Question

Baba Plc is expanding and wishes to appraise some suitable investment opportunities. In order to do this, the Weighted Average Cost of Capital (WACC) needs to be calculated. It currently has 1,350,000 ordinary shares, with a share price of £4.25. A dividend was paid on these shares of £0.42 per share recently. The risk free rate of return is 5%. The market premium is 4%. The beta of Baba Plc has been calculated as 0.96. There is an 7% loan redeemable in 5 years time with a nominal value of £2,500,000 and a market value of 98%. The redemption will be at a premium of 3%. A bank loan also exists at an interest rate of 6% of £1,100,000. Tax on the company profits is at 20%. The Finance Director has sent you the following email: ‘I need to know the WACC of Baba Plc, including all of the workings, so I can present this to the other Board members. Also, can you write a set of business notes on how this WACC might change if we raise the investment cost via more debt? It might be worthwhile for the Board to be aware of how this may also affect the market value of the company.’ You have been informed that the new WACC after issuing more redeemable bonds will increase by 2%. Requirements: Reply to the Finance Director’s email, including the following: Calculate the WACC of Baba Plc. marks) Discuss, with reference to capital structure theories, how the WACC may change if more debt is raised to fund the investment, and how this is demonstrated by the 2% increase in Baba Plc’s WACC. Include how this could affect the market value of the company. (There is a word limit of 400 words for this part b of the question.)

Answer 1

Calculated Baba Plc's WACC at 5.63%. Increasing debt raises WACC due to higher financial risk (Trade-off Theory) and negates tax shield benefits. This likely leads to a 2% WACC increase and could decrease market value unless investment returns outweigh higher costs.

As requested, I have calculated the WACC of Baba Plc and analyzed how it might change with increased debt financing. Here's a breakdown:

1. Calculating WACC:

Equity Cost of Capital (Ke):

Dividend Yield (D/P) = £0.42 / £4.25 = 0.099 ≈ 10%

Cost of Equity Capital (Ke) = Rf + β(Rm - Rf) = 5% + 0.96 * (4% - 5%) = 4.24%

Debt Cost of Capital (Kd):

Loan 1: Yield to Maturity (YTM) = (7% + 3%) / 98% = 10.20%

Loan 2: Cost of Debt (Kd) = 6%

Weighted Average Cost of Debt (Kd): (1.02 * 0.7 + 0.06 * 0.3) = 6.74%

WACC:

WACC = Ke * We + Kd * Wd

Where: We = Equity Weight = 1.35 million shares / (1.35 million + 2.5 million + 1.1 million) = 36.84%

Wd = Debt Weight = 1 - We = 63.16%

WACC = 4.24% * 36.84% + 6.74% * 63.16% = 5.63%

2. Impact of Increased Debt on WACC:

Introducing more debt generally increases the WACC. This aligns with capital structure theories like the Trade-off Theory and the Modigliani-Miller (M-M) Theorem.

Trade-off Theory: Increased debt raises the cost of debt (Kd) due to higher financial risk. This higher Kd outweighs the tax shield benefit of debt, leading to a higher WACC.

M-M Theorem (Irrelevance Proposition): In a perfect market with no taxes or bankruptcy costs, capital structure (debt-to-equity ratio) is irrelevant to company value. However, Baba Plc operates in a real-world context with taxes and bankruptcy risk. Increased debt increases the bankruptcy risk, decreasing the firm value and offsetting the potential tax benefits, eventually leading to a higher WACC.

The expected 2% increase in WACC after issuing more bonds confirms this principle. Higher debt raises the financial risk and Kd, outweighing the tax shield to elevate the overall WACC.

3. Impact on Market Value:

An increase in WACC can negatively impact the market value of a company. A higher WACC implies a higher required return for investors, reducing the present value of future cash flows and consequently, the company's valuation. Additionally, the increased bankruptcy risk associated with higher debt can further depress investor confidence and market value.

However, if the investment funded by the debt generates sufficient returns to overcome the increased WACC, the market value could still improve. This emphasizes the importance of careful project selection and financial analysis alongside debt financing choices.