In-depth Analysis: Cost of Capital and Valuation of Parcel’s Limited

This report provides a comprehensive analysis of Parcel’s Limited, focusing on the calculation and implications of its weighted average cost of capital (WACC). Initially, the WACC is determined under the assumption of full equity financing, followed by a valuation of the firm using discounted cash flow (DCF) methods. The analysis then incorporates debt financing into the capital structure, recalculating the WACC and reassessing the firm's value. The report concludes with recommendations, suggesting that Parcel’s Limited should prioritize equity financing due to the increased cost of capital associated with debt, which negatively impacts the firm's overall valuation. The calculations and findings are supported by relevant academic literature, offering a robust evaluation of Parcel’s Limited’s financial strategy. Desklib provides access to this and other solved assignments.

Running Head: ANALYSIS OF PARCEL’S LIMITED 0
Analysis of Parcel’s Limited.

ANALYSIS OF PARCEL’S LIMITED 1

ANALYSIS OF PARCEL’S LIMITED 2
Table of Contents
Introduction................................................................................................................................2
Current cost of capital................................................................................................................2
Value of the Parcel’s Limited....................................................................................................4
Revised Cost of Capital..............................................................................................................4
Revised Value of Parcel’s Limited............................................................................................6
Recommendations......................................................................................................................7
References..................................................................................................................................8

ANALYSIS OF PARCEL’S LIMITED 3
Introduction
Weighted average cost of capital also known as WACC is a method of calculating the
cost of capital of the firm or any organisation. Under this each kind of the capital is weighed
in a proper proportion. Under the calculation of the WACC all the sources of the capital are
taken into consideration like the common stock, bonds any long term debt or preferred stock.
WACC of any organisation can be increased when the beta and the rate of return on equity
increases. An increase in the WACC reflects a decrease in the valuation and increase in the
risk. To calculate the WACC, the cost component is multiplied by the respective proportional
weights and the summation of both is taken for the purpose of the overall result. It is one of
the easiest methods to calculate the cost of capital (Frank and Shen, 2016).
Current cost of capital
Calculation of the Current Cost
of Capital
CAPM MODEL
Particulars
Parcels
Limited
Risk free Rate of return (Rf) 8%
Beta (B) 1.2
Market rate of Return (Mr) 13%
Cost of Equity [Rf+B(Mr-Rf)] 14%
WACC= E/(E+D)*COST OF EQUTIY +D/(E+D)* COST OF DEBT (1-TAX RATE)

ANALYSIS OF PARCEL’S LIMITED 4
Calculation of WACC
WACC Values
Market value of Cost of Equity 14%
Market value of Cost of Debt 0%
Total market value of the company 14%
Cost of Equity 14%
Cost of Debt 0%
Tax Rate 28%
Cost of
Equity
Cost of
Debt WACC
E/E+D D/E+D
14.0% 0.0% 14%
Cost of capital is a type of return which is required to from a capital budgeting
project. Cost of capital is a formation of the cost of debt and cost of equity. Another way to
define the cost of capital is to through the cost of funds (Li, 2015). Cost of capital totally
depends upon the mode of finance whether through equity and debt. Many companies use a
combination of both and for these companies the calculation is done on the basis of the
weighted average cost of capital. The cost of capital generally determines a hurdle rate that a
company needs to overcome before it can generate value. This cost is exclusively used in the
process of the capital budgeting to simply remove the confusion about whether the company
should proceed with a project or not (Mukherjee, 2017).

ANALYSIS OF PARCEL’S LIMITED 5
From the above calculation it can be seen when the Parcel Limited was fully equity
financed the WACC is 14%.
Value of the Parcel’s Limited
Calculation of the Value of
Parcels
Cash flow 150000
WACC rate 14.0%
Value of Parcels 1071428.571
Discounted Cash Flow is a valuation which is used to measure the attractiveness of an
investment opportunity (Billett, Hribar and Liu, 2015). The DCF model generally uses the
future free cash flow projections and these cash flows are further utilising the annual rate to
arrive at the estimates of the present value. This present value estimate is then used to derive
the potential investment (Lorenz, Kruschwitz and Löffler, 2016).
CF= Cash Flow
R= Discount Rate
From the above calculation the value of the Parcel’s Limited using discounted cash
flow method amounts to 1071428.57.
Revised Cost of Capital
WACC Values
Market value of Cost of Equity 60%

ANALYSIS OF PARCEL’S LIMITED 6
Market value of Cost of Debt 40%
Total market value of the company 100%
Cost of Equity 14%
Cost of Debt 10%
Tax Rate 28%

ANALYSIS OF PARCEL’S LIMITED 7
Cost of
Equity
Cost of
Debt 1- Tax rate
WAC
C
E/E+D*Key D/E+D*Kid
8.4% 4.0% 72.0% 21.20%
Under the revised cost of capital structure the firm’s overall cost of capital us
calculated on the basis of the equity component as well as the debt component using the
weighted average formula for cost of capital (Barberis, et al (2015). Therefore the WACC of
the parcel limited after the inclusion of the component is 21.20%. This cost of capital is
further used to discount cash flows and to evaluate the value of the firm. The firms generally
try to attain an optimal mix for various resources of finance. Secondly the debt financing has
an edge over the equity financing. Under the debt financing the advantage of tax can be
availed. Due to the interest expenses which are available for deduction and dividends on the
common shares are allocate dafter the tax the cost gets stable. However, it shall also be
ensured that not too much debt is used for financing which may result into higher interest
rates which are decided by the lenders to offset the higher risk of default.
Revised Value of Parcel’s Limited
Calculation of the Value of
Parcels
Cash flow 150000
WACC rate 21.20%
Value of Parcels 707547.1698

ANALYSIS OF PARCEL’S LIMITED 8
Recommendations
From the above calculations of the parcel limited it can be observed that the debt
component is 40% of the total finance and the cost if debt is 10%. So it can be concluded that
a higher weighted average cost of capital is risky for the firm. Investors tend to require the
additional return to assume the additional level of risk (Borisova, et al 2015). This is an
indication that the company is actually losing its value. Even If the debt component is taken
into consideration it does not guarantee that the company will perform at par. For the purpose
of the debt saving the company can opt for debt financing but keeping in mind the cost of
capital and its output.
Therefore it is recommended that the Parcel Limited shall keep equity finance only as
the cost of capital robustly increased after inclusion of the debt component. Right from 14%
to 21.20% the company has to pay huge amount of interest and other expenses which is
costly. A higher WACC is not favourable for the company. The value investors might also be
concerned of the WACC is higher than actual returns. The company also talks about the
perpetuity (Dhaliwal, Judd, Serfling and Shaikh, 2016). Under the infinite cash flows of
$150000, the company has to incur 21.20% which is higher; hence it is advised not to include
the debt component for financing as the value of the parcel limited also decreased by almost
$363881.

ANALYSIS OF PARCEL’S LIMITED 9
References
Barberis, N. et al (2015) X-CAPM: An extrapolative capital asset pricing model. Journal of
financial economics, 115(1), pp.1-24.
Billett, M.T., Hribar, P. and Liu, Y. (2015) Shareholder-manager alignment and the cost of
debt.
Borisova, G. et al (2015) Government ownership and the cost of debt: Evidence from
government investments in publicly traded firms. Journal of Financial Economics, 118(1),
pp.168-191.
Dhaliwal, D., Judd, J.S., Serfling, M. and Shaikh, S. (2016) Customer concentration risk and
the cost of equity capital. Journal of Accounting and Economics, 61(1), pp.23-48.
Frank, M.Z. and Shen, T. (2016) Investment and the weighted average cost of
capital. Journal of Financial Economics, 119(2), pp.300-315.
Li, X., (2015) Accounting conservatism and the cost of capital: An international
analysis. Journal of Business Finance & Accounting, 42(5-6), pp.555-582.
Lorenz, D., Kruschwitz, L. and Löffler, A. (2016) Are costs of capital necessarily constant
over time and across states of nature?: Some remarks on the debate on ‘WACC is not quite
right’. The Quarterly Review of Economics and Finance, 60, pp.81-85.
Mukherjee, S. (2017) Cost of capital. Asian Journal of Multidimensional Research
(AJMR), 6(7), pp.115-118.