Investment Appraisal and Cost of Capital Analysis for Trust Plc

This report provides a comprehensive analysis of Trust Plc's financial management, focusing on the computation of market value, book value, and cost of capital. It evaluates the finance director's proposal to increase debt and its impact on the overall cost of capital. The report also examines the relationship between Weighted Average Cost of Capital (WACC) and Internal Rate of Return (IRR) in investment decisions. Furthermore, it discusses various valuation techniques such as Price Earnings Ratio, Discounted Cash Flow method, and Dividend Valuation method, highlighting their challenges and providing recommendations for Kings Plc. The analysis includes recalculations of the cost of capital under different scenarios and offers a critical perspective on the impact of gearing on the company's financial structure. This resource helps students understand complex financial concepts and investment appraisal techniques, and similar solved assignments and past papers are available on Desklib to aid in their studies.

Management

Table of Contents
...........................................................................................................................................................
INTRODUCTION.......................................................................................................................3
QUESTION 1............................................................................................................................3
1. Computation of market value , book value and cost of capital for Trust Plc...................................3
b) Recalculation of cost of capital of the business and creation of comments to prediction of the
finance director:.................................................................................................................................6
C) Serious argument on whether by overview of gearing the overall cost of capital has been
condensed to an acceptable level:.....................................................................................................7
d) Estimation of association among WACC and IRR with regard to the investment. Correlation
between WACC and IRR.....................................................................................................................8
QUESTION 3............................................................................................................................9
a) Price Earnings Ratio........................................................................................................................9
b) Discounted Cash Flow Method.....................................................................................................10
c) Dividend Valuation Method.........................................................................................................10
d) Critically converse above the challenges that bare associated with the valuation techniques used
above. Also recommend that what are the techniques that could be recommended to the board
member of Kings Plc.........................................................................................................................11
CONCLUSION.........................................................................................................................12
REFERENCES..........................................................................................................................13

INTRODUCTION
The report explains how financial management can be used as a technique and tool in
several companies that would help to carry out related financial activities and operations in
competitive market. It serves a systematic approach for carrying out transactions more efficiently
and effectively during the year that would help business to run properly (Duffy and Criner,
2019). It is explained as a combined method that takes in account different functions such as
planning, preparing and developing of budgets that would serve as a guide in the hour of need.
This report covers various set of questions that consider queries asking in managing funds and
finance related operational activity. The report includes two questions that would help to have a
clear idea about what is being talked about and how a company and business work in related
environment and contribute in development of situation. It also states different tools that is being
used for calculation and computation of price earnings ratio and dividend growth models as well.
Discounted cash flow and price earning ratio has also been taken in consideration. There are
various recommendations given to management which model would suit best from available
models that have been laid and applicable.
QUESTION 1
1. Computation of market value, book value and cost of capital for Trust Plc.
It depicts the quantity of money that the organisation would be investing in certain assets
in order to get return by use of specific machinery is known as cost of capital. For example: If
any person is investing some of its funds for installation of new machine in their related business
for ascertaining targeted objectives in the organisation, then the expenses is included in the
machinery is said to be cost of capital and against this organisation want some return that would
be able to justify those costs.
Weighted average cost of capital reflects average cost of capital for organisation which
would be paid by business towards its associated bondholders and shareholders as well.
Generally, in WACC if organisation demand funds to be invested in their business for growth
and expansion then the company must issue bonds or common stocks for people so that they can
purchase them and invest the money in the firm and against this the enterprise would provide
some extra return to its investors as well (American Diabetes Association, 2018). For example: If
a organisation need fund and cash then they can issue some related stock I public then the

company can make a bundle of average related cost of capital and give some expected return as
well to investor linked with firm.
Book value of WACC: It depicts the quantity of balance of an asset that is possessed and
reflected in prepared balance sheet of company. Basically, it shows the asset that are being
valued on the firm balance sheet in which corporation can formulate its asset valuation which are
present and available in financial position of business. The balance is complete presentation of
the finance related balance of enterprise that present the finance related positioning of the
organisation.
Market value of WACC: If business compute its anticipated expense related to cost of capital,
then the weighted average calculated on the base of market price of various factors is not present
in book value. Market value is the price on which an asset would be imported or exported on
basis of highest bidding value between various competitors present.
Computation of book value weighted average cost of capital:
In order to calculate the WACC the following figures needs to be addressed:
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
30000 .50 24 % 12 %
Preference
Share Capital
10000 .17 7 % 1.19 %
Reserves and
surplus
5000 .08 24 % 1.92 %
Bonds 15000 .25 10 % 2.50 %
Total 60000 1.00
WACC 17.61%
Working Notes: -
The cost of preference shares = 7 %
The cost of bonds = 10 5
The cost of Reserves and surplus will be equivalent to the cost of Equity
The cost of equity will be calculated as under: -

It will be calculated by using the Gorden growth model formula: -
Ke = D1 / P0 + G
Here growth rate is calculated as under
Growth rate
= (.31 / .23) .20
= .42 or 42 %
Now the expected dividend will be:
D1
= D0 + Growth Rate
= .31 + 42 %
= .44 p
Cost of Equity will be: -
= .44 / 2.56 + 42 %
= 24 %
Estimation of market value weighted average cost of capital:
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
76800 .73 24 % 17.52 %
Preference
Share Capital
7500 .07 7 % .49 %
Reserves and
surplus
5000 .05 24 % 1.2 %
Bonds 16050 .15 10 % 1.50 %
Total 105350 1.00
WACC %

b) Recalculation of cost of capital of the business and creation of comments to prediction of the
finance director:
The finance director of the firm which is Ms Zara Green is on side of increasing debt in the
enterprise so that overall expense of capital can be minimized. They are proposing for
raising £16m by issue of 12% redeemable bonds. Such bonds can be issued at premium of
5% and they can be redeemed after 7 years.
The cost of these bonds will be calculated as follows:
The formula of calculating the bonds
= {Interest (1 – tax rate) + (Redeemable Value – Net Proceeds) / N} / (Redeemable Value + Net
Proceeds / 2) * 100
= {1.92 (1 - .30) + (16.80 – 16) 7} / (16.80+16 / 2) * 100
= (1.34 + .1143) / 16.40 * 100
= 8.87 %
With the help of such funds they can repurchase the share of company @ 2.95 per share
and anticipate that the growth rate will be 15 %. They think that worth of the bonds will remain
the same but price of preference share will fall to .68p
The revised weighted average cost of capital considering the above adjustment has been
calculated as under: -
Revised cost of Capital:
Particular Amount Weights Cost of
Capital
WACC
Equity Share
capital
88500 .67 23.12 % 15.49 %
Preference
Share Capital
6800 .05 7 % .35 %
Reserves and
surplus
5000 .04 23.12 % .92 %
Bonds
Irredeemable
15000 .11 10 % 1.10 %
Bonds
Redeemable
16000 .13 8.87 % 1.15 %

Total 131300 1.00 WACC 19.01 %
Working Notes: -
The cost of equity will be computed as under: -
It will be calculated by using the gordens growth model formula: -
Ke = D1 / P0 + G
Revised Growth rate
= 42 % + 15 %
= 48.30 %
Now the expected dividend will be:
D1
= D0 + Growth Rate
= .31 + 48.30 %
= .46 p
Cost of Equity will be: -
= .46 / 2.95 + 48.30 %
= 23. 12 %
The expense of preference share stays same which is 7%.
C) Serious argument on whether by overview of gearing the overall cost of capital has been
condensed to an acceptable level:
AT the time of introducing debts by an organisation in their related capital structure the
overall cost in relation with company reduced by 1.70 % and their revised weighed average cost
of capital results as 19.01 %. At the time when fixed price of cost of capital is more in company
then the firm has to pay fixed rate of interest and their expected return is also limited to interest,
they expect. Therefore when an firm is geared by m0re equity in their capital structure then in
that situation the entity is require to pay more amount for fulfilling the need of shareholder’s
expectation as they taken risk when they are planning to invest In certain specific company. In
stated case the faith plc changed their capital structure by addition on more redeemable debt in
their capital structure the overall expenses of them have shortened that is taken by equity and has
been shifted towards debtholders.

.
d) Estimation of association among WACC and IRR with regard to the investment. Correlation
between WACC and IRR.
Meaning of Weighted average cost of capital
It helps the company to make the bundle of average cost of capital so the firm can pay the returns
against investment to their stakeholders and shareholders of the company. Basically in other
circumstances company issue stocks or some other security when they need funds in their
business for the growth and development of their company. After issuing of security interested
investors buy the securities and hold it for long term so, they will get good results in invested
security (Bhargava and Trivedi, 2018).
Meaning of Internal rate of return
This method is helps to check the financial stability of the business and analyse the profitable
condition of the firm. So, basically it assists the investor is good to invest in the company or not
in a very long period. And it also defines as the internal rate of return is a sum of all cash inflows
and outflows becomes zero. There is one formula to calculate internal rate of return of a
business:
IRR = cash flow / (1 + r)i
Let's talk about the relationship between the WACC and IRR: -
 In this point it shows the IRR = WACC means weighted average cost of capital and
Internal rate of return they both are equal to each other because it says that the
investment done by the investor in financial activities creates expectation of market
participation and show that the purchasing value is equal to the fair value of acquire
firm.
 Another relation between IRR > WACC the Internal rate of return and weighted average
cost of capital is that IRR is greater than the WACC. Basically it means they do
investment in financial activities perform into the organization it includes that the
synergy of specific purchaser or the investment in activities is so positive then the
buying of goods was generated at a bargain value.
 The final relation between them is IRR < WACC It means Internal rate of return is less
than the weighted average cost of capital. Basically it tells about that the investment in

financial activities is above from all the expectation of market participant positivity or
in other circumstance investment in activities can also become too conservative if buyer
more pay for the targets.
The relationship between the weighted average cost of capital and internal rate of return manifest
about which method is easier to use. So, it is concluded that WACC is good to use for
the company as compare to the IRR because in WACC company make a bundle of all
the average cost of capital and provide returns to their investment but in IRR is difficult
to use because it predicts about the profitability of business for the potential investor
and risk is also involved in it. And it makes all cash flows of the company becomes
zero. So, according for the above relationship it may come out that the Weighted
average is much (Nenadál, 2018).
QUESTION 3
a) Price Earnings Ratio
The price to earnings ratio can be explained as a method that helps and assists in value
computation that helps to measure its present share price comparative to its earning per share. It
is also recognised as price multiple. Also, it is useful for predicting whether investors are willing
to pay an increased share rates in current situations the reason being growth expected in near
future. It is calculated by division of market price per share by earnings per share. Such method
is useful for valuation of businesses and is helpful for examining whether they are undervalued
or overvalued (Armstrong and Taylor, 2020). P/E ratio helps in understanding terms related to
growth potential of a respective firm.
Types of Profit earnings ratio:
 Forward P/E ratio: In such cases earnings are predicted for over a period of 12 months
that are considered. Investors take help of forward Profit earnings ratio for assessing
ways through which organisations are expected to perform in related future and think of
its growth rate on an estimated scale.

 Trailing P/E Ratio: Earnings/ Income generated from past 12 months are taken into
account for determining profit earning of a stock. It ascertains a more reliable, accurate
and objective aspect of results served by an enterprise.
The formula for the above is = Market share price / Earnings per share
= 4.25 / 0.31
= 13.71
Value of the firm Dragon Plc which could be computed by using the P/E ratio of the Kings Plc is
below:
= Earnings per share of Dragon Plc * P/E of Kings plc
= (40.4 / 210) * 13.71
= 0.19 * 13.71
= 2.605
b) Discounted Cash Flow Method.
It is counted as a valuable tool and technique that can prove to be helpful in estimating the
value of an investment made which is based on its predicted future cash inflow and outflow.
Discounted cash flow method is an attempt to find out the value of present time investment at
present, which is formed on the basis of anticipation as what amount of funds can be generated in
futuristic situation. There are certain advantages that are related to Discounted Cash Flow model
such as it helps in determining intrinsic value of a company, is descriptive and extremely detailed
as well, does not demand any comparable organisations, takes in record all future related
expectations in working of as firm. DCF rightfully captures the related key drivers in a business
(weighted average cost of capital, re investment rate, cost of equity and growth rate as well).
Therefore, there are many assumptions that are taken into consideration while computing DCF
such as that the worth of money is higher than what it is expected to become in future period and
another assumption is that while DCF is being computed it is assumed that a firm or an asset will
be generating cash inflow and outflow in coming days. The word 'Discounted' in such cases
denotes adjustment for the diminishing amount of funds (Hallman, and Denlinger, 2019).
Annual After tax synergy / Cost of Capital
= 5.36 / 11% = 48.73

c) Dividend Valuation Method
Po = D1 / (Ke – G)
= 12p / (6.13% - 2.5%)
= 12p / 3.6%
= 333.33 p or £ 3.33
Valuation of Dragon Plc
= Number of Equity Shares * the current market price per share
= 210 * 3.33
= £ 699.33.
Here,
Po - Current Market Price per share
Ke - Cost of Equity
D1 - Expected dividend per share
G - Growth rate
Working Notes:
 Cost of Equity:
CAPM = Rf + B (Rm – Rf)
= 5.5 + 1.05 * (11% - 5.5%)
= 5.5 % = 1.05 * (5.5%)
= 5.55 + 0.58
= 6.13 %
 Calculation of Expected Dividend per share:
D1 = Dividend Paid (Do) + Growth Rate (G)
= 12p + 2.5
= 12.3 p
d) Critically converse above the challenges that bare associated with the valuation techniques
used above. Also recommend that what are the techniques that could be recommended to
the board member of Kings Plc.
Challenges that is faced by using the above methods are: