This analysis of Parcel’s Limited includes the calculation of cost of capital, value of the company, revised cost of capital and recommendations. The report suggests keeping equity finance only as the cost of capital robustly increased after inclusion of the debt component.
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Running Head: ANALYSIS OF PARCEL’S LIMITED0 Analysis of Parcel’s Limited.
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ANALYSIS OF PARCEL’S LIMITED2 Table of Contents Introduction................................................................................................................................2 Current cost of capital................................................................................................................2 Value of the Parcel’s Limited....................................................................................................4 Revised Cost of Capital..............................................................................................................4 Revised Value of Parcel’s Limited............................................................................................6 Recommendations......................................................................................................................7 References..................................................................................................................................8
ANALYSIS OF PARCEL’S LIMITED3 Introduction Weighted average cost of capital also known as WACC is a method of calculating the cost of capital of the firm or any organisation. Under this each kind of the capital is weighed in a proper proportion. Under the calculation of the WACC all the sources of the capital are taken into consideration like the common stock, bonds any long term debt or preferred stock. WACC of any organisation can be increased when the beta and the rate of return on equity increases. An increase in the WACC reflects a decrease in the valuation and increase in the risk. To calculate the WACC, the cost component is multiplied by the respective proportional weights and the summation of both is taken for the purpose of the overall result. It is one of the easiest methods to calculate the cost of capital (Frank and Shen, 2016). Current cost of capital Calculation of the Current Cost of Capital CAPM MODEL Particulars Parcels Limited Risk free Rate of return (Rf)8% Beta (B)1.2 Market rate of Return (Mr)13% Cost of Equity [Rf+B(Mr-Rf)]14% WACC= E/(E+D)*COST OF EQUTIY +D/(E+D)* COST OF DEBT (1-TAX RATE)
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ANALYSIS OF PARCEL’S LIMITED4 Calculation of WACC WACCValues Market value of Cost of Equity14% Market value of Cost of Debt0% Total market value of the company14% Cost of Equity14% Cost of Debt0% Tax Rate28% Cost of Equity Cost of DebtWACC E/E+DD/E+D 14.0%0.0%14% Cost of capital is a type of return which is required to from a capital budgeting project. Cost of capital is a formation of the cost of debt and cost of equity. Another way to define the cost of capital is to through the cost of funds (Li, 2015).Cost of capital totally depends upon the mode of finance whether through equity and debt. Many companies use a combination of both and for these companies the calculation is done on the basis of the weighted average cost of capital. The cost of capital generally determines a hurdle rate that a company needs to overcome before it can generate value. This cost is exclusively used in the process of the capital budgeting to simply remove the confusion about whether the company should proceed with a project or not (Mukherjee, 2017).
ANALYSIS OF PARCEL’S LIMITED5 From the above calculation it can be seen when the Parcel Limited was fully equity financed the WACC is 14%. Value of the Parcel’s Limited Calculation of the Value of Parcels Cash flow150000 WACC rate14.0% Value of Parcels1071428.571 Discounted Cash Flow is a valuation which is used to measure the attractiveness of an investment opportunity (Billett, Hribar and Liu, 2015).The DCF model generally uses the future free cash flow projections and these cash flows are further utilising the annual rate to arrive at the estimates of the present value. This present value estimate is then used to derive the potential investment (Lorenz, Kruschwitz and Löffler, 2016). CF= Cash Flow R= Discount Rate From the above calculation the value of the Parcel’s Limited using discounted cash flow method amounts to 1071428.57. Revised Cost of Capital WACCValues Market value of Cost of Equity60%
ANALYSIS OF PARCEL’S LIMITED6 Market value of Cost of Debt40% Total market value of the company100% Cost of Equity14% Cost of Debt10% Tax Rate28%
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ANALYSIS OF PARCEL’S LIMITED7 Cost of Equity Cost of Debt1- Tax rate WAC C E/E+D*KeyD/E+D*Kid 8.4%4.0%72.0%21.20% Under the revised cost of capital structure the firm’s overall cost of capital us calculated on the basis of the equity component as well as the debt component using the weighted average formula for cost of capital (Barberis, et al (2015).Therefore the WACC of the parcel limited after the inclusion of the component is 21.20%. This cost of capital is further used to discount cash flows and to evaluate the value of the firm. The firms generally try to attain an optimal mix for various resources of finance. Secondly the debt financing has an edge over the equity financing. Under the debt financing the advantage of tax can be availed. Due to the interest expenses which are available for deduction and dividends on the common shares are allocate dafter the tax the cost gets stable. However, it shall also be ensured that not too much debt is used for financing which may result into higher interest rates which are decided by the lenders to offset the higher risk of default. Revised Value of Parcel’s Limited Calculation of the Value of Parcels Cash flow150000 WACC rate21.20% Value of Parcels707547.1698
ANALYSIS OF PARCEL’S LIMITED8 Recommendations From the above calculations of the parcel limited it can be observed that the debt component is 40% of the total finance and the cost if debt is 10%. So it can be concluded that a higher weighted average cost of capital is risky for the firm. Investors tend to require the additional return to assume the additional level of risk (Borisova, et al 2015).This is an indication that the company is actually losing its value. Even If the debt component is taken into consideration it does not guarantee that the company will perform at par. For the purpose of the debt saving the company can opt for debt financing but keeping in mind the cost of capital and its output. Therefore it is recommended that the Parcel Limited shall keep equity finance only as the cost of capital robustly increased after inclusion of the debt component. Right from 14% to 21.20% the company has to pay huge amount of interest and other expenses which is costly. A higher WACC is not favourable for the company. The value investors might also be concerned of the WACC is higher than actual returns. The company also talks about the perpetuity (Dhaliwal, Judd, Serfling and Shaikh, 2016).Under the infinite cash flows of $150000, the company has to incur 21.20% which is higher; hence it is advised not to include the debt component for financing as the value of the parcel limited also decreased by almost $363881.
ANALYSIS OF PARCEL’S LIMITED9 References Barberis, N. et al (2015) X-CAPM: An extrapolative capital asset pricing model.Journal of financial economics,115(1), pp.1-24. Billett, M.T., Hribar, P. and Liu, Y. (2015) Shareholder-manager alignment and the cost of debt. Borisova, G. et al (2015) Government ownership and the cost of debt: Evidence from government investments in publicly traded firms.Journal of Financial Economics,118(1), pp.168-191. Dhaliwal, D., Judd, J.S., Serfling, M. and Shaikh, S. (2016) Customer concentration risk and the cost of equity capital.Journal of Accounting and Economics,61(1), pp.23-48. Frank, M.Z. and Shen, T. (2016) Investment and the weighted average cost of capital.Journal of Financial Economics,119(2), pp.300-315. Li, X., (2015) Accounting conservatism and the cost of capital: An international analysis.Journal of Business Finance & Accounting,42(5-6), pp.555-582. Lorenz, D., Kruschwitz, L. and Löffler, A. (2016) Are costs of capital necessarily constant over time and across states of nature?: Some remarks on the debate on ‘WACC is not quite right’.The Quarterly Review of Economics and Finance,60, pp.81-85. Mukherjee, S. (2017) Cost of capital.Asian Journal of Multidimensional Research (AJMR),6(7), pp.115-118.