Investment decisions companies make today will have a direct impact on their ability to reach financial objectives. Most companies are faced with questions such as: which projects should your company invest in, which returns are needed and what risks are the company willing to take to achieve company goals?
This paper will explain what is, and how to calculate a weighted average cost of capital of Tesco Plc based on company’s balance sheet1 and cash flow statement.2 The second part will focus on a report on the Tesco’s cash flow over the two year period starting in 2005. In the last part essay will explain what discount rate Tesco Plc. should use when deciding on major investment projects.
a) Calculate the company’s weighted average cost of capital and explain/justify your calculation.
Weighted average cost of capital (WACC) is used to determine whether company should invest in a project. By comparing cost of capital on investment and expected return on capital, a company can decide whether investment is worthwhile. Companies use this method as a discount rate for financed projects, because cost of capital is reasonable method to use to evaluate profitability of an investment. Broadly speaking, a company’s assets are financed by either debt (less risky to creditors, so it has lover cost of capital) or equity (more risky to investors, so it has higher capital cost). Thus the capital structure of a company consists of three elements: preferred equity, common equity and debt. WACC is the average cost of these three components that takes their weight in to consideration and delivers the expected cost of new capital for the company. The measure is the overall required return on the finances employed as a whole; it is often used internally by company managers to judge expansion opportunities.
As mentioned before calculating WACC requires knowing the required rates of return for all of the sources of financial resources. Cost of capital is the true cost of securing founds that business uses to pay for its asset base.
Calculation of Cost of capital of equity:
ke = rf + RP
ke - cost of capital
rf - risk free return, treasury bond with maturity of 10 years, RP - the risk premium,
1 – balance sheet - extracted from 2006 Annual Report of Tesco Plc. p. 46 2 – cash flow statement - extracted from 2006 Annual Report of Tesco Plc. p. 46
Risk premium is the extra return that stocks offer over what investors would pocket in risk-free investments, chiefly government bonds. It also takes the systematic risk into account, so the difference is multiplied by beta of the company. The risk premium arises from capital-asset pricing model (CAPM), where beta adjusts for correlation between share price and benchmark movements, therefore the final formula is:
ke = rf + β(rm – rf)
rf - risk free return,
β - Beta of a company,
rm - expected return of market.
Therefore for Tesco formula will look like this:
ke = 4.7% + 0.60 (10.71% – 4.7%)
ke = 8.306%
Second form of financing is debt capital which can be raised by taking out a loan or issuing corporate bonds. Generally, bonds pay higher rates than government bonds due to the increased risk, consequently the return and therefore risk are lower then on equity capital. A company that is highly geared has a high debt capital to equity capital ratio. For the purpose of WACC calculation cost of debt is ajusted by the corporate tax. therefore the formula is:
kdat = kdbt (1 – T)
rf - risk free return,
kdat - cost of capital after tax,
kdbt - cost of capital before tax,
In the case of Tesco’s bonds, the redemption yield before tax is 7.68%. That compares to the redemption yield on a gilt maturing at around the same time of about 4.7%. The company pays 30% corporate tax, therefore the formula will be:
kdat = 7.68% (1 – 0.3)
kdat = 5.376%
From the calculation above it is clear that Tesco’s cost of capital of two sources of...
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