Weighted Average Cost of Capital

Topics: Capital asset pricing model, Interest, Free cash flow Pages: 12 (3335 words) Published: March 5, 2009
1 - Introduction

Cadbury Schweppes plc, was formed by two different people in charge of different companies coming together. John Cadbury was in charge of making confectionery and Jacob Schweppes was producing and distributing beverages. Both of these came together in 1969 to form Cadbury Schweppes plc. This company is engaged in the manufacturing, distributing and sale of branded beverages and confectionery. It supplies its products through whole sale and retail outlets in almost 200 countries. The company make focus is on two things confectionery and beverages. Cadbury Schweppes has manufacturing facilities in 25 countries with a range of products on sales in over 170 countries. These products are sold everywhere convenience stores, grocery stores and kiosks.

2 - Cost of Capital

A company’s capital is consists of mostly debt or equity. Equity and debt are external sources of financing and financing from external sources is not without cost. The cost of capital is the cost to raise capital through equity and debt. It can be defined as the weighted sum of the cots of equity and the cost of debt. It determines the rate of return that a firm would receive if it invested its money in another option with a similar risk. A risky business will have a higher cost of capital than one involving less risk as the investors expect to be compensated for the greater risk.

It is easy to determine the cost of debt. Cost of debt is simply the weighted rates of interest paid by the company on its debts. However, cost is equity is not so straightforward. The cost of equity is based on an estimate of a reasonable rate of return on the shareholders' investment. The term ‘reasonable’ is what makes all the difference. There are various models which are used to estimate this reasonable rate of return which will satisfy the shareholders. One such model is Capital Asset Pricing Model (CAPM). 3 - Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) was first developed by Harry Markowitz in 1959 and after a decade more work was done by William Sharp, John Lintner and Jack Treynor. CAPM describes the relationship between risk and return and it is used as a model for the pricing of risky securities. The model says the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. (Answers Corporation, 2007) The investment should only take place if the expected return does meet or is higher then the required return. The model according to Brealey et al, 2004 assumes that the expected return depends on compensation for the time value of money (risk free rate) and a risk premium that depends on beta and market risk premium. Therefore it can be said that Capital Asset Pricing Model is a theory of the relationship between risk and return which states that the expected risk premium on nay security equals its beta times the market risk premium. (Will, 2007)

The model is based on two types of risks an investment is subject to:

• Risks that can be removed through diversification or unsystematic or specific risks. These risks are not correlated to market moves. • Risks that cannot be removed through diversification or systematic or market risk. These include risks like interest rate fluctuations.

CAPM takes into account an investment’s sensitivity to systematic risk. (Wikipedia, 2007)

3.1 - The CAPM Formula

This systemmatic risk is referred to as beta (β). The equation to determine the required rate of return (k) under the CAPM is as follows: r = Rf +(ß(RM-Rf) )(12manage, 2007)

The above formula can be translated to:
Expected return = Risk free + (Beta (Market Return – Risk free))

3.1.a - The risk free rate of return - Rf

This tends to be about rate of return where there is zero risk. In order words the risk free rate of return is the interest expected by investors in a certain time period, it reflects the time value of money. In the real...
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