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Financial and Strategic Decision Making - Goodway Plc

University: Regent College of London

  • Unit No: 3
  • Level: Undergraduate/College
  • Pages: 12
  • Words: 3000
  • Paper Type: Assignment
  • Course Code:

    L/508/77433

  • Country: UK
  • Downloads: 0
Question :

Goodway Plc is a holding company that owns shares in various subsidiary business. The directors of the business are attempting to use discounted cash flow techniques for their project but have not weighted average cost of capital.

  • Determine the calculation of Weighted Average cost of capital from the given scenario of Goodway Plc.
  • Providing a consideration of the Shilpa Gohal’s opinion focusing on calculation of suitable cost of capital.
  • Determining the possibility of using Capital asset pricing model for the purpose of calculating cost of capital for project of Goodway Plc.
  • Conducting a critical analysis on the possibility of issuing more debt in order to lower the WACC.
  • Conducting a critique of organic and acquisition growth for Goodway plc.
Answer :
Organization Selected : Goodway Plc.

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%

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

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 of47.37% 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:

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 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 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 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.

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