1a.
Market Value Cost of Capital
It represents the minimum rate of return a company must earn on its investments to satisfy its
investors and maintain its market value.
Cost of equity using the Dividend Growth Model.
Dividend growth rate
Dividend growth rate=((29 - 22) / 22) * 100=31.82%
Average dividend.
Average Dividend=(22 + 23 + 25 + 27 + 29) / 5=25.20
Cost of equity using the Dividend Growth Model formula:
Cost of Equity = (D1 / P0) + g, where D1 is the next year's expected dividend, P0 is the current
share price, and g is the dividend growth rate.
Cost of Equity= ((25.2 * 1.318181) / 2.65) + 0.318181=12.85
Cost of Preference shares.
Cost of Preference Shares = (Dividend per Preference Share / Preference Share Price).
Cost of Preference shares= (0.07 * 100) / 0.75= 9.33
Cost of debt.
Cost of Debt = (Interest Payment / Bond Price) * (1 - Tax Rate).
Cost of Debt= ((10 / 102) * (1 - 0.3))=0.07
Market value WACC
WACC = (E/V) * Re + (P/V) * Rp + (D/V) * Rd
where E is the market value of equity, P is the market value of preference shares, D is the market
value of debt, V is the total market value of the company, Re is the cost of equity, Rp is the cost
of preference shares, and Rd is the cost of debt.
WACC= ((15000 / 50000) * 12.8533) + ((10000 / 50000) * 9.3333) + ((15000 / 50000) *
0.068627)=5.743
Based on the information provided, the market value cost of capital for Athena plc is calculated
to be 5.74%.
Book Value Cost of Capital
It represents the average rate of return required by investors based on the accounting/book values
of the company's debt and equity.
Calculate the cost of each component of capital and then find the weighted average cost of
capital (WACC).
Cost of ordinary shares.
Calculate the cost of share use the dividend growth model.
Growth rate of Dividend= ((29 - 22) / 22) * 100=31.8181%
Current dividend, which is the most recent dividend (29p) multiplied by (1 + growth rate).
Current Dividend=29 * (1 + 0.318181)= 38.23
Cost of shares using the dividend growth model formula:
Cost of Ordinary Shares = (Current Dividend / Ordinary Share Price) + Dividend Growth Rate.
Cost of Ordinary shares (38.23 / 2.65) + 0.318182=14.74356 or 14.74%.
Cost of Preference shares
Cost of Preference shares is the dividend rate/preference share price.
Cost of Preference shares (0.07 * 100) / 0.75=9.33
Cost of bonds.
find the after-tax cost of interest, which is the interest rate multiplied by (1 - corporate tax rate).
0.10 * (1 - 0.30)=0.069
The after-tax cost of interest is 7%.
Calculate the cost of bonds using the yield to maturity (YTM) method.
YTM is: Cost of Bonds = (After-tax cost of interest * (Par value / Bond price)) + ((Par value Bond price) / Years to maturity).
(0.07 * (100 / 102)) + ((100 - 102) / 7)= -0.217086
The cost of bonds is -0.22%. This negative value indicates that the bonds are trading at a
premium, and the company is effectively earning money on its debt
Weighted average cost of capital (WACC) using the formula: WACC = (Cost of Ordinary Shares
* Weight of Ordinary Shares) + (Cost of Preference Shares * Weight of Preference Shares) +
(Cost of Bonds * Weight of Bonds).
WACC: (14.74356 * (15000 / 50000)) + (9.3333 * (10000 / 50000)) + (-0.217086* (15000 /
50000))=6.2246109
Based on the information provided, the book value cost of capital for Athena PLC is calculated
to be 6.22%.
1b.
Proportion of ordinary shares
Proportion of ordinary shares=15000 / 50000= 0.3
Proportion of preference shares
Proportion of preference shares= 10000 / 50000=0.2
Proportion of bonds.
Proportion of bonds=15000 / 50000=0.3
Calculate the New Cost of equity: The cost of equity can be calculated using the dividend growth
model (assuming constant growth): Cost of Equity = (Next Year's Dividend / Current Share Price)
+ Dividend Growth Rate
Next Year's Dividend = Current Dividend * (1 + Dividend Growth Rate) Next Year's Dividend =
£0.29 * (1 + 0.20) = £0.348
Cost of Equity = (£0.348 / £2.78) + 0.20 = 0.125 + 0.20 = 0.325 or 32.5%
Calculate the New Cost of preference shares: The cost of preference shares is the dividend yield
on preference shares: Cost of Preference Shares = Dividend / Preference Share Price
Dividend = £0.07 (7% * £1.00) Preference Share Price = £0.75
Cost of New Preference Shares = £0.07 / £0.75 = 0.0933 or 9.33%
Calculate the New cost of debt: The cost of debt is calculated using the yield to maturity (YTM)
of the bonds. Since the bonds are being issued at a premium, we need to adjust the YTM
accordingly:
Coupon Payment = Coupon Rate * Par Value = 0.10 * £100 = £10.00 Premium = 5% * £100 =
£5.00 Effective YTM = (Coupon Payment + Premium) / Bond Price = (£10 + £5) / £102 =
0.1471 or 14.71%
Calculate the weights of each component: Weights = Component Value / Total Capital
Component Value: Ordinary Shares = £15,000,000 (£2.65 * 15,000,000) Reserves =
£10,000,000 Preference Shares = £7,500,000 (£0.75 * 10,000,000) Bonds = £15,000,000 (£102 *
15,000,000 / £100)
Total Capital = £50,000,000
Weights: Ordinary Shares = £15,000,000 / £50,000,000 = 0.30 or 30% Reserves = £10,000,000 /
£50,000,000 = 0.20 or 20% Preference Shares = £7,500,000 / £50,000,000 = 0.15 or 15% Bonds
= £15,000,000 / £50,000,000 = 0.30 or 30%
Calculate the tax-adjusted cost of debt: Tax-Adjusted Cost of Debt = Cost of Debt * (1 - Tax
Rate) Tax Rate = 30%
Tax-Adjusted Cost of Debt = 0.1471 * (1 - 0.30) = 0.10297 or 10.297%
Calculate the WACC: WACC = (Weight of Equity * Cost of Equity) + (Weight of Preference
Shares * Cost of Preference Shares) + (Weight of Debt * Tax-Adjusted Cost of Debt)
WACC = (0.30 * 0.325) + (0.15 * 0.0933) + (0.30 * 0.10297) = 0.0975 + 0.0140 + 0.0309 =
0.1424 or 14.24%
The cost of capital increases significantly after the proposed changes by the director,
1c.
To reduce the company's weighted average cost of capital (WACC), Athena PLC's finance
director is recommending adjustments to the capital structure. However, it is important to take
into account any possible inaccuracies in her estimations. These inaccuracies could be caused by
a number of variables, such as market conditions, investor behavior, and the finance director's
assumptions.
First, the finance director assumes that the firm will be able to lower its cost of capital by issuing
additional debt in the form of 11% bonds. There are risks involved with raising the company's
leverage, despite the fact that debt financing may be less expensive than equity financing. These
risks, such as the possible rise in the cost of debt or the increased financial risk to the firm, may
not be properly taken into account in the finance director's assessment of the effect on the
company's cost of capital.
The company's share price is anticipated to increase to £2.78 as a result of repurchasing and
canceling ordinary shares, according to the finance director. This presumption, nevertheless, is
based on the efficient market hypothesis, which holds that stock prices accurately represent all
information. In reality, a variety of factors, such as investor behavior, market conditions, and
market sentiment, may affect stock prices. The finance director's assessment may not accurately
reflect the effect of the share the repurchase on the share price.
The finance director also expects that the share repurchase will raise the dividend growth rate
compared to current levels by 20%. Forecasting future dividend growth rates, however, is
fundamentally unpredictable and is reliant on a number of variables, such as the company's
financial performance, market circumstances and management's dividend policy. The estimate of
the finance director for the probable effect of the share repurchase on the company's dividend
growth may not be correct.
In addition, the finance director believes that the suggested alterations won't have an impact on
the cost of the 10% bonds. Interest rates, credit ratings, and market demand are only a few
variables that have an impact on bond pricing. The estimated bond prices provided by the finance
director may not completely account for future market situation changes. Finally, the finance
director anticipates a decline in the price of the preference shares to 68p. Changes in interest
rates, market circumstances, and investor preferences are just a few of the variables that might
affect the price of preference shares. These elements may not be properly taken into account in
the finance director's assessment, making her forecast inaccurate.
In conclusion, there are a number of potential inaccuracies in the finance director's projections.
These errors result from a combination of assumptions made by the finance director, market
circumstances, investor behavior, and other unknowns. To appropriately estimate the possible
effects of the proposed changes to the company's capital structure, it is crucial to be aware of
these potential inaccuracies and carry out further research and sensitivity testing.
1d.
A hotly debated topic in finance is how to incorporate a reasonable amount of gearing into a
company's capital structure to reduce its weighted average cost of capital (WACC). There is no
universal agreement on the subject, despite the fact that empirical study offers useful insights.
By including debt in their capital structure, businesses may be able to reduce their WACC,
according to a number of studies. The tax shield provided by debt financing is one of its main
benefits. Tax deductions for loan interest payments decrease the cost of debt and hence lower the
WACC. Empirical research highlighting the effect of corporate tax rates on the link between
capital structure and WACC, such as Graham (2000) and Titman and Wessels (1988), have
validated this tax benefit.
Debt financing may also result in decreased expenses for the agency. Debt holders serve as
monitoring agents, putting their interests in line with those of shareholders and minimizing issues
of agency between management and shareholders. The WACC may be lowered as a result of this
increased governance since it may result in better decisions and lower agency expenses. The
argument is supported by Jensen and Meckling's (1976) study, which places special emphasis on
the debt holders' involvement in agency issue mitigation.
Additionally, a company's cost of capital may be impacted by market conditions and investor
perspectives. High debt levels may be seen as risky by investors, which would raise the cost of
shares and raise borrowing costs. The availability and cost of debt finance may also be impacted
by market variables including economic cycles and industry-specific traits. According to
research by Rajan and Zingales (1995) and Frank and Goyal (2009), the market environment and
investor attitude have a big impact on a company's cost of capital and ideal capital structure.
2a.
Straight line Depreciation
Calculation is shown in the table below
Year
1
Book Value (Beginning of Depreciation
the year)
Charge
588300.00
83342.50
Book Value (End
Of the year)
504957.50
2
504957.50
69452.08
435505.42
3
435505.42
57876.74
377628.68
4
377628.68
48230.61
329398.07
5
329398.07
40192.18
289205.89
6
289205.89
33493.48
255712.41
Scrap 88245
Value
Straight Line Depreciation=Annual Depreciation Expense/ (Cost of Machine –Salvage Value)
Cost of machine = 588300
Scrap value = 0.15*original cost of machine = 0.15*588300 = £88245
(i)Payback Period
Item
Investment
Year 0
(£588,30
0.00)
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Cash
Inflow
£223,60
0
£223,600.
00
£223,600
£223,600
£223,600
£223,600
Cash
Outflow
(£32,700 (£32,700)
)
(£32,700) (£32,700) (£32,700) (£32,7000
NCF
(£588,30
0.00)
£256,30
0
£256,300
£256,300
£256,300
£256,300
£256,300
Discounted
NCF
(£588,30
0.00)
£227,83
1.22
£227,903.
22
£228,551
.22
£234,383
.22
£86,871.
22
£759,263.
22
(£360,46 (£132,565. £95,985.
8.78)
56)
67
£330,368
.89
£617,240
.11
£1,376,50
3.33
Cumulative
NCF
Net cash flow = Initial Investment-Cash inflow + Cash outflow
Discounted cash flow = Net cash flow/ (1+cost of capital) Year
Net cash flow/ (1+0.08%)Year
Cumulative cash flow = Current year cash flow + sum of all previous
From the Payback table, Cumulative cash flow is positive in year 3, so the payback period is
between year two and year 3. Therefore, payback period = 2+132565.56/228551.22 = 2.58years
(ii)Accounting Rate of Return
Item
Year O
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Initial
£588300
Cash Inflow
223600
223600
223600
223600
223600
223600
Cash
(32700)
(32700)
(32700)
(32700)
(32700)
(32700)
Investment
Outflow
Depreciation
(83342.50)
(69452.0)
(57876.74)
(48230.61)
(40192.18)
(33493.48)
Net Profit
248657.50
262547.92
274123.26
283769.39
291807.82
298506.52
Average Net
276568.74
Profit
47.04%
ARR
Net profit = Initial investment –(Cash inflow + Cash outflow + Depreciation)
Average net profit = average of all net profit from year 1 to year 6
ARR = Average net profit/-Initial investment = 276568.74/588300.00 = 47.04%
(iii)Net Present Value
Year
0
1
2
3
4
5
6
Total present value
Net Present value
Cash flows
588300
248657.50
262547.92
274123.26
283769.39
291807.82
298506.52
Cost of capital (8%)
1.000
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
(588300)
230231.98
225082.33
217599.04
208570.50
198604.40
188118.81
1268207.06
679907.06
(iv)IRR
The discount rate at which NPV = 0 is the IRR.
Therefore,
588,300.00=190,900.00/(1+IRR)+190,900.00/(1+IRR)2+190,900.00/(1+IRR)3+190,900.00/(1+I
RR)4+190,900.00/(1+IRR)5+190,900.00/(1+IRR)6
IRR = 23.16%
2b.
A fast-food firm called Newtake Limited is debating two different proposals regarding allocating
money for the acquisition of a new storage equipment. The initial suggestion made by the
finance director advises allocating 40% of the entire capital outlay for the the repurchase of some
equity capital and utilizing the remaining money for cash dividends. The management of
Newtake, on the other hand, intends to distribute a script dividend as opposed to a cash dividend.
The suggestion to repurchase equity capital made by the finance director may have a variety of
impacts on Newtake Limited. The signaling hypothesis is one relevant theory that contends share
repurchases may be an indication that management of the firm thinks its stock is undervalued.
This may promote investor confidence and raise the value of the company's shares. Additionally,
by lowering the total number of outstanding shares, a repurchase of equity capital may raise the
company's profits per share (EPS).However, there can be disadvantages to the repurchasing of
stock capital. According to the pecking order theory, businesses choose internal finance like
retained profits above external borrowing. Repurchasing stock capital might send the wrong
message to investors about Newtake Limited's ability to make successful investments or create
enough returns. This may undermine investor confidence, which would then cause the stock
price of the firm to fall.
In the second proposal, a script dividend is proposed as opposed to a cash dividend. The issuing
of script dividends may be seen as a signal that the firm wishes to keep its profits for potential
future growth prospects, which is in line with this proposal's signaling theory. This may attract
investors who would rather reinvest in the business than get cash dividends right away. By
issuing script dividends, Newtake Limited may preserve cash reserves that can be used for other
investment initiatives or to improve its financial condition. This is consistent with the financial
flexibility theory, which places a strong emphasis on the need of preserving financial flexibility
and having enough cash to respond to unforeseen events or investment opportunities.
The issuance of script dividends may, however, have potential diluting effects. A big number of
new shares being issued could result in a decline in EPS and stock price. The dividend
irrelevance theory contends that because shareholders may generate their desired cash flows by
selling shares if necessary, the option between cash dividends and script dividends shouldn't
have an effect on the company's value. However, the market's responses to script dividends may
vary, and some investors may see them as a possible harbinger of impending dilution, which
might have a detrimental impact on the stock price.
2c.
A number of criteria need to be taken into account while evaluating the three suggested sources
of funding for the Newtake Limited project. The cost of capital, risk, control implications, and
the availability of finances are some of these factors. The first suggested financial source is
equity financing. Equity finance is the process of obtaining funds by issuing firm shares. This
may be accomplished either via an initial public offering (IPO) or by looking for funding from
private equity or venture capital organizations. Equity financing has the benefit of not requiring
repayment and posing no financial pressure on the firm. In contrast, it dilutes ownership and
control as new shareholders take a stake in the business. As a private business without access to
the public market, Newtake Limited may have less access to equity funding than a listed firm has.
The second suggested source is debt financing. Debt financing is taking out loans from lenders
like banks or issuing bonds for businesses. With debt financing, a certain sum of money is made
available that must be returned with interest over a predetermined time frame. It enables the
business to maintain ownership and management, but since interest payments and principle
payback requirements must be satisfied, the financial risk grows. Due to the need for collateral
and the company's insufficient credit history, Newtake Limited may find it difficult to get debt
financing. As a result of their established reputation and creditworthiness, listed firms often have
easier access to debt funding.
Retained profits or internal funding is the third suggested source. Internal finance is the process
of funding new projects or investments using business earnings. There are no external
commitments or ownership dilution associated with this type of funding. However, it is
dependent on the company's profitability and cash on hand. Depending on its past financial
performance and retained profits strategy, Newtake Limited may be able to fund the project itself.
As a private firm with limited access to external financial markets, Newtake Limited may have
more difficulties obtaining internal finance than a publicly traded corporation.
There are observable distinctions between these suggested sources of financing and a listed
company. Listed firms benefit from simpler access to debt and equity funding through public
markets. To raise money, they might issue more shares or bonds. Moreover, because of their
established reputation and creditworthiness, listed companies often have easier access to debt
funding. They might bargain for more favorable loan conditions and interest rates. However,
regulatory agencies, shareholders, and other stakeholders may be more scrutinizing and
demanding of compliance from listed corporations. Due to the participation of several
stakeholders, the decision-making process could be more complicated. Private companies like
Newtake Limited, on the other hand, could be more adaptable and agile in their decision-making,
but they may have greater access restrictions to external financing options.
2d.
Different methods are used to analyze the financial sustainability of investment projects. The
Payback Period, the Accounting Rate of Return (ARR), the Net Present Value (NPV), and the
Internal Rate of Return (IRR) are a few of the investment assessment approaches. Each method
has particular characteristics, advantages, and drawbacks. The Payback Period is a
straightforward method for calculating the length of time needed to recoup the original
investment cost. It is determined by dividing the original investment by the yearly cash inflows
and focuses on the project's liquidity. The simplicity of the Payback Period, which enables rapid
evaluations and comparisons across projects, is one advantage. Additionally, it places a strong
emphasis on cash flow timing and gives an idea of the project's risk and payback time. Its
primary flaw, however, is that it doesn't take the time value of money or cash flows into account
beyond the payback period. This may result in poor investment choices and a disregard for the
project's long-term viability.
The average yearly accounting profit is compared to the original investment to determine how
profitable an investment is using the Accounting Rate of Return (ARR). It is determined by
dividing the original investment by the average yearly profit and is often stated as a percentage.
ARR has the advantage of being simple and compatible with accounting data, which makes it
simple to comprehend for non-financial management. However, it has drawbacks such relying on
accounting profits rather than cash flows, ignoring the time value of money, and failing to take
the project's duration into consideration.
The Net Present Value (NPV) method of investment analysis is commonly regarded as being
better. By discounting all future cash flows at the firm's cost of capital, it determines their
present value. The net contribution of the project to the company's worth is shown by the NPV.
The time value of money is taken into account by NPV, which ensures a more accurate estimate
of cash flows throughout the course of the project. A clear indicator of a project's potential for
value generation is provided by NPV. The dependency of NPV on precise cash flow and
discount rate predictions, which may be difficult in reality, is however one of its limitations.
Another well-liked investment assessment method for calculating the rate of return on a project
is the Internal Rate of Return (IRR). The discount rate at which the NPV equals 0 is known as
this. IRR determines if a project is profitable by comparing its rate of return to the necessary rate
of return. IRR has the advantage of taking time worth of money into account and offering a
percentage return that can be compared to other investment alternatives. IRR has certain
drawbacks, such as the possibility of numerous IRRs for projects with unconventional cash flows
and the unrealistic assumption that cash flows can be reinvested at the computed IRR.
In conclusion, each method of investment analysis has advantages and disadvantages. While the
Payback Period offers a rapid evaluation of liquidity, it ignores the time worth of money.
Although straightforward and consistent with accounting data, the Accounting Rate of Return
ignores cash flows and time value of money. The Net Present worth evaluates the worth of a
project while taking into account the time value of money, but it depends on correct cash flow
and discount rate projections. The Internal Rate of Return takes into account the project's rate of
return and enables comparison with needed rates of return, however it might have restrictions
with respect to non-conventional cash flows and reinvestment assumptions. The features of the
project, corporate preferences, and the availability of trustworthy data all play a role in selecting
the best approach.