Corporate Finance Solved Assignment

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Corporate Finance

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Table of Contents
INTRODUCTION...........................................................................................................................3
MAIN BODY...................................................................................................................................3
1. Use two appropriate methods of calculating cost of equity of AstraZeneca...........................3
2. Calculation of cost of debt by using two appropriate methods................................................6
......................................................................................................................................................7
3. Calculate the WACC of AstraZeneca Plc by using appropriate method.................................7
CONCLUSION................................................................................................................................9
...................................................................................................................................................9
REFERENCES..............................................................................................................................10
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INTRODUCTION
Corporate finance is the part of finance where organization identify the various funding
sources. It includes the capital structure, investment decision and other financial resources which
help the corporation to deals with it (Brealey and et.al, 2012). Corporate finance majorly focuses
on maximising shareholders value with the help of long term as well as short term goals. It
would be implemented through various strategies. Corporate finance helps the organization to
identify their values with the help of various methods. It includes the various activities from
capital investments to investment banking for the for the future decision making process.
AstraZeneca selected for the better understanding of this concept. It is British multinational
pharmaceutical and biopharmaceutical company and it was founded in 1990 in the Cambridge.
Company have a combination of products for the major diseases and it includes cancer,
cardiovascular, gastrointestinal, infection etc. This report includes the various topics such as
calculation of cost of equity, cost of debt with the help of different methods. In addition,
Weighted average cost of capital (WACC) also required to calculate through collecting various
financial information from the annual report of the company.
MAIN BODY
1. Use two appropriate methods of calculating cost of equity of AstraZeneca
Cost of Equity: It is the return which required by the shareholders on their investments
and it further helps the organization to decide whether its meet with the capital return
requirements or not. Mostly organization use the capital budgeting for the requirement of rate of
returns (Damodaran, 2016). There are two types of financing will be done by the organization
such as equity and debt financing. Leveraged firms are those which use the debt financing where
business have debt finance more than equity. On the other hand, UN-leveraged firm use the
equity financing which have equity more than debt. In the UN-leverage firm, sale of new stock
will not affect the profit margin because it is distributed in the large number of shareholder. In
the leverage firm, organization fulfil their financial requirement through debt financing. It
includes the lenders, bond holders and interest. Payment of interest will reduce the net profit as
well as cash flow. There are two methods available for calculating cost of equity, first one is
dividend capitalization and another one is capital assets pricing model (CAPM).
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Preferred Method: Both methods can be applied together, as Dividend capitalisation model's
formula employs CAPM to assist in find out current values and discount future dividend.
However, CAPM is most widely and useful method. DDM is not used if funds are not dividend
issuing stocks but CAPM can by applied for any any short of funds. So CAPM is preferred in
context of Cost of Equity (CAPM Vs. DDM. 2018). Also for calculation of WACC, cost of equity
from CAPM is used.
Cost of equity by using dividend capitalization model:
Dividend capitalization model: This method used for the calculation of cost of equity
and it is based on the future dividend stream. Here, they assume the growth rate of dividend
which required for the calculation of cost of equity. It is also called dividend growth model
because it includes the growth rate of each year. Here is the formula and calculation of the cost
of equity of AstraZeneca Plc which is mentioned below:
Formula:
Cost of Equity = (Dividend per share / Current market value of stocks ) + Growth rate of
dividend
Cost of equity by using capital assets pricing model:
Capital assets pricing model: It is the model which describe the relationship between
the returns and risk related to the investments in the various securities. It represented that,
expected returns of the investments is equal to the risk free returns along with risk premium and
it is totally based on the beta of that particular security in which individual going to invest
(Ehrhardt and Brigham, 2016). There are various assumptions can be taken by the organization at
the time of calculating cost of equity with the help of CAPM model. It considers only systematic
risk because most of the investors have diversifies portfolio which generate unsystematic risk for
the organization. Some of the organization consider this model as a most effective to analyse the
risk and return of the security. It is the most usable method for calculating cost equity
(Vernimmen and et.al, 2014). In the CAPM mode, it is assumed that risk free beta will constant
for the discounting period. If organization wanted to increase risk free rate, then cost of capital
also required to increase which shows stock overvalue. Risk free rate is the kind of rate of
return on their investment which have zero risk. It represent the interest of the investors who
required to invest in the risk free security to make their investment safe. Those securities are risk
free than they provide the low rate of return and that is selected by the investor themselves. This
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is all for the theoretical understanding but in the real life risk free rate does not exist because
safest investment also involve the small value of risk. For example: Treasury bills consider as a
risk free security for the US based investors (Risk free rate, 2019). This method used for the
calculation of cost of equity and it is mentioned below:
Formula:
Cost of equity:
E ( R I ) = R ( f ) + ß [ E ( m ) – R ( f ) ]
R I = Risk – Free rate of return
ß = Beta of the stocks
E ( m ) = Market rate of return
[ E ( m ) - R ( f ) ] = Equity risk premium (Brusov, Filatova and Orekhova, 2013).
Cost of equity
1. Dividend Method
2017
Dividend per share 2.8
Market price per share 40
r (growth rate of dividend) nil
Cost of equity = [(DPS/MPS)+
r ]*100 (2.8/40) *100= 7
2. CAPM Method:
Using levered beta:
Risk free rate of
returnhttps://www.gurufocus.com/econo
mic_indicators/123/10year-treasury-
constant-maturity-rate
1.13
Market rate of return 6
Levered Beta 1.01
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Ke = Rf + (Rm – Rf) * levered beta 1.13 + (6 – 1.13) * 1.01 = 6.0487
Using unlevered beta:
Risk free rate of return 1.13
Market rate of return 6
Levered Beta 0.89
Ke = Rf + (Rm – Rf) * unlevered beta 1.13 + (6 – 1.13) * .89 =5.4643
Interpretation:
Here cost of equity is calculated by using dividend capitalisation method and CAPM
Method. Dividend per share is obtained through financial statement of company and
dividend growth rate is nil because company has dividend per share is same during year
2017, 2016 and 2015 as per annual report and financial statement of company. Dividend per
share is obtained from company's annual report and financial statement. Risk free rate is taken
10 year government bonds rate (Long-Term Government Bond Yields: 10-year, 2019).
Market rate of return is assumed on the basis of industry trends. Risk free rate is 1.13%
and for company's market rate of return is assumed at 6 % for calculation of cost of equity.
As in recent years dividend per share is constant i.e. 2.8 and company profit has been
decreased from 3406m to 2868m which indicates that in coming year company may
decrease dividend rate. In CAPM cost of equity is calculated using levered and un-levered beta.
As per given task cost of equity is required to be calculated by two methods so both un levered
and levered beta is used to calculate of equity. Levered beta is used in case both debt and equity
is considered whereas un levered beta is used if only equity is considered.
2. Calculation of cost of debt by using two appropriate methods:
Cost of Debt: It is the return which provided by the company to its debt holders and
other creditors. Interest rate plays important role in this calculation otherwise it is straight
forward methods to calculate cost of debt. It is very simple to calculate in comparison to the cost
of equity. With the help of this, organization also identify the default risk and the level of interest
rate available in the market (Fracassi, 2016). With the help of this, organization evaluate the risk
which is associated with the cost or it can reduce the returns of the securities. Cost of debt have
significance importance such as, it maximises the value of firm, helps in taking capital budgeting
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decision. In addition, it helps the manager to take decision regarding leasing and effectively
management the working capital. Along with this, cost of debt helps in taking decision regarding
dividend distribution. In the leverage firm, fixed income securities and preferred stock used in
the capital structure of the company. Financial levered firm has value because of interest tax
shield which is very afforded as per the corporate law of income tax. Value of leverage will be
increased due to purchase of assets where debt capital earning is more than cost of the debt. Both
the cases, financial leverage increase the profitability of the business.
Leverage used as funding source where organization plan to invest for the expansion of
business assets and generate more returns on risky capital. As firm increase the financing
through equity which automatically increase the risk and affect the organization. So it will affect
the company in order to increase debt financing which helps the organization to make more
leverage firm. Following are the methods for calculation of cost of debts:
1. Estimated actual cost of debt:
In this method, it is assumed that future or estimated cost of debt approx remains
same or equal to actual cost of debt during recent previous period. Under this method
obtain amount of interest paid in last accounting period through annual statement of
company and divide that by average debt:
Actual interest paid during last financial year: $ 454 millions
Average debt outstanding during the year: ($14501 + $15560)/ 2 = $15030.5 millions
Cost of Debt = 454 /15030.5 *100 = 3.0205 %
2. Credit risk premium approach:
In this method, risk-free rate which is equal to that rate of government bonds
equivalent to organisation's average debt fund maturity plus premium in respect of
estimated risk of credits. Such premium can be computed from organisation’s bond issues.
RF + credit risk premium = 1.13 + 3.8 = 4.93 %
Preferred Method: Estimated actual cost of debt is applied and simple method. In credit
risk premium approach, use of estimated risk of credit makes this approach more complex
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and some times an inappropriate figure of risk of credit can lead to inaccuracy in WACC's
outcomes. So here Estimated actual cost of debt is used in calculation of WACC.
3. Calculate the WACC of AstraZeneca Plc by using appropriate method
Weighted Average Cost of Capital (WACC): It is required for the calculation of cost of
capital which include the weighted proportion of all the categories (Gullifer and Payne, 2015).
WACC calculation includes the various sources such as bonds, preferred stock, common stocks,
capital and long term debt. Value of WACC will be increased when beta or rate of returns on
equity also increased. There is an opposite relation between the WACC and valuation of of firm.
Another relation between the WAAC and risk which increases along with each others.
Methodology for calculating WACC:
Firstly, identify the market value of equity which is denoted from E.
After that, identify the market value of debt which denoted through D.
Calculate the cost of equity and cost of debt both required for the calculation Weighted
Average Cost of Capital (WACC).
After all the calculations, it required interpretation for the better understanding of other.
Interpretation depends upon the returns of the company which will be analyse at the end
of the financial period. If returns are goods then investor happily invest in the company or if
organization not generate the profit then it forces the investors to think twice (Hillier and et.al.,
2014). At the time of calculating WACC, it is important to know that all the calculation can be
done of book value or in market value.
Formula:
WACC = E / V * R e + D / V * R d * ( 1 - T )
R e = Cost of equity
R d = Cost of debt
E = Equity's market value
D = Market of value of Debt
V = E + D, Total market value of the organization
E / V = Percentage of equity
D / V = Percentage of debt
T = Tax rate
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WACC = E / (E + D) *
Cost of
Equity + D / (E + D) * Cost of Debt * (1-t)
=
61614.343/
(61614.343
+15560) * 6.05 +
15560/
(61614.343
+15560) * 3.02% * (1-.30)
0.798378
58807557
3
* 6.05 +
0.2016214
* 3.02% * 0.7
WACC = 5.256417565
*E =1266221605 shares x 48.66 (Market Price*) = 61614.343
Here, Market rate of share of AstraZenec is as on 31/03/2018 (London Stock Exchange, 2019).
Interpretation:
For calculation of weighted average cost of capital, cost of equity calculated using CAPM
method (considered levered beta) is used. Because AstraZenec have both equity and debt funds.
Cost of debt post tax is considered in calculation (Tricker and Tricker, 2015). In all three year
amount of equity and debt is obtained from company's annual report. Company has WACC of
5.30%. WACC indicates the minimum or optimum rate of return at which a business
organisation or company provides value for its various investors. From above calculation it has
been analysed company's WACC is increased which indicates that overall valuation of company
is decrease and risk is increased. With the help of WACC, business identify the value of firm
which further helps the manager to take their decision in order to implement their strategies.
CONCLUSION
From the above discussion, it has been concluded that organization required funding from
various sources which helps in generating more products and increase the profit margin. With the
help of various methods, organization calculate the cost of capital which include the various
elements too. Cost of equity, cost of debt and WACC calculate for the valuation of firm because
it further helps the manager to analyse their financial position. It is also required at the time of
developing stargates and taking effective decision in respect of the company which helps in
achieving business goals & targets. Cost of capital include the various assumptions such as no
change in the capital structure and no change in the risk due to new project.
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