Corporate Finance Analysis: Capital Structure and Discount Rate

This report provides a comprehensive analysis of corporate finance, focusing on the capital structure and discount rate of Middle East Machinery Plc. It begins by discussing the importance of capital structure in determining the level of finance and associated costs, emphasizing the balance between debt, equity, and other financing sources. The report calculates the cost of equity using the Capital Asset Pricing Model (CAPM), considering both geared and ungeared beta. It then evaluates the cost of debt based on interest rates and credit ratings, which are influenced by the level of debt. The weighted average cost of capital (WACC) is determined to find the optimal mix of debt and equity that minimizes the cost of capital. The appropriate discount rate for evaluating new projects is also discussed, incorporating the cost of debt and equity. The analysis concludes with recommendations on the optimal capital structure and discount rate, providing insights for financial decision-making, considering both business and financial risks.

Running head: CORPORATE FINANCE ANALYSIS
Corporate Finance
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
Introduction......................................................................................................................................2
Discussion........................................................................................................................................2
Cost of Equity..............................................................................................................................2
Cost of Debt.................................................................................................................................3
Weighted Average Cost of Capital..............................................................................................4
Appropriate Discount Rate..........................................................................................................5
Conclusion.......................................................................................................................................6
References........................................................................................................................................8

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Introduction
Capital Structure of a company plays a crucial role while deciding upon the level of
finance and the cost associated with each of the financing sources. It is important that companies
maintain an optimal capital structure whereby an optimal mix of debt, equity and other financing
sources are proportionately applied in the overall financing structure of the company (Brusov et
al., 2018). It is important that the business risk and financial risk of the company are well
analysed before deciding upon the optimum level of debt that the company would be taking in
the overall capital structure of the company (Callen 2016).
Discussion
Cost of Equity
The cost of equity for the stock was calculated with the help of the Capital Asset Pricing
Model where the required rate of return formula applied for the computation of the same was as
follows:
CAPM, Ke = Rf + (Rm – Rf) β
Where;
Ke: Cost of Equity
Rf: Risk Free Rate
Rm: Return on Market
B: Beta
It is important to consider both geared and ungeared beta for the purpose of relevant
exposure of equity and asset beta of a company. Alteration in the Capital Structure of a company
can significantly affect the profitability or the net income of the company. It is important the

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weight and level of equity as compared to the level of debt remains constant (Hirth and Steckel
2016). The weight of equity in the company was determined at different level so that the
associated cost of equity remains at a substantial rate. The geared equity was also calculated for
the calculation part, which was determined by taking the geared equity position and the
respective weight of the equity and debt position in the financials of the company (Schleich et
al., 2016). The cost of equity for the company would change as the level of debt financing
undertaken by the company increases from a certain level. The increase in the cost of equity
increases as the level of debt increases and the reason behind such increase is due to the higher
risk associated with the financing. The rise in the cost of equity is comparatively less than the
rise in the cost of debt for the company (García-Gusano et al., 2016).
% Debt (Debt /
(Debt +
Equity))
Post Tax
Cost of
Debt
Cost of Equity WACC
10% 4.55% 13.33% 12.45%
20% 4.97% 13.99% 12.19%
30% 5.46% 14.84% 12.03%
40% 5.95% 15.97% 11.96%
50% 7.00% 17.56% 12.28%
60% 8.40% 19.94% 13.02%
70% 10.50% 23.91% 14.52%
Cost of Debt
The cost of debt for the company can be calculated with the help of the different level of
interest rate that is charged by the lender depending upon the credit risk of the borrower. The
cost of debt for the company will differ significantly as the weight of debt changes in the total
capital structure of the company (Johnstone 2016). The credit rating for the company would vary
as the level of debt changes. The credit rating for the company would decline from AAA to C if
the level of debt changes from 10% to 70%. The pre-tax cost of debt for the company is given

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whereby the applicable tax rate would be taken into consideration for the purpose of evaluation
of the post-tax cost of debt. Debt financing helps the company enjoy the lower cost of financing
as well as the tax-deductible interest expenses that is paid by the company (Sweeney 2018).
Weighted Average Cost of Capital
The optimal cost of capital for the company would be derived with the help of the
optimal weights of debt and equity that results in the total lower of cost of capital for the
company. The optimal weights that would result in the lowest possible cost of capital would be a
combination of 60% equity and 40% debt, which would result in the WACC of about 11.96%. It
is essential that the optimal weight of debt and equity to be kept at an optimal rate so that the
same minimizes the financial risk of the company (Ondraczek, Komendantova and Patt, 2015).
The WACC for the company should be at a minimal rate so that the cost of financing is
comparatively lower for the company and in line as per the industry average.
% Debt (Debt /
(Debt +
Equity)) Rating
Pre-tax
cost of
debt
Post Tax
Cost of
Debt
% Equity
(Equity/Equit
y +Debt)
Geared
Beta
Tax
Rate
Ungeared
Beta
Cost of
Equity Rf
Market
Return WACC
10% AAA 6.50% 4.55% 90% 0.92 30% 0.85 13.33%
6
% 14.0%
12.45
%
20% AA 7.10% 4.97% 80% 1.00 30% 0.85 13.99%
6
% 14.0%
12.19
%
30% A 7.80% 5.46% 70% 1.11 30% 0.85 14.84%
6
% 14.0%
12.03
%
40% BBB 8.50% 5.95% 60% 1.25 30% 0.85 15.97%
6
% 14.0%
11.96
%
50% BB 10% 7.00% 50% 1.45 30% 0.85 17.56%
6
% 14.0%
12.28
%
60% B 12% 8.40% 40% 1.74 30% 0.85 19.94%
6
% 14.0%
13.02
%
70% C 15% 10.50% 30% 2.24 30% 0.85 23.91%
6
% 14.0%
14.52
%
The above capital structure of the company with a weight of 40% equity and 60% debt
should be an optimal one. Yes the company should adopt the above capital structure as the

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optimal capital structure as it would give the company with a exposure of lower cost tax
deductible finance and lower risk financing of equity. However, there are several other factors
and consideration that the company should consider while evaluating the proposed capital
structure by analysing the business risk or the variability in the operations of the company. The
changes in the financial position of the company is also one of the key factor that should be
evaluated while considering the optimal capital structure of the company. Both the sources of
financing have their own advantages and disadvantages while considering from a single point
however mixing them in an optimal basis can lower down the actual cost of capital for the
company.
Appropriate Discount Rate
The appropriate discount rate that should be taken into consideration is the selection of
the debt and equity at a proportionate rate so that the cost of capital (Kc) of the firm stays at an
optimal rate. The appropriate discount rate shows the minimum required rate of return for the
company on a pre-tax EBIT. In this scenario, the net income would not be considered as the debt
financing also plays an important role in the capital structure of the company (Frank and Shen
2016).
Cost of Debt: The cost of debt for the company would be calculated with the help of the YTM
generated by the bond and the same would be determined. The determination of the YTM would
be done by taking the face value of the bond as £100, CMP as £103, debenture rate as 7% that
will be the coupon rate payable on a semi-annual basis. The weight of debt for the company
would be determined with the help of the overall value of debt divided by total capital. The
above factors that were taken into consideration gave a cost of debt for the company as 3.36%.

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Cost of Equity: The cost of equity for the company would be calculated with the help of the
CAPM model. Factors that would be taken into consideration is the risk free rate of 6%, market
risk premium of 8% and equity beta of 1.1 times. The cost of equity for the company came to
around 14.8% for the company.
Cost of Capital: Given, the weights and proportions of each of the financing sources the weights
for each of the financing source would be determined. The cost of capital for the company says
about the total required rate of return required by the capital holders of the company for taking
the level of risk associated with financing. The appropriate discount rate that should be applied
for the purpose of evaluation of new project is 11.28% and the same is determined as follows:
Discount Rate Evaluation
Cost of Debt
30.77
%
Cost of Equity
69.23
%
Cost of Debt: 3.36%
Cost of Equity:
14.80
%
Discount Rate:
11.28
%
However, there are several other factors and consideration that the company should
consider while evaluating the proposed discount rate by analysing the business risk or the
variability in the operations of the project. The changes in the financial position of the company
is also one of the key factor that should be evaluated while considering the optimal capital
structure of the company.

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Conclusion
Optimal Capital structure and discount rate for evaluating a new project were the two
main concepts developed and discussed in the assignment. The optimal cost of capital for the
company was derived with the help of the optimal weights of debt and equity that resulted in the
total lower of cost of capital for the company. The optimal weights that would result in the
lowest possible cost of capital would be a different combinations that were tried for computing
the cost of capital. The appropriate discount rate that should be taken into consideration is the
selection of the debt and equity at a proportionate rate so that the cost of capital (Kc) of the firm
stays at an optimal rate and the project of a company could be evaluated well.

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References
Brusov, P., Filatova, T., Orekhova, N. and Eskindarov, M., 2018. New meaningful effects in
modern capital structure theory. In Modern Corporate Finance, Investments, Taxation and
Ratings (pp. 537-568). Springer, Cham.
Callen, J.L., 2016. Accounting valuation and cost of equity capital dynamics. Abacus, 52(1),
pp.5-25.
Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of
Financial Economics, 119(2), pp.300-315.
García-Gusano, D., Espegren, K., Lind, A. and Kirkengen, M., 2016. The role of the discount
rates in energy systems optimisation models. Renewable and Sustainable Energy Reviews, 59,
pp.56-72.
Hirth, L. and Steckel, J.C., 2016. The role of capital costs in decarbonizing the electricity sector.
Environmental Research Letters, 11(11), p.114010.
Jagannathan, R., Matsa, D.A., Meier, I. and Tarhan, V., 2016. Why do firms use high discount
rates?. Journal of Financial Economics, 120(3), pp.445-463.
Johnstone, D., 2016. The effect of information on uncertainty and the cost of capital.
Contemporary Accounting Research, 33(2), pp.752-774.
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.
Ondraczek, J., Komendantova, N. and Patt, A., 2015. WACC the dog: The effect of financing
costs on the levelized cost of solar PV power. Renewable Energy, 75, pp.888-898.
Schleich, J., Gassmann, X., Faure, C. and Meissner, T., 2016. Making the implicit explicit: A
look inside the implicit discount rate. Energy Policy, 97, pp.321-331.

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Sweeney, R.J., 2018. The Information Costs of Capital Controls. In Capital Controls in
Emerging Economies (pp. 45-61). Routledge.