1CORPORATE FINANCE Table of Contents Introduction......................................................................................................................................2 Discussion........................................................................................................................................2 Cost of Equity..............................................................................................................................2 Cost of Debt.................................................................................................................................3 Weighted Average Cost of Capital..............................................................................................4 Appropriate Discount Rate..........................................................................................................5 Conclusion.......................................................................................................................................6 References........................................................................................................................................8
2CORPORATE FINANCE Introduction Capital Structure of a company plays a crucial role while deciding upon the level of finance and the cost associated with each of the financing sources. It is important that companies maintain an optimal capital structure whereby an optimal mix of debt, equity and other financing sources are proportionately applied in the overall financing structure of the company (Brusov et al., 2018). It is important that the business risk and financial risk of the company are well analysed before deciding upon the optimum level of debt that the company would be taking in the overall capital structure of the company (Callen 2016). Discussion Cost of Equity The cost of equity for the stock was calculated with the help of the Capital Asset Pricing Model where the required rate of return formula applied for the computation of the same was as follows: CAPM, Ke = Rf + (Rm – Rf) β Where; Ke: Cost of Equity Rf: Risk Free Rate Rm: Return on Market B: Beta It is important to consider both geared and ungeared beta for the purpose of relevant exposure of equity and asset beta of a company. Alteration in the Capital Structure of a company can significantly affect the profitability or the net income of the company. It is important the
3CORPORATE FINANCE weight and level of equity as compared to the level of debt remains constant (Hirth and Steckel 2016). The weight of equity in the company was determined at different level so that the associated cost of equity remains at a substantial rate. The geared equity was also calculated for the calculation part, which was determined by taking the geared equity position and the respective weight of the equity and debt position in the financials of the company (Schleich et al., 2016). The cost of equity for the company would change as the level of debt financing undertaken by the company increases from a certain level. The increase in the cost of equity increases as the level of debt increases and the reason behind such increase is due to the higher risk associated with the financing. The rise in the cost of equity is comparatively less than the rise in the cost of debt for the company (GarcÃa-Gusano et al., 2016). % Debt (Debt / (Debt + Equity)) Post Tax Cost of Debt Cost of EquityWACC 10%4.55%13.33%12.45% 20%4.97%13.99%12.19% 30%5.46%14.84%12.03% 40%5.95%15.97%11.96% 50%7.00%17.56%12.28% 60%8.40%19.94%13.02% 70%10.50%23.91%14.52% Cost of Debt The cost of debt for the company can be calculated with the help of the different level of interest rate that is charged by the lender depending upon the credit risk of the borrower. The cost of debt for the company will differ significantly as the weight of debt changes in the total capital structure of the company (Johnstone 2016). The credit rating for the company would vary as the level of debt changes. The credit rating for the company would decline from AAA to C if the level of debt changes from 10% to 70%. The pre-tax cost of debt for the company is given
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4CORPORATE FINANCE whereby the applicable tax rate would be taken into consideration for the purpose of evaluation of the post-tax cost of debt. Debt financing helps the company enjoy the lower cost of financing as well as the tax-deductible interest expenses that is paid by the company (Sweeney 2018). Weighted Average Cost of Capital The optimal cost of capital for the company would be derived with the help of the optimal weights of debt and equity that results in the total lower of cost of capital for the company. The optimal weights that would result in the lowest possible cost of capital would be a combination of 60% equity and 40% debt, which would result in the WACC of about 11.96%. It is essential that the optimal weight of debt and equity to be kept at an optimal rate so that the same minimizes the financial risk of the company (Ondraczek, Komendantova and Patt, 2015). The WACC for the company should be at a minimal rate so that the cost of financing is comparatively lower for the company and in line as per the industry average. % Debt (Debt / (Debt + Equity))Rating Pre-tax cost of debt Post Tax Cost of Debt % Equity (Equity/Equit y +Debt) Geared Beta Tax Rate Ungeared Beta Cost of EquityRf Market ReturnWACC 10%AAA6.50%4.55%90%0.9230%0.8513.33% 6 %14.0% 12.45 % 20%AA7.10%4.97%80%1.0030%0.8513.99% 6 %14.0% 12.19 % 30%A7.80%5.46%70%1.1130%0.8514.84% 6 %14.0% 12.03 % 40%BBB8.50%5.95%60%1.2530%0.8515.97% 6 %14.0% 11.96 % 50%BB10%7.00%50%1.4530%0.8517.56% 6 %14.0% 12.28 % 60%B12%8.40%40%1.7430%0.8519.94% 6 %14.0% 13.02 % 70%C15%10.50%30%2.2430%0.8523.91% 6 %14.0% 14.52 % The above capital structure of the company with a weight of 40% equity and 60% debt should be an optimal one. Yes the company should adopt the above capital structure as the
5CORPORATE FINANCE optimal capital structure as it would give the company with a exposure of lower cost tax deductible finance and lower risk financing of equity. However, there are several other factors and consideration that the company should consider while evaluating the proposed capital structure by analysing the business risk or the variability in the operations of the company. The changes in the financial position of the company is also one of the key factor that should be evaluated while considering the optimal capital structure of the company. Both the sources of financing have their own advantages and disadvantages while considering from a single point however mixing them in an optimal basis can lower down the actual cost of capital for the company. Appropriate Discount Rate The appropriate discount rate that should be taken into consideration is the selection of the debt and equity at a proportionate rate so that the cost of capital (Kc) of the firm stays at an optimal rate. The appropriate discount rate shows the minimum required rate of return for the company on a pre-tax EBIT. In this scenario, the net income would not be considered as the debt financing also plays an important role in the capital structure of the company (Frank and Shen 2016). Cost of Debt:The cost of debt for the company would be calculated with the help of the YTM generated by the bond and the same would be determined. The determination of the YTM would be done by taking the face value of the bond as £100, CMP as £103, debenture rate as 7% that will be the coupon rate payable on a semi-annual basis. The weight of debt for the company would be determined with the help of the overall value of debt divided by total capital. The above factors that were taken into consideration gave a cost of debt for the company as 3.36%.
6CORPORATE FINANCE Cost of Equity:The cost of equity for the company would be calculated with the help of the CAPM model. Factors that would be taken into consideration is the risk free rate of6%, market risk premium of 8% andequity beta of 1.1 times. The cost of equity for the company came to around 14.8% for the company. Cost of Capital:Given, the weights and proportions of each of the financing sources the weights for each of the financing source would be determined. The cost of capital for the company says about the total required rate of return required by the capital holders of the company for taking the level of risk associated with financing. The appropriate discount rate that should be applied for the purpose of evaluation of new project is 11.28% and the same is determined as follows: Discount Rate Evaluation Cost of Debt 30.77 % Cost of Equity 69.23 % Cost of Debt:3.36% Cost of Equity: 14.80 % Discount Rate: 11.28 % However, there are several other factors and consideration that the company should consider while evaluating the proposed discount rate by analysing the business risk or the variability in the operations of the project. The changes in the financial position of the company is also one of the key factor that should be evaluated while considering the optimal capital structure of the company.
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7CORPORATE FINANCE Conclusion Optimal Capital structure and discount rate for evaluating a new project were the two main concepts developed and discussed in the assignment. The optimal cost of capital for the company was derived with the help of the optimal weights of debt and equity that resulted in the total lower of cost of capital for the company. The optimal weights that would result in the lowest possible cost of capital would be a different combinations that were tried for computing the cost of capital. The appropriate discount rate that should be taken into consideration is the selection of the debt and equity at a proportionate rate so that the cost of capital (Kc) of the firm stays at an optimal rateand the project of a company could be evaluated well.
8CORPORATE FINANCE References Brusov, P., Filatova, T., Orekhova, N. and Eskindarov, M., 2018. New meaningful effects in modern capital structure theory. InModern Corporate Finance, Investments, Taxation and Ratings(pp. 537-568). Springer, Cham. Callen, J.L., 2016. Accounting valuation and cost of equity capital dynamics.Abacus,52(1), pp.5-25. Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital.Journal of Financial Economics,119(2), pp.300-315. GarcÃa-Gusano, D., Espegren, K., Lind, A. and Kirkengen, M., 2016. The role of the discount rates in energy systems optimisation models.Renewable and Sustainable Energy Reviews,59, pp.56-72. Hirth, L. and Steckel, J.C., 2016. The role of capital costs in decarbonizing the electricity sector. Environmental Research Letters,11(11), p.114010. Jagannathan, R., Matsa, D.A., Meier, I. and Tarhan, V., 2016. Why do firms use high discount rates?.Journal of Financial Economics,120(3), pp.445-463. Johnstone,D.,2016.Theeffectofinformationonuncertaintyandthecostofcapital. Contemporary Accounting Research,33(2), pp.752-774. Krüger, P., Landier, A. and Thesmar, D., 2015. The WACC fallacy: The real effects of using a unique discount rate.The Journal of Finance,70(3), pp.1253-1285. Ondraczek, J., Komendantova, N. and Patt, A., 2015. WACC the dog: The effect of financing costs on the levelized cost of solar PV power.Renewable Energy,75, pp.888-898. Schleich, J., Gassmann, X., Faure, C. and Meissner, T., 2016. Making the implicit explicit: A look inside the implicit discount rate.Energy Policy,97, pp.321-331.
9CORPORATE FINANCE Sweeney, R.J., 2018. The Information Costs of Capital Controls. InCapital Controls in Emerging Economies(pp. 45-61). Routledge.