Calculations in Corporate Finances - Essay Example

Macquarie group limited 2014 financial report, the share price as of 30 December 2014 was $57.93. The company’s last ten years' average total dividends, return on equity, and payout ratios were $3.76, 11.1%, and 66.8%.

The company has the current market price (Po) of ($57.93) and we, therefore, are required to approximate the growth rate and consequent dividend in the next year.

Growth rate = (1-66.8%)*11.1% = 3.69%

Dividend in the next period = dividend in the current period * (1+ the growth rate) = $3.76* (1+3.69%) = $3.89. now the three fundamental inputs are available and we can now punch into the equation below to get the return on equity:

Cost of equity = + the growth rate.
The cost of equity = $3.89/$57.93 + 3.69 = 10.41%.

Where Es = expected return on the share, Rf = expected risk-free in the market, βs = sensitivity to the market risk for the security, and Rm = historical return on the stock market.

According to Pratt and Grabowski (2008), Cost of Equity = Beta Coefficient × (Market Rate of Return − Risk-Free Rate) + Risk-Free Rate.

The beta coefficient is 1.35, the market rate of return is 7.92% and the risk-free rate is 0.72%.

Cost of equity = 0.72% + 1.35 (7.92% – 0.72%) = 10.44%.

It is assumed that all investors do aim at maximizing the economic utilities and the asset quantities are fixed. The investors are risk-averse and rational. The investors are price takers and there is no way they can influence market prices. The investors have the same expectations that are related to the market.

From the finance point of view, the cost of debt is calculated by using the following formula Kd=  where I is the annual interest while P is the current market value of a debenture. The Macquarie group limited had an annual interest of $359m. However, the market price of the debenture was $3507m. The cost of debt can, therefore, be computed by punching in the above inputs into the formula (359/3507) = 0.1023 hence 10.24%.

The cost of capital of the company is the opportunity cost to undertake a certain investment. It is thus the rate of return that is required to persuade the investors to invest: WACC =   *Re +   *Rd *(1-Tc)

This is where Re= cost of equity, Rd= cost of debt, E= the market value of the company’s equity, D= the market value of the firm's debt, V= total value of debt and equity (E+D). Percentage of financing equity = E/V while the percentage of finance by debt = D/V and Tc = corporate tax rate.

From Morningstar (2015), Macquarie Group Limited (Australia) had a debt of 117.2 billion and equity of 11.7 billion. From this data, we can find:
The total company’s market value (V) by adding the two sources of finance that are (117.2 +11.7) = 128.9illion.
The percentage financed by equity = (11.7/128.9)*100 = 9.0777%
The percentage financed by debt = (117.2/128.9)*100 = 90.9232%

The corporate tax for the company is 30%. From Modigliani Miller's irrelevant theory, tax-deductibility increases the value of the firm. This is by increasing the cash flows to respective equity shareholders. The tax deductibility of the debt downscales the weighted average cost of capital hence increasing the value of the firm.
The cost of equity = 10.41%
The cost of debt = 10.24

Since we have all the inputs for the computation of the cost of capital, we can, therefore, feed the figures into the formula.
WACC =   *Re +   *Rd *(1-Tc).

The cost of equity, Re, is higher than the cost of debt, Rd, but the saving in the cost of debt Rd is more hence making up for it leading to a lower WACC. This decrease in WACC is due to the presence of tax shields in Modigliani Miller proposition II.
WACC =   *10.41% +   *10.24% *(1-0.3)
WACC= 0.090777*10.41% + 0.909232*10.24%*0.7
WACC = 0.9450+6.5174
WACC = 7.4624%.