Applying Finance Concepts To Estimate Firm’s Cost Of Capital: A Report To Management

Calculating the Firm’s Cost of Debt

Board of the company is considering expansion of pharmaceutical operation into breeding, cultivating and manufacturing of cannabis for use and sale in Australia, because it is a major project large amount of investment required to be made by the company initially and cash flows will be received in later years and there is great amount of risk involved a wrong decision taken cannot be reversed financial feasibility of project becomes important.

The purpose of this report to help the board of directors in deciding on the acquisition of an already listed public company (Cann group ltd) by applying Theories and concepts of finance.

Cann group ltd is an Australian company established in 2014 engaged in the cultivation of cannabis for human, medical and research purposes. It is the first company to have a cannabis research License issued by the Australian drug office of government control in February 2017. It is a company listed on the Australian stock exchange since May 2017. The license gives power to the company to produce cannabis with a relevant permit for research purposes. The board of directors of the Cann group has extensive experience in the field of agriculture and the health research sector. (About Cann Group Ltd, 2019).

The weighted average cost of capital is an estimated return of both equity holders and debt holders of the company. It is also used as a discounting rate for discounting cash flows associated with projects. It is an opportunity cost for equity and debt holder of putting money in the company. It is the financial cost to the company associated with acquiring finance that the company must earn to survive and to provide a return to equity holders and fulfill the interest obligation of debenture holders (Armitage, 2005).It is calculated by the following formula:-

 

 Source: – (Desai, 2008).

Cost of debt: – It is an essential component for the purpose of calculating weighted average cost of capital. Cost of debt shows that cost of raising debt capital by company. It can be calculated before tax and after tax. Greater its proportion in capital structure lower is the weighted average cost of capital as it is cheaper than equity.

On analysis of data of the company data cost of debt is found .90% which is nominal in comparison to equity, the reason of it is company is using nominal amount of debt in its capital structure and its calculation along with source from where data has been extracted is show below.

Cost of   raising debt capital:
Particulars	Amount in $ of the Year 2018
Net finance cost	8,381.00
Less: Tax @30%
After-tax cost of debt	8,381.00
Total Borrowings( Long term+ Short term)	927,674.00
After-tax cost of debt (%)	0.90%

Calculating the Firm’s Cost of Equity Using CAPM

Source of Data: (Cann Group, 2019).

Note: – As the company is incurring losses tax shied on finance cost has been ignored.

Cost of Equity: – It is also an essential requirement for the purpose of calculating weighted average cost of capital. It shows rate of raising equity capital from company’s point of view. From the investor point of view it is rate of expected return on capital invested for risk undertaken. There are different methods to calculate cost of equity such as capital asset pricing model, dividend growth model etc.

Here based on the given information capital asset pricing model has been used to calculate the cost of equity. Cost of equity is found 7.87% which is huge in comparison to cost of debt the reason is again the same the company is using equity capital majorly in its capital structure.

Company could have used lesser equity and it would have lowered the WACC of company but because company has been incurring losses from previous year lender might be reluctant to lend money to company.

Calculation of cost of equity along with source of data is shown below.

Cost of Equity: CAPM model	Amount in $ of the Year 2018
A. Risk-free rate (RBI Australia, 2019)	1.03%
B. The market rate of return(Spread of 6% is used based on research)	7%
C. Beta (Yahoo finance, Cann group Ltd., 2019)	1.14
Cost of Raising Equity Finance	7.87%

Beta: – Purpose of calculating Beta of the company is to find out sensitivity of stock in relation to changes in the market. It is also the measure of riskiness of stock. If it is exactly equal to 1 that means stock is exactly volatile to the market but if it is more than 1 it indicates that stock is more volatile to the market but if it is less than one it indicates that stock is less volatile to the market. Moreover if beta of company is zero it means stock is uncorrelated to market and if beta is negative it indicates that stock is negatively correlated to the market. It is the reason why the investor expects return higher than risk free rate.

In the above calculation, the currently published beta of 3 months is used because it is considered that since It is engaged in similar operation project that means risk is not substantially different from existing business and beta of 3 month shows there not much possibility of changes in stock prices in relation to market in comparison to beta of 5 year and 10 year which shows that there are more possibility of changes in stock prices in relation to market Source: – (Yahoo finance, Cann group Ltd., 2019).

Calculating Beta of Cann Group Ltd

Beta of Cann group Ltd is 3.14 which means that stock of the company is more volatile (Risky) to a change than the change in the market.

Risk free Rate: – It is a rate of return that can be earned without taking any risk associated with investment.

Here 10 year commonwealth government treasury bond rate source (RBI Australia, 2019)  is used as risk free rate for calculation of cost of equity for the purpose of calculating WACC since decision to acquire already listed public company for expansion of business by the board is a long term decision and in absence of given information 10 years is assumed as project life term. The purpose of using a Risk-free rate of 10 years rather than 30 days or 3 months is to maintain consistency of risk-free rate with the project life.

Market Return: – Here spread of 6 percent is used for calculating market return according to research instead of calculating return on the market.

Weighted average cost of capital: – It can be calculated using book value weights and Market value weights. Market value is considered more relevant as it is determined by independent forces of the market.

Here WACC based on both book value and market value has been calculated and WACC based on market value weights has been adopted as it is more realistic and independent for the purpose of evaluation of the project. WACC based on market value is found 7.85% and WACC based on book value weights is found 7.80%.

Based on the calculation shown below in context of company it is evident that WACC with respect to market value weights is higher than WACC with respect to book value weights. Higher WACC indicates the higher cost of raising finance for the company that means the company is riskier and it is also used to calculate the value of the firm/company and to find out whether the company’s market value is overvalued or undervalued. If the WACC is higher than the return from the project becomes unacceptable and vice versa.

Calculation of book values, market values of debt and equity and WACC along with source from where data has been extracted is shown below:-

Market  Value Weights	Amount in $ of the Year 2018	Amount in $ of the Year 2018	Amount in $ of the Year 2018
	Debt	Equity	Total
Equity shares		407,038,547.20 (Yahoo finance, Historical Data, 2019)
Value of debt (short term borrowings+ long term borrowing)	927,674.00
Total	927,674.00	407,038,547.20	407,966,221.20
Weights	0.0022738990	.9977	1.00

Source: (Cann Group, 2019).

Book Value Weights	Amount in $ of the Year 2018	Amount in $ of the Year 2018	Amount in $ of the Year 2018
	Debt	Equity	Total
Equity shares		85,872,834.00
Value of debt (short term borrowings+ long term borrowings)	927,674.00
Total	927,674.00	85,872,834.00	86,800,508.00
Weights	0.0106874259	0.9893	1.00

Source: (Cann Group, 2019)

Weighted Average Cost of Capital
Particulars	Debt	Ordinary Shares	Total
Cost of Finance	0.90%	7.87%
Market Weights	0.0023	0.9977
Book Weights	0.0107	0.9893
WACC through use of Book value Weights	0.01%	7.79%	7.80%
WACC through use of Market value Weights	0.00%	7.85%	7.85%

Source: (Cann Group, 2019).

Capital in simple words means value arrived after deducting current liabilities from Total Assets or in other words it can be said that it is total of equity share capital, preference share capital, debenture, long term loans. The capital structure in a company mainly consists of two components debt and equity. Debt includes debenture and long term loans and equity is broadly divided into equity share capital, preference share capital, and Retained earnings in its scope. (Baker & Martin, 2011). Deciding the optimum amount of capital structure is a crucial decision as it affects organization profit maximization and wealth maximization objective. Optimum capital structure is the mix of equity and debt in the capital structure in such a way where the weighted average cost of capital is at a lowest possible level and the Market value of the company is at maximum possible level (Ghosh, 2017).

Calculating the Risk-Free Rate

Ratio analysis helps in drawing a conclusion based on the financial statement and thus helps in    decision making about undertaking a new project. (Fridson & Alvarez, 2011).

Capital Gearing Ratio Analysis shows impact of debt in capital structure.

Difficulty observed here in analyzing the capital structure gearing ratio is that the as company is   running in losses some ratio have been derived in negative form which give rise to inverse interpretation.

 Here debt expenses as per accounts have been used for calculating interest coverage ratio.

Debt Ratio: – Debt Ratio indicates the solvency of the company. Debt Ratio shows percentage of company liabilities to total Assets. In other words it indicates how much asset entity needs to sell to pay of its liability (Houstan & Brigham, 2012).

Based on calculation shown below Debt ratio of company is found 1.08%; it was 2.82% in previous year which indicates company solvency position has improved from previous year.

Calculation of debt equity ratio along with source of data is shown below:-

Gearing ratio	2018 in $	2017 in $
Debt Ratio
Total Debt(Short term Liabilities+Long term Liabilities)	927,674	413,868
Capital employed(Total Assets-Current Liabilities)	85,889,203	14680785
Answer:(Long term Liabilities/Capital employed)	1.08%	2.82%

Source: (Cann Group, 2019)

Debt Equity Ratio: – Debt to equity ratio shows ratio of debt to equity. Higher ratio indicates that company is heavily dependent on debt for financing. It indicates risk of solvency (Sharan, 2011).

Based on calculation shown below Debt to equity ratio of the company is found 1.08%; it was 2.82% in previous year. It indicates that financial risk of solvency has been reduced from previous year but it does not matter because debt is already in nominal amount in the capital structure of the company.

Calculation of debt to equity ratio along with source of data is shown below:-

Debt Equity Ratio	2018 in $	2017 in $
Total Debt	927,674	413,868
Total Equity	85,889,203	14680785
Answer(Total Debt/Total Equity)	1.08%	2.82%

Source: (Cann Group, 2019).

Interest Coverage Ratio: – This ratio shows how well company can meet its interest obligation. It is an important factor to determine solvency of the company and for shareholder in determining expected rate of return (Banarjee, 2015).

Based on the calculation shown below interest coverage ratio is 562.88(-ve) times, It was 3973.52(-ve) times in previous year that means that company ability to repay debt has been reduced so shareholders can expect higher return on their capital.

Interest Coverage Ratio	2018 in $	2017 in $
EBIT	-4,717,476	-2,181,461
Finance Cost	-8,381	-549
Answer(EBIT/Finance Cost)	562.88	3973.52

Source: (Cann Group, 2019).

Profitability Ratio Analysis:- It shows measures to assess the profitability of the company.

Return on Equity: – This ratio indicates how much amount company can earn on capital invested by shareholder in the company. This ratio is important from the perspective of shareholder as they want to know how much amount is earned by company on the amount invested to evaluate company’s performance (Bose, 2011).

Calculating the Weighted Average Cost of Capital (WACC)

Calculation of return on equity along with source of data is shown below-

Return on Equity	2018 in $	2017 in $
Net Income after tax	-4,725,857	-2,588,445
Shareholder’s Equity(Total Assets- Outside liabities)	85,872,834	14,660,148
Answer( Net Income after tax/Shareholder’s Equity)	-5.50%	-17.66%

Source: (Cann Group, 2019)

Return on Capital Employed: – This ratio indicates profit earned by the company on the total capital and it is expressed in terms of percentage. It also shows efficiency of capital use by the company (Fernandis, 2014).

Return on capital employed is 550.23(-ve) in current year and it was 1763.16(-ve) in previous year that means company instead of earning profit on capital has been incurring losses although the ratio has improved from previous year there is still lot more to do by the company.

Return on Capital employed	2018 in $	2017 in $
Net Income after tax	-4,725,857	-2,588,445
Capital employed(Total Assets-Current Liabilities)	85,889,203	14,680,715
Answer(Net Income after tax/Capital employed)	-550.23%	-1763.16%

Source: (Cann Group, 2019).

Earnings per Share: – It shows earning available to shareholder per share. Higher the ratio greater will be the market share of the company in the market (Williams & Dobelman, 2017).

Based on calculation shown below Earnings per share of company is 0.034(-ve), It was 0.050(-ve) in previous year. It is not a good sign. It means that company instead of earning profits has been incurring losses although ratio has improved from previous year there is lot more to do by the company.

Calculation of return on equity along with source of data is shown below-

Earnings Per Share	2018 in $	2017 in $
Total Comprehensive Loss available to Shareholder (A)	-4,275,857	-2,588,445
Weighted Average number of shares (B)	125,281,943	52,238,805
Answer(A/B)	-0.034	-0.050

Source: (Cann Group, 2019)

Further on the basis of analysis of capital structure of the company it is evident that debt component in the capital structure is nominal in comparison to equity although the amount of debt has been increased from previous year  as evident from cash flow statement of company it has increased at a slower rate than increase in equity. Possible reason in context of company could be risk of insolvency as the company is already running in losses and with usage of debt in capital structure there comes the commitment of meeting interest obligation Periodically as well principal repayment at the end of loan term failure of which may lead to liquidation of company and debt holder stands at priority over equity shareholder and secured debt holder stands at top in the list.

 Company should try to increase the component of debt through resorting to borrowing to finance the company expansion operation and for making investment in market and reduce the component of equity through buy back of shares, reduction in paid up capital etc. as it will reduce weighted average cost of capital and enhance the value of the company.

Conclusion:

On Analysis of Financial statement of the company it is apparent that company has been running in loss although in some area company has improved from the previous year such as Earning Per share, Return on equity, Return on capital employed but it is advisable to board not to acquire such company as huge amount of investment will be required and return would not be available from the first year of acquisition because initial years profit will be used to set off accumulated losses of previous year. Moreover capital structure of the company is not optimum, debt proportion is negligible in comparison to Total Capital. As the company is running in losses lender may not be willing to lend money due to which company is not able raise capital at cheaper cost and enhance earnings before interest and taxes ultimately it’s earning per share moreover due to such debt proportion company is not able to reduce WACC and enhance value of company.

References:

About Cann Group Ltd. (2019). Retrieved October 12, 2019, from www.canngrouplimited.com: https://www.canngrouplimited.com/about

Armitage, S. (2005). The cost of capital Intemediate Theory. Cambridge: Cambrige University Press.

Baker, H. K., & Martin, G. S. (2011). Capital Structure and Corporate Financing decision. Hoboken, New Jersy: John Wiley & sons.

Banarjee, B. (2015). Fundamentals of financial management. Delhi: PHI Learning Pvt. Ltd.

Bose, D. C. (2011). Fundamentals of financial management. Delhi: PHI Learning Pvt. Ltd.

Cann Group. (2019). Investor-Cann group Ltd. Retrieved October 24, 2019, from https://investors.canngrouplimited.com: https://investors.canngrouplimited.com/FormBuilder/_Resource/_module/yM6msxTP1UW4aDu9PKkjiw/reports/CannGroupLtd-AR2018.pdf

Desai, M. A. (2008). Internation Finance. Delhi: Aggarwal Printing Press.

Fernandis, N. (2014). Finance for executives. NPV Publishing.

Fridson, M., & Alvarez, F. (2011). Financial Statement Analysis (Vol. 4). Wiley Finance.

Ghosh, A. (2017). Capital Structure and Firm Performance. New York: Routledge.

Houstan, J., & Brigham, E. (2012). Fundamentals of financial Managemnet. Bostan, Massachusetts: Cenage Learning.

RBI Australia. (2019). Goverment bond: Reserve Bank of India. Retrieved October 14, 2019, from www.rba.gov.au: https://www.rba.gov.au/statistics/tables/xls/f02hist.xls

Sharan, V. (2011). Fundamentals of financial management. Chennai: Pearson Education India.

Williams, E. E., & Dobelman. (2017). Financial Statement analysis. World Scientific book Chapters.

Yahoo finance. (2019). Cann group Ltd. Retrieved October 14, 2019, from https://in.finance.yahoo.com: https://in.finance.yahoo.com/quote/CNGGF?p=CNGGF&.tdata-src=fin-srch

Yahoo finance. (2019). Historical Data. Retrieved October 14, 2019, from https://in.finance.yahoo.com: https://in.finance.yahoo.com/quote/CNGGF/history?period1=1530210600&period2=1530469800&interval=1d&filter=history&frequency=1d