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Part A:
1 The Weighted Average Cost of Capital (WACC) of Premier Foods plc
1.1 Calculation of the “cost of debt”:
To calculate the cost of debt, it is necessary to include the long term liabilities. There, it corresponds to the long term debts because their length was superior to one year. Moreover, the deferred tax implies that these taxes are reported on the long term. Then, the provisions are considered as long term liabilities like the pensions liabilities. Finally, bank overdrafts could be considered as long term debts because in the annual report of Premier Foods, each year an important overdraft is reported.
So the cost of debt is equal to 9.2% (see Appendix for details)
Moreover, the corporation tax rate reached 28% in 2008 (HM Revenue & Customs, 2009). Thus, the “after tax cost of debt” is equal to 6.62%.
1.2 The return of equity using the Gordon Growth Model:
The return on equity could be obtained thanks to the Gordon Growth Model. According to the company Premier Foods, dividends paid have dropped from 14.25p in 2005 to 6.30p in 2007. Finally, in 2008, there were no dividends paid.
To use the Gordon Growth model, it is necessary to have the dividend paid for 2008. There, no dividends in 2008 were paid. Thus, It is conceivable to estimate this amount using the average growth rate in dividend from 2005 to 2007. With a growth rate of -33.5% between 2005 and 2007, the estimate amount of dividend for 2008 is 4.19p. (cf appendix)
Then, the next step is calculating the next period dividend which corresponds to the year 2009. The growth rate is equal to -33.5% so the estimate return of equity is
-33.1% (cf appendix)
This solution gives estimate about the possibility to have a positive dividend paid in 2008. However, it is sure and demonstrated in the financial reports of Premier Foods plc that the company didn’t pay any dividend in 2008. The growth rate was not stable and finally the estimate return on equity is negative. Consequently, it is more realistic to use the CAPM model to estimate the Premier Food’s return of equity.
1.3 Calculation of the return on equity using CAPM:
First, in 2008, the Beta of Premier Foods plc was equal to 1.02 (FAME, 2009). Moreover, the Bank of England (2009) indicates that the official bank rate was 5% in September 2008. It could be considered as the risk free rate of return. The market risk premium is equal to 5% (Watson and Head, 2009). So, in this case, the cost of equity finance is 10.1% (cf appendix).
1.4 The gearing ratio
The formula for gearing ratio is: debt finance / (debt finance + equity finance). According FAME database (2009), shareholders funds reached �991,700 in 2008 and debt finance were equal to �2,022,000. So, in 2008, the gearing ratio was equal to 67.1% (cf appendix).
Consequently, it is implied that the cost of equity represent 32.9% (100-67.1=32.9) of the cost of capital of Premier Foods.
1.5 Calculation of the WACC
Consequently, in 2008, the WACC of Premier Foods plc was equal to 7.76% (cf appendix).
2 The Weighted Average Cost of Capital (WACC) of ABF plc
2.1 Calculation of the “cost of debt”:
In ABF plc Annual Report (2008), the long term debt of ABF plc reached �1,465 million in 2008. The interest bearing short term corresponding to the bank overdrafts is equal to �278 million. Finally, the finance expense, related to the interest paid by the company for banks (�53 million in 2008), for leasing (�1 million in 2008) and other interest paid (�20 million in 2008), reached �74 million (FAME, 2009).
So, the cost of debt is equal to 4.25% (cf appendix)
As it is explained in the first part with Premier Foods plc, the assume corporation tax was 28% in 2008. Consequently, in 2008, the after tax cost of debt was 3.06%.
2.2 Calculation of the return on equity using the Dividend Growth Model
First, the dividend paid in 2004 (D04) was equal to 16.4p and in 2008 (D08) it was 20.25p. The share price in September 2008 reached �7.10. The next step consists to calculate the growth rate g. There, g is equal to 5.4%. Hence, the cost of equity finance is 8.41% (cf appendix).
2.3 Calculation of the return on equity using the CAPM model
According to FAME (2009), in 2008 the Beta of Premier Foods Company was 0.53. As it is explained in the first part of this essay, in 2008, the risk free rate of return was equal to 5% and the market risk premium reached 5%. Thus, the return of equity is 7.65% (cf appendix).
2.4 The gearing ratio
The gearing ratio corresponds to the debt finance divided by the debt finance plus the equity finance represented there by shareholders funds. According to the ABF plc Annual Report (2008), the amount of shareholders funds reached �4,844 million. However, in FAME (2008), shareholders funds are lower than in the report company, it reaches �4,554 million. This last figure could be more reliable because it appears in an independent report on a database. Furthermore, for the calculation of the Premier Foods WACC, the amount of shareholders funds was found in FAME.
Thus, in 2008, the gearing ratio of ABF plc attained 27.7% (cf appendix). Consequently, the cost of equity represents 72.3% of the cost of capital.
2.5 Calculation of the WACC
As a result, in 2008, the WACC of ABF plc was equal to 6.38% (cf appendix):
3 Comparison between the WACC of Premiers Foods plc and ABF plc
To begin, the WACC of Premier Foods plc and ABF plc are almost similar (6.38% for ABF plc against 7.76% for Premier Foods plc). However, these two companies don’t have same capital structure.
Effectively, Premier Foods has a greater cost of debt than ABF plc (6.62% for Premier Foods against 3.06% for ABF plc). Thus, Premier Foods supports more interest for debt than ABF.
Then the return on equity using CAPM model is larger for Premier Foods than for ABF plc (10.1% against 7.65%). It is partly due to the different Betas: ABF has a beta equal to 0.53 whereas for Premier Foods it is 1.02. Beta takes into account business risk, which reflects the responsiveness of a company to the evolution of the economic climate, and of financial risk, which reflect the responsiveness of a company to changes on the interest rates (Watson and Head, 2007). Here, it means that Premier Foods is considered as a riskier company than ABF.
The most important difference between the two firms is the level of gearing. Effectively, Premier Foods is highly geared because its level of gearing is equal to 67.1% whereas for ABF it is only 27.7%. It means that Premier Foods is facing a greater level of financial risk than ABF plc. It could frighten the shareholders because they may fear bankruptcy risk.
To conclude, even if the WACC of these two companies are almost the same, investors have to take into account the different betas of the firms and the higher level of gearing of Premier Foods plc. Finally, the dividend paid for shareholders has decreased since 2005. In 2008, Premier Foods plc does not pay any dividends at the end of the year. This is not a good sign for shareholders who invested in it.
Part B:
4 Issues involved in the calculation and application of the Weighted Average Cost of Capital (WACC)
The WACC does not reflect reality because of the complexity of all data we have to analyse for a company. But, today it still remains a famous way to calculate the cost of capital (McLaney et al, 2004). Effectively, Arnold and Hatzopoulos (2000) found that 54% of companies of a 96 English firms sample used the Weighted Average Cost of Capital. (Arnold and Hatzopoulos, 2000 in McLaney and al, 2004). But, the calculation of the WACC involves some problems to reflect reality. The main issues for calculation and application of this model will be explained in the following paragraphs.
4.1 The capital structure of the company must remain the same
First, in order to have a reliable cost of capital, capital structure of a company must remain unchanged as the cost of debt and the cost of equity are weighted. Thus, if a company has more debts than before without more shareholders funds, its gearing ratio would increase. Consequently, cost of debt would also rise. In this case, it is recommended to recalculate the weighted average cost of capital with the new data. Additionally, Lumby and Jones (2003) add that the weighted average cost of capital can change according to risk. A company more financed by debt than before and consequently less financed by equity will become less risky. Effectively, the company is obliged to pay the bank interests at first and only then dividends to shareholders. So it is sure that the company will be financed correctly.
4.2 All projects of the company should are in the same risk class
To have a reliable WACC, all company projects should be in the same risk class. McLaney and al (2004) argue that firms which produce different products are confronted to different project risks. And these authors add that only few companies take these varied risks into account. It means that in this case, the weighted average cost of capital take into account a global and average risk but it is not specific to each project. Consequently, the following part will deal with the use of a single or a multiple discount rate to assess the project’s risk.
4.3 Use a single company-wide discount rate or a multiple discount rate?
Martin and Titman (2008) cited a survey which explains that more than half of interrogated companies use a single wide discount rate to assess all their investments projects. It could not be relevant because all projects does not engender the same weight of risks, consequently, risk can be understated or overstated and the cost of capital too. That led the board of directors to undertake decisions with imprecise evaluation. Martin and Titman (2008) gives some reasons which lead companies to use a single wide discount rate, for example when firms are engaged in a few activities, they do not need to use multiple discount rates. Moreover, another reason is that using multiples discount rates is more difficult to analyse. Hence, managers have to assess if they will get more benefits using a multiple discount rates instead of using a single wide discount rate and if they will not be so confused with the complexity of the model. Therefore, if some investment projects are similar, a single discount rate may be sufficient. Moreover, Martin and Titman (2008) gives another reason: using multiple discount rates can engender problems if these are managers who assess the profitability of an investment. They can influence the board of director’s decision making by overstating expected cash flows, underestimating projects risk and of course, costs of capital, just for their own benefit to win the deal and earn a bonus. This kind of behaviour refers to the influence costs.
4.4 A lot of source of finance can be included in the weighted average cost of capital
In the WACC, it is possible to include a lot of source of finance but we have to know for which reason we want to include them in the calculation. First, “if finance is being used to fund the long-term investments of a company, it should be included in the calculation. Equity finance, preference shares, medium- and long-term debt and leasing should all therefore be included” (Watson and Head, 2007: 256). Generally, short term debts are not included in calculation because they do not finance long term assets. However, Watson and Head (2007) mention that it could sometimes be relevant to include bank overdraft in calculation if these short term debt are repeated. For Premier Foods, each year we have a bank overdraft. In 2008, it reached �156,700, that is an increase of 58% in comparison to 2007.
4.5 Problems concerning market values
First, Watson and Head (2007) explain that some securities do not have market prices because they are not often traded, like ordinary shares of private firms. So it is difficult to include them in the cost of equity. One possible solution is to find company implied in the same business branch. At this moment, we can calculate cost of equity with its particular market price and add a premium to reflect higher risk of private firm. This calculation does not reflect real market value of an ordinary share but it permits to make estimation. Moreover, it is possible to find market value of a bond by taking another bond with equal maturity, with an equivalent risk and interest rate.
4.6 Issue to choose between book values and market values
Sometimes, it is difficult to find market values. Watson and Head (2009) explained that the book values can be found in the company accounts whereas market values can be obtained using, for example, financial databases like FAME. Moreover, they claim that book values are not so reliable compared to market values because they are based on historical costs. If reality is not reflected, for example, if company cost of equity is understated, then the WACC will also be understated. As a result, this error can lead company to accept project which would not be profitable and company value would drop.
4.7 Utilising Capital Asset Pricing Model or the Dividend Growth Model?
First, McLaney et al (2004) argue that the CAPM overestimated cost of capital compared to the Dividend Growth model. But the CAPM is the most commonly used by companies. Effectively, according to a survey realized by Arnold and Hatzopoulos (2000), 70% of UK firms calculating the weighted average cost of capital for their company using CAPM .
However, it is possible to critic this model because of the assumptions we make about Beta or equity risk premium. McLaney et al (2004) explain that beta is less relevant than company’s market capitalisation.
Companies can also use Dividend Growth Model to estimate returns on equity. The problem raised by McLaney et al is the difficulty to have reliable growth rate because it is based on expectations. We need to estimate forecast of next dividend’s period by using growth rate. But if it appears as an important change in the business environment during the year or an important drop in the revenue, this growth rate would become totally irrelevant. Hence, weighted average cost of capital would be biased. For Premier Food, the calculation of cost of equity with the Dividend Growth model was not relevant because there were no dividends paid in 2008, consequently the estimation of the next dividend period was almost impossible. Watson and Head (2009) have an interesting conclusion about that. They explain that each company is different and sometimes if their growth rate is constant it is better for them to use the dividend growth model. On the contrary, if the beta of a company is unstable the weighted average cost of capital will not be reliable. It is the reason why I used the CAPM which was in this case more reliable (the beta was more constant contrary to the growth rate) for Premier Food’s WACC.
4.8 Reassessment of WACC
Watson and Head (2009) argue that the value of weighted average cost of capital can vary with time. Effectively, cost of the source of finance can change because of evolution of bank interest rates, corporation tax or share price of the company. McLaney et al (2004) add the WACC must be often reassessed to be more relevant and reliable. However, in a survey made in 1997, more than half of interrogated firms responded that they only reviewed their cost of capital annually (McLaney et al, 2004). Other firms reassess their cost of capital when they deal with important projects like launching of a new product, or important decisions like a merger or acquisition. According to McLaney et al (2004), companies should reassess their cost of capital regularly because if it is overvalued, the firms can cancel a project. On the other hand, if cost of capital is understated, shareholders will not have expected returns.
Conclusion
To conclude, it is important for Premier Foods Company to choose the greater model (CAPM or the dividend Growth Model) to assess its cost of equity finance and also to prefer market values rather than book values. Finally, the company should often reassess its WACC to undertake efficient business decisions.
References
Bank of England (2009) News Release Bank of England Maintains Bank Rate at 5.0%. Available at http://www.bankofengland.co.uk/publications/news/2008/045.htm
[Accessed: 16 November, 2009]
Associated British Food plc (2008) Associated British Foods plc Factsheet [Online] Available at http://www.abf.co.uk/assets/abf_factsheet_web.pdf [Accessed: 17 November, 2009]
FAME (2009) Premier Food plc [Online] Available at https://fame.bvdep.com/version-20091031/cgi/template.dll?product=1&user=ipaddress [Accessed: 16 November, 2009]
FAME (2009) Associated British Food plc [Online] Available at https://fame.bvdep.com/version-20091031/cgi/template.dll?product=1&user=ipaddress [Accessed: 16 November, 2009]
HM Revenue & Customs (2009) Corporation tax rate. Available at http://www.hmrc.gov.uk/rates/corp.htm [Accessed 16 November, 2009]
Lister R, ‘Cost of capital is beyond our reach’, Accountancy, December 2006 p42 – 43
Lumby , S. and Jones, C. (2003) Corporate Finance: Theory & Practice. 7th edn. London: Thomson [Online] Available at http://72.3.142.35/dxreader/jsp/StartReading.jsp?filenumber=1259072742459440&url=http://72.3.142.35/dxreader/jsp/BookLoader.jsp [Accessed: 23 November, 2009]
Martin J and Titman S, (2008) ‘ Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process’, Journal of Applied Corporate Finance, Volume 20 Number 2, Spring 2008
McLaney E, Pointon J, Thomas M, and Tucker J, (2004) ‘Practitioners’ perspectives on the UK cost of capital’, The European Journal of Finance 10, 123 – 138, April 2004
Premier Foods (2009) Dividend Information Available at http://www.premierfoods.co.uk/investors/shareholder-services/dividend-information.cfm [Accessed 17 November, 2009]
Scopulus Business Resources (2009) UK Tax Rates 2008-9. Available at http://www.scopulus.co.uk/taxsheets/uktaxrates2008-9.htm#CorporationTax4-5 [Accessed: 16 November, 2009]
Watson, D. & Head, A. (2007) Corporate Finance Principles & Practice. 4th edn. Harlow, Edinburgh Gate: FT Prentice Hall
Business Finance 3BUS0210 – H�l�ne Ageorges 09203136
Appendices
1 The Weighted Average Cost of Capital of Premier Foods plc
1.1 Calculation of the “cost of debt”:
1.1.1 Cost of debt
These following figures are taken from the financial database FAME (2009).
|
Au 31/12/2008 in GBP |
|
|
Long term debt |
1,632,600 |
|
Deferred tax |
193 100 |
|
Other provisions |
28 100 |
|
Pension liabilities |
11 500 |
|
Bank overdrafts |
156 700 |
|
TOTAL |
2022 000 |
|
Interest paid |
186 100 |
The cost of debt is equal to:
186100/ (1632600 + 193100 + 28100 + 11500 + 156700)
= 186100 / 2022000
= 9.2%
1.1.2 After tax cost of debt
9.2% x (1-0.28) = 6.62%
1.2 The return of equity using the Gordon Growth Model:
The total dividends paid from 2005 to 2008 according to Premier Foods Company (2009) were:
|
2005 |
14.25p |
|
2006 |
13.05p |
|
2007 |
6.30p |
|
2008 |
0p |
Estimation of the dividend paid in 2008:
D2007 = D2005 x (1+ g)� => g = [(6.3/14.25)^0.5] – 1
So g = -33.5%
The estimate amount of dividend for 2008 is: 6.3 x (1-33.5%) = 4,19p
The next period dividend corresponding to the year 2009 is:
D2008 = D2005 x (1+g)^3
=> g = [(4.19/14.25)^(1/3)] – 1
g = -33.5%
The estimate return of equity is: [(4.19 x (1 – 33.5%)) / 710] + (-33.5%) = -33.1%
1.3 Calculation of the return on equity using CAPM:
Formula of the CAPM:
expected return on equity = risk free rate of return + Beta x (expected return on the market – risk free rate of return)
Expected return on equity = 5% + 1.02 x 5% (market risk premium)
= 10.1%
1.4 The gearing ratio
The calculation is: 2022000 / (2022000 + 991700) = 67.1%
1.5 Calculation of the WACC
The WACC for Premier Foods plc was 32.9% x 10.1% + 67.1% x 6.62% = 7.76%
2 The Weighted Average Cost of Capital of ABF plc
2.1 Calculation of the “cost of debt”:
2.1.1 Cost of debt
The cost of debt is equal to: 74 / (1465+278) = 4.25%
2.1.2 After tax cost of debt
The after cost of debt is 4.25 x (1-0.28) = 3.06%.
2.2 Calculation of the return on equity using the Dividend Growth Model
D08 = D04 x (1+g)^4
20.25 = 16.4 (1+g)^4
=> g=((20.25 / 16.4)^1/4) -1
g = 5.4%
The cost of equity finance is equal to:
(20.25 x (1 + 5.4%)) / 710 + 5.4% = 8.41%
2.3 Calculation of the return on equity using the CAPM model
The return on equity is equal to: 5% + 0.53 x 5% (the Market risk premium) = 7.65%
2.4 The gearing ratio
It is equal to: (1465 + 278) / (1465 + 278 + 4554) = 27.7%
2.5 Calculation of the WACC
The WACC of ABF plc is equal to 72.3% x 7.65% + 27.7% x 3.06% = 6.38%
Business Finance 3BUS0210 – H�l�ne Ageorges 09203136