Financial Management: Computation of Cost of Capital and Investment Appraisal Techniques

Financial
Management

Table of Contents
INTRODUCTION...........................................................................................................................1
QUESTION 1...................................................................................................................................1
a. Computation of market and book value cost of capital............................................................1
b. Recalculation of cost of capital of company............................................................................4
c. Discussion on minimisation of weighted average cost of capital by integrating the sensible
level of gearing in to the capital structure....................................................................................5
d. Effects of short-termism on agency problem and bankruptcy.................................................5
QUESTION 3...................................................................................................................................6
a. Calculation of different investment appraisal techniques such as pay back period, ARR,
NPV and IRR...............................................................................................................................6
b. Limitations and benefits of different investment appraisal techniques.................................10
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Financial management is the process of taking control over all the finance related
activities which are performed by an organisations for the purpose of achieving predetermined
business objectives. It is mainly focused with application of management principles to all the
monetary sources of entity. With the help of it, future requirements of funds for operations could
be determined (Antonopoulos and Hall, 2018). In order to make sure that all the procedures
related to it performed systematically it is very important for managers to analyse final accounts
appropriately so that judgements for future could be passed. For the completion of this report
questions one and three are selected. This assignment will cover various topics such as
calculation of market and book value of WACC, proposed changes in capital structure of
organisation and effect of short termism on bankruptcy and agency problem. Apart from this,
calculations with the help of different investment appraisal techniques along with their
advantages and disadvantages are also done in this project.
QUESTION 1
a. Computation of market and book value cost of capital
In all the organisations all the debts and equities are kept in a systematic manner which is
known as capital structure. In order to achieve all the objectives such as higher profitability,
large number of investors etc. it is very important for companies to make sure that they are
managing their securities appropriately (Baños-Caballero, García-Teruel and Martínez-Solano,
2016). While analysing it cost of capital is used to determine cost of all the equities, bonds, debts
etc. By analysing the financial statements the finance director of Kadlex Plc have assessed that
weighted average cost of capital of company is low. It is very important for the company to
improve it for this purpose the director have planned to issue new bonds in the market. The
impact of issuing them could be analysed with the help of below calculations:
For year 1 to 5 the growth are 21, 23, 25, 27 and 28 individually.
Calculation of growth=
Formula= Sn=S0*(1+g)n
28=21*(1+g)4
28/21=(1+g)4
1.33=(1+g)4
1

(1.33)0.25= (1+g)
g=1–1.0757
=0.0757 or 7.57%
(Here, g =growth, S0 =First dividend, n =number of years, Sn =Last dividend)
Computation of rate of growth for all the stocks is as follows:
Cost of irredeemable bonds:
Formula= Kd=[j*(1–CT)]*(Po/Pn)
Kd =[0.10*(1–0.30)]*(100/107)
=0.0654 or 6.54%
(Here, P0 =Initial Price, CT =Rate of Corporate tax rate, Kd =Cost of Irredeemable Bonds,
Pn =Current Price, j =Rate of interest on bonds)
Cost of equities:
Formula= Ke =[Sn*(1+g)+g ])/P0
Ke =[28*(1+0.075)+0.075]/2.65
=(28*1.15)/2.65
=12.15%
(Here, Sn =First dividend, P0 =Current share price of equity shares excluding dividend, Ke
=Cost of Equity, g =Growth rate, )
Cost of preference share:
Formula= Kp=(j)/Pf
= 7/75
= 0.0933 or 9.33%
(Here, Pf =Current price of preference share excluding dividend, j =Dividend on
preference shares, Kp =Total cost of Preference Shares)
Computation of weighted average cost of capital for market and book value is as follows:
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