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Evaluating Potentiality Of Investment

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Question:

Discuss about the Evaluating Potentiality of Investment.
 
 

Answer:

Introduction:

The cost of capital is an important factor, used for evaluating the potentiality of any investment. It depicts the cost, incurred by any firm, for obtaining and maintaining its capital fund. However, most of the firms raise its capital fund through equity financing and debt financing. Therefore, the financial analysts rely on Weighted Average Cost of Capital more than normal cost of equity capital. WACC is calculated on the basis of both the costs, incurred for equity capital and debt capital. Thus, it can depict the overall cost of capital and satisfy both the shareholders and creditors.

Arabian Cement Co. Ltd. is an enlisted company in UAE Stock Exchange. The cost of the capital of the company is computed under weighted average method to evaluate the potentiality of the company for investment purpose.

Weighted Average Cost of Capital:

The two main components of WACC are the cost of equity capital and cost of debt capital. Cost of debt capital can be ascertained from the finance expenses, stated in the financial statements. The cost of equity is, on the other hand, cannot be determined so easily. The most popular method of calculating the cost of capital is the Capital Asset Pricing Model, which determines the cost of equity on the basis on the market stock prices.

According to the CAPM Model, the cost of equity is calculated by using the following formula:

Cost of Equity = Risk Free Return + Beta x (Market Return – Risk Free Return)

For determining the cost of equity of Arabian Cement, the coupon yield rate of 1 yr. treasury bond of UAE is considered as risk free return and the average daily return of UAE stock market index is taken as the market return rate. Beta coefficient is the volatility level of the stock of Arabian Cement in comparison to UAE stock market return.

 

As per the above discussion, the cost of equity of Arabian Cement is determined in the following table:

After determining the cost of equity, the WACC of the company is computed by using the following formula in the table below:

WACC = (Weightage of Equity x Cost of Equity) + (Weightage of Interest Bearing Debt x Cost of Debt)

Conclusion:

As per the above table, the WACC of the company is 7.55%, whereas, the industrial benchmark of cost of capital is 6.50%. The WACC of the company is higher than the industrial benchmark. Such variance has occurred as the industry is consisted with variety of companies. The cost of equity for the small companies uses to be lower than the large companies, whereas, the large companies can enjoy lower rate of interest on debt capital due to the goodwill and large amount of assets. However, the variance denotes that the company use to incur higher cost than the overall industry for maintaining its capital.

The return on equity of Arabian Cement is 36.60%. It can be stated that the company raises its capital at lower cost but provides higher return on the capital. Therefore, though the WACC of the company is higher than the average industrial rate, the investors can consider Arabian Cement Co. Ltd. as a potential investment option.

 

Bibliography:

Arabian Cement Company - Cement, Concrete, Wassal. (2016). Arabian Cement Company - Cement, Concrete, Wassal. [online] Available at: https://www.arabiancement.com/financial-statements-2015 [Accessed 14 Dec. 2016].

Marketstoday.net. (2016). ARCCO | Historical Prices - MarketsToday.net. [online] Available at: https://www.marketstoday.net/companies/arabian-cement-co-ltd/Historical-Prices/42/en/# [Accessed 14 Dec. 2016].    

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