The Validity of the Views of Cost of Capital - Essay Example

A Study of White plc Discuss the validity of the three views of cost of capital which exist in the company Weighted Average Cost of Capital (WACC Definition: The average of the current costs of the sources of finance employed by the company is the WACC of the company (Investopedia, 2008). Rationale for use: The main rationale behind the use of weighted average cost of capital is that the firms will be able to increase the market price of its stock in the long run by financing in proportionate amounts and by accepting projects that yield returns higher than the weighted average cost of capital. Assumptions: It is essential to understand that the correct cost of capital to be used for an investment appraisal is the marginal costs of funds used to finance the investment. As mentioned earlier the weighted average cost of capital can be considered as the safest and most reliable guide of marginal costs of extra funds, but based on the fact that the company would have to continue investing in the future: a) In projects with similar business risk as that of the existing projects b) Also by raising funds in a manner where the existing capital is not altered (GSW, 2008). Calculation of WACC: Weighted average cost of capital is also referred to as the overall cost of capital. The weighted average cost of capital is calculated using (12 Manage, 2008): a) Without Tax: Ko = Ke . (Ve / Vo) + Kd. (Vd/Vo) b) With Tax: Ko = Ke . (Ve / Vo) + Kd. [Vd (1-T) / Vo] Where, Ko = WACC Ve = Market value of equity Vd = Market value of debt Vo = Total Market value of Firm (Ve + Vd) T = Corporation Tax Rate Projects with higher values than the weighted average cost of capital should be accepted. In the case of White plc, the case of this method will help the company since the company dealt with materials handling equipments which belongs to the medium risk industry. The company firstly dealt with just one type of business risk i.e. medium risk. Thus this method has been very useful for the company allowing the company to correctly and accurately use the weighted average cost of capital as the discount rate. Cost of Debt: There are two main categories of debt debentures within a company: a) Irredeemable Debentures: In this type the capital is never repaid, only the interest is paid to the holders by the company for ever. b) Redeemable Debentures: In this type the face value of the debentures is repaid to the debentures holders at the end of a particular period. The interest is also paid over this period to the debenture holders (CBDD, 2008). Definition: The discount rate which discounts the cash flows stream from the debenture to the holders into equal value as the market value of the debt is known as the cost of issued debt capital. For the calculation of the cost of debentures, the current market value of the debentures is used instead of the face value or the nominal value (Binsbergen,et.al., 2008). Calculation of: a) Irredeemable Debt: i) Calculating the cost of irredeemable debt Before Tax: Pd = i / Kd Where: Pd = Market price per unit ex dividend i.e. after the payment of the current interest Kd = Cost of debt i = Interest payment per annum paid to perpetuity. ii) After Tax: It is essential to understand that an important difference between the equity and debt is the interest payment on the debt capital can be reduced from the profits as an expense before charging the tax. In this case the net after the tax will be lower due to the tax savings. Kdt = i (1 - T) / Pd Where: Kdt = after tax cost of irredeemable debt T = Tax rate (CIMA, 2008) b) Redeemable Debt: i) Calculating the cost of redeemable debt Before Tax: Here the interpolation method is used. Pd = i / ( 1 + Kd)1 + i / ( 1 + Kd)2 + i / ( 1 + Kd)3 +…+ R+ i / (1 +Kd)n Where: i = Annual interest payable R + i = The redemption value (R) of the debenture which needs to be redeemed after a fixed number of years + the interest payable while redemption ii) After Tax: Here the formula remains the same with one slight difference of the substitution of i(1 – T) in the equation Pd = i(1 – T) / ( 1 + Kd)1 + i(1 – T) / ( 1 + Kd)2 + …+ R+ i(1 – T) / (1 +Kd)n Where: T = Tax rate It is essential to understand that the cost of redeemable debt and the irredeemable debt would normally remain the same in perfect capital markets for organizations with similar characteristics like the risk, size, earnings, etc. However these will differ in a few cases where the markets are imperfect, the securities offered are different, the business risk that has been anticipated is different and lastly the gearing of the company is higher due to reasons like bankruptcy and financial risks (Scribd, 2008). Risk Adjusted Discount Rate This method takes into account the risk of a project. The discount rate consists of a) the risk free rate and b) risk premium. The risk adjusted rate is used along with the net present value to obtain the risk adjusted NPV (RANPV) (Free Dictionary, 2008). The main basis of the decision rule is if the RANPV > 0 then the project can be accepted similarly projects are ranked by the RANPVs. The method is very simple and is used to appraise projects. This can be derived using the CAPM model to apply to projects. The formula used to appraise projects is: Rp = Rf + Bp (Rm – Rf) Where: Rp = Expected rate of return on the project Rf = Risk free rate of return Bp = Project’s beta Rm = Stock Market Return on Equity Bp (Rm – Rf) = This represents the risk premium, which reflects the systematic risk of the project. The methods to calculate the project beta: a) direct estimate of the project business risk that is mainly calculating the betas from the forecasted data and, b) deriving estimates from already published equity beta which mainly refers to using the historical data to calculate the betas. In both the methods CAPM is used to derive the company’s cost of capital which is then used as the discount rate for individual projects (Learning Matters, 2008). This section has focused on understanding the weighted average cost of capital, the cost of debt and finally the risk adjusted discount rate. This has provided a better understanding of the basics of the methods. The next section deals with understanding the best method that can be used for White Plc., where the company has undertaken three different projects each with different risk levels. Recommend which method should be used. Explain how your recommended method should be applied in practice The company has a number of different methods that can be followed by the company to be able to calculate the cost of capital to find the rate of interest. The one method that will be discussed within this report is the asset beta: CAPM and projects with different business risk profiles. Business and financial risks; business risks refers to the systematic risk of a company of its cash flows, in simple words , the business risk relates to the systematic risk of the net cash flows that results from the operation of the company’s assets. Both the equity and the debt holders in a company bear this risk. The financial risk however, refers to the additional systematic risk which is borne only by the equity holders of the geared company. There are two main factors that affect a company’s equity beta: a) the level of systematic risk of the company’s investments i.e. the systematic business risk and b) the level of the financial gearing employed by the company i.e. Systematic financial risk (Encycogov, 2008). The asset beta of a company’s assets reflects only the business rick and not the financial risk. It is the company’s assets which should be used in CAPM to determine the risk adjusted discount rate to apply in appraising the company’s investment proposal. The overall asset beta of a company operating indifferent industries i.e. undertaking different projects with different business risk will be a weighted average of the asset betas in each division. In the situation, it is inappropriate to use the company’s overall weighted average cost of capital based on its equity beta or the asset beta. Instead, a specific discount rate must be calculated for each division or business activity, which reflects the systematic business risk of those particular business activities (Value Based Management, 2008). The company can adopt the CAPM method to calculate the cost of capital for the company and ensure that the company’s risks are correctly balanced. Markowitz contribution showed that the benefits of diversification depend not just on risking individual assets but also on how the asset returns interact with each other, or the correlation between returns. E.g. A combination of investments in Umbrellas and Ice Creams will eliminate the risk of one another, i.e., the low returns from ice creams in rainy season will be compensated by the umbrella sales. High returns in one industry, in this case, always offset low returns in the other to give a positive return with certainty because returns on the two assets are inversely correlated. Risk of a portfolio (combination of shares) depends on the correlation between the expected return of every pair of shares in a portfolio. Correlation varies between +1 and -1. Thus a perfectly positively correlated portfolio would mean a +1 and a negatively correlated portfolio would mean -1. In a positively correlated portfolio the expected return would move in the same direction in the same proportion at all times, however in a negatively correlated portfolio the returns would move in the opposite direction (J Ogilvie & B Koch 2002). A change in any of the variables (proportions of the individual stocks, their variances and covariance’s) would directly affect the risk of the portfolio (Meir Statman, 1987). It has been seen that the risk of a portfolio decreases with an increase in the number of shares in a portfolio. Apart from Markowitz Portfolio theory there are a few other models which would help investors to select optimal portfolios. These models unlike Markowitz have less stringent assumptions about the investor’s choice framework. The following are the choices: The Geometric Mean Return Safety First Stochastic Dominance References 12 Manage. Analysing the cost of invested capital. Expalnation of WACC. 08 November 2008 < http://www.12manage.com/methods_wacc.html> Binsbergen, J.H., Graham, J.R and Yang, J. The cost of Debt. January 2008 < areas.kenan-flagler.unc.edu/Accounting/taxsym/Documents/mccurve012108.pdf> CBDD. Cost of Debt and Equity Capital. 2008. CIMA. Management Accounting Financial Strategy. May and November 2008. < http://books.google.co.in/books?id=y8wUgyAlNJMC&printsec=frontcover&dq=irredeemable+debt+cost+of+debt&source=gbs_summary_s&cad=0> Encycogov. Model CAPM. 2008. Finance. Asset Pricing and risk Management. November 27, 1995. Free Dictionary. Risk Adjusted Rate. 2008 GSW. Weighted Average Cost of Capital. 2008. Investopedia. Weighted Average Cost of Capital. 2008 < www.investopedia.com/terms/w/wacc.asp - 31k> J. Ogilvie and B. Koch, CIMA Study System Intermediate Level Finance, 2nd edn., Viva Books Private Limited, New Delhi. Learning Matters. Caluculating Risk – Adjusted rate of return. 2008 < http://www.learningmatters.com/idx/7750/index.html> Scribd. Cost of Capital. 2008 Statman, M. , How Many Stocks Make a Diversified Portfolio?, Journal of Financial and Quantitative Analysis, Vol 22, No.3, Sep 87. Value Based Management. Capital Asset Pricing Model. 2008 < http://www.valuebasedmanagement.net/methods_capm.html> Read More