,000 15.4 (10/65) 14.05 2.7 TOTAL 18.03 Part 2: Financing (30%) Innovate Plc. Have the options to use debt and equity in financing their projects. The debt option involves debt issue of 12% redeemable debentures while the equity option involves a combination of retained earnings and sale of ordinary shares. Both options, notably debt issue and equity have disadvantages and disadvantages as provided in the section that follows. Debt issue (redeemable debentures) Advantages Disadvantages A company raises large amounts of capital by issuing debentures since investors view them as safe and have fixed return rates. Debentures are permanent burdens to a company since they have affixed interest rate and must be repaid regardless of the profits made. Debentures do not give investors voting rights and hence cannot dilute shareholder standpoint Failure to pay interest at the required time may lead to liquidation of a company Debentures are usable for long-term financing hence the company is able to finance large projects for expansion A company’s capacity to acquire loans from other lenders may be lessened when it is overburdened with debentures since much of its income is directed towards such payments Debentures offer tax shields as the interest payable for debentures is generated from the company’s profits Common investors are barred from purchase of debentures as they are issued using high denominations In comparison to equity and preference shares, debentures are less costly since the rate of interest is lower in comparison to the dividends payed on shares. Debentures nay lead to loss of stock market credit worthiness as a company is obliged to mortgage some of its assets. Debentures are remedy to overcapitalisation since a company can redeem them upon such instances. High stamp duties may render issuing debentures an expensive source of financing. Equity (ordinary shares) Advantages Disadvantages The funding from issuing ordinary shares is directed towards funding the company’s intended projects Preparation of a prospectus inviting the public to buy shares may render it an expensive source of financing The company only issues dividends depending on the profits earned with no further obligations such as interests and loan servicing as opposed to debentures. Issue of shares may lead to loss of control as new shareholders exercise their shareholder rights As the investors expect the business to deliver value and grow simultaneously, the company is obliged to explore growth ideas and hence better opportunity for growth. There may be a higher cost of capital as the company struggles to compensate the high risk for shareholders with higher returns. As the business grows, investors are often ready to provide follow-up funds for further growth. Time consuming during preparation of legal documents, advertising and successful issuing of shares. Number of shares to issue, a possible price and a theoretical ex-rights price The company has 20 million ordinary shares. The company can consider issuing 1 for 4 rights shares using an exercise price of £3.5. This is relative to the current market value for the shares at £4. Theoretical EX-Rights Price will therefore be determined as follows; i. Market value of Innovate Plc. Prior to the rights issue will be; (4 x 20,000,000) = £80,000,000 ii. Cash proceeds generated from the rights issue will be; 20,000,000/4 = 5,000,000 5,000,000 x 3.5 = 17,500,000 iii. Number of shares immediately after the issuing of rights will be; 20,000,000 + 5,000,000 = 25,000,000 iv. Theoretical Ex-Rights Price will therefore be 80,000,000 + 17,500,000 = £3.9 25,000,000 Recommended financing option The company should consider issuing of rights as the best option for financing its projects. This is because issuing of the rights will generate more than the required £10 million for the proposed projects with less additional costs such as in the case of debentures which would have to be repaid with considerable interests rates. Revised cost of capital Cost of equity D1 = 50p × 1.05 = 52.5p P0 = 350p Ke = D1 + g = 52.5p + 5 = 20% P0 350p Ke = Kr = 20% Type of capital Amount £000’s weight After Tax Cost Weighted Cost 50p ordinary share 97,500 68.4 20 13.68 Retained profit 35,000 24.6 20 4.9 12% redeemable debentures 10,000 7.0 14.05 2.9 TOTAL 142500 100 21.48 Part 3: The Investment Decision (30%) Methods of financial valuation Financial evaluation using Net Present Value COST OF CAPITAL- 21% OR 0.21 Project A. -2,500,000 + 1,450,000 + 1,450,000 + 1,450,000 = 507,203.82 (1.21)1 (1.21)2 (1.21)3 B. -1,700,000 + 753,000 + 753,000 + 753,000 + 753,000 = 167,224.17 (1.21)1 (1.21)2 (1.21)3 (1.21)4 C. -1,400,000 + 520,000 + 520,000 + 520,000 = -321,554.49 (1.21)1 (1.21)2 (1.21)3 D. -4,500,000 + 753,000 + 753,000 + 753,000 + 753,000 + …+ 753,000 = (1.21)1 (1.21)2 (1.21)3 (1.21)4 (1.21)10 = -1,447,279.29 E. -2,950,000 + 1,200,000 + 1,200,000 + 1,200,000 + 1,200,000 = 98,529.26 (1.21)1 (1.21)2 (1.21)3 (1.21)4 F. -1,800,000 + 530,000 + 530,000 + 530,000 + 530,000 + …+ 530,000 = 59,211.60 (1.21)1 (1.21)2 (1.21)3 (1.21)4 (1.21)7 Feasible projects from Present Net Value findings Projects A, B, E and F cab be undertaken. These projects, as opposed to C and D have positive Net Present Values and thus should be considered as optimal projects to implement. Additional factors to consider Before making decisions based on the findings of the Present Net Value, it is crucial to consider that even when a project yields a positive Net Present Value, the cash flows provided are just projected estimations. As such, the accuracy of such estimated cash flows is subject to the experience and skills of the analyst. Furthermore, materialization of the cash flows is dependent on the financial risks attached to the proposed project. Reference list Hann, R.N., Ogneva, M. and Ozbas, O., 2013. Corporate diversification and the cost of capital. The journal of finance, 68(5), pp.1961-1999. Lambert, R.A., Leuz, C. and Verrecchia, R.E., 2012. Information asymmetry, information precision, and the cost of capital. Review of Finance, 16(1), pp.1-29. Öztekin, Ö. and Flannery, M.J., 2012. Institutional determinants of capital structure adjustment speeds. Journal of financial economics, 103(1), pp.88-112. Read More