Financial Management: Cost of Capital, Capital Structure, and Investment Appraisal Techniques

This report provides practical solutions related to issues of cost of capital and investment appraisal including theoretical analysis of the same in response to the given company. It covers topics such as calculation of book value and market value cost of capital, recalculation of company’s cost of capital to reflect certain changes, and different investment appraisal techniques.

Management

Contents
INTRODUCTION...........................................................................................................................3
Question 1. Cost of capital and Capital structure............................................................................3
Calculation of book value and market value cost of capital........................................................3
Recalculation of company’s cost of capital to reflect certain changes........................................5
Critically discuss the ability of the business to minimize their WACC......................................6
Discuss the relationship between WACC and IRR and also discuss the impact of the agency
problem on Trust PLC's ability to make a viable investment......................................................6
Question 2. Investment Appraisal Techniques................................................................................7
Calculation of Different Investment Appraisal Techniques........................................................7
Critical evaluation of the effects of new proposal by the financial director..............................10
Advantages and Disadvantages of different investment appraisal techniques..........................10
CONCLUSION..............................................................................................................................13
REFERENCES..............................................................................................................................14

INTRODUCTION
Management is an action that is carried out with a certain goal in mind. It is anything that
focuses a group's efforts toward achieving pre-determined objectives. It is the process of
collaborating with and through others to achieve the organization's objectives while maximising
the use of limited resources in an ever-changing reality. Of course, these objectives may differ
from one company to the next (Martin, Keown, and Titman, 2020). Financial management is a
branch of management which focuses on managing the financial funds that are provided to the
business. it is a broad concept which provides insight to the business about how much funds are
required, from where they can attain these funds and how much they need to pay in return of
these funds acquired. The following report consists of practical solutions related to issues of cost
of capital and investment appraisal including theoretical analysis of the same in response to the
given company.
Question 1. Cost of capital and Capital structure
Calculation of book value and market value cost of capital
The cost of capital is the amount of money that a corporation invests in an asset or a project in
order to receive a favourable return. Consider the following scenario: A business owner
purchases paint mixing gear to produce colours and receives a decent return on his investment
(Mitchell, and Calabrese, 2019). So, in this case, cost justification is critical since the aim is to
generate a decent return on investment.
The cost of capital that a corporation must pay to its shareholders is known as the weighted
average cost of capital. Simply said, if a corporation wants to invest in its business, it will need
finances to do so. The proprietor of such business can then offer stocks and bonds to the general
public in order to attract investment capital. The money is then utilised by the company to make
investments.
The book value of WACC represents the worth of the assets that are available to the
company. This asset balance is shown on the company's balance sheet.
WACC market value- If a company analyses its expected cost of capital, it uses the weighted
average cost of capital approach, which is based on a number of market values. The rate at which
assets are meant to be exported and imported on the basis of high mortgage value between
various rivals is referred to as market value (Brigham, and Daves, 2021). The constituents of

special numbers are required for such values. The value of kind is accessible between the two
parties participating in an auction, and it tends to drive up transaction prices.
The following factors are meant to be evaluated for WACC purposes:
Particular Amount Weights Cost of capital WACC
Equity share capital 30000 0.5 24.00% 12.00%
Preference share
capital
10000 0.17 7.00% 1.19%
Reserves and
surplus
5000 0.8 (£000) 24.00% 1.92%
Bonds 15000 0.25 10.00% 2.50%
Total 60000 1
WACC 17.61%
Working note-
 The cost of preference shares = 7%
 Cost of bonds= 105
 Cost of reserves and surplus is equal to the cost of equity.
Calculation of market value weighted average cost of capital:
Particular Amount Weights Cost of capital WACC
Equity share capital 76800 0.73 24.00% 17.52%
Preference share
capital
7500 0.07 7.00% 0.49%
Reserves and
surplus
5000 0.05 24.00% 1.20%
Bonds 16050 0.15 10.00% 1.50%
Total 105350 1
WACC 20.71%

Recalculation of company’s cost of capital to reflect certain changes
Ms. Zara Green, the organization's finance director, wants to raise the company's debt in order to
lower its cost of capital. The company is proposing to raise £16 million by selling 12 percent
redeemable bonds (Plaskova, Prodanova, and Reshetov, 2020). The redeemable bonds are sold at
a 5% premium and can be redeemed after a period of seven years.
The formula mentioned below can be used to calculate bonds:
= {Interest (1- tax rate) + (Redeemable value – Net proceeds) / N } / {Redeemable value + Net
Proceeds / 2) * 100
= {1.92 (1 – 0.30) + (16.80 – 16) / 7} / (16.80 + 16 / 2 ) * 100
= ( 1.34 + .1143) / 16.40 * 100
= 8.87%
Revised Cost of capital:
Particulars Amount Weights Cost Of capital WACC
Equity share
capital
88500 0.67 23.12% 15.49%
Preference
share capital
6800 0.05 7.00% 0.35%
Reserves and
surplus
5000 0.04 23.12% 0.92%
Irredeemable
bonds
15000 0.11 10.00% 1.10%
Redeemable
bonds
16000 0.13 8.87% 1.15%
Total 131300 1 WACC 19.01%

Critically discuss the ability of the business to minimize their WACC
When a company offers additional debt, the overall cost of capital falls by 1.70 percent, resulting
in a WACC of 19.01 percent. The company must pay the predetermined amount of interest if the
fixed rate cost of capital is greater (Arnold, and Lewis, 2019). When a corporate entity has
greater equity in its capital system, it is also required to pay a bigger amount in order to meet the
demands and expectations of its shareholders, who invest in the company in order to earn a
profit. In this scenario, Faith Plc introduces a variation in their capital structure by transferring
the ad to redeemable debt.
Discuss the relationship between WACC and IRR and also discuss the impact of the agency
problem on Trust PLC's ability to make a viable investment.
The Weighted Average Cost of Capital and Internal Rate of Return have a primary
connection that is equal. It denotes that the projects' investments are made with the anticipation
of market involvement in mind. The Internal rate of return is larger than the WACC, which is
another link between the two.
Definition of WACC: It displays a group of average cost of capital for covering the
organization's shareholders' returns. It is mostly relevant in the context of investors that want to
invest in a firm for a longer period of time. In other words, the internal rate of return may be
defined as the total of all outflows and inflows equaling zero. Internal rate of return is calculated
using the following formula:
IRR = CF/ (1+r) ^i
Let's have a look at how IRR and WACC are related:
 Internal rate of return is reported to be smaller than Weighted average cost of capital in
the first relationship constructed between the two. As a result, if the investment made in
finance-based project plans is not in line with market demand or the predicted investment
outcomes are too conservative, the customer will pay more for the goals.
 The second relationship between the two is that IRR > WACC, which means that the
internal rate of return is higher when compared to the weighted average cost of capital. It
aids in displaying investment made in financial plans that contain synergy of a certain
customer or planned investment that seems to be overly optimistic and the purchase was
made at a negotiating price.

 The third relationship between internal rate of return and weighted average cost of capital
is WACC = IRR, which shows that investments in finance-related plans take into account
the possibility of market participation, and the purchase price is comparable to the fair
value of the obtained enterprise.
As a result of the relationship between internal rate of return and weighted average cost of
capital, it can be concluded that weighted average cost of capital would be the best technique
when compared to internal rate of return because WACC provides returns in accordance with
investor increment and is also easier to compute, whereas IRR would be useful for forecasting
the profitability scale of a company.
Question 2. Investment Appraisal Techniques
Calculation of Different Investment Appraisal Techniques
This strategy entails using investment assessment tools such as Net present value,
profitability index, ARR, and pay back term to promote or appraise the activities of a newly
forthcoming project. These strategies provide a very good indication of whether a project is
acceptable and profitable or not.
Payback period: This technique describes how long it will take for a given project to
recoup its costs. Essentially, the application of this strategy is critical since every business
requires a return on its investment in a certain project. As a result, they attempt to recoup the
costs paid in certain initiatives. If a company's payback period is longer than average, it means
that the project's duration is longer than average. The firm prefers projects with a shorter payback
period. It is determined by dividing the original investment by the typical cash inflows.
Year Annual Cash
Inflow
Annual Cash
Outflow
Annual Net Cash
flows
Cumulative
Cash Inflows
0 -588.5 -588.5 0
1 233.7 33.2 200.5 200.5
2 233.7 33.2 200.5 401
3 233.7 33.2 200.5 601.5
4 233.7 33.2 200.5 802
5 233.7 33.2 200.5 1002.5
6 233.7 33.2 200.5 1203
7 233.7 33.2 200.5 1403.5

7 SV 76.505 - 76.505 1480.005
Total 1635.9 -356.1 891.505 1480.005
Payback Period = Number of complete years + (Cash outflow – total inflow till date) /
Cumulative cash inflow
= 2 + (588.5-401) /601.5
= 2 + 0.312
= 2.312 Years
Average Rate of Return: In this approach, ARR refers to the average yearly amount of cash
flow generated during the investment's lifetime (Khemakhem, and Fontaine, 2019). The average
rate of return is computed by dividing the total expected cash flow by the number of years since
the firm was last invested. The time value of money is ignored, and the average of earnings is
used to calculate the ARR.
ARR = Average of annual amount of cash flow / Initial investment
ARR = Annual Average Profits / Cost of Investments * 100
= (127.36 / 588.5) * 100
= 21.64%
Where, Annual Average Profits = 1480.005/7
= 121.36
Net Present value: It indicates that this approach distinguishes between the current value
of cash inflows and outflows over a certain time period. It aids in capital budgeting and
investment planning by identifying predicted investment gains. It's also useful to know how
much of a dividend is going to be paid out to shareholders. The following is a formula for
calculating net present value:
NPV= Rt / (1+ I)^t
Years
Net
Cash
Inflows
Discounting @ 9% PV of Cash Inflows
1 233.7 0.917 214.3029
2 233.7 0.842 196.7754
3 233.7 0.772 180.4164
4 233.7 0.708 165.4596

5 233.7 0.65 151.905
6 233.7 0.596 139.2852
7 233.7 0.547 127.8339
PV of Cash Inflow (A) 1175.9784
PV of Cash Outflow (B) 588.5
Net Present Value (A-B) 587.4784
Internal Rate of Return (IRR): It is a current approach of valuing investments. It's used
to figure out how profitable a proposed venture will be. It is the discount rate that causes the
NPV to equal zero.
Years
Cash
inflows
Discounting
Factor 9%
PV value of cash
inflow
1 233.7 0.917 214.3029
2 233.7 0.842 196.7754
3 233.7 0.772 180.4164
4 233.7 0.708 165.4596
5 233.7 0.65 151.905
6 233.7 0.596 139.2852
7 233.7 0.547 127.8339
Total Cash inflow 1175.9784
Total Cash outflow 588.5
NPV (A-B) 587.4784
Years
Cash
inflows
Discounting
Factor 20%
PV value of cash
inflow
1 233.7 0.833 194.6721
2 233.7 0.694 162.1878
3 233.7 0.579 135.3123
4 233.7 0.482 112.6434
5 233.7 0.402 93.9474
6 233.7 0.335 78.2895
7 233.7 0.279 65.2023
Total Cash inflow 842.2548
Total Cash outflow 588.5
NPV (A-B) 253.7548
IRR = Lower rate + Lower Rate NPV/ (Lower Rate NPV – Higher Rate NPV) * Diff. in Rates
= 9% + (587.48 / 587.48 - 253.75) * (20 – 9)
= 9% + (587.48 / 333.73) * 11

= 9% + (1.76) * 11
= 9% + 19.36
= 28.36%
Recommendation: The payback period, net present value, and internal rate of return are
all examples of investment assessment methodologies. In a nutshell, the payback period is the
time it takes to recoup the cost of an investment. The net present value approach is the most
optimal method of valuing an investment. It is the best strategy since it is useful in the situation
of projects that are mutually incompatible. These are projects that should only be considered one
of the two possibilities offered. The key rationale for choosing this method is because it
considers the time worth of money and aids management in making better decisions. It also takes
into account the company's cost of capital. The project with the highest positive NPV will be
considered, while the one with the lowest negative NPV will be avoided.
Critical evaluation of the effects of new proposal by the financial director
PM Limited's financial director proposes that half of the entire capital be used. The finance
director's decision to apply 50% of the project's inflow for repurchasing equity share capital and
the remainder for paying cash dividends to current equity shareholders was made. The goal of
the organisation is to expand the number of promoters. It will also lower the company's
obligations. Investors pay cash dividends, which provide owners with a consistent stream of
income.
Advantages and Disadvantages of different investment appraisal techniques
Payback period:
Advantages Disadvantages
 This method is easier to compute than
other capital budgeting strategies and
is more manageable.
 This strategy is useful in situations
when there is a lot of ambiguity
(Barroy, and Gupta, 2020). It is also
useful in situations where there are a
lot of technological hurdles.
 Ignores the time value of money: This
technique does not account for the
cost of time, which causes a
reinvestment difficulty (Brigham, and
Houston, 2020).
 Ignores profitability: Profit is always a
top concern in company, and
profitability is often overlooked due to

cost recovery.
Net present value:
Advantages Disadvantages
 It contains all cash flows: In net
present value, the corporation defines
each cash flow (Oladimeji, and Aina,
2018). This is not the same as a
payback period that includes half of
the cash flow.
 Factors of risk: In this technique,
discount rates are used while
calculating the NPV. As a result, it
creates a risk associated with
commercial and financial risk..
 Finding the needed rate of return is
challenging: In this procedure,
determining the required rate of return
in which cash flow was discounted for
the finance team is quite difficult
(Hasibuan, Lubis, and HR, 2018).
 Determining opportunity cost: It is
difficult to estimate opportunity cost
since it is available in the inner outlay.

Average rate of return:
Advantages Disadvantages
 Accounting details are available: In
this technique, all of the information
needed to compute the rate of return is
already provided (Clemente, and et.al.,
2018).
 Calculating the rate of return is easier
using this technique since the amount
of all earnings is divided by the entire
number of years.
 It ignores some cash flow terms: This
technique of calculating the average
rate of return is simpler to use, but it
ignores some cash flow terms.
 It ignores the time worth of money:
This approach is simple to compute,
but because it ignores the time value
of money, it makes investing difficult
(Mosteanu, 2019).
Internal rate of return:
Advantages Disadvantages
 It is the simplest method of calculation
and does not take into account the
hurdle rate. It's a subjective figure that
comes down to a guess. When the IRR
is multiplied by the cost of capital, the
project is chosen (Muczyński, 2020).
It provides a rapid overview of the
new equipment's potential value and
cost savings.
 It is calculated by using an interest
rate at which the present value of
future cash flows equals the capital
investment required.
 It does not take project size into
account when comparing different
projects. When two projects have
distinct capital structures, it creates a
challenge. A higher internal rate of
return is required for small projects.
 It does not take into account
reinvestment rates.
 There exists a variety of discounting
rates, which causes uncertainty in the
company's multiple cash flows (Lo,
and Liao, 2021).

CONCLUSION
Based on the information gathered, it can be concluded that the corporation is attempting to
improve the organization's work performance. It clarifies the significance and use of working
capital and internal rate of return. The study also aids in the calculation of net present value and
the identification of methods for enhancing profitability ratios and revenue scales. It also acts as
a resource for learning about various technologies and practises that might help businesses run
more efficiently and save money.

REFERENCES
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