Financial Management: Calculation of Cost of Capital, Valuation Techniques and Relationship between WACC and IRR

This report covers different set of question which comprises of financial management question. Out of the three question two question has been addressed in this report which are related to calculation of book value and market value debts for the current and revised capital structure of the entity. The another set of question is related to different valuation techniques that has been used by Kings plc to evaluate the valuation of the entity.

MANGEMENT

Contents
INTRODUCTION...........................................................................................................................2
MAIN BODY...................................................................................................................................2
Question No 1:.................................................................................................................................2
A) Calculation of Book value and market value cost of capital for Trust Plc:......................2
B) Recalculation of cost of capital of the company and making comments to projection of the
finance director:......................................................................................................................5
C) Critical discussion on whether by introduction of gearing the overall cost of capital has
been reduced to an acceptable level:......................................................................................6
D) Evaluation of relationship between WACC and IRR with respect to the investment.
Relationship between WACC and IRR:.................................................................................7
Question no 3:..................................................................................................................................8
A) Price earnings ratio model for valuation:..........................................................................8
B) Discounted cash flow method:..........................................................................................9
C)Dividend valuation method:...............................................................................................9
D) Problems associated with usage of the above techniques along with recommendation that
which technique is viable along with justification to board of Kings Plc:...........................10
CONCLUSION..............................................................................................................................11
REFERENCES..............................................................................................................................12
1

INTRODUCTION
Financial management is a technique used in various organisation that help the financial
activities carried during the financial year. Financial management provides a systematic
approach to carry the transaction in such a way that effectiveness and efficiency will get
enhanced. It is combined part of various function such as preparation, classification, guiding and
monitoring the financial transaction takes place with the corporate. This report covers different
set of question which comprises of financial management question. Out of the three question two
question has been addressed in this report which are related to calculation of book value and
market value debts for the current and revised capital structure of the entity. The another set of
question is related to different valuation techniques that has been used by Kings plc to evaluate
the valuation of the entity. Such models which are used herein are Dividend growth model, Price
earnings ratio method, discounted cash flow method. At the end of this report the suggestion
have been given to the management that which models is best suited for the amongst the various
model they have applied.
MAIN BODY
Question No 1:
A) Calculation of Book value and market value cost of capital for Trust Plc:
It shows that the amount of money company invests in some assets in order to get return by using
of that particular machinery is called as cost of capital. For example: If a person invests some
money for installing a new machinery in their business for achieving the target goals in the
organization then the cost included in the machinery is cost of capital and against this company
wants some returns to justify its cost.
WACC represents the average cost of capital for the company which company pay to his
shareholders or bondholders. Basically in weighted average cost of capital if company needs
funds to invest in their business for its expansion then company issue common stock or bonds for
the peoples so, they buy them and invest money in the company and against this firm provide
some expected returns to their investors. For Example: if a company needs funds then they issue
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some stocks in public then the firm make a bundle of average cost of capital and provide some
expected returns to the investors of the company.
Book value of WACC: It represents the amount of balance of an assets available in the firm’s
balance sheet. Basically it shows the assets value based on the firm’s balance sheet in which
company can formulate its asset value which were present in balance sheet of the company. The
balance is complete presentation of the financial balances of the business which represents the
financial position of the company.
Market value of WACC: If company calculate its anticipated cost of capital then the weighted
average cost of capital formulate on the basis of market values of the various elements not in
their book value. Market value is the rate at which an asset would export and import on the basis
of the highest auction value among the various competitors. Market value is same as market
price. Market value also needed the component of special figures, it means that they available
between the two participants in which they create the fair price of the higher transactions.
 Calculation of book value weighted average cost of capital:
In order to calculate the WACC the following figures needs to be addressed:
(£000)
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
30000 .50 24 % 12 %
Preference
Share Capital
10000 .17 7 % 1.19 %
Reserves and
surplus
5000 .08 24 % 1.92 %
Bonds 15000 .25 10 % 2.50 %
Total 60000 1.00
WACC 17.61%
Working Notes: -
 The cost of preference shares = 7 %
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 The cost of bonds = 10 5
 The cost of Reserves and surplus will be equal to the cost of Equity
 The cost of equity will be calculated as under: -
It will be calculated by using the gordens growth model formula: -
Ke = D1 / P0 + G
Here growth rate is calculated as under
Growth rate
= (.31 / .23) .20
= .42 or 42 %
Now the expected dividend will be:
D1
= D0 + Growth Rate
= .31 + 42 %
= .44 p
Cost of Equity will be: -
= .44 / 2.56 + 42 %
= 24 %
 Calculation of market value weighted average cost of capital:
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
76800 .73 24 % 17.52 %
Preference
Share Capital
7500 .07 7 % .49 %
Reserves and
surplus
5000 .05 24 % 1.2 %
Bonds 16050 .15 10 % 1.50 %
Total 105350 1.00
WACC 20.71 %
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B) Recalculation of cost of capital of the company and making comments to projection of the
finance director:
The Finance director of the entity that Ms Zara Green is in favour to increase the debt in
the organisation so that the overall cost of capital can be reduced. They are proposing to
raise £16m by issuing the 12 % redeemable bonds. These bonds are issue at the
premium of 5 % and they are redeemed after the 7 years.
The cost of these bonds will be calculated as follows:
The formula of calculating the bonds
= {Interest (1 – tax rate) + (Redeemable Value – Net Proceeds) / N} / (Redeemable Value
+ Net Proceeds / 2) * 100
= {1.92 (1 - .30) + (16.80 – 16) 7} / (16.80+16 / 2) * 100
= (1.34 + .1143) / 16.40 * 100
= 8.87 %
From such funds so raise they want to repurchase the share of the company @ 2.95 per
share and expect that the growth rate will be 15 %. They think that price of the bonds
will remain the same but price of preference share will fall to .68p
The revised weighted average cost of capital considering the above adjustment has
been calculated as under: -
Revised cost of Capital:
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
88500 .67 23.12 % 15.49 %
Preference
Share Capital
6800 .05 7 % .35 %
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Reserves and
surplus
5000 .04 23.12 % .92 %
Bonds
Irredeemable
15000 .11 10 % 1.10 %
Bonds
Redeemable
16000 .13 8.87 % 1.15 %
Total 131300 1.00 WACC 19.01 %
Working Notes: -
The cost of equity will be calculated as under: -
It will be calculated by using the gordens growth model formula: -
Ke = D1 / P0 + G
Revised Growth rate
= 42 % + 15 %
= 48.30 %
Now the expected dividend will be:
D1
= D0 + Growth Rate
= .31 + 48.30 %
= .46 p
Cost of Equity will be: -
= .46 / 2.95 + 48.30 %
= 23. 12 %
The cost of preference share remains the same that is 7 %
C) Critical discussion on whether by introduction of gearing the overall cost of capital has been
reduced to an acceptable level:
When an organisation introduced more debt in their capital structure then the overall cost
of capital of the organisation has been reduced by 1.70 % and their revised weighted
average cost of capital will be 19.01 %. When the fixed rate cost of capital is higher in
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the organisation then the entity has to pay the fixed rate of interest and their expectation
is also restricted to interest they want to earn. Whereas when an entity is geared by more
equity in their capital structure then it that case the entity has to pay the higher amount to
fulfil the need of shareholder’s expectation as they taking the risk when they invest in a
particular organisation. In the given case when Faith Plc change their capital structure by
adding on more redeemable debt in their capital structure the overall cost of them has
been curtailed down because the risk that is taken by equity has been shifted to
debtholders.
D) Evaluation of relationship between WACC and IRR with respect to the investment.
Relationship between WACC and IRR:
Meaning of WACC (Weighted average cost of capital)
It represents the bunch of average cost of capital to pay the returns of the company stakeholders
or bondholders. Basically On the other hand it can be say that company issue stocks and bonds
when they need funds in their business for the growth. After issuing the stocks public buy that
stocks of the company and hold that stocks or bonds for the long time. So, they get good returns
in invested stocks.
Meaning of IRR (Internal rate of return)
This method is used to review the financial statement of the company to check the profitable
situation of the business. So, basically it helps the investor to invest in the company for the long
period of time. In other terms it can also say that the internal rate of return creates the sum of all
inflows and outflows becomes zero. Here is the formula to calculate internal rate of return:
IRR = CF / (1 + r) ^i
Now let’s discuss about the relationship between the WACC and IRR.
1. The first relation between the weighted average cost of capital and internal rate of return
is IRR = WACC it shows that the investment in financial projects consider the
expectation of market participation and the buying value is same as the fair value of
obtain firm.
2. The second relation between them is internal rate of return is greater that the weighted
average cost of capital IRR> WACC. Basically it shows the investment in financial
projects involves synergy of specific buyer or the projected investment is so positive then
the purchase was created at bargain value.
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3. The third relation between them is if weighted average cost of capital is more than the
internal rate of return IRR<WACC then it shows that the investment in financial projects
is out from all the expectations of market competitors synergy or the projected
investment becomes too protective then the buyer more pays for the targets.
This relationship between the weighted average cost of capital and internal rate of return
shows about which method is more convenient to use so, it is concluded that the weighted
average cost of capital is best to use as compare to the internal rate of return because in
Weighted average cost of capital company provide returns according to the investment of
the investor and its easies to calculate but in internal rate of return it forecast the
profitability of the business for the potential investors.
Question no 3:
A) Price earnings ratio model for valuation:
This ratio is one of the most appropriate method to calculate the security of the company
through the formulation of price earnings ratio. It represents the firm actual share price
how much relative to its earning per share (EPS). This ratio also helps to analyse the
expansion capacity of the business. If P/E ratio is high, then its indicate the positive
future income of the firm and the investors are able to pay high but it also shows the
stocks are exceeded.
Price earnings ratio model used the following formula to conduct the valuation
= MPS / EPS
= 4.25 / .31
= 13.71.
Here the value of the Dragon plc has been arrived on the basis of competitor data that is
Kings Plc by using the below formula
= Earnings per share of competitors * PE ratio of the company
= 40.40 / 210 * 13.71
= .19 * 13.71
2.605
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B) Discounted cash flow method:
This method shows to identify the rate of investment today and on the basis of project its
need to find out how much money it will create in future. Basically discounted cash flow
method is depending upon the time value of money and helps to formulate the how much
value a company invest in some asset and at which time it will create a future cash flows
of the company. For Example: If a company invest $1000 in some asset then what will
the value of $1000 after 1 year. Here is one formula to measure Discounted cash flow:
DCF = Cash flow / (1+r) ^t
This model used the following formula to calculate the values
= After tax annual profits / Cost of Capital
= (5.36 / 11 %)
= 48.73
C)Dividend valuation method:
This method is helps to forecast the value of company's stocks and bonds this is also
known quantitative method. It’s truly depends on the expectation that the current value of
stock is sum total of the firm’s future dividends. In this method there are three types of
dividend discounted model:
 Constant rate of growth model: This method is one of the most commonly used
method. It is introducing by American economist Myron j. Gordon it helps to find
the intrinsic value of the stock. Here is the formula to calculate:
 V0 = D1 / r-g
 Dividend one- year discounted model: This model is less capable as compare to
the Gordon Growth model. It helps to identify the intrinsic value of the stocks
when he/she sell stock in a period of one year. Formula to calculate one period
model:
 V0 = (D1 / 1+ r) + (P1 / 1+r)
 Dividend numerous discounted model: This method is more capable as compare
to one- period discounted model. It helps to hold the stock for so many years. But
the main factor for this model is to predict dividend payment for every year is
required. Formula to calculate this model:
 V0 = (D1 / 1+ r) ^1+ (D2 / 1+r) ^2+....Den / (1+r) ^n
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In this model the formula which has been used will be
P0 = D1 / Ke – G
Here D1 is expected dividend per share, ke is cost of equity capital, and G stands for
growth rate
Valuation of Dragon Plc has been made as under:
= No of shares * MPS
= 210 * 3.33
= Pound 699.33
Working Notes: -
 Cost of Equity has been calculated using the Capital Asset pricing model whose
formula is:
Ke = Rf + B (Rm – Rf)
= 5.50 + 1.05 (11 – 5.50)
= 5.55 + .58
= 6.13 %
 The Expected dividend per share has been calculated as under: -
= (Last Dividend Paid + Growth Rate)
= 12 +2.50 %
= 12.30p
D) Problems associated with usage of the above techniques along with recommendation that
which technique is viable along with justification to board of Kings Plc:
Problems associated with the models has been listed below: -
 Price earnings ratio method: The main problem associated with this method is that it does
not account for the growth rate. Further many entities have debt related issues that are
high in number but this model considers only the equity share price of the enterprise and
not the debt hold by the organisation. Further the results derived from this model is
sometimes misleading as the entity report positive earning but in actual they have
negative cash flows.
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 Discounted cash flow method: The major drawback of this method is that it is easily
prone to errors, having wrong assumptions, overconfidence towards the net worth of the
organisation. The major drawback with this system is that it does not consider time value
of money and not only this it also ignores the depreciation. In order to apply this method
on a particular investment appraisal a lot of assumption has to be taken with which makes
the result not fruitful. Further this method is over complex and very sensitive to changes
in assumptions depending the case under consideration.
 Dividend valuation method: This method is very simple which does not provide accurate
justification to the results obtained thereunder. Further this method works only on those
shares which are regularly paying the dividend to its shareholders. There are some other
non-monetary factors too that affect the valuation of the entity such as customer
retention, loyalty towards brand etc. This model only values payment in the form of
dividend as the return on investment. This model is also very sensitive to the quality of
information involved because if the information is not correct then valuation will differ
completely.
Recommendation on which techniques must be followed by Kings Plc:
It is recommended to kings Plc is that to use dividend valuation method as their capital structure
cover both equity and debt and they are readily paying the dividend to its holders of security.
Therefore, from the above method they must consider dividend model to make valuation of their
company.
CONCLUSION
The above report consists of two different set of question relating to financial management that
has been addressed accordingly. The first question deals with capital structure of the organisation
which consist of equity, debt and reserves and surplus. Them after the weighted average cost of
capital has been calculated using book value and market value debts. In the next question the
valuation of Kings plc has been made using different models such as price earnings ratio method,
discounted cash flow method, dividend valuation method and recommendation has been made to
them that which models they must follow to carry out their valuation.
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