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Weighted Average cost of capital

Discuss About The Executives A Practical Guide For Managers.

Stock analysis is a procedure of evaluating a particular instrument or stocks of a company. It also deals with the evaluation of the market as a whole. Generally, stock analysts apply this procedure to determine the past movements in the stock prices and to predict the future performance of the same. In addition, many of the investors and traders take their selling and buying decisions on the basis of such analysis only. By critically examining the past trends, they can easily decide about the future performance of a stock (Edwards, Magee & Bassetti, 2012). 

The reject shop is a discount variety store chain in Australia, founded in 1981 by Ron Hall & John Shuster. The shop has over 5600 employees and is headquartered in Kensington, management. Majority of chickenfield stores situated in Tasmania are been replaced by this group. In 1994, the chain was owned by Macquarie Bank and it got traded on Australia stock exchange in 2004 after the decision of offloading the shares was taken by the bank. As of 2016, the revenue earned by TRS was A$ 800 million with a net income of A$ 17.1 million during the same year (The Reject Shop. 2018).

Baby Bunting Pty Ltd is a family owned business established in Melbourne for over 30 years. It is the largest nursery retailer and one stop baby shop operating in Australia. The store provides all the services to its customers having children from infants to three years of age. Wide range of baby products are made available like Prams, toys, Manchester, Car Seats, Nursery and many more. The products used are from best brands that includes Slivercross, Bugaboo, Maxi Cosi, Ergobaby, Boori and many more. The company is listed on ASX and is traded with a symbol BBN: ASX. In 2016, the revenue of the company was A$ 237 million and its net income accounted for the year was A$ 8 million (Baby Bunting. 2018).

The firm’s cost of capital in which the debt and equity component are proportionately weighted is known as weighted average cost of capital of the company. It is stated that when the value of beta and return on equity increases, the WACC also rises. With an upsurge in the WACC, the risk also increases and the valuation decreases. Generally, companies finance their operations through debt and equity which comprises its total capital. However, the shareholders and lenders expect some return on the funds they have invested in the company. The same is been determined by figuring out the WACC for the firm as it indicates the returns that both the lenders and shareholders will get (Fernandes, 2014). 

Dividend Policy

Talking about The Reject Shop Ltd., the WACC of the company falls continuously in the past three years that is from 2015 to 2017. In 2015, it was 2.93% which reduces to 2.87% and 2.67% respectively in the next two years. This was due to the constant reduction in Reject Shop’s cost of equity and cost of debt. Reason behind such difference in cost of capital is the variation in the value of beta over the years which affected the cost of equity of TRS. The beta of the company reduces constantly from 0.53 to 0.11 during the three years. As a result of which, the cost of equity decreases from 3% to 2.7% over the years (The Reject Shop. 2017). As far as cost of debt is concerned, the change in the interest rate causes the fluctuations in it. It can be seen that rate has been continuously decreased over the past years that is from 2.4% to 1.9%. Moreover, the difference also depends upon the proportion in which the debt and equity component is been categorized in the capital of the company. TRS has high equity financing as compare to the portion of debt element. This makes the company less risky in financial terms and also makes it WACC low. However, a slightest increase was there in the total debt of TRS in 2017 which do not have any significant impact on its WACC (The Reject Shop. 2017).

2015

2016

2017

Weights (A)

Cost of capital (B)

A*B

Weights (A)

Cost of capital (B)

A*B

Weights (A)

Cost of capital (B)

A*B

Equity

               0.92

3.0%

           0.0273

           0.92

2.9%

  0.0270

           0.91

2.7%

  0.0250

Debt

               0.08

2%

           0.0020

           0.08

2.0%

  0.0017

           0.09

1.9%

  0.0016

WACC

2.93%

2.87%

2.67%

Looking at the WACC of Baby Bunting Group limited, it is observed that its WACC has shown reverse trend and has increased from 2.73% to 2.85 in the past three years.  In 2016, it was 2.96% and the reason behind this was a significant increase in company’s beta from 0.04 to 0.50. This brought an upsurge in firm’s cost of equity from 2.7% to 3%. However, reduction in the interest rate decreases Baby Bunting’s cost of debt from 3% to 2.4% (Baby Bunting Group Limited. 2017).

2015

2016

2017

Weights (A)

Cost of capital (B)

A*B

Weights (A)

Cost of capital (B)

A*B

Weights (A)

Cost of capital (B)

A*B

Equity

               0.90

2.7%

           0.0244

           1.00

3.0%

  0.0296

           0.95

2.9%

  0.0274

Debt

               0.10

3%

           0.0029

              -   

2.6%

          -   

           0.05

2.4%

  0.0012

WACC

2.73%

2.96%

2.85%

However, apart from the above reasons sometimes the market return and risk free rate also changes time to time which cause a difference between the costs of capital of the firm. In this case, both the rates are kept same for the evaluation of WACC over the past three years. Only the fluctuations in beta factor and interest rate are considered which has an ultimate impact on both the companies’ cost of capital.

A set of some guidelines which are been used by the companies for deciding the amount that is to be paid to the shareholders is known as dividend policy. However, some facts and researches states that the dividend policy followed by the firms are not of very much relevance for some investors, as they can sell their share of equity as and when they want cash. Irrespective of this, the policy of dividends does impact the share price of company’s stock. Generally, when a company declare dividends, its stock prices tend to increase as they serve as an income to the investors (Baker, 2009). Firms paying off regular dividend will attract more investors as they find out as an opportunity to earn regular and recurring income. So, basically dividends impact both the share prices and profitability of the companies. In order to determine the amount of dividend, companies calculate their dividend payout ratio which measures the value of total dividends paid to the shareholders against the net income of the company. It also calculated by dividing dividend per share with the company’s earnings per share. In both the cases, the payout ratio remains the same and it shows the dividend policy followed by the company (Frankfurter, Wood & Wansley, 2003). 

In case of The Reject Shop, the DPR of the company shows fluctuations during the past three years. In 2015, it was 60.73% which increases to 74.20% in 2016. In 2017, the same was reported at 56.07%. The upsurge was due to the increase in amount of dividends declared by TRS from 30 cents per share to 44 cents per share. The same then decreases to 24 cents per share along with the reduction in its earnings per share.  It can be observed that the declaration of such dividends impacted the share price of TRS to some extent.

The reject Shop

2015

2016

2017

Dividend per share (in cents)

30

44

24

Earnings per share (in cents)

49.4

59.3

42.8

DPR

60.73%

74.20%

56.07%

(Source: Yahoo Finance. 2018).

The above chart shows the fluctuations in the prices of Reject Shop’s shares during the past three years starting from 2015 to 2017. As per the data available on Yahoo finance, the company declared a dividend on September 2015 which increases its share price from A$7.69 to A$10.42 in October 2015. After that the price reduces by the end of the year. Economics , in start of 2016, the share price increases to A$12.69 per share which later on declines after the declaration of dividends worth 25 cents by the company. The price continues to fall after 2016 and were highly impacted by the dividends offered by TRS to its shareholders. The stock prices of the company got negatively affected and reduced to A$ 4.73 on July 2017 (Yahoo Finance. 2018).

From the below table, it can be observed that BBN has not declared any sort of dividends in 2015 which makes its payout ratio zero. The reason for this was the earnings of the company which were insufficient to offer dividends to the shareholders. While, in 2016 the company offered 6.3 cents of dividend to its investors against its EPS of 7 cents. This boosted up the DPR to 90% during the year. However, the dividend per share declared by Baby Bunting in 2017 reduces to 4.3 cents which makes the ratio to fall at 44.33%.

2015

2016

2017

Dividend per share (in cents)

0

6.3

4.3

Earnings per share (in cents)

6.2

7

9.7

DPR

0.00%

90.00%

44.33%

(Source: Yahoo Finance. 2018).

The graph shows the movement in stock prices of BBN during the past three years. It is been observed that initially the price rises continuously and after in the start of January 2017, fall is been noticed which continues for the whole year. BBN has not declared any sort of dividends in 2015 and during that period the stock prices of the company raised at good pace. On August 25, 2016 the firm paid dividends worth 6.3 cents per share which led to an increase in share price from A$2.79 to A$2.88 in September 2016. However, after that the price continues to fall and reaches to A$1.95 in starting of February 2017. During the year, the next dividend was declared on March 2017 worth 4.3 cents, lower than the previous one. This affected the stock prices of BBN to some extent and bring a decline in the same from A$ 1.95 to A$ 1.67 (Yahoo Finance. 2018).

In both the above cases, it can be said that payment of dividends do affect the share price and profitability of the companies. Talking about the dividend policies, it is noticed that The Reject Shop has followed a regular dividend policy, declaring them at different rates. The company is offering dividends from last three years and will continue to do the same in future also. On the other side, Baby Bunting Group Limited has followed an irregular dividend policy as it has not declared any dividends in 2015 and in the previous years. One reason can be the low earnings of the company which were not sufficient for paying dividends to the shareholders. Relevant theories of dividend given by Walter and Gordon applies to the above patterns noticed in both the companies. They had paid dividends out of their retained earnings which has some impact on their share prices.

With the amount of $10 million, it will be recommended to purchase the shares of The Reject Shop. Reason being, the company is offering regular dividends to its shareholders and also has low financial risk. Its WACC has reduced during the past three years which reflected that the debt component of TRS has been reduced constantly during the period. It makes the company less risky and improved its capital structure. Moreover, as compared to BBN the TRS has reported continuous dividend pay-out from 60.73% to 56.07%. Therefore, it will be better to invest the amount in Reject Shop instead of Baby Bunting as the company will provide constant returns to the investors as well as to its shareholders.

Conclusion

From the above report, it can be concluded that stock analysis is very much important to study the position of an entity within the market and the industry in which it operates. Calculating WACC, evaluating the dividend policies and observing the share price fluctuations provide a clear picture to the analyst and others about the position of the companies and performance of its stocks. Furthermore, such analysis helps in taking investment related decisions like whether to purchase a particular company’s share or not.

References

Baby Bunting Group Limited. (2017). APPENDIX 4E. Retrieved from: https://www.babybuntingcorporate.com.au/wp-content/uploads/2017/08/App

endix-4E-and-FY17-Annual-Report-final.pdf 

Baby Bunting. (2018). Accounting. Retrieved from: https://www.babybunting.com.au/about-us/ 

Baker, H. K. (Ed.). (2009). Dividends and dividend policy (Vol. 1). John Wiley & Sons.

Edwards, R. D., Magee, J., & Bassetti, W. H. C. (2012). Technical analysis of stock trends. 2nd ed. Boca Raton: CRC Press.

Fernandes, N. (2014). Finance for Executives: A practical guide for managers. NPVPublishing.

Frankfurter, G., Wood, B. G., & Wansley, J. (2003). Dividend policy: Theory and practice. Elsevier.

The Reject Shop. (2017). APPENDIX 4E. Retrieved from: https://www.rejectshop.com.au/medias/Appendix-4E-and-Annual-Report-2017.pdf?context=bWFzdGVyfHJvb3R8MTAxNDU5NTB8YXBwbGljYXRpb24vcGRmfGgzOS9oNWMvODgwMTY5ODI4MzU1MC5wZGZ8Yzc4NTk5NTk5YjkyMTJ

iZTMzOTNhNWU5MGQ

xMTE4MTNjYTM4MTJmZTQ1YzMyYmRhMGE4YWNhNmJmZWRiMTAzNQ 

The Reject Shop. (2018). COMPANY INFORMATION. Retrieved from: https://www.rejectshop.com.au/aboutus/companyinformation 

Yahoo Finance. (2018). Baby Bunting Group Limited (BBN.AX). Retrieved from: https://au.finance.yahoo.com/quote/BBN.AX/history

?period1=1438194600&period2=1501353000&interval=1mo&filter=history&frequency=1mo 

Yahoo . (2018). The Reject Shop Limited (TRS.AX). Retrieved from: https://finance.yahoo.com/quote/TRS.AX/history?period1=1438194600&period2=1501353000&interval=1mo&filter=history&frequency=1mo

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