Financial Management: Cost of Capital and Capital Structure

This document discusses the concepts of financial management, specifically the cost of capital and capital structure. It explains the market value and book value cost of capital of a company and explores the benefits of adequate debt financing in reducing the cost of capital. Additionally, it evaluates the effects of short-termism on bankruptcy and agency problems in companies.

APC 308 FINANCIAL
MANAGEMENT

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
QUESTION 1...................................................................................................................................1
a) Market Value and Book value cost of capital of Kadlex plc. ................................................1
b) Capital structure of Kadlex and calculation of cost of capital of company reflecting the
changes . ......................................................................................................................................4
c) Adequate debt financing will help in reducing the cost of capital of company.......................7
QUESTION 3...................................................................................................................................9
i) Payback Period ......................................................................................................................10
ii) The Accounting Rate of Return.............................................................................................10
iii) The Net Present Value..........................................................................................................11
iv) The Internal Rate of Return..................................................................................................12
CONCLUSION .............................................................................................................................13
REFERENCES..............................................................................................................................14

INTRODUCTION
''Financial management refers to the activities which are concerned with planning,
raising, controlling and administering funds used in the business. - Guthman and Dougal
Financial management means to plan, organize, to direct and control the financial activities like
procurement & utilization of monetary resources of enterprise. It refers to application of general
principles of management to the financial resources of enterprise. Financial management is also
concerned with procuring, allocating and controlling the financial resources of concern. It
ensures that there is regular plus adequate supply of the funds required for running the business
operations (Reyes, Miranda and Vera-Martínez, 2019). The report will include the concepts of
financial accounting that are used by the organisations. For the organisations to have proper
records of the transaction have to ensure that the procedure is followed in a given manner.
Report will give understanding about the financial concepts used by the organisations to assists
them in decision making. This enables the, to plan their future steps. In the given file question 1
& 3 have been answered.
QUESTION 1
Cost of Capital and Capital structure
a) Market Value and Book value cost of capital of Kadlex plc.
Capital Structure
Capital Structure
Book Value Market Value
Current Value of Equity
Number of shares 20000 20000
Price per share 1 2.65
Value of Equity 20000 53000
(No. of shares* Price per share)
Current Value of Debt
Number of Bonds 150 150
Price per bond 100 107
Value of Debt 15000 16050
(Number of bonds * price per
bond)
1

Current Value of Preference
Capital
Number of Preference Shares 10000 10000
Price per share 1 0.75
Value of Preference share 10000 7500
(No of pref share * price per
share)
Total value of Capital funds
Total Value of Debt and Equity
Book Value Market Value
Value of Equity 20000 53000
Value of Debt 15000 16050
Value of Preference share 10000 7500
Total Capital 45000 76550
Calculation of costs of funds raised by company.
DIVIDEND DISCOUNT MODEL
Book Value Market Value
0 Year 1 Year
Expected dividend 0.28 0.336 0.336
Current stock price 1 2.65
Growth Rate 20.00% 20.00%
Cost of Equity = Expected Dividend in 1
year ÷ Current Stock Price + Growth
Rate
Cost of Equity 53.60% 32.68%
Cost of Preference Capital
Book Value Market Value
Dividend per share 0.07 0.07
Net proceeds 1 0.75
Cost of Preference Share Capital 7.00% 9.33%
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(Dividend / Net proceeds)*100
Cost of debt 10.00%
After tax debt (1 – 30%)
Cost of debt 7.00%
(debt*(1-tax rate)
Calculation of Weights
Weights
Book Value Market Value
Weight of Equity
Equity 20000 53000
Total Capital 45000 76550
Weight 44.44% 69.24%
(Equity / Total Capital)
Weight of Preference Capital
Preference Capital 10000 7500
Total Capital 45000 76550
Weight 22.22% 9.80%
(Pref share / Total Capital)
Weight of Debt
Debt 15000 16050
Total Capital 45000 76550
Weight 33.33% 20.97%
(Debt / Total Capital)
Calculation of Cost of Capital
Weighted Average Cost of Capital
As per Book Value Value Weight Cost
Weight*Cos
t
Value of Equity 20000 44.44% 53.60% 23.82%
Value of BOND 15000 33.33% 7.00% 2.33%
Value of Preference share 10000 22.22% 7.00% 1.56%
Total Capital 45000 100.00% 67.60% 27.71%
(Cost = Ke*W + Kp*W +
Kd*W)
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As per Market Value
Value of Equity 20000 69.24% 32.68% 22.63%
Value of BOND 15000 20.97% 7.00% 1.47%
Value of Preference share 10000 9.80% 9.33% 0.91%
Total Capital 45000 100.00% 49.01% 25.01%
(Cost = Ke*W + Kp*W +
Kd*W)
b) Capital structure of Kadlex and calculation of cost of capital of company reflecting the
changes .
New Capital Structure
Value of Equity
Number of shares 20000
Price per share 2.85
Value of Equity 57000
Value of Debt 15000
Value of Preference share
Number of Preference Shares 10000
Price per share 0.68
Value of Preference share 6800
Total Value of Debt and Equity
Value of Equity 57000
Value of Debt 15000
Value of Preference share 6800
Total Capital 78800
Calculation of Costs
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Cost of Equity
Expected dividend 0.336
Current stock price 2.85
Growth Rate 20.00%
Cost of equity = Expected Dividend
in 1 year ÷ Current Stock Price +
Growth Rate
Cost of Equity 31.79%
Cost of Preference Capital
Dividend per share 0.07
Net proceeds after selling 0.68
Cost of Preference Share Capital 10.29%
Cost of debt
Maturity Period 7
Par Value 100
Net proceeds(Par+Premium) 105
I 11
Premium 5
Mp 7
I+(premium/Mp) 11.71
P 100
np 105
P+np/2 102.5
Tax Rate (1-0.3) 0.7
Cost of Debt Capital 11.43%
After tax debt 8.00%
Weights
Weight of Equity
5

Equity 57000
Total Capital 78800
Weight 72.34%
Weight of Preference Capital
Preference Capital 6800
Total Capital 78800
Weight 8.63%
Weight of Debt
Debt 15000
Total Capital 78800
Weight 19.04%
Cost of Capital
Weighted Average Cost of Capital
Book Value Value Weight Cost
Weight*Cos
t
Value of Equity 57000 72.34% 31.79% 22.99%
Value of BOND 15000 19.04% 8.00% 1.52%
Value of Preference share 6800 8.63% 10.29% 0.89%
Total Capital 78800 100.00% 50.08% 25.41%
(Cost = Ke*W + Kp*W +
Kd*W)
Finance director projects that reducing the cost of capital using the issuance of new bonds
in the market. Director proposes to use the funds raised by company in purchasing the ordinary
shares of company. The new structure will raise the price per share of the company as the
number of shares outstanding of the company are reduced. This helps in distributing the wealth
of equity capital amongst the reduced number of shareholders (Schwarz, 2018). Issuing new
bonds will help in reducing the average cost of capital of the company. Debt financing involves
less risks as the fixed amount of interest have to be paid by the irrespective of its profitability
statues. Also the restructuring the capital structure will reduce the book value weighted average
cost of capital from the existing rate of 27.71. Restructuring will reduce the capital cost to
25.41%. so it can be said that projections of the directors can be adopted by the company as
increased share prices also boost the growth of company in market. The profits of company will
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be distributed to reduced number of shareholders which and per share dividends will be
increased. Therefore he projections are right of finance director for reducing the cost of capital of
company.
c) Adequate debt financing will help in reducing the cost of capital of company.
Weighted average cost of capital refers to aggregate rate at which the borrowed capital
are repaid by the company. Every enterprise raises funds mainly by equity capital and debt
financing. Computing WACC consists of adding average cost of debt to average cost of the
equity. Reduction in WACC stretches spread lying between them. WACC can be reduced by
companies by cutting down its debt financing, lowering the equity costs and by capital
restructuring.
It is simple average between cost of equity & cost of the debt. Every company tries to
have the lowest and cheapest sources of finance by averaging two cost (Amah and Ken-
Nwachukwu, 2016). Every company is aware about the fact that cost of debt is relatively
cheaper than of equity. Debt involves risks, as return required for compensating the financial
debt investors is not higher as compared with the return required for compensating the equity
investors. Debt is also less riskier from equity as interest payment in debt is of fixed amount and
is compulsory in the nature. Other reason of debt being less riskier is that in case of liquidation,
debt holders are paid in priority in before the equity investors (Capital Structure, 2019).
Leveraging also helps companies in reducing the tax liability of company due to different tax
treatments of dividend and interest. Company gets relief on interest payment where the dividends
do not get any tax relief. Companies could gear up through replacing much expensive equity
with cheaper debt for reducing average, WACC. Also raisin g higher debt will result in
increased interest payments from the profits of company. Interest payment increases volatility of
the dividend payment to shareholders.
On the payment of interest whole of the profits remains to the company. Profits gets
distributed due to the increased number of shareholders. Companies are not left with enough
funds after distributing the dividends that can be utilised and invested in more productive
activities. The funds requirement for companies with higher equity capital should be met with
raising the debt finance (Ashenah and Shahverdi, 2017). Debt financing is relatively much
cheaper in comparison to the equity therefore funds should be raised through this source of
finance. Cost of capital will be reduced if company used appropriate mix of debt and equity.
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Debt is financing is less costlier but raising excessive funds through this source will also involve
financial risks due to increased payment of interest. High equity financing is also riskier for the
company, therefore it has to ensure that the company do not raises equity after specified limit.
Company can raise debt for the buy back of equity capital for reducing the cost of capital. Return
expectations of investors are high in case of equity as debt involves fixed payment. Therefore it
could be said that for reducing the cost of capital not only the debt is to be raised and equity to be
removed but it is also important to ensure that high debt will also increase high risks (Hamad,
Tuzlukaya and Kırkbeşoğlu, 2019). Company should always have an appropriate mix of debt
and equity so that the average cost of capital is lower and adequate.
d) Evaluating effects of short termism over bankruptcy and agency problem in company.
Bankruptcy
Having a right balance between long term and short term perspectives is crucial for
sustainability of successful business. However there are evidences that corporations often neglect
long term objective due to increased concentration over the short term goals. The short-termism
deteriorated the competitiveness, increases the systematic risks and also long term potential for
economy as a whole. Short-termism is found mainly in public companies as they ar under
pressure from investors expecting short term results.
The short term approach is pushed by globalisation of the financial markets, new
technologies and reduced trading times & the transaction costs. Pressures are executed by
shortening executive tenures or by influencing remuneration schemes. Theses pressures results in
management to take decisions for achieving the outcomes in short terms and quickly this often
results in business failures and bankruptcy (Mahmoud, 2016). Companies often neglect to see
the effects of taking the sort decisions neglecting the long term objectives that can be achieved if
decisions are taken appropriately.
Bankruptcy is very negative failure of business where company is unable to run its
operations and has gone out of funds. Management before taking decisions should ensure both
long as well as short benefits of the operations it is planning to adopt for the business. Short term
objectives and long term objectives should be balanced by the company. Short term objectives
involving higher risks should not be adopted by companies as it is important for the business to
remain profitable and operative rather than failing due to having short term goals. Shareholders
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pressures should not be over the short term benefits from company. They should also focus over
long term objectives of company where their wealth can be maximised.
Agency problem
Agency problem refers to conflict of interests inherent in relationships where 1 party is
expected of acting in the best interest of other. At corporate levels agency problems generally
arises in conflict of interests between management and stockholders of company. Management
acting as agent for shareholders or the principals are expected of making decisions which will be
maximising wealth of shareholder.
There is an universal problem between the corporate firms that they do not behave in the
best interests of principals. In every contractual relationship where one party promises the
performance to other, are potentially subject to the agency problem. Problems are arising as
agents possess more accurate information as compared to the principals as regard the relevant
facts. There are generally three agency problems arising in the business entities. First involves
conflicts of interest between hired manager and owner of the firm. Principals are the owners and
agents are the managers. Problem lies over assuring that managers of company are responsive
interests of owners instead of pursuing personal interests of their own. Second problem of
agency is between owners possessing controlling or majority interests in firm and non
controlling or minority owners. Non controlling owners are principals & controlling owners are
the agents. Difficult is to assure that formers are not being expropriated by latter.
Third problems is related to conflicts between firms itself, specifically owners and other
parties contracting with firm like creditors, customers and employees (Ashenah and Shahverdi,
2017). Here difficulty is to assure that agent is not behaving opportunistically towards these
other principals like exploiting workers, expropriating creditors or misleading consumers.
Agency problems affect the smooth functioning as on such difficulties agents are not given the
authority of functioning and taking decisions in the best interests of company.
QUESTION 3
Investment Appraisal Techniques
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Cash Flows
Years
Annual cash
inflows
Annual
cash
outflows
less:
depreciatio
n EBIT
add:
Depreciatio
n
Net cash
inflows
1 85000 12500 41250 31250 41250 72500
2 85000 12500 41250 31250 41250 72500
3 85000 12500 41250 31250 41250 72500
4 85000 12500 41250 31250 41250 72500
5 85000 12500 41250 31250 41250 72500
6 85000 12500 41250 31250 41250 72500
i) Payback Period
The pay back period refers to the time within which the investment will be able to
recover its cost. In simple words it is duration of time that an investment will be taking t reach
over its break even point. Desirability of investment is related directly to the payback period. An
investments tends to be feasible and attractive if it allows the company to generate adequate cash
flows that could enable company in recovering its cost of investment (Kengatharan and
Prashanth Diluxshan, 2017). This is simple and easy method which is used by various businesses
before investing funds in particular project.
Asset cost 275000
Useful life in years 6
Salvage value 41250
Depreciation 38958
Initial investment -275000
Payback period
Years Cash inflows
Cumulative
CF
1 72500 72500
2 72500 145000
3 72500 217500
4 72500 290000
5 72500 362500
6 72500 435000
3
Initial
Investment 57500
10

(275000-
217500)/
72500 0.9
Payback
period 3+0.9 3.9 Years
ii) The Accounting Rate of Return
This is also used by management to identify whether the projects proposed to be adopted
by company will be able to generate adequate returns over the period. This is essential for the
business enterprise to identify whether the return rate will enable the company to recover its cost
of investments. It is financial ratio and capital budgeting technique (Ndanyenbah and Zakaria,
2019). This technique does not takes into account the time value of money concept. It calculates
the return that could be generated from the net income of proposed capital investments. ARR is
calculated in terms of percentage.
Accounting Rate of Return
Year
Cash flows (IN-
OUT) Depreciation Net cash flow
1 72500 38958 33542
2 72500 38958 33542
3 72500 38958 33542
4 72500 38958 33542
5 72500 38958 33542
6 72500 38958 33542
Average 33542
Initial investment 275000
ARR 12%
(average initial
investment [(initial
investment + scrap
value) / 2])
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iii) The Net Present Value
Net present value represents change in net worth and equity of company generated from
acceptance of project. The technique uses the time value of money for coming at the present
value of future cash flows. Project is considered viable and profitable if the NPV of project is
positive.
Net Present Value
Year
Cash flows
(IN-OUT) Depreciation
Net cash
flow
Net cash flow*(1-tax
rate)
Final cash flow
(Addition of
depreciation)
1 72500 38958 33542 27169 66127
2 72500 38958 33542 27169 66127
3 72500 38958 33542 27169 66127
4 72500 38958 33542 27169 66127
5 72500 38958 33542 27169 66127
6 72500 38958 33542 27169 66127
Sum of the
discounted cash
flows 396763
Less: Initial
investment 275000
NPV 121763
Sum of discounted
cash flows – Initial
investment
iv) The Internal Rate of Return
It is an another technique used in capital budgeting. It refers to rate of return where the
NPV of projects become zero. It is discounting cash flows technique giving the rate earned by
project. This does not consider external factors affecting the viability of the project.
Internal Rate of Return
Year Cash Flows
0 -275000
1 72500
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2 72500
3 72500
4 72500
5 72500
6 72500
IRR
((72500)/(1+0.12)^6 –
275000) 15%
(Cash flows)/ (1+r)^i –
Initial outlay
Carrying out the calculations of various techniques used in capital budgeting. Company is
proposing to purchase new machine for the business. Machine will be making the business more
efficient in achieving the goals and objectives of company. The payback period of company
shows that costs of machine will be recovered in 3.9 years. Using the machine internal rate of
return will be around 15%. Cash generated by the machine will be able to provide average return
of 26.36%. Net present value of cash values generated by the machine is 23120 which is also
positive. The techniques used by management of company shows that outcomes are positive as
the cost of investment will also be covered by company within time and internal rate of return
generated by company is not low (Bader, Al-Nawaiseh, and Nawaiseh, 2018). NPV of the
project is positive which shows that project is profitable for the company. Food manufactures
should adopt the project of purchasing new machines as the machine will help in generating
positive outcomes.
CONCLUSION
Conclusions can be drawn from the above study that financial management is playing a
critical role in ever organisation. Organisation cannot operate their business successfully without
the help of financial management. Financial management provides for the various tools and
techniques through which management can make decisions for their business. The capital
structure and cost of capital of the company have to be managed properly. The cost of capital of
the company should have an optimum mix of debt and equity so that the weighted average cost
of capital can be reduced to minimum. Viability of the investments could also be investigated by
the companies using the investment appraisal techniques. This has helped company to prevent
investments in projects that are not yielding adequate returns or not profitable for the business
13

enterprise. Therefore it could be said that financial management is helping the business in proper
management of funds and making appropriate decisions.
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REFERENCES
Books and Journals
Reyes, J.A.P., Miranda, M.R. and Vera-Martínez, J., 2019. Capital structure construct: a new
approach to behavioral finance. Investment Management & Financial Innovations. 16(4).
p.86.
Schwarz, D., 2018. The ability of listed companies to optimize their capital structure, shape their
distribution policy and fight hostile takeovers by repurchasing their own
shares. Entrepreneurship and Sustainability Issues. 6(2). pp.636-648.
Amah, K.O. and Ken-Nwachukwu, C., 2016. Capital structure composition and financial
performance of firms in the Brewery Industry: Evidence from Nigeria. Research Journal
of Finance and Accounting. 7(16). pp.7-15.
Ashenah, N. and Shahverdi, G.A., 2017. Investigating the Impact of Corporate Governance on
the Cost of Debt and Cost of Capital in Companies Listed on the Stock Exchange. Journal
of Administrative Management, Education and Training. 13(2). pp.17-24.
Hamad, A.A., Tuzlukaya, Ş. and Kırkbeşoğlu, E., 2019. The Effect of Social Capital on
Operational Performance: Research in Banking Sector in Erbil. Copernican Journal of
Finance & Accounting. 8(1). pp.101-122.
Mahmoud, O., 2016. Managerial Judgement versus Financial Techniques in Strategic Investment
Decisions: An Empirical Study on the Syrian Coastal Region Firms. International Journal
of Business, Economics and Management. 3(3). pp.31-43.
Kengatharan, L. and Prashanth Diluxshan, C., 2017. Use of Capital Investment Appraisal
Practices and Effectiveness of Investment Decisions: A Study on Listed Manufacturing
Companies in Sri Lanka. Asian Journal of Finance & Accounting. 9(2). pp.287-306.
Ndanyenbah, T.Y. and Zakaria, A., 2019. Application of Investment Appraisal Techniques by
Small and Medium Enterprises (SMEs) Operators in the Tamale Metropolis, Ghana.
Bader, A., Al-Nawaiseh, H.N. and Nawaiseh, M.E., 2018. Capital Investment Appraisal
Practices of Jordan Industrial Companies: A Survey of Current Usage. International
Research Journal of Applied Finance. 9(4). pp.146-161.
Online
Capital Structure. 2019.[Online]. Available through :
<https://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-
resources/f9/technical-articles/optimum-capital-structure.html>.
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