Cost of Capital Estimation Electrocomponents and James Fisher & Sons Plcs

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Cost of Capital Estimation

Electrocomponents and James Fisher & Sons PLCs

1. Introduction

1.1 Overview of WACC

The Weighted Average Cost of Capital (WACC) has been an important concept in the study of Corporate Finance. By using weighted averages, the formula is applied to estimate a firm’s cost of capital. However, the WACC makes several assumptions, and through using averages, by default it carries several limitations (Bodie, K. et al 2014).

1.2 Objectives and Methodology

This study set out to determine the predictive validity of the WACC model. Firstly we selected two companies, namely A) Electrocomponents PLC and B) James Fisher and Sons PLC. For our study we took the following hypothetical scenario; that company A, was exploring a potential opportunity to invest into B. The WACC was its preferred estimation model to calculate the Net Present Value (NPV) of the project and we set out to calculate it. Equation 1.0 described how the WACC was calculated. Further, we tested our model’s robustness via a sensitivity analysis where each variable within the predictive model was adjusted.

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Equation 1.0 WACC

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1  Was calculated using the CAPM (1964) as explained later in Section 4.0.[pic 7]

2 Our investigation utilized a mixture of primary and secondary data sources from company reports, Thomson Reuters EIKON, research papers and textbooks; each referred to in their respective areas.

1. Analysis

2.1 Financial Gearing

2.1.1 Overview of Gearing Results

In order to estimate the WACC, several components of its calculations needed to be identified. The first of these was gearing. Gearing is a measure of financial leverage, which demonstrated to what level firms A and B were funded by owner-equity versus creditor funds.

Using equation 2.0, the gearing ratios were calculated into Table 1.0. 3

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Equation 2.0: Gearing Ratio

An important point was the distinction made in Equation 2.0 between debt and liabilities. Debt was classified as liabilities that held interest-bearing obligations.

Table 1.0: Gearing Calculations

2.1.2 Gearing Analysis

As stated in its annual report, (p121, 2015) the aim of Electrocomponents PLC’s board’s has recently been to maintain a strong capital base, with an ‘appropriate’ mixture of debt and equity. This was to ensure investor, creditor and market confidence. By managing a relatively ‘low’ gearing ratio of just 7.43%, it seems that Electrocomponents has been following up on its promise.

3 Data Sources

a) P84, Balance Sheet, Electrocomponents PLC Annual Report 31st/12/2015

b) P56, Balance Sheet, James Fisher & Sons PLC Annual Report 31st/4/2016

c) Thomson Reuters EIKON for Market Cap.

According to James Fisher & Sons’ Annual Report (p81, 2016), the board’s primary objective of capital management policy was to maintain a strong credit rating, and covenant ratios, to maximize shareholder value. One method of achieving this objective was to project a low gearing ratio of 10.54%. However, one could argue that low debt levels may have adversely affected the objective of maximizing shareholder value, as increasing debt may have potentially provided further tax shielding. However, the group was required to maintain positions within its covenant ratios, under contractual obligations of its loan agreements. This restricted the amount of money, or net debt, that could be borrowed and was set externally by its bank, which seemed to be its main lender.

Gearing analysis amongst both companies, showed both similarities and differences in board policy, which consequently affected the levels of gearing in each. One should note that both levels of gearing in this case were extremely similar. The differences that arose may have been for several reasons. Firstly, different industries have their own ‘standard’ gearing levels. For example, one could infer that firms operating in the marine industry, such as company B, typically take out higher levels of trade finance, which hence increases their gearing. Company A is a large supplier of electronic products, which are mostly manufactured in China and consequently sold at very high margins in the Western world. Consequently, electronics manufacturers, due to their cash-rich nature do not require as much leverage to operate. Also, as seen through reading annual reports, gearing levels are affected by covenants, which are set to protect shareholder value. Furthermore, macroeconomic shifts and government policy may also affect gearing levels. For instance, low interest-rate environments may encourage firms to take out additional ‘cheap’ debt, instead of raising equity to finance growth.

3.2 Electrocomponents PLC Cost of Debt and Tax Rate

3.2.1 Cost of Debt

Cost of debt Electrocomponents PLC = 2.26%

Cost of debt was defined as the average rate, which an organization paid on all of its debts, which typically consisted of bond-obligations and bank loans. (Schmidt, 2016). For Electrocomponents’ Group, the cost of bonds did not need to be considered since it only had bank loans outstanding. The total interest paid by the group at the end of the accounting period was £7.5m (p85, 2016 Annual Report). The cost of debt was then calculated using equation 3.0.