Valuation with WACC and Accounting
Below, we have calculated the weighted average cost of capital given the underlying company’s data. We have also listed and discussed the major assumptions of the WACC as a discount rate in investment appraisal. What’s more, we have explained similarities and differences between debentures and ordinary shares as sources of finance. More solutions are based on the advantages of using debentures over preference shares.
Calculating the WACC and Explaining the Assumptions Made
a) Given the following information, calculate the weighted average cost of capital (WACC) explaining any assumptions you make. The ex-div market price per share, P0 = 95p Dividends
There are currently eight million shares in issue. The company has previously issued eight hundred thousand (800,000) redeemable debentures each with a coupon rate of 8% that are redeemable in 4 years’ time. The current market price of these debentures is £82.50 excluding interest, per unit. The company also has outstanding a £10,000,000 bank loan repayable in 7 years’ time. The rate of interest on this loan is variable, being fixed at 7% above the bank's rate which is currently 10%. There is NO CORPORATION TAX.
WACC is 21.05% assuming that the company will keep the current debt to equity structure and redeemable bonds will not be redeemed and that the company will maintain the same growth rate level for dividends.
b) List and discuss the assumptions behind the use of the WACC as a discount rate in investment appraisal.
- The company is expected to keep financing its operations at the same level as the current financing costs level.
- It is market-driven.
- It is a function of the investment.
- It is forward-looking according to the expected returns.
- The WACC is measured based on the market value.
- It’s often measured in nominal terms, which includes expected inflation.
- It is the link, called a discount rate, which equates expected future returns for the life of the investment with the present value of the investment at a given date.
Comparing and Contrasting Debentures and Ordinary Shares as Sources of Capital
a) Compare and contrast debentures and ordinary shares as potential sources of finance.
The ordinary shares represent ownership in the company where the holder of shares is called shareholder, while the debenture represents debts to the company and the holder is creditor or debenture holder. Shareholders receive dividends while debenture holders receive interest. The company, in normal circumstances, is not obligated to pay dividends, however, it must pay interests each designated period as stated in the debenture regardless of whether the company made a profit or not. And that interest payments are considered expenses thus it reduces taxes to be paid by the company, however, dividends are not business expenses, they are considered and capital distributions and are not allowed as deductions.
Some debentures “convertible” can be converted to equity “shares”, but there are no convertible ordinary shares. If the company goes bankrupt, debenture holders have priority over shareholders to receive payments.
Also, shares have voting rights when decisions are to be made while debenture holders do not have any, however, there might be some restrictions or collaterals related to debentures.
Debentures can be issued at discounts and primum while there is legal compliance regard issuing shares at discount. Also, there is a legal limitation about the number of shares authorized.
Discussing Why Debentures Are Cheaper Than Preference Shares
(b) It is always cheaper to raise finance using debentures than preference shares. Discuss.
Debentures receive the coupon rate at the end of the period regardless of profit or loss. The interest payments are deductible, thus a certain amount of the interest payments are reduced from taxes. For example, if the tax rate is 30% and the company paid 10000 interest expenses, the net expense will be 7000.
Preference shareholders receive a fixed rate of dividend plus certain amounts of dividend when the company earns a profit. Dividend payable is not a tax-deductible amount. So, there are no tax adjustments required for comparing with the cost of debt. Thus a 10000 preference share dividends are 10000 cashout.