How sources of capital and cost of capital influences the company performance
Glee plc. is one of the leading construction companies in Alba, UK founded by Gawain Colwich in 1972. The company is currently facing disequilibrium in their capital structure because of not having pertinent techniques to assess their investment opportunities. This problem arises due to the board directors ignoring the importance of balanced capital structure; to bring down the cost of capital of the company. In order Glee to resolve the crisis; there must be a capital reform to enable the company to achieve lower cost of capital. There are three main areas where Glee should look into is (1) the sources of capital, (2) the optimum capital structure, and (3) the investment appraisal techniques which will help Glee to achieve its goal of controlling their cost of capital and to maximise their shareholders wealth.
How sources of capital and cost of capital influences the company performances
The method use to enable Glee’s to generate capital
In order Glee’s to commence an investment; the company required to obtain its capitals through sources of capital. As a public listed company, it is compulsory to have an applicable method to obtain its capitals through long-term sources of capital because through long-term capital sources – the repayment period is over a year.
There are two options for the company to acquire its sources of capital:-
Capital ownership is where the capital is owned by the shareholders. There are two types of ownership capital:-
Equity Shares Capital
“The equity shares are bought and sold at the bourse market” (Marshall & Johnston, 2010) . it is wise for Glee to obtain their resources through equity because the dividends only pay when the company is profitable otherwise the dividend is voidable. There are three type of techniques to increase the company equity that are through 1. New issue, 2. Right issue, and 3. Retaining earnings. Furthermore, the shareholders does not have claiming right on the company assets. However, Glee might risks themselves on losing influence and control over the company since the shareholders have voting right to elect or to remove the directors from the company, and having the preemptive right to buy new issue shares.
Preferred Shares Capital
The preferred shares is “part of risk bearing ownership in the company because the preferred shareholders dividends only be paid after settled the interest rates on debt” (McLaney, 2009). The preferred share dividend is fixed and there is no voting right for shareholders. However, the price of the preferred is determined by the rates of the interest e.g. when the interest rate increase; the preferred share price will decline, or otherwise. In addition, If, Glee’s bankrupted the preferred shareholders have the claiming right its assets.
Non-ownership capital is where “the debt borrowed from the financier with a fixed term and interest rate” (Watson & Head, 2007). There are several methods for Glee’s to increase its capitals that are through term loan, bonds, debentures and leasing. The benefit of debt capital is the company could control over the ownership right and with tax exemption over its interest rate.
However, the fear of bankruptcy might occur when the company could not repay their debt, the finance institutions have the claiming right over the company assets, and when debt increased shareholders will lose confident over the company.
The Cost of Capital
“The cost of capital is the projected rate of returns for assessing investment decisions” (Pratt & Grabowski, 2008). The capitals acquired by Glee’s from the sources of capital are required to repay its costs and maintaining the company profit. Besides that, the company have to esure their cost of capital is lower than its returns. In addition, cost of capital is determined by Ke, Kd and Kp
Cost of Equity (Ke)
Cost of Debt (Kd)
Cost of preference (Kp)
Weighted Average Cost of Capital (WACC)
WACC is to evaluate the cost of capital of a company. As we know, Glee’s acquired its capital through the ownership (equity and preferred shares) and non-ownership capitals (debts) to structure its capital. It is wise that the company uses WACC to determine the cost of capital and the weights of the capital structured components. In WACC, Glee’s could determine the hurdler rate. For example, if the investment below the hurdler rate means the cost is higher than return. However, if above the hurdler rate means the returns is higher than the cost. Based on appendix A has clear show that Glee’s should undertake project 2 because the expected returns is higher compare to project 1 as in 15.29%>12% and 10.15%<12%.
Practice with optimal capital structure
“The optimal capital structure debate addresses the question of whether a company can minimise its cost of capital by adopting a particular” (Watson & Head, 2007) because most of the companies’ includes Glee’s are debating for the optimum capital structure, which determine how much capital should acquires in the mixture of debt/equity capitals.
The traditional prospective
According to McLaney (2009), the traditional approach evaluate the value of the shares value differently, and the evaluation is depend on whether the dividend is paid or otherwise. In traditional prospective, Glee could determine the percentage of risks might affect the company future market value and their the dividend. It is because the market and dividend values is influenced by the shareholders perception on risk taking. As we knows, when the investment risk is high, the shareholders will demand for higher dividend which will cause the share price to fluctuated which will also causing the dividend rate to be lower, and it will affect the shareholders wealth and their confident towards the company.
The Modigliani and Miller prospective
The M&M theory (1958) claimed that “the company market value is determined by the expected performance and commercial risk” (Watson & Head, 2007). Based on M&M, debt capital is the cheaper compare with equity where Glee could counterbalance the rise of cost of equity and improved the WACC value and the market value.
Based on Appendix B 2.2.1 has shown that when a company
The M&M theory (1963) claimed that companies should take tax advantages to shield debt. Based on the theory, Glee should replace equity with debt as it will reduce the leverage of the company, and with 100 per cent of debt capital Glee will achieve optimal capital structure for the company.
“The investment appraisal is a method to evaluate the desirable of the investment projects” (Gillespie, 2001). In order Glee’s improve its profitability; the company should only accept the profitable investment. The reason the Glee’s failed is because the company never carryout a thorough investment analysis to determine the investment is profitable or otherwise. Again, every investment accepted without thorough valuations which cause the company incurred additional costs. If, investment appraisal has been used, the company will not face lower returns because investment appraisal plays an important role in investment decision-making.
There are four (4) methods used to evaluate investment appraisal:-
Payback is “the duration of time takes for the company to recover its initial investment” (Gillespie, 2001). Based on appendix B: Payback Period for project A and B; it has indicate that Project A has better cash flows compare to Project B because Project A only took 25 months to recover its initial cost of their project but Project B took 31 months to recover which might defer the potential investment opportunities, if available. In this case, Glee’s should consider project A because its payback period is shorter as as result the risk of illiquidity will be lower unlike project B where the payback period is higher which might face higher risk in illiquidity.
This method will help Glee to measure and to prevent illiquidity of their cash flows besides that the shorter period of cash flows recovery is better because the company could reinvest to new projects. In constrast, the longer the recovery took, the company might face financial risk of illiquidity. However, Payback might overlook the potential time value of money because of the prolonging and thorough analysis before the decision can be made which is not applicable in short-term investment. In addition, if the project payback period is comparable it is difficult to determine which project has the potential. Besides that, payback does not take account into the length and timing of the investment as like ARR
Accounting Rate of Return (ARR)
ARR is “the average annual profit in a percentage of the initial investment” (Gillespie, 2001). Based on Appendix B: ARR has shown Glee that Project A is the most preferred choice for investment because it has higher returns compare to Project B; in the tabulation has indicate that Project A has 26.87pc which above the desired benchmark of 20pc compare to Project B which below the desired benchmark.
ARR will assist Glee to select their potential project by accepting the project with higher ARR returns such as Project A. However, by using AAR technique the company unable to evaluate the cash flows or market value of the investment because ARR is based on book value of the investment. Besides that, the uses of arbitrary cut-off point by placing a benchmark to determine whether the investment is acceptable which fail to overlook the time value of money. Also, ARR does not take account of the length and timing of the investment which similar to payback period.
Net Present Value (NPV)
NPV is “to measure the amount of value created today through an investment” (Gillespie, 2001). For the example on Appendix B: NPV, the most preferred project would be Project A since it has the highest NPV of £ 118,721 compare to Project B only £ 36,295. Even though both projects have the positive NPV however Project A is bringing higher returns to the shareholders.
This technique will assist Glee to have the right decision on the right investment because it will provide the right ranking for the mutually exclusive project based on the positive or negative value. The golden rules of NPV are accepting the positive value and reject the negative. In addition, NPV is using discounted cash flow to determine the value of an investment, taking account of time value of money and the risk of the forthcoming cash flows. However, NPV is facing difficult to recognise the right discount rate for Glee, and it requires a decision-in-principle to be specified before implementing the project which might deferring the investment opportunities. Nevertheless, the NPV only specify the value of the cash flows without providing the rate of return of the investment.
Internal Rate of Return (IRR)
“IRR is the discount rate which connected to the present value of a project’s expected future net inflows with the supply price; e.g. NPV=0” (Gillespie, 2001). The golden rules of IRR are accepting the project when the IRR higher than the cost of capital. Based on Appendix B: IRR, Project A has exceeded the desired rate of returns of 60pc which is 79.58pc compare to Project B only 51.93pc which below the benchmark. If, Glee invests on Project B, it might cause the company to face financial risk due to unprofitable investment where cost of capital is higher than the rate of returns.
IRR can be evaluated by the company without required the estimate the cost of capital. Besides that, time value of money will take into account since IRR using the discounted cash flow to analyse the investment potential. In addition, this method also helping the company to pick the right project through comparing the IRR with interest rate. If, the rate of interest of the investment invested is lower than the IRR, it will give Glee’s a positive present value, and vice versa. However, IRR might assume reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project.
However, the company might overestimate the size of the return when the IRR is higher than the initial re-investment rate for interim cash flows, the size will over-estimate the annual return of the project because this method assumes that the company has additional projects with equally desirable prospects, to invest the interim cash flows.
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