Calculation of Weighted Average Cost of Capital and Gearing Ratios of Wesfarmers (Coles)

This document explains the calculation of weighted average cost of capital and gearing ratios of Wesfarmers (Coles). It includes the calculation of risk free rate of return, market equity premium rate of return, beta, cost of debt, cost of equity, and WACC. It also includes the calculation of gearing ratios such as debt equity ratio and interest coverage ratio.

1
Assessment Task: 2

2
Task 1 and 2: Calculation of weighted average cost of capital (Including explanation of
calculations and judgments made in arriving the answers)
(a) Risk free rate of Return
In this section current risk free rate has been determined through using the information
provided on the Reserve Bank of Australia. Risk free rate is taken of 10 years maturity period of
Capital Market Yields of Government Bonds. Link to Reserve Bank of Australia is
https://rba.gov.au/statistics/tables/#interest-rates. The value of interest rate of 10 years
Government Bond as on 31 Dec, 2018 was 2.43% (Reserve Bank of Australia, 2019).
(b) Market equity premium rate of return
In this section of the assignment market rate of return has been calculated through using
the historical market premium method. Market equity premium refers to market return less risk
free rate of return. Under historical market premium method market return is calculated as
average of market return for last ten years. For this purpose there is need to find the market index
on which Wesfarmers (Coles) is being traded. Wesfarmers (Coles) is traded on Australian Stock
Exchange and it is listed under ASX 200 index. In order to calculate the average historical
market premium, market price of last 10 years has been selected and data has been taken from
January 01, 2009 to December 31, 2018. In order to calculate the data it has been decided to
extract the historical price form the Yahoo Finance. Historical data of last years of ASX 200 has
been given below (Source: Yahoo Finance: ASX 200, 2019).
Monthly price of ASX 200
for last ten years
Date
Adjusted
Close
31/01/2009 3344.50
28/02/2009 3582.10
31/03/2009 3780.50
30/04/2009 3818.00
31/05/2009 3954.90
30/06/2009 4244.00
31/07/2009 4479.10
31/08/2009 4743.60
30/09/2009 4643.20
31/10/2009 4701.40
30/11/2009 4870.60
31/12/2009 4569.60
31/01/2010 4637.70
28/02/2010 4875.50
31/03/2010 4807.40

3
30/04/2010 4429.70
31/05/2010 4301.50
30/06/2010 4493.50
31/07/2010 4404.20
31/08/2010 4582.90
30/09/2010 4661.60
31/10/2010 4584.40
30/11/2010 4745.20
31/12/2010 4753.90
31/01/2011 4831.70
28/02/2011 4837.90
31/03/2011 4823.20
30/04/2011 4708.30
31/05/2011 4608.00
30/06/2011 4424.60
31/07/2011 4296.50
31/08/2011 4008.60
30/09/2011 4298.10
31/10/2011 4119.80
30/11/2011 4056.60
31/12/2011 4262.70
31/01/2012 4298.50
29/02/2012 4335.20
31/03/2012 4396.60
30/04/2012 4076.30
31/05/2012 4094.60
30/06/2012 4269.20
31/07/2012 4316.10
31/08/2012 4387.00
30/09/2012 4517.00
31/10/2012 4506.00
30/11/2012 4649.00
31/12/2012 4878.80
31/01/2013 5104.10
28/02/2013 4966.50
31/03/2013 5191.20
30/04/2013 4926.60
31/05/2013 4802.60
30/06/2013 5052.00
31/07/2013 5135.00
31/08/2013 5218.90
30/09/2013 5425.50
31/10/2013 5320.10

4
30/11/2013 5352.20
31/12/2013 5190.00
31/01/2014 5404.80
28/02/2014 5394.80
31/03/2014 5489.10
30/04/2014 5492.50
31/05/2014 5395.70
30/06/2014 5632.90
31/07/2014 5625.90
31/08/2014 5292.80
30/09/2014 5526.60
31/10/2014 5313.00
30/11/2014 5411.00
31/12/2014 5588.30
31/01/2015 5928.80
28/02/2015 5891.50
31/03/2015 5790.00
30/04/2015 5777.20
31/05/2015 5459.00
30/06/2015 5699.20
31/07/2015 5207.00
31/08/2015 5021.60
30/09/2015 5239.40
31/10/2015 5166.50
30/11/2015 5295.90
31/12/2015 5005.50
31/01/2016 4880.90
29/02/2016 5082.80
31/03/2016 5252.20
30/04/2016 5378.60
31/05/2016 5233.40
30/06/2016 5562.30
31/07/2016 5433.00
31/08/2016 5435.90
30/09/2016 5317.70
31/10/2016 5440.50
30/11/2016 5665.80
31/12/2016 5620.90
31/01/2017 5712.20
28/02/2017 5864.90
31/03/2017 5924.10
30/04/2017 5724.60
31/05/2017 5721.50

5
30/06/2017 5720.60
31/07/2017 5714.50
31/08/2017 5681.60
30/09/2017 5909.00
31/10/2017 5969.90
30/11/2017 6065.10
31/12/2017 6037.70
31/01/2018 6016.00
28/02/2018 5759.40
31/03/2018 5982.70
30/04/2018 6011.90
31/05/2018 6194.60
30/06/2018 6280.20
31/07/2018 6319.50
31/08/2018 6207.60
30/09/2018 5830.30
31/10/2018 5667.20
30/11/2018 5646.40
31/12/2018 5814.60
Calculation of Market Premium
Years Jan-01 31-Dec Return in
%
Risk Free
Rate of
Return
Market
Premium
2009 3344.50 4569.60 26.81% 2.43% 24.38%
2010 4569.60 4753.90 3.88% 2.43% 1.45%
2011 4753.90 4262.70 -11.52% 2.43% -13.95%
2012 4262.70 4878.80 12.63% 2.43% 10.20%
2013 4878.80 5190.00 6.00% 2.43% 3.57%
2014 5190.00 5588.30 7.13% 2.43% 4.70%
2015 5588.30 5005.50 -11.64% 2.43% -14.07%
2016 5005.50 5620.90 10.95% 2.43% 8.52%
2017 5620.90 6037.70 6.90% 2.43% 4.47%
2018 6037.70 5814.60 -3.84% 2.43% -6.27%
Average mean of market premium for last 10 years 2.30%
(Brigham & Michael, 2013)
(c) Beta
Beta has been taken directly from Yahoo Finance and it is 0.91 (Yahoo Finance: Wesfarmers
(Coles), 2019).

6
(d) Cost of Debt
In order to estimate the cost of debt information given in latest financial statements are
used and financial statement is available on web link: https://www.Wesfarmers
(Coles).com.au/docs/default-source/reports/wes18-044-2018-annual-report.pdf?sfvrsn=4.
Calculation of Cost of Debt
Items Value at end of year 2018 Source
Amount in million $
Gross interest expense $211 million
Income Statement of
Wesfarmers (Coles)
(Annual Report)
Long term Debt $ 2,965 million
Balance Sheet of
Wesfarmers (Coles)
(Annual Report)
Short term debt $1159 million
Balance Sheet of
Wesfarmers (Coles)
(Annual Report)
Cost of Debt Interest/Total Debt
Cost of Debt of Wesfarmers
(Coles) 5.12%
(Annual Report, 2018)
(e) Cost of Equity
Formula: Risk free rate of return + Beta * (Market risk premium) (Madura, 2014)
= 2.43% + 0.91 * 2.30% = 4.52%
Weighted Average Cost of Capital of Wesfarmers (Coles)
Formula: = (E/V x Re) + ((D/V x Rd) x (1 – T)) (Damodaran, 2011)
Where:
 E: Market Value of equity
 D: Book value of firm’s debt
 V: Total Value of firm’s capital

7
 Re: Cost of Equity
 Rd: Cost of Debt
 T: Tax rate
Calculation of Weight of equity and debt capital Source
Debt Capital
Long term Debt $ 2,965 million Financial Statement
(Annual Report)
Short term debt $1159 million Financial Statement
(Annual Report)
Book value of total debt $ 4124 million
Equity Capital
Market price as on 31 December, 2018
$
32.22 Yahoo Finance
Total number of share issued 1131 million
Notes to accounts of
financial statements
(Annual Report)
Market value of Equity capital
$36,440.82
million
(Annual Report, 2018)
Information Gathered for WACC
Cost of debt (Rd) 5.12%
Cost of Equity (Re) 4.52%
Market Value of equity (E) $36,440.82 million
Book Value of Debt (D) $ 4,124 million
Total value of firm’s capital (V) $40,564.82 million
Calculation of WACC
Capital Value Weight
s
Cost of
Capital
Weighted cost
of capital
Equity
Capital $ 36,440.82 0.90 4.52% 4.06%
Debt Capital $ 4,124.00 0.10 5.12% 0.52%
$ 40,564.82 WACC 4.58%
Task 3: Gearing Ratios
Financial Data 2017 2018
$ million $ million
Total Liabilities $ 16,174.00 $ 14,179.00

8
Shareholder's Equity $ 23,941.00 $ 22,754.00
EBIT $ 4,177.00 $ 4,061.00
Interest Expenses $ 248.00 $ 211.00
Gearing Ratios of Wesfarmers (Coles)
Ratios 2017 2018
Debt Equity Ratio 0.68 0.62
Interest Coverage Ratio 16.84 19.25
Debt to Equity ratio
Formula: Total Liabilities / Shareholder’s Equity
Debt to equity ratio provides the proportion of total debt to total equity. This ratio helps
to evaluate the capital structure of the company as it shows proportion of debt to equity. The
information required to calculate the debt to equity ratio is easily available on annual report of
Wesfarmers (Coles) in financial statements section. As such no difficulties have been faced
while calculating the debt to equity ratio.
Interest Coverage ratio
Formula: EBIT/Interest (Moles & Kidwekk, 2011)
Interest coverage ratio helps to evaluate the financial strength of the company as it
provides times the company is capable to pay the interest on debt capital. It means this ratio
evaluate the capital efficiency of the company. All the values required to estimate the interest
coverage ratio is easily available in income statement of Wesfarmers (Coles), so no difficulties
are faced while calculating interest coverage ratio.
Task 4: Analysis of Findings in Reference to Capital Structure Theory
Capital structure theory refers to the use of systematic approach used by business firms
for funding their operational activities with the use of equity and liabilities. The theory is mainly
used for providing explanation in relation to the different types of funds that are used by
businesses to conduct their operations such as debt and equity. It has stated that a firm can
maximize its value by enhancing the proportion of debt in its capital structure. This is because
enhancing the debt proportion will help in reducing the capital cost and thereby maximizing the
profitability obtained. The proportion of equity and debt used by a business firm helps in
determining the weighted average cost of capital and their value. The use of the theory can be
done by the business firms to develop an optimum capital structure that refers to maintaining
optimum mix of debt and equity for generating higher returns (Damodaran, 2011).
As per capital structure theory it has been found that Wesfarmers (Coles) has been
successful in keeping the optimal mix of debt and equity in current year.

9
Task 5: Recommendation to the Board
It can be stated by analyzing the current capital structure of the firm that it should
increase the proportion of debt in its capital structure. This is because a firm should maintain an
optimum balance of debt and equity that enables it to reduce the cost of capital and maximizing
the value of a firm. The debt funding can be enhanced in the capital structure by a firm by the
Board through issuing of long-term notes payable or bond issues. A firm by increasing its
leverage can achieve an optimum capital structure through reducing its weighted average cost of
capital. This is because cost of equity is relatively higher that the debt cost and thereby
enhancing the equity funds can result in increasing the weighted average cost of capital. The
rising interest payments due to use of higher debt sources in the capital structure can help a firm
to achieve tax benefit through lowering the taxable income. As such, Board is recommended to
develop an optimum mix of debt and equity in the capital structure that leads to reducing the cost
of capital and maximizing the value of the firm (Madura, 2014).
Task 6: Reflection of the Overall Work
In estimating the weighted average cost of capital of Wesfarmers (Coles) the major
problem faced was estimating the weights of equity and debt capital. As equity shares of
Wesfarmers are being traded on stock exchange, it has been decided to calculate the market
value of equity and for debt capital book value has been taken as they are not traded on market.
The weights obtained from market value of equity and book value of debt and weights obtained
from book value of equity and book value of debt differs as book value of equity is much lower
than the market value of equity that indicates that shares of Wesfarmers are traded above book
value on stock exchange. Risk free rate of return has been taken for 10 years as it provides
average of return provided by government bonds during last 10 years. There is difference if we
take risk free rate of return below 10 years i.e. 30 days, 3 month etc as return obtained during the
last 1 or 3 months can be significantly different from returns obtained during last 10 years. Beta
has been taken directly from published source on Yahoo finance as published beta on yahoo
finance has been estimated through using all the factors that affects the beta value. Market return
has been estimated through using average of returns obtained during last 10 years as assuming
the spread between the market and risk free rate of return does not provide required result and
there can be significant different between the values.

10
References
Annual Report. 2018. Wesfarmers. Retrieved January 17, 2019, from
https://www.wesfarmers.com.au/docs/default-source/reports/wes18-044-2018-annual-
report.pdf?sfvrsn=4
Brigham, F., & Michael C. 2013. Financial management: Theory & practice. Cengage Learning.
Damodaran, A, 2011. Applied corporate finance. John Wiley & sons.
Madura, J. 2014. Financial Markets and Institutions. Cengage Learning.
Moles, P. and Kidwekk, D. 2011. Corporate finance. John Wiley &sons.
Reserve Bank of Australia. 2019. Interest Rates. Retrieved January 17, 2019, from
https://rba.gov.au/statistics/tables/#interest-rates
Yahoo Finance: ASX 200. 2019. Historical data. Retrieved January 17, 2019, from
https://au.finance.yahoo.com/quote/%5EAXJO/history?
period1=1230748200&period2=1547490600&interval=1mo&filter=history&frequency=
1mo
Yahoo Finance: Wesfarmers (Coles). 2019. Wesfarmers (Coles) Limited (WES.AX). Retrieved
January 17, 2019, from https://finance.yahoo.com/quote/wes.ax?ltr=1