Portfolio Theory and Cost of Equity Capital

This document provides a comprehensive overview of portfolio theory, including its origins, the Markowitz model, and the Capital Asset Pricing Model (CAPM). It also examines the relationship between corporate tax avoidance and the cost of equity, as well as the impact of national culture on debt costs. The assignment includes references to several research studies and articles in the field, making it a valuable resource for students studying finance and accounting.

INVESTMENT ASSIGNMENT

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
1. Cost of capital estimation by Kyle books for Royal Mail Plc.................................................1
2 First decisions in New Heritage Doll Company.......................................................................5
4 Finding fair value of share price...............................................................................................7
REFERENCES..............................................................................................................................12

INTRODUCTION
With the globalization of the companies, firm expanded their businesses at the global
market place and in order to finance their worldwide operations, they procure capital from both
the debt and equity by paying interest and dividend as financial cost. The report here lay
emphasizes upon examining the cost of capital estimate of Royal Mail Plc reported in the Kyle
book. Besides this, New Heritage Doll Company’s will be suggested with the best capital
budgeting decisions for accelerating business growth & progress. Lastly, American Greeting
business will be recommended with an appropriate advice regarding whether it should
repurchase its shares or not.
1. Cost of capital estimation by Kyle books for Royal Mail Plc
Royal Mail Plc is one of the world’s leading pioneer companies that provide postal
services across the world. The company is headquartered in London and listed on London Stock
Exchange. In order to finance firm’s capital requirement, Royal Mail Plc procure funds from
both the sources that are debt & equity funds. Collecting funds through any of these sources
bring cost to the company as the monetary return to the fund suppliers. In other words, cost of
capital can be regarded as the financial cost that entity needs to pay in return for the fund utilized
so as to finance the business function. It depends upon the mode or source of fund that Royal
Mail Plc had used in its organization either debt or equity. In economics and investment, it is
defined as a rate of return that firm could earn by putting the capital in a different investment
prospective with equivalent risk (Boubakri, Guedhami and Saffar, 2016). Alternatively, it also
can be regarded as an opportunity cost that is required to make a specific investment.
Capital structure: As already said that Royal Mail Plc’s finance manager use a
combination of equity & debt in designing an optimum capital structure, therefore, it incur both
the cost of equity & cost of debt in the business. Thus, it’s overall cost means weighted average
cost of capital (WACC) is the mixture or composition of return requires to compensate all the
creditors. It really matters for the valuation purpose, it is because, companies look after
procuring required amount of capital at least cost. Moreover, it is also used as a discounting
factor in order to derive fair value of investment.
Finding out the opportunity cost of capital/WACC typically involves the computation of
return for both the debt suppliers and equity holders. It is necessary for the Royal Mail Plc to
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obtain a minimum return equal to WACC so that it can satisfy its financial commitments to the
fund providers.
Royal Mail Plc’s capital structure in 2015
Source of capital Book value (GBP million) Capital contribution %
Current debt 290 6.18%
Non-current debt 559 11.91%
Shareholder’s equity 3846 81.92%
Total Capital 4695 100.00%
Current Debt Non-current Debt Equity
290 559
3,846
Source of capital
Figure 1 Sources of capital of Royal Mail Plc in 2015
Cost of debt: Debt capital is an external source of finance wherein company take
borrowings from the lenders for the required period and which is paid in periodical instalments
as per the repayment schedule (Chui, Kwok and Zhou, 2016). On such source, although firm
owes statutory obligation to pay interest as cost, still, the benefit associated with this is it offers
tax advantages because tax authority charge taxes on earnings after tax. This is the only reason
why debt is treated as cheaper financial source which offers trading on equity benefits to
maximize shareholder return. Cost of debt indicates the effective rate which Royal Mail Plc need
to pay to the lender on the borrowed capital (Goh and et.al., 2016).
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Cost of debt (Kd): Interest/Debt value*100(1-corporate tax rate)
Evidencing from the 2014’s annual report of Royal Mail Plc, it can be seen that it has
used current and non-current debt worth £286m and £860m which grown up to £290m and
£559m in the end of year 2015. Cost of non-current debt is computed considering the coupon
rate on bond issued by the firm. It is because; bonds are taken as long-term loan and using the
bond rate of recent issue is the best way to determine Kd. Taking into account the stated case,
firm has obtained current debt @ 0.90% interest rate per annum whereas for the long-term
borrowing of £559m, Kyle has used coupon rate of 4.375% on its recently issued 10-year bond.
As it is a long-term bond issued & rated recently by S&P at BBB therefore, it is considered as
the best rate for cost of debt calculation. Besides this, as discussed, that debt use provided tax
shields to the firm therefore, cost of debt is computed as an after-tax (Badertscher and et.al.,
2015). Referring the Royal Mail Plc, Kyle has used 20% marginal tax rate which is current
applied in UK and as per which, all the businesses have to pay tax at this rate on their profit after
taxation. Thus, by this way, firm’s cost of debt will be computed as follows:
Current debt: 0.900%
Non-current debt: 4.375% coupon rate on 10-year bond
Weighted Average: 0.900%*(£290m/£849m) + 4.375%*(£559m/£849m)
= 0.307% + 2.881%
= 3.188%
Cost of debt after–tax = 3.188% *(£849m/£4695m)*(1-20%)
= 0.461%
Cost of equity: On the capital gathered through equity, Royal Mail Plc is liable to pay
dividend as return for the risk undertaken by the entity (Lui, Ngai and Lo, 2016). In order to
compute cost of equity (Ke), Kyle had approached two methods, one is dividend yield and
another one is capital asset-pricing model (CAPM). Out of these, Kyle had used first model as he
considered this method as more prudent to be conservative and present the ultimate return of
investors over their investment held. Evidencing from the outcome, Ke has been derived at
4.11% considered the last year’s dividend of 21 pence at a reflected share price of 511 pence.
However, in contrast, it is better to use CAPM model as it clearly exhibit risk-return relationship.
The method encompasses 3 elements that are risk free rate, beta and market risk premium as well
(KUEHN, Simutin and Wang, 2017).
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Figure 2 Capital assets pricing model
(Source: Dhrymes, 2017)
Risk free rate presents the return at zero default risk, zero value of beta and no volatility.
Kyle had used average yield of 1.551% on the 5-year bond, although, it is better to use 10-year
government bond, still because, Royal Mail privatization came into force in 2013 therefore, this
period is founded appropriate. Beta presents the volatility in firm’s stock with the change in
overall market. Thus, high data reflects greater volatility or vice-versa and helps to consider
systematic risk (Tong, Hu and Hu, 2017). Due to recent privatization, few estimates were
available and a report published by equity research firm, Chambers and Thompson reflecting
beta for Royal Mail Plc of 0.65 has been used. Such firms have investment experts and
specialists who have excellent market knowledge and provide really prudent results that facilitate
clients in making well-informed decisions. Therefore, the taken beta of 0.65 is good statistical
measurement for systematic market risk. On the other hand, risk premium presents excess of
market return over risk –free return. For this, Kyle had used British investors’ survey report
which presented a market premium of 5.8%. Hence, I opined Royal Mail Plc to use CAPM mode
for the cost of equity computation, calculated as follows:
CAPM: Risk free return + beta (market risk premium)
Here, Risk premium = Market return – risk free return
1.551% + 0.65(5.8%)
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= 5.321%
In contrast, Kyle had used cost of equity @ 4.11% considering dividend model, however,
it is not considered as prudent way because it does not use beta as a measurement of market
volatility. Thus, it is advisable to firm to use Ke @ 5.321% using CAPM framework. As per this,
weighted average cost of capital will be determined here as under:
WACC: Kd(1-t)*debt/(debt + equity)+Ke*Equity/(Debt + equity)
= 3.188% (1-20%)*(*(£849m/£4695m) + 5.321%*(£3845m/£4695m)
= 0.461% + 4.359%
= 4.820%
The above WACC is greater than the calculated WACC of 3.828% under dividend model
because it considered dividend whereas CAPM had given value to the volatility in the stock price
in relation with the change in market stock. Comparable companies National Grid, Severn Trent,
Tesco, United Utilities and Vodafone Plc had reported WACC of 3.853%, 3.136%, 5.475%,
3.281% and 5.660% respectively due to different composition of debt & equity capital in the
capital structure. Royal Mail Plc’s WACC is comparatively below than Vodafone and Tesco
whilst other rivalries WACC is comparatively higher return might be due to more volatile stock
which reflect riskier return.
2 First decisions in New Heritage Doll Company
On analysis of facts related to New Heritage Doll company it can be observed that initial
investment amount is given which is 1470 and expense that are made on the selling,
administrative expenses are equiavalent to 1250. It can be said that in the initial year investment
is made and along with this sales as well as administrative expenses are made in the business. It
can be observed that in the first year of cash flows return is gained. It can be seen that revenue of
4500 is earned in the first year. Fixed overhead of 575 is incurred in the business followed by
2035 value of amount is spend on variables erxpenses which are part of production cost.
Depreciation amount is 152 which is very low and it can be said that less amount of non finance
expenses are bear in the business. Total overall production cost is 4131 which is the high
production cost in the business (Lang and Maffett, 2011). It can be said that in the first year
heavy amount of cost is incurred. Selling and adminsitrative expenses declined to some extent
from 1255 to 1155.Overall total operating cost is 3917. After considering all expenses operating
profit is 583. There are some assumptions that are made in respect to working capital. It can be
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seen from the table that is attached in the appendix that minim cash balance as percentage of
sales is 3%. Days sales outstanding is 59.2 which reflect that in initial stage condition is not so
good. Inventory tunover rate is 7.7 which reflect that it is expected that in the upcoming time
period inevntory will be converted in to sales 7 times in a year. Days payable outstanding
assumed value is 30.8 which reflect that one month time will be taken by the firm to make any
payment if occur to the creditors. In first year capital expenditure of 952 is made in comparison
to initial year expenditure which reflect that firm is making more investment in its project which
may lead to further generation of cash flows in the business. It can be said that mentioned project
may prove good for the firm and it may earn good amount of profit in its business. This
possibility will further increased when there will be strong control on expenses that will be
incurred in the project.
New Heritage Doll Company has launched its broad segments in dividing two products.
One is for the digital/visual games and other is for the games and toys. The company starts
operations in 2010 which has no revenue growth, production cost and any further expenses. It
has the expended over the selling, general and administrative as 1,201 which was the total
operating expenses occurred that year. There is unfavorable loss in the operating profit of the
year 2010 of the same amount which lead the capital expenditure about 4610. In the year 2011
the company did not do any operational activity as it has nil accounts throughout the year.
Company does not have any cash flow during this year, no business, no financial changes made
this year.
In the year 2012 the company started its working on the revenue generated about 6000 on its
account. This will be the proper financial start of the company. The production of the products
started and has the fixed production expenses about 1,650 which was good as compared to the
revenue (Liu, Zhang and Liu, 2011). Company has the variable production expenses about 2,250
and the depreciation at 310. This shows the expenses occurred on the production which set the
total about 4,210. Other operation expenses include the selling, general and administration of the
product was 1,240 its sets up to the total operating expenses about 5,450. After deduction of the
expenses from the revenue the total operating profit was left as 550. The favorable result on the
operating profit shows the company's growth in the right direction and the company has acquired
the right strategic plan in the daily operation of the business (Sinha and Labi, 2011). This was the
growth year for the company as it shows the financial cash flow. Assumption was made in
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concern with the working capital of the company included minimum cash balances as 3.0% of
the sales made that year. This was the first financial growth of the company so it was better for
the company to change the selling strategies as to improve the revenue of the company. The
changes should be made in concern to improve the cash flow of the company and to generate
more revenue which will resolutely help in making good capital budget as to meet the future
targets (Shen, Shen and Sun, 2012). The further calculations were made as to know the final
expenditure made for the capital expenditure. Days sales outstanding was 59.2x, Inventory
turnover was 12.2x which was through the calculation made on the production cost/ending
inventory and the Days payable outstanding was 33.7x which was based on the total operating
expenditure. The year ends with the total capital expenditure about 310 (Song, Wang and Li,
2013). This year shows the favorable cash flows on the operations related with the sales and
production of the company. The proper administration was done on the production,
manufacturing of the products. The company should acquire the better promotional techniques
as to improve the sales of the products. This will resultantly help in the growth of the company in
the upcoming years.
4 Finding fair value of share price
Valuation is the one of the main method that is used for valuation of equity. There are number of
approaches that can be used for equity valuation by the business firms. Some of these methods
are dicounted cash flow model and price earning ratios. There is huge significence of these
methods for the busines firms because same help firm in identifying real value of shares. In the
excel sheet provided in context of American Greetings valuation is done by using EV/EBITDA
method. There are some loopholes in the mentioned approach that is applied on the mentioned
company (Koller, Goedhart and Wessels, 2010). It can be observed that value of total cash is
wrong as its value in calculation of mentioned ratio is 86 instead of 172. This reflects that value
that is computed by using ratio EV/EBITDA is wrong and it does not reveal actual valuatio of
sharss.
This can be understand from single concept enterprise value or EV is reflecting
combination of debt and equity. EBIT is reflecting earning before interest and tax which is
simply a cash flow. When EV is divided by EBIT result is reflecting number of times enterprise
value is greater then earning before interest and tax. It is not revealing fair value of shares.
However, if peer firms are compared with American Greetings then only it can be identiified
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whether firms shares are overvalued or undervalued relative to competitors. Main target is to
identify the correct price of shares of American Greetings and due to this reason formula
EV/EBITDA is not effective in nature (Warr and et.al., 2012). Apart from this in calculation of
enterprise value cash amount is also taken in to account but in the calculation that is given above
cash amount is not taken in to account. Thus, it can be said that calculation is not done in proper
manner and there are number of mistakes in same. There is need to revise the calculation that is
in the excel sheet. In case in valuation model total cash amount is changed to 172 and due to this
reason enterprice value get altered. Cash value that was not taken in to account is deducted from
enterprise value amount that was computed earlier. In order to compute EBITDA multiple
simply EV or enterprise value is divided by EBITDA or earning before interest and direct tax.
Due to all these corrections value of ratio changed to 2.7 which is less then al peer firms. It can
be said that firm ratio value is lower then 10 which is good but their value is much lower then
peer firms (Foster, Kasznik. and Sidhu, 2012). It can be said that there is need to improve
performance by the businss firms and in this regard it must take number of steps time to time so
that performance can be improved to great extent. By doing so shares value can be improved to
maximum possible extent.
It can be observed that there were lots of mistakes in the calculatuion and same are
rectified but in order to compute share price EV/EBITDA approach can not be used by the
business firms. It must be noted that discounted cash flow model is the one of the best option that
is available to the business firm. This is because under this approach forecasting of the firm
project revnue and expenses is done. Thereafter by using discount rate cash flows present value
is computed and same are summed up to identify real value of cash flows (Shamma and Hassan,
2011). After this, long term growh rate of firm is estimated and discount rate is taken in to
account. Further, enterprise value is computed which is basically a combination of debt and
equity. From the equity value debt amount is reduced and cash is added to find equity value.
Ultimately, enterpise value is divided by number of shares issued to find out real value of shares.
In order to understand calcualtions in proper manner images are given below.
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Figure 3Cost of equity
In order to compute cost of equity CAPM model is used which is known as capital asset pricing
model. Under this model risk free rate is taken in to account and along with this beta value as
well as market premium is also taken in to account. Simply, value that is obtained on
multiplication of beta to market premium is added to risk free rate of return. In this way cost of
equity is computed. Beta value is 1.63 which is reflecting that shares price is volatile more then
index (Poitras, 2010). This is very risky thing in respect to project because in case index will
increased by 1% share price may increased by 4% but in case index reduced by 1% then share
price may change by -4%. It can be said that in case index changed by small percentage big
variaion can be observed in case of share price which is not good for the busines firm.
Figure 4Interest charged on debt
Interpretation
It can be observed that finance cost on debt increased from 7% to 8% which reflect that
slight increase happened to finance cost. It can be said that finance cost of the firm reamin under
control in past years. Mentioned rate is further used to compute weighted average cost of capital
which is used to do discounting of cash flows.
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Figure 5Calculation of enterprise value
In order to calculate enterprise value varied items are taken in to account namely current market
price, diluted shares and long term liability as well as cash and its equivalents. First of all current
market price is multipled to shares outstanding and in this way market capitalization is computed
(Discounted cash flow model, 2017). Thereafter, long term liability amount is added to market
capitalization amount and from same cash and its equivalents are subtracted to identify enterprise
value.
Figure 6Calculation of weighted average cost of capital
Weighted average cost of capial is computed above which include both cost of capital of debt
and equity. This weighted average cost of capital is taken in to account to compute present value
of cash flows.
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Figure 7Net income calculation
Net income is given above which is reflecting amount of profit that is expected to earn by the
firm in case expenses are made in specific direction. By using discount rate of 13% present value
of cash flows is computed and same are further used to do calculation.
Figure 8Terminal value percentage
Termainal value percentage of total value is computed and in this regard first of all sum of
present values is computed. Thereafter, weighted average cost of capital is taken in to account.
Long term growth in revneue is estimated to be equal to 3%. Finally present value of terminal
value is calculated. In this way, termianl value as percentage of total value is calculated. It can be
said that appropriate approach is followed for equity valuation.
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Figure 9Calculation of equity value
In this stage enterprise value is calculated at 574 and from same debt amount is deducted and
cash amount is addded. In this way net debt amoun tis calculated. In order to identify equity
value simply enterprise value is added to net debt and in this way equity value is computed. This
is the final value that is used for calculation of per unit of equity.
Figure 10Computation of fair price of shares
Finally in order to calcualted fair value of equity simply calcualted value of equity is divided by
diluted shares and in this way fair price of shares is calculated which is $17. If compared with
the current share price which is $12 it can be said that firm shares are underpriced. From
investment point of view it can be said that it is best time to make purchase firm shares.
It is recommended that firm must repurchase its shares because fair value of its shares is
$17 and it is available in market at $12. Hence, shares are reduced at level which is less then fair
price and due to this reason it can be said that it will be better for the firm to repurchase its shares
from the market (McNichols and Stubben, 2015). This is because if less then fair value shares are
available in the market then it means that shareholders are not receiving apprpriate amount on
sale of shares and this also reflect that share value is declining consistently. Thus, in such sort of
situation purchase of shares is the only option that is available to the business firm. This is
because by purchasing shares firm can increase demand for its product in the market and this will
lead to increase in price of shares. It can be said that it will be better for the firm to do repurchase
or buyback shares from the market. In this regard firm need to follow specific procedure and it
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must follow all relevant rules and regulations in proper manner so that buy back can be done in
proper manner. In this regard firm must contact with well known investment banker to make
prudent decisions.
REFERENCES
Books and Journals
Tong, J., Hu, J. and Hu, J., 2017. Computing equilibrium prices for a capital asset pricing model
with heterogeneous beliefs and margin-requirement constraints. European Journal of
Operational Research. 256(1). pp.24-34.
KUEHN, L.A., Simutin, M. and Wang, J.J., 2017. A labor capital asset pricing model. The
Journal of Finance. 12(3). pp.16-39.
Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection.
In Portfolio Construction, Measurement, and Efficiency. Springer International Publishing.
10(2). pp. 39-48.
Lui, A.K., Ngai, E.W. and Lo, C.K., 2016. Disruptive information technology innovations and
the cost of equity capital: The moderating effect of CEO incentives and institutional
pressures. Information & Management. 53(3). pp.345-354.
Goh, B.W. and et.al., 2016. The effect of corporate tax avoidance on the cost of equity. The
Accounting Review. 91(6). pp.1647-1670.
Chui, A.C., Kwok, C.C. and Zhou, G.S., 2016. National culture and the cost of debt. Journal of
Banking & Finance. 69(12). pp.1-19.
Badertscher, B.A. and et.al., 2015. Private ownership and the cost of debt: Evidence from the
bond market.
Boubakri, N., Guedhami, O. and Saffar, W., 2016. Geographic location, foreign ownership, and
cost of equity capital: Evidence from privatization. Journal of Corporate Finance. 38.
pp.363-381.
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Koller, T., Goedhart, M. and Wessels, D., 2010. Valuation: measuring and managing the value
of companies (Vol. 499). john Wiley and sons.
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Financial and Quantitative Analysis. 47(3). pp.589-616.
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importance of country and industry factors versus company‐specific financial reporting
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Online
Discounted cash flow model, 2017. [Online]. Available through:,
http://macabacus.com/valuation/dcf/overview. [Accessed on 28th July 2017].
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