Corporate Finance: Cables & Wires Plc - Assignment Example

Corporate Finance Introduction The company selected for the purpose of this assignment is Cables & Wires Plc, one of the FTSE 100 companies. The first part evaluates the weighted average cost of capital employed in Cables & Wires Plc as at 31March 2008. The second part of the write up takes into account the performance of cash flows in Cable & Wires Plc over the previous two years; and the third portion is the consideration of several factors involved in selecting a discount rate while making a decision about capital investment for the entity. a) Calculations of Weighted Average Cost of Capital A company’s cost of capital is the weighted average cost of various sources of long term finance used by the company, viz., equity, preference, and debt. WACC is calculated with reference to proportion of each type of capital employed in the company using the following formula: WACC = (Proportion of equity)(Cost of Equity) + (Proportion of Preference Capital) (Cost of Preference Capital) + (Proportion of debt) (Cost of debt) Cables & Wires Plc has two types of capital employed. One is debt capital and the other is equity capital. The different types of capital employed in Cables & Wireless Plc as at 31 March 2008 and their proportion of employment to total capital employed are calculated as under: Cost of Debt Capital: Conceptually, the cost of debt instrument is the yield to maturity that can be calculated either by a trial and error procedure or using the following formula I +(F- Po)/ n rD= ---------------------, Where rD = Cost of a debenture, Po= Current market price of debenture, 0.6Po+ 0.4F I= annual interest payment, n = number of years left of maturity, and F = maturity value of debenture. As the market values of Sterling unsecured bonds repayable in 2012 and 2019 are not available, it is assumed that coupon rate that is 8.750% for bonds repayable in 2012 and 8.625% for bonds repayable in 2019 are the cost of such debt capital. Accordingly an average rate of 8.687% may be treated as cost of sterling unsecured bonds. Unlike debentures, a bank loan is not traded in the secondary market. The cost of a bank loan is simply the current interest the bank would charge if the firm were to raise a loan now. The rate of interest on outstanding US Dollar loan ranges between 0% to 6.86%. Accordingly 6.86% may be treated as cost of US Dollar and other currency loans. When an entity uses different types of debt capital, its cost of total debt capital may calculated by averaging the different costs calculated as under: For the sake of convenience in absence of secondary market for bank loan, the book value of debts are treated as market value for averaging the costs: Cost of equity capital Equity capital of Cable and wireless as per its balance sheet as at 31 March, 2008 (Annual Return 2008)i consists of issued capital and retained earnings. ‘In a strict accounting sense, the retention of earnings increases common stock equity in the same way that the sale of additional shares of common stock does. Thus, the cost of retained earnings to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock. Stock holders find the firm’s retention earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds.( Lawrence J Gitman, page 509)ii. Therefore calculations of cost of retained earning are taken up in the same way as that cost of issued capital. ‘The cost of common stock equity is the rate at which investors discount the expected dividends of the firm to determine its share value.’(Lawrence J Gitman, page 507)iii Using the constant growth valuation model (also known as Gordon Model), the cost of issued capital can be calculated as per following formula D1 ks = ----------- + g , where Po ks = required return on common stock Po= Value of common stock, D1 = per share dividend expected at the year g = constant rate of growth in dividends On the basis of dividend paid on the outstanding stock during the last two years by Cables & Wires Plc and expected dividend in next two years as per analyst estimates (Yahoo.com), the constant growth rate is calculated as under: Using the dividend growth rate formula the cost of issued capital is calculated as under: Based on above calculated cost of debt (3.4%) and cost of issued capital (12.38%), the weighted average cost of capital is calculated here under: b) Report on Cash Flow Cash flow management of a concern is dependent on its Cash Conversion Cycle. The efficiency in cash conversion cycle is related to operations of its operating cycle, i.e., average age of inventory, average collection period, and average payment period. This is because ‘the part of operating cycle that’s left after the average payment period is deducted is the cash conversion cycle of the enterprise. So the cash conversion cycle is the period of time when your cash is tied up in inputs and debtors, but you haven’t got the money from debtors for sale of your inventory.’(A. Stoltz and M. Viljoen, page 317)iv Changes in cash conversion period largely affect the business operations of the entity. In fact cash flow management is like managing the blood line of the business. This is why working capital directly gets influenced by cash in flow and out flow of the business. The comparative cash conversion cycles for the last two years of chosen company, Cables & Wires Plc are computed as under: Cash conversion cycle (CCC) of Cables & Wireless was (–) 55days in 2007 and that further increased to (–) 68 days. The above calculations show that Cables & Wireless Plc has not employed its cash into the cash conversion cycle. Rather the firm has employed creditors’ cash into its working capital system. That is to say the company has more of current obligations than its current assets. The company is suffering from cash shortage over the last two years and due to such a position the company might be finding very difficult in meeting its current obligations. The company has negative cash investment of its own during last two years. There was complete shortage of required cash by Cables and Wires Plc. This can further be tested with reference to its current ratio and quick ratio calculated as under: Current ratio of 2:1 and quick ratio of 1:1 are considered optimum for any industry. The liquidity position of Cables and Wires Plc was very delicate in 2007 with its current ratio at 0.67:1 and quick ratio at 0.66:1. This situation worsened in 2008 when its current ratio came down to 0.45:1 and 0.44:1 respectively. This is an indication that liquidity position of the company is very precarious. All this has direct effect on cash flow of the firm. With negative Cash Conversion Cycle and very poor quick ratio, the Cables & Wires Plc is certainly suffering from cash crunch. The company is finding difficulties in collecting cash from debtors and that is why payments to its creditors are being delayed. The company’s cash flow was managed inefficiently during the last two years’ of its performance. c) Discount rate selection for major capital investment project Decision on capital projects are usually taken on the basis Net Present Value (NPV) technique. That is present value of net future cash flows are evaluated in order to take a capital investment decision. The financial tool that helps in evaluating the present value is called ‘discount rate’. ‘The discount rate allows the company to adjust cash flows received in the future to their value in the present. In DCF (Discounted cash flow) analysis the discount rate or required rate of return is a critical variable because it can significantly affect the financial desirability of a project. Projects with high discount rate must generate a greater amount of cash than those with low discount rate to recover the original investment.’(Lianabel Oliver, page 115)v There are certain factors that make an impact on the selection of discount rate: Cost of capital Cost of capital determines the use of type of capital to be employed in the capital project. Whether the entity will employ owned capital or debt capital or a mix of the two depend a lot on the cost of capital that will be used for the project. ‘The fact that the firm may have raised its finance in several different ways makes it more realistic to use average cost of capital which is based on an analysis of its capital structure.’(M W E Glautier and Brian Undertown, page 496)vi Moreover, the Weighted Cost of Capital (WACC) ‘reflects the overall cost of capital to the company of all its sources of long term finance.’(Richard Slack, 1 July 1999)vii The basic principle is that selected discount rate must cover the rate of cost of capital. That is why Net Present Value (NPV) has to be positive in order to take a decision about capital investment projects. Alternative uses of capital Alternative use of capital affects the discount rate in an effective way. That is why discount rate is also called opportunity cost. This opportunity cost must be earned in order to make an equitable decision of capital budgeting. The entity takes decision from different alternatives of investments. Accordingly the opportunistic costs of different alternatives play an imperative role in deciding about the discount rate that fairly evaluates the fair opportunistic costs of alternatives. Risks involved in the project Risks attached to the capital project must be considered while selecting discounting rate to compute present values of future cash flows of the involved project. In fact ‘risk in capital budgeting is the degree of variability of cash flows. Projects with small chance of acceptability and a broad range of expected cash flows are more risky than projects that have a high chance of acceptability and a narrow range of expected cash flows.’(Lawrence J Gitman, page 453)viii The selected discount rate should reflect the level of risk associated with the project. ‘The adjustment of the discount rate for project risk is usually a judgment call by management and should be well documented.’(Lianabel Oliver, page 116)ix The above factors need serious consideration in selecting the discount rates in order to make decisions about capital investment. References Read More