Understanding Capital Structure And Evaluation Of WACC

Importance of Capital Structure and Target Capital Structure

Capital structure is the combination of different sources of finance which has been used by the company to run its operations effectively. On the other hand, target capital structure is the future prediction of the sources. Capital structure and target capital structure of an organization is quite helpful for the analyst and the management of the company to evaluate the weighted average cost of capital. Capital structure is a process which evaluates the total weight of the funds of the company and the total cost of equity and debt that finally leads to the cost of capital of the company (Oliver and Schoff, 2017).

Without evaluating the capital structure and target capital structure, it is not possible for an organization to identify the total cost as before evaluating the total cost, it is required for the organization to identify the total sources which have been used by the company to raise the funds which could be evaluated through analyzing the capital structure of the company. Following formula could make it easier to understand that why capital structure is quite significant to evaluate the total WACC of the company:

The given case explains that the AA Mobil is one of the largest companies and it has various business units. The company is using a single cost of capital for evaluating the capital expenditure of all its business units which is not a perfect measure to evaluate the capital expenditure.

Cost of capital of an organization depends on the cost of equity, cost of debt and cost of preference shares of a company. The formula of cost of capital explains that the capital expenditure depends upon many variables which could be different to business to business or company to company such as the capital structure of all the business unit are different to each other as well as the market premium and beta of the companies also varies according to the industry and fluctuation in the stock price (Kinsky, 2011). On the other hand, the debt holding % of each debt is also different and thus the cost of capital of all the business units of an organization could not be same. Thus, it is recommended to the company to evaluate different cost of capital of each company.

1. Problem solving

Cost of equity calculation explains that the cost of equity of the Drury Corporation is 11.71%.

1. Theoretical Question
2. Profitability index:

Profitability index is a method to evaluate the capital expenditure opportunity of a business. Profitability index is a current value of anticipated future cash flows of a company which is dividend by initial outlay. The formula of profitability index is as follows:

Calculation of Cost of Equity and Profitability Index

Profitability Index (PI) = Present Value of Cash Inflows/Present Value of Cash Outlay (Kaplan and Atkinson, 2015)

Profitability index calculation explains about the capital rationing as well as the net initial cash outlay of the company. It explains that if the Profitability index is more than 1 then the project should be accepted by the company. This technique makes it easier for the company or the analyst to make a better conclusion than NPV as it considers the initial outlay as main element to evaluate the index. The higher the index would be the more the profitability of the company would be.

1. Explanation:

The given statement depicts that discount rate impacts on the present value of future cash flow. It explains that the lower discount rate directly affects the present value of future cash flows. The given statement is quite false. As the lower the discount rate of return would be the more the present value factor and the more the present value factor, the more the present value of future cash flows would be (Higgins, 2012). The statement could be understood through following calculations:

It explains that in case of lower, discount factor, the present value of future cash flows are higher in comparison with the higher discount rate.

1. Problem solving
2. NPV:

Calculation of net present value of both the machineries is as follows:

The above calculation briefs that the net present value of old machinery would be $ 8,23,395.54 and net present value of new machinery would be $ 8,95,517.61. It explains that the new machinery would offer huge return to the company in context with the old machinery and thus, it is recommended to the company to buy new machinery for efficient and effective use.

If there are few qualitative difference among both the machineries than the management is required to consider and evaluate the following factors before making any decision about the replacement:

• Mass production
• Flexibility
• Fixed cost
• Machine intelligence
• Labour friendly
• Safety purpose
• Production speed
• Scrap level etc (Hillier, Grinblatt and Titman, 2011)

These factors are required to be considered by the management of the company and must make the decision about the machineries accordingly.

1. Theoretical Question
2. Systematic risk and unsystematic risk:

Systematic risk and unsystematic risk part of investment risk in an organization. Systematic risk consist the fluctuation in the stock price on daily basis. Systematic risk is an outcome of uncontrollable and external variables that are not related to industry or a specific market and it affects the entire stock of the company.

On the other hand, unsystematic risk depicts the risk that emerges out of known and controlled variables which are specifically related to the industry and the market. Unsystematic risk could be eliminated from the market whereas the systematic risk could not be eliminated.

Effects of Discount Rate on Net Present Value

Further, an investor should not expect any extra return from unsystematic risk as if investors would get extra return to bear the unsystematic risk that the portfolios which are made up of many stocks along with huge unsystematic risk would provide large returns to the investors equally with the risk portfolios with lesser unsystematic risk (Brown, Beekes and Verhoeven, 2011). Unsystematic risk depicts the risk that emerges out of known and controlled variables which are specifically related to the industry and the market. The process of unsystematic risk explains that if bearing the unsystematic risk would offer huge return to the investors than they would never bear the systemic risk and would always invest into the portfolios.

It has been found that the investors who are bearing systematic risk are only liable for the extra return and that return also based upon the stock price and the performance of the company.

CAPM is capital asset pricing model which describes about the systematic risk and expected return relation among the expected return and systemic risk of particular stock and assets.  Capital asset pricing model is widely used by the analyst, investors and management of the company to evaluate the cost of equity of the company. Following is the formula of capital asset pricing model:

CAPM formula explains to the investors that how much return would be got through investing into the particular stock. It evaluates the risk free rate of the country, market return of the market and systematic risk of the company to evaluate the cost of equity of the company.

CAPM is a measurement which explains about the expected return and systemic risk relationship through presenting a graph of SML. SML is security market line which represented the CAPM formula (Brav et al, 2005). It plots the beta on X axis and expected return on Y axis. Intercept point represents the risk free rate and the slope in the graph represents about the market return. Following is the graph of security market line:

It explains that if the security is plotted above the SML than the stock is undervalues as the higher return is expected by the investors through the stock. On the other hand, if SML is plotted below than the stock price of the company is overvalued as lower return would be accepted by the company at this level (Madhura, 2011).

1. Problem solving
2. Cost of equity

Cost of equity of the company would be 7.52%.

1. b)
2. i) Required rate of return

Expected return of the company would be 14.50%.

The above calculation express that the expected return of the stock is 13% and the expected return of the investor is 11% which explains that the investor should invest into the stock as this stock would offer higher return than the expected return by the investors.

References:

Brav, A., Graham, J.R., Harvey, C.R. and Michaely, R., 2005. Payout policy in the 21st century. Journal of financial economics, 77(3), pp.483-527.

Brown, P., Beekes, W., and Verhoeven, P. 2011. Corporate governance, accounting and finance: A review. Accounting & finance, 51(1), 96-172.

Higgins, R. C., 2012. Analysis for financial management. McGraw-Hill/Irwin.

Hillier, D., Grinblatt, M. and Titman, S., 2011. Financial markets and corporate strategy. McGraw Hill.

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

Kinsky, R. 2011. Charting Made Simple: A Beginner’s Guide to Technical Analysis. John Wiley & Sons.

Lord, B.R., 2007. Strategic management accounting. Issues in Management Accounting, 3.

Madura, J. 2011. International financial management. Cengage Learning.

Oliver, J. and Schoff, P., 2017. Agency and Competition Law in Australia Following ACCC, Journal of European Competition Law & Practice, 8(5), pp.321-328.

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