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

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Added on  2021-02-18

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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

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

   Added on 2021-02-18

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Strategic and Financialdecision making
Risk Adjusted Cost of Capital: How organizations can lower the WACC_1
TABLE OF CONTENTSINTRODUCTION...........................................................................................................................1Task 1 Weighted average cost of capital in different scenario...................................................1Task 2 Cost of capital..................................................................................................................2Task 3 Estimation of risk-adjusted Weighted Average Cost of Capital.....................................33.1 Calculation of risk adjusted specific discount rate......................................................33.2 WACC for Noggin plc.................................................................................................3Task 4 How organizations can lower the WACC.......................................................................4Task 5 Benefits of two types of growth: Organic and Acquisitive growth.................................6CONCLUSION................................................................................................................................7REFERENCES................................................................................................................................8Appendix..........................................................................................................................................9
Risk Adjusted Cost of Capital: How organizations can lower the WACC_2
INTRODUCTIONStrategic and financial decision making plays very important role from the businessperspective. It usually involves defining the objective of the organization by identifying itsresources and quantifying its resources. This report is divided into five tasks, each task isdepicting its own importance. Task 1 is giving brief information about Weighted average cost ofcapital with proper calculation in same series task 2 to calculate suitable cost of capital and innext 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 typesof growth i.e. organic and inorganic growth.Task 1 Weighted average cost of capital in different scenarioOrganization's weighted average cost of capital indicates the combination cost of capitalamong all the sources which consists of common shares, preferred shares and debt. Every cost ofcapital is being weighted by its own percentage of aggregate capital which is summed of. Theformula 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 iscost 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 preferredstock.WeightPost TaxTotal weightCapital640000000Weighted cost (preferred shares)0.310.110.03Weighted cost (3% loan stock)0.220.080.02Weighted cost (9% loan stock)0.230.080.02Weighted cost (6% loan stock)0.230.080.02Cost of Preferred Stock45.60%3% debt cost74.30%WACC8.94%9% debt cost42.20%6% debt cost70.40%1
Risk Adjusted Cost of Capital: How organizations can lower the WACC_3
Interpretation: In the above scenario market value of preferred stock price is20,00,00,000 and the dividend on the preferred stock is 11.4 along with the cost of preferredstock is 46%. There are three scenarios for the debt cost i.e. 3%, 6% and 9% the tax rate has beengiven as 35% for all. The market value of 3% debt has been calculated as 140000000 with thecoupon amount of 0.948 and maturity of 10 years. So the cost of debt before tax and cost of debtafter tax has been calculated as 74.3% and 48.30% respectively. The market value of 6% debthas been calculated as 150000000 with the coupon amount of 6 and maturity of 6 years. So thecost 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 couponamount of 9.29 and maturity of 10 years. So the cost of debt before tax and cost of debt after taxhas been calculated as 42.20% and 27.43% respectively. The total capital is 64,00,00,000 so theweighted cost is calculated of 3%, 9% and 6% loan stock as 0.31, 0.22 and 0.23 respectively andcost of debt after tax has been referred for determining WACC which is 8.94%.Task 2 Cost of capitalCost of capital is referred as the opportunity cost of some particular investment. Byputting some money into a some unique investment which has equal risk so the rate of return canbe determined. It consists of both cost of debt and cost of equity for financing the business. Thecost 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 andequity(David, 2011). The organisations capital structure has been determined by choice offinancing which makes the important variable to cost of capital. Usually organisations look forproper optimal combination of financing which gives adequate funding and to minimise the costof capital. The most common way to measure the cost of capital is to use weighted average costof capital. Under this method all the fund's sources are been used for the calculation of givenweight according to the proportion of the structure of capital.Post taxTotal weightCost of Preferred Stock52.63%0.180.103% debt cost24.01%0.080.029% debt cost13.45%0.050.016% debt cost9.91%0.030WACC12.69%2
Risk Adjusted Cost of Capital: How organizations can lower the WACC_4

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