6AG525 Financial Strategy Demonstrate a Critical Understanding

A) Identify the relevant cash flows and cost of capital for investment appraisal

B) Calculate the payback and the accounting rate of return of the proposed investment.

C) Calculate the net present value of the project and determine the internal rate of return.

D) Evaluate the sensitivity of the proposed investment to the potential variations in cash flows.

E) Discuss the advantages and disadvantages of the payback, accounting rate of return and net present value techniques.

The weighted average cost of capital refers to the average cost that the firm incurs on the utilization of capital funds. This involves the cost of equity funds as well as the cost of debt funds. The computation of weighted average cost of capital is done simply by multiplying the cost of equity and cost of debt with their respective weights in the total capital of the firm (Brigham and Ehrhardt, 2016). The significance of weighted average cost of capital is perceived in the context of financial evaluation of the projects. The management needs to undertaken financial evaluation of the projects being considered for future investment so as to ensure that the firm’s financial health is bettered. For this purpose, the cost of capital is used as the measure to discount the cash flows related to the project and evaluate the present value of the costs and benefits (Brigham and Ehrhardt, 2016).   

Computation of Cost of Equity: Pearson plc

The cost equity refers to the cost that the firm incurs on the use of equity funds. The equity funds comprises of cost of common stock and cost of retained earnings. There are two primary models being used in computation of the cost of equity such as capital asset pricing model and dividend discount model (Pratt and Grabowski, 2010). Applying these two methods, the cost of equity of Pearson plc has been computed as below:

Method-1: Capital Asset Pricing Model (CAPM)

The capital asset pricing model is the most commonly used model in computation of the cost of equity. This model computes the cost of equity by applying the following formula:

CAPM= R_f+beta*(R_M-R_f)

In this formula, this “Rf” is risk free rate of return and “Rm” is market rate of return. The beta refers to volatility of the stock and “Rm-Rf” refers to the market risk premium (Baker and Martin, 2011). Applying the above formula, the cost of equity of Pearson Plc has been arrived as under:

Method-2: Dividend Discount Model (DDM)

The dividend discount model works as an alternative to the CAPM model in determining the cost of equity. This model assumes that the dividend payout is the only cost that the company incurs against the use of equity funds. The formula used for computation of cost of equity in this model is given below:

Cost of Equity (K_e) = Dividend-1+P_o*g/ P_o

    In this formula, the “Po” refers to price of the stock and “g” refers to the growth rate (Baker and Martin, 2011). The computation of cost of equity using the dividend discount model for Pearson Plc is given below:

Computation of Cost of Debt: Pearson plc

The cost of debt is the second important factor that plays crucial role in determination of the weighted average cost of capital of the firm. Generally, the cost of debt is computed with reference to the interest cost incurred by the firm on the long term debt borrowed by it. However, the cost of debt can also be computed by referring to the external market such as yield of bond of similar company (Baker and Martin, 2011). In regards to Pearson Plc, the calculation of cost of debt by applying both the methods is given as follows:    

Method-1: Taking Interest Cost as Base

Under this method, the cost debt is computed with reference to the net finance cost that the firm incurs against the use of debt funds in the business (Baker and Martin, 2011). In the current case of Pearson Plc, the net finance cost has been found to be €M76 and the total borrowings have been found to be €M1698.33 for the year 2013. The amount of borrowings involves both the current as well as non-current borrowings.      

Method-2: Referring to External Market

In this method, the cost of debt of the firm is determined by referring to the bond yield in the prevailing in the market (Baker and Martin, 2011). For instance, the bond yield of the similar company operating in the same industry can also be taken. In the current case of Pearson Plc, the cost of debt has been computed with reference to the bond issue of University of Liverpool as detailed below:

WACC of Pearson plc

The computation of the weighted average cost of capital of Pearson plc has been given below:

It may be noted that the cost of equity and the cost of debt have been computed applying two methods for each. Therefore, for the purpose of computation of the WACC, the average of the costs computed under two methods has been used. Further, the market value of the equity has been taken based on the prevailing market cap as on March 19, 2017. In the case of debt book value has been used as extracted from the balance sheet of the year 2013 (Pearson Plc, 2013).    

Evaluating the use of WACC as an Approach to the Calculation of the Cost of Capital 

From the aforementioned discussion in this report, it could be observed that the cost of capital of the company represents the minimum return that the company should earn in order to meet out the expectations of the investors (Mitra, 2011). The cost of capital is significant in determining the net present value of the costs and benefits of the cash flows of various projects being considered for analysis. Further, the weighted average method is considered the best for determining the cost of capital. The cost of capital computed based on the weighted average method takes into account the cost of equity and cost of debt both based on their respective weights. Thus, computation of the cost of capital applying the weighted average method is considered reasonable (Mitra, 2011).        

The professionals in the finance field understand the importance of weighted average cost of capital. The cost of capital is important not only from the company’s view point but it is also crucial from the investor’s view point (Mitra, 2011). The company analyzes the project’s financial viability using the cost of capital and the investors evaluate company’s financial standing by referring to its cost of capital. Thus, the decision making from both the sides is dependent largely on the analysis of the cost of capital. Though, the use of weighted average cost of capital in handy in the investment decisions, but it is argued that in certain situations, use of WACC may not be appropriate (Mitra, 2011).

It has been observed that the use of WACC in evaluating the project having similar risk profile is appropriate, but when the projects differ in risk from the overall firm, the use of WACC becomes inappropriate (Fernandez, 2011). For instance, in case Pearson Plc goes for expansion of its existing business, then the use of WACC would be perfect. On the other hand, if Pearson Plc goes for expansion by entering into the new business of say manufacturing cars, then the use of WACC of the company will not be appropriate in analyzing the car manufacturing project’s viability. In that case, the risk analysis of the car manufacturing business needs to be done separately and thus; the WACC of company which is based on the existing risk profile can not be used in analyzing the costs and benefits of new business (Fernandez, 2011).

Further, there is one more consideration in regards to use of WACC in analyzing the project’s financial viability. Before using WACC for the purpose of analysis, it is to be ensured that the project is financed by using a mix of debt and equity. This is because the computation of WACC takes debt and equity both the factors in computing the cost of equity (Campani, 2015). Thus, if the project is financed entirely through equity or debt then the use of WACC will not be proper. In that case if the project is financed entirely through equity and WACC is used for analysis, the incorporation of risk would be less. The use of equity only to finance the project increases the risk of the project and thus, in that case, the cost of capital should be only the cost of equity rather than the WACC (Campani, 2015).

Further, the WACC may sometimes become computationally cumbersome making its use less desirable. Commonly, the difficulties arise in the computation of cost of equity because there is no standard set for this. There are different methods to compute cost of equity and the results of different methods may at times deviate significantly (Campani, 2015). Further, the computation of the market weights may also pose problems in case of unlisted entities. The securities of the unlisted companies are not listed on the stock exchange; therefore, the estimation of market value of shares becomes very subjective in those cases (Campani, 2015).

Evaluating Alternative Methods to Calculate the Cost of Capital

The weighted average cost of capital is the foundational method that provides for computation of the cost of capital. However, it is not necessary that the WACC will fit in each and every situation. There might be circumstances when the weighted average cost of capital might not be suitable to incorporate the level of risk attached with the project being considered for analysis (Schlegel, 2015). In the situations when the WACC can not be used for computation of the cost of capital, alternative methods are applied. However, the basic concepts used in the alternative methods are the similar to the concepts used in WACC. For example, in certain situations, the use of adjusted weighted average cost of capital may be more meaningful than the simple WACC (Schlegel, 2015).

The use of adjusted weighted average cost capital will be essential in analyzing the projects that involve investments outside the country i.e. the foreign projects. The risk of the foreign projects would definitely differ from the risk of the local projects (Madura, 2007). Certain additional risk factors such as foreign currency translation risk and political risks would be added in case the company makes investment outside the country. Therefore, the rate arrived at based on WACC model would be needed to be adjusted for these risk factors to make its use appropriate in analyzing the risk. The risk in foreign investment would generally be higher than the risk of local project. Thus, the WACC of the company would be required to be increased by the percentage of premium considered adequate for foreign exchange risk (Madura, 2007).

Further, in certain situations, the cost of equity alone may be applied in computing the cost of capital of the firm. This alternative is used when the firm is only equity financed which means that the firm has only equity in its capital structure. Thus, the firm with no debt would use the cost of equity as the cost of capital in analyzing the costs and benefits of the project. Further, there are available different alternatives to compute the cost of equity also. For example, the cost of equity can be computed using the CAPM model and it can also be computed using the dividend discount model. The decision as to which method is to be used would depend upon the nature of the company’s stock. For example, if the company has growth stock, the use of CAPM would be desirable; however, in case the stock is value stock, then the use of dividend discount model would be more appropriate. It may be noted that the change in computation of cost of equity would affect the computation of weighted average cost of capital also.

Further, the problems will arise in computing the cost of capital by applying the WACC method in case of newly established company. The company which has set up a new business would not have data in regards to stock prices, dividends, and other financial items that are considered necessary in computing the cost of debt and cost of equity. Thus, in the absence of the cost debt and cost of equity, the computation of the WACC would not be possible. In this situation, the company can use the cost of capital of similar company in the industry as an alternative. However, the use of cost of capital of the similar company requires caution. It is to be ensured that the company whose cost of capital is being considered for use as proxy is of same size and conducts the same business under similar conditions.             

Conclusion

The discussion carried out in this report relates to determination of the cost of capital. In this regards, it has been observed that the cost of capital plays an essential role in the analysis of financial viability of the project. The cost of capital is computed by applying the weighted average cost of capital method which involves the use of cost of debt and cost of equity. However, in certain situations the use of weighted average cost of capital may not be suitable; thus, alternative methods should be applied in those situations to compute the cost of capital. Further, it has been observed that the primary methods of determination of the cost of equity are CAPM and dividend discount model. The cost of debt can be computed by taking the finance cost as the basis or taking the proxy rate of similar company having same credit ratings.              

References 

Baker, H.K. and Martin, G.S. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons.

Barclays. 2016. Debt capital markets financing for the UK education sector. [Online]. Available at: https://www.barclayscorporate.com/content/dam/corppublic/corporate/Documents/sector_expertise/financing-for-the-uk-education-sector.pdf [Accessed on: 19 March 2017].

Brigham, E.F. and Daves, P.R. 2014. Intermediate Financial Management. Cengage Learning.

Brigham, E.F. and Ehrhardt, M.C. 2016. Financial Management: Theory & Practice. Cengage Learning.

Campani, C.H. 2015. On the Correct Evaluation of Cost of Capital for Project Valuation. Applied Mathematical Sciences, 9(2015), pp. 6583-6604.

Fernandez, P. 2011. WACC: Definition, Misconceptions, and error. [Online]. Available at: https://www.iese.edu/research/pdfs/DI-0914-E.pdf [Accessed on: 19 March 2017].

Madura, J. 2007. International Financial Management. Cengage Learning.

Mitra, S.K. 2011. Revisiting WACC. Global Journal of Management and Business Research, 11(1), pp. 88-96.

Pearson Plc. 2013. Annual Report of Pearson Plc for the year 2013. [Online]. Available at: https://www.pearson.com/content/dam/one-dot-com/one-dot-com/global/Files/annual-reports/ar2013/2013--annual-report-accounts.pdf [Accessed on: 19 March 2017].

Pratt, S.P. and Grabowski, R.J. 2010. Cost of Capital: Applications and Examples. John Wiley & Sons.

Schlegel, D. 2015. Cost-of-Capital in Managerial Finance: An Examination of Practices in the German Real Economy Sector. Springer.

Yahoo Finance. 2017. Pearson Plc: Market Cap. [Online]. Available at: https://in.finance.yahoo.com/quote/PSO?p=PSO [Accessed on: 19 March 2017].

Yahoo Finance. 2017. Pearson Plc: Profile. [Online]. Available at: https://finance.yahoo.com/quote/PSO/profile?p=PSO [Accessed on: 19 March 2017].

Yahoo Finance. 2017. Pearson Plc: Stock Price. [Online]. Available at: https://in.finance.yahoo.com/quote/PSO?ltr=1 [Accessed on: 19 March 2017].