Risk Adjusted Cost of Capital: How organizations can lower the WACC

The market value of equity and debt has been calculated as : WACC = (E/V * Re) + ((D/V * Rd)) In the above formula, E represents market value of the organisation's equity which can be also known as market cap, D represents market value of organisation's debt, V represents total value of capital i.e. equity plus debt, E/V % of capital that is equity, D/V % of capital that

Strategic and Financial
decision making

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Task 1 Weighted average cost of capital in different scenario...................................................1
Task 2 Cost of capital..................................................................................................................2
Task 3 Estimation of risk-adjusted Weighted Average Cost of Capital.....................................3
3.1 Calculation of risk adjusted specific discount rate......................................................3
3.2 WACC for Noggin plc.................................................................................................3
Task 4 How organizations can lower the WACC.......................................................................4
Task 5 Benefits of two types of growth: Organic and Acquisitive growth.................................6
CONCLUSION................................................................................................................................7
REFERENCES................................................................................................................................8
Appendix..........................................................................................................................................9

INTRODUCTION
Strategic and financial decision making plays very important role from the business
perspective. It usually involves defining the objective of the organization by identifying its
resources and quantifying its resources. This report is divided into five tasks, each task is
depicting its own importance. Task 1 is giving brief information about Weighted average cost of
capital with proper calculation in same series task 2 to calculate suitable cost of capital and in
next capital asset pricing model comes in picture by adjusting risk with specific discount rate.
Task 4 elaborates the method for reducing WACC and in next part the significance of two types
of growth i.e. organic and inorganic growth.
Task 1 Weighted average cost of capital in different scenario
Organization's weighted average cost of capital indicates the combination cost of capital
among all the sources which consists of common shares, preferred shares and debt. Every cost of
capital is being weighted by its own percentage of aggregate capital which is summed of. The
formula for WACC can be denoted as :
WACC = (E/V * Re) + ((D/V * Rd) * (1-T))
In the above formula, E represents market value of the organisation's equity which can be also
known as market cap, D represents market value of organisation's debt, V represents total value
of capital i.e. equity plus debt, E/V % of capital that is equity, D/V % of capital that is debt, Re is
cost of equity or required rate of return, Rd is yield to maturity on existing debt or cost of debt
and T is referred as tax rate(Merigó and Casanovas, 2011). The main purpose for calculating
WACC is to determine cost of each and every part of capital structure of the organisation
structure as to know the proportion of preference shares, equity and debt. Every component has
its own cost to the organization. Fixed rate of interest is paid on debt and fixed yield on preferred
stock.
Weight Post Tax Total weight
Capital 640000000
Weighted cost (preferred shares) 0.31 0.11 0.03
Weighted cost (3% loan stock) 0.22 0.08 0.02
Weighted cost (9% loan stock) 0.23 0.08 0.02
Weighted cost (6% loan stock) 0.23 0.08 0.02
Cost of Preferred Stock 45.60%
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3% debt cost 74.30% WACC 8.94%
9% debt cost 42.20%
6% debt cost 70.40%
Interpretation: In the above scenario market value of preferred stock price is
20,00,00,000 and the dividend on the preferred stock is 11.4 along with the cost of preferred
stock is 46%. There are three scenarios for the debt cost i.e. 3%, 6% and 9% the tax rate has been
given as 35% for all. The market value of 3% debt has been calculated as 140000000 with the
coupon amount of 0.948 and maturity of 10 years. So the cost of debt before tax and cost of debt
after tax has been calculated as 74.3% and 48.30% respectively. The market value of 6% debt
has been calculated as 150000000 with the coupon amount of 6 and maturity of 6 years. So the
cost of debt before tax and cost of debt after tax has been calculated as 70.40% and 45.76%
respectively. The market value of 9% debt has been calculated as 15,00,00,000 with the coupon
amount of 9.29 and maturity of 10 years. So the cost of debt before tax and cost of debt after tax
has been calculated as 42.20% and 27.43% respectively. The total capital is 64,00,00,000 so the
weighted cost is calculated of 3%, 9% and 6% loan stock as 0.31, 0.22 and 0.23 respectively and
cost of debt after tax has been referred for determining WACC which is 8.94%.
Task 2 Cost of capital
Cost of capital is referred as the opportunity cost of some particular investment. By
putting some money into a some unique investment which has equal risk so the rate of return can
be determined. It consists of both cost of debt and cost of equity for financing the business. The
cost of organisation usually depends on the type of financing which company selects to rely on.
As the organisation rely on totally equity or total debt or may be the combination of debt and
equity(David, 2011). The organisations capital structure has been determined by choice of
financing which makes the important variable to cost of capital. Usually organisations look for
proper optimal combination of financing which gives adequate funding and to minimise the cost
of capital. The most common way to measure the cost of capital is to use weighted average cost
of capital. Under this method all the fund's sources are been used for the calculation of given
weight according to the proportion of the structure of capital.
Post tax Total weight
Cost of Preferred Stock 52.63% 0.18 0.10
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3% debt cost 24.01% 0.08 0.02
9% debt cost 13.45% 0.05 0.01
6% debt cost 9.91% 0.03 0
WACC 12.69%
Interpretation: The organisation's equity is of 52.63% and total debt of 47.37% which
includes 3% debt cost, 9% debt cost and 6% debt cost of 24.01%, 13.45% and 9.91%
respectively. The corporate tax is been assumed as 35% so post tax amount has been calculated
of debt and equity. By multiplying proportion and post tax amount, there is an aggregate of total
weight which has been concluded as weighted average cost of capital. It is the easiest method for
calculating cost of capital, the yield on the organization's debt is refereed as cost of debt and
yield on preferred stock of the organisation is referred as cost of equity. The total weight of 3%
debt cost, 9% debt cost and 6% debt cost is 0.02, 0.01 and 0.003 respectively and cost of equity's
total weight is 0.10. The combination of weight of debt and equity is 12.69% which replicated
the weighted average cost of capital.
Task 3 Estimation of risk-adjusted Weighted Average Cost of Capital
3.1 Calculation of risk adjusted specific discount rate
The capital asset pricing model specifies the relationship between expected return and risk of
investing in security based on assumptions of market risk and it should be compensate it in the
form of risk premium i.e. market return should be greater than risk free rate(Larkin, 2011).
Market
RM 0.14
RF 0.05
Market (RM-RF) 0.09
Beta 0.78
Rf*Beta 0.039
CAPM 0.35%
Interpretation: in the above table, market return is 0.14 and in same series risk free rate
is considered as 0.05. From the two figures market risk premium has been calculated i.e. 0.09.
The measure of a stock's risk is reflected in the above table as 0.78. So the CAPM formulae is:
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CAPM = RM + Beta (RM – RF)
From the above formula CAPM is calculated as 0.35%
3.2 WACC for Noggin plc.
Post tax Sum of weight
Total capital 4706000
Weight of cost of equity 0.45 0.16 0.07
Weight of cost of debt 0.55 0.19 0.11
Cost of Equity 18.59%
Cost of debt 0.35% WACC 17.69%
Interpretation: In the above scenario, total capital of Noggin is 47,06,000 so weights of
equity and debt is calculated as 0.45 and 0.55 respectively. Cost of equity and debt is 18.59%
and 0.35% respectively. Tax rate is 35% so after adjusting tax rate sum of weight of equity and
debt is calculated as 0.07 and 0.11 respectively. WACC for Noggin plc. Is 17.69%.
Task 4 How organizations can lower the WACC
Weighted average cost of capital is simple average of cost of debt and cost of equity or it
is an average rate on which organization is expected for paying its finance. Market value of
equity and debt are in proportions of different weights which usually vary(Krüger, Landier and
Thesmar, 2015). If the capital structure of company is changing then it will directly impact
WACC. Finding the appropriate capital structure becomes procedure for lowest WACC as it is
minimised along with this organization or shareholder's wealth is maximised. Organisation can
reduce WACC by lowering equity costs, reducing debt financing costs and capital restructuring.
 Equity Costs: it is investment's return which is expected by shareholders in the form of
earnings of the company. It consists of retained earning and common stock. Equity's cost
has the inherent risk in the context of company's profitability which is referred as equity
risk premium as factor of compensating for opportunity costs i.e. alternative investments
which are similar to risk levels which has been pursued by shareholders. If the risk is
reduced then it signifies equity cost is also reduced(Grüninger and Kind, 2013).
 Capital restructuring: For reducing WACC organisation should review the structure of
debt in bid. In this restructuring debt can be substituted for equity because of lower costs
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after taxation. If equity is raised then it will directly attracts the marginal cost of capital
which signifies raising new capital's cost along with equity risk premium. Organisations
can substitute common stock by preferred stock for decreasing WACC which is less
expensive as compared to common stock due to less equity premium rates.
Cost of debt is less expensive from cost of equity because of factor risk, equity is more
risky as compared to debt, return which is required for compensating debt is less than equity
because of interest payment is of fixed amount which is paid initially in the form of dividend
payments. Debt is less risky than equity because of liquidation factor, capital repayment will be
first received by debt holders before shareholders because of top position in creditor hierarchy
and last payment is paid to shareholders. In debt financing costs, debt's cost is interest rate which
is applied on loans borrowed from financial institutions and non bank financial institutions. The
interest rate which is applicable reflects risk for non payment relative collateral which is required
for attaching loans. Non payment leads to cutting debt, if the alternative capital's interest rate is
higher, then organisation should pay off the debt and alternative capital should be sourced so
obligation for repayment of alternative capital at less interest rates(Zabarankin, Pavlikov and
Uryasev, 2014). From the organization's perspective also debt is cheaper than compared to equity
because of taxation that corporate tax of interests and dividend's treatment. Interest is excluded
before the calculation of tax in profit and loss account and companies get tax free on interest.
When tax is calculated dividends are excluded and there is no tax relief on dividends by the
organisation. More expensive equity replaces by less expensive debt for reducing the average
WACC. If more debt is issued which is also referred as gearing then more interest payment on
profits before the payment of dividends by shareholders and interest payment increases then
volatility of payment of dividends to shareholders because if company is facing poor year then
still payments of interests should be still paid giving effect on the ability of organisation to pay
dividends. If the volatility is increased for dividend payment to shareholders which will lead to
increment in financial risk for shareholders. And if the financial risk of shareholders increases
then there is huge requirement of return for compensating them for risk increment and if the
equity's cost will increase then it will lead to increment in WACC.
After knowing all the elements of WACC the first step is working on the ways how to
lower it. In the context of debt, organisations can decrease cost of issuing bonds by less interest
rate which is offered to investors. Even this can be done by being most credit worthy. The
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organisations whose credit rating is worse should offer bonds with higher rates. If the company is
moving for high tax rate but this leads to counter productive. In terms of equity, shares of less
beta can be offered by the company to low risky investors who offers less risk premium. In the
same series general market risk and risk free premium are not in company's control i.e. outside
the company's control. Caution should be always taken regardless of company's method for
reducing WACC because of each method depends on the suitability on existing capital structure
of the company(Kukko, 2013). As huge amount of debts which are long-term can be extremely
burden and difficult to the organization.
Last but not least, WACC can be the lowest by: issuing more debt but contrary to that
more debt increases the WACC as Financial risk, gearing, beta equity and Keg WACC. Keg is
beta equity's function which consists of both financial risk and business risk. If there is increment
in financial risk then beta equity will increase, Keg will increase and majorly WACC will
increase. The WACC reduction is majorly caused by great amount of less expensive debt or the
increment in WACC is due to Increase in the financial risk.
Task 5 Benefits of two types of growth: Organic and Acquisitive growth
Two types of growth are: Organic growth and Acquisition growth
Organic growth: It is the growth rate of company which can be achieved by enhancing
sales and increasing output internally or the expansion of the organization by the operations from
its own resources which are generated internally without borrowing or acquiring other
companies. As it is from perspective of long term, so many investors and executives value it and
gives perfect commitment for building a business. This can be also taken as in negative manner
because it signifies contracting of business. Organic growth observed by investors for the
purpose of keeping track on increasing revenues and sales and to check the sustainability is
increasing or not in long term(Geus, 2011). Organic growth shows that how the management of
the organisation is optimising and utilising the internal resources for generating a rise in sales
and output. There is presence of artificial boost on organization's sales and revenue figures by
mergers, takeovers and acquisitions. The special focus on organic growth shows that how
organization is able to achieve it goals and objectives along with internal means.
Organic growth is usually more preferred by investors because of management's efficient
use of resources and commitment for the business and also because it gives proper analysis of the
organization and in easy manner. By observing the financials of the company, the main
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indication is about to note that sales and revenue numbers must be inflated because of recent
acquisitions. And because of this, investors will rid off the non organic growth from the financial
of the organization which signifies potential of true growth to the company's core. There are very
less organisation who relies on mergers and acquisitions because there analysis is about to get
only the core figure. It can maintain current management culture, style and ethics as it is less
risky which can expand where it is expertise. It makes easier for the organization to manage
internal growth. There is less disruption changes i.e. worker's productivity and efficiency and
their morale should be at highest.
Acquisition growth: It can be also refereed as inorganic growth, in which the operation's
growth of business comes from acquisition and merger, instead of increment in organisation's
own business activity. Goodway Plc can also expand into the unfamiliar industry by acquisition
i.e. Noggin plc. If there is need of expansion, then company can select to facilitate by acquiring
some small business. This acquisition leads to fast and rapid growth but along with this difficult
issues are also in the picture. The main advantage of acquisition is that organisation can gain
experience, assets and goodwill of other organization. Efficiency can be improved from the
merger if the acquired business compliment others about its operations. There is positive
relationship between staff, assets and output, profits. Strength and weakness of both the
companies should be merged.
Acquisition leads to excitement in shareholders like if public company's shareholders
hear the news of acquisition or merger then positive framework has been established as well as
valuation of the organisation (Pal, and.et.al, 2018). It may leads to rise in stock price and
investment's equity. It will lead to focus on the priorities and business aspects which are more
important for development. It will give encouragement to build and grow a better and bigger
business. The experience of company will help in curing calculated risks for growth which is
optimal. Wit the help of acquisitions, new people brings fresh ideas and perspectives to run
business for creating brand image and good margins. Knowledge base is required while working
with the expert team who are more passionate about guiding to achieve and accomplish goals
and objectives.
CONCLUSION
From the above report it has been concluded that strategic and financial decision-making
is very important from the perspective of business for every organization. To evaluate cost of
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capital, many methods are used like Weighted average cost of capital, Capital Asset pricing
model by adjusting risk. It has been cleared from the report that Weighted average cost of capital
considers full capital structure i.e. weight of cost of debt and weight of cost of equity. It is the
easiest method for calculating cost of capital. If risk free rate, required rate of return and beta has
to be considered for measuring cost of capital then Capital asset pricing model should come into
the picture. As in the series of growth there are basically two types of growth which are organic
growth and acquisition growth. For some small companies organic growth is important but in the
present case for company to increase cost of capital inorganic growth has been considered. From
this we can conclude that type of growth is based on type of industry.
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REFERENCES
Books and Journals
Brusov, P.and.et.al., 2011. Weighted average cost of capital in the theory of Modigliani–Miller,
modified for a finite lifetime company. Applied Financial Economics. 21(11). pp.815-824.
Da, Z., Guo, R. J. and Jagannathan, R., 2012. CAPM for estimating the cost of equity capital:
Interpreting the empirical evidence. Journal of Financial Economics. 103(1). pp.204-220.
David, F. R., 2011. Strategic management: Concepts and cases. Peaeson/Prentice Hall.
Fernandez, P., Aguirreamalloa, J. and Linares, P., 2013. Market Risk Premium and Risk Free
Rate used for 51 countries in 2013: a survey with 6,237 answers.
Geus, A., 2011. The living company: Growth, learning and longevity in business. Nicholas
Brealey Publishing.
Grüninger, M. C. and Kind, A. H., 2013. WACC calculations in practice: Incorrect results due to
inconsistent assumptions-status quo and improvements. Accounting and finance
research. 2(2). p.36.
Krüger, P., Landier, A. and Thesmar, D., 2015. The WACC fallacy: The real effects of using a
unique discount rate. The Journal of Finance. 70(3). pp.1253-1285.
Kukko, M., 2013. Knowledge sharing barriers in organic growth: A case study from a software
company. The Journal of High Technology Management Research. 24(1). pp.18-29.
Larkin, P. J., 2011. To iterate or not to iterate? Using the WACC in equity valuation. Journal of
Business & Economics Research (Online). 9(11). p.29.
Merigó, J. M. and Casanovas, M., 2011. Induced aggregation operators in the Euclidean distance
and its application in financial decision making. Expert Systems with Applications. 38(6).
pp.7603-7608.
Pal, R. P., and.et.al., 2018. Influence of feeding inorganic vanadium on growth performance,
endocrine variables and biomarkers of bone health in crossbred calves. Biological trace
element research. 182(2). pp.248-256.
Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with
drawdown measure. European Journal of Operational Research. 234(2). pp.508-517.
Online
Cost of Capital, 2018. [Online]. Available through
<https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/>
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