Cost of Capital, Capital Structure and Investment Appraisal Analysis

Question 1- Cost of capital and Capital structure

The newly appointed finance director of Faith PLC is currently reviewing the capital structure of her company. She is convinced that the company is not financing itself in a way that minimises its cost of capital (WACC). The company’s financing as at 31 December 2020 is as follows:

The new finance director, Ms. Zara Green feels that by issuing more debt the company will be able to reduce its cost of capital. She proposes the issue of £16m of 12 per cent redeemable bonds. These bonds will be sold at a 5 per cent premium to their par value and will mature after seven years. The funds raised will be used to repurchase ordinary shares which the company will then cancel. Ms. Green expects that this repurchase will cause the company’s share price to rise to £2.95 and the future dividend growth rate to increase by 15 per cent (in relative terms). Zara expects the price of the 10 per cent bonds to be unaffected, but the price of the preference shares to fall to 68p. Corporate tax stands at 30 per cent.

a. Calculate the book value and market value cost of capital (WACC) for Trust (10 marks)

b. Given the proposed changes to Trust capital structure, recalculate the company’s cost of capital to reflect these changes and comment on the finance director’s (10 marks)

c. Critically discuss whether you agree that companies, by integrating a sensible level of gearing into their capital structure, can minimise their weighted average cost of capital, ensuring the response integrates relevant empirical research within this area of (15 marks)

d. Critically evaluate the relationship between WACC and IRR on investment; also discuss the effects of agency problem on potential viable investment for Trust PLC, ensuring the response is supported with relevant academic. (15 marks)

 Pizza Mat (PM) Limited a fast food company is considering purchasing a new storage machine for £588.5m. The company is expecting an annual cash inflow of £233.7m from the sale of its products and an annual cash outflow of £33,2m for each of the seven years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using a straight-line method. The machine is expected to last for seven years, with a residual value estimated to be at the rate of 13% of the original cost of the machine. The cost of capital for (PM) Limited is 9%.

You are required to:

a. Calculate (to two decimal places) using the following investment appraisal techniques, and provide brief recommendations as to the economic feasibility of acquiring the machine:

1. The Payback
2. The Accounting Rate of
3. The Net Present
4. The Internal Rate of Return (20 marks)

b. Alternatively, the financial director of (PM) Limited is proposing to use 50% the total capital outlay for the above investment to repurchase some of the equity capital and the remaining funds to pay for cash Ensuring the response draws upon relevant academic research and theories within this highly topical area of financial management, critically evaluate the effects of this proposal on the company. (10 marks)

c. Critically evaluate the benefits and limitations of each of the differing investment appraisal techniques, ensuring the use of relevant academic (20 marks)

 The managing directors of Kings PLC are considering what value to place on Dragon PLC, a company that they are planning to take-over soon. Kings’ share price is currently £4.25 and the company’s earnings per share stand at 31p. Kings PLC weighted average cost of capital is 11%.

The board estimates that annual after-tax synergy benefits resulting from the takeover will be £5.36m, that Dragon’s distributable earnings will grow at an annual rate of 2.5%. That duplication will allow the sale of the £32m of assets, net of corporate tax (currently standing at 22%), in a year’s time.

Given the above information calculate the value of Dragon PLC using the following valuation methods:

d) Drawing relevant academic literature on the mergers and takeovers, critically discuss the problems associated with using the above valuation Based on your opinion, which of the above valuation techniques would you recommend with economic justifications to the board of Kings PLC to pursue in this acquisition. (20 marks)

 The learning outcomes for this module assessed by this piece of work are

Knowledge

1. Examined and critically evaluated the key strategic decisions that a business may have to make and appreciated how accounting and finance can assist in making and evaluating those
2. A critical understanding of specific analytical skills in key decision areas within strategy and finance at local and international level
3. A critical understanding of the limitations of the current state of financial theory in making strategic business decisions

Skills

4. Applied the key valuation concepts and methodologies of financial decision making in order to contribute to the wider decision making of the organisation