An assignment on sainsbury’s discussing the sources of income, considerations taken into account by management when choosing type of finance. Calculating WACC based on 2014 balance sheet. Problems that might be encountered by company.
In this report we are going to study regarding WACC which is an important part of capital structure or we can say helps in taking capital structure decision, the various external sources of finance & factors to be kept in mind while making choice of types of finance. The calculation of WACC is required as co wants to raise its capital at lowest possible cost & yield higher return.
John Pemberton was an American pharmacist who developed Coca cola in 1886 & it was sold in 1888 to a businessman who promoted the drink among public by selling free products along with it such as calendars, clocks etc. in 1895 coca cola was started selling in bottles so that it could be consumed everywhere by the customer. In 1917 the export of coca cola was started firstly in Cuba, France Puerto Rico etc. After that many big promotional campaigns were launched in 1920s such as Olympic Games in Amsterdam, bullfighting games in Spain etc. There are near about 400 beverage brands of coca cola such as Fanta, Sprite, Minute maid etc. launched in many countries. (Cleveland, 1995)
It refers to raising money from sources outside the business. It includes short term, long term as well as medium term finance.
Bank overdraft
This facility is available to businessmen having current accounts with banks. Bank provides credit to the businessmen which are more than the balance in their account. Such advance given by the bank is decided earlier as bank provides a limit to the businessmen whoused it to meet his short term liabilities as he can overdraw amount up to this limit allowed by the bank.(Annon, 2008)
Trade Credit
It refers to allowing credit to customers or providing them grace period to make payment for the purchases made by them. Grace period may be of 60 days, 90 days depending upon the nature & type of organization.(Mike, 1996)
Factoring
This facility is used when business is in urgent need of cash. They get the bill discounted by selling it to a factoring company & result of which factoring company will now collect money from the customer.
Hire Purchase
It refers to buying an asset by making few payments as down payment & balance in installments over a period of time agreed under hire purchase contract. Interest will also be charged on these installments.(Ehsan, 2006)
Leasing
It involves use of an asset by lessee but ownership of that asset is not transferred. The lessee will make the payment to lessor till the time the asset is used by him as rent
Bank Loan
It involves getting loan from bank for longer period by providing security against that loan. Business is required to repay this loan in installments along with interest.
Share Issue
it involves public limited co issuing shares up to authorized capital while private limited companies issuing shares to their existing shareholders.
Sales and lease back
It involves making a sale to Investment Company& then leases back this property after a long period of time for using it into the business.
The long term finance provides permanent source of capital as it involves fixed amount of return which will be paid to investors whether there are profits or not but sometimes it can be a problem for the company to make interest payments.(Natalie, 2012)
In medium term finance leasing can provide benefit as asset is not required to be purchased & can be used by business. But sometimes cost of leasing asset can be more than cost of purchasing the asset.
In case of short term finances bank overdraft facility provided is beneficial as it is flexible & limit can be changed anytime as per the needs of business. But interest rates of banks may be high & they may demand repayment at short notice which may create problem for the business.
For making investment it is necessary to check cash flow position of the company as cash is required for making interest payment as well as repayment of principal amount.(Saritha, 2009)
Although this ratio is not considered as appropriate factor while making capital structure decision but still it is considered to determine the earnings available for making interest payments.
The weakness of ICR is overcome by DSCR ratio as this ratio helps in determining the cash available for making payments. This ratio reflects the debt paying capacity of the company.
This is another factor to be considered while making investment as greater ROI will determine the debt capacity of the company.
It determines the capacity of the company to take debts. Hence it should be kept in mind while determining capital structure.(H, 2011)
It helps in determining the debt cost which will decrease in case tax rate increases.
It is dependent on utilization of debt capital as it will increase with increased use of debt capital. This will also increase the risk of equity shareholders
It refers to expenditure incurred while issuing securities such as underwriters, brokerage commission etc. the floatation cost of equity capital is more than debt capital.
There can be operating risks and financial risks. Risk factor must be kept in mind while taking capital structure decisions.
Capital structure should be flexible as capable of changing in amount of capital. Capital amount can be increased or decreased but decrease in amount is possible only in case of debt capital. There is no repayment in case of equity share capital. Hence we can say that issue of debt capital & preference capital is preferable.(Zane, 2003)
Capital structure is also influenced by control as it must be kept in mind that interest of shareholders should not be affected while taking investment decisions. It is better to raise capital through debt as it will not affect the control position of the company.
The regulations provided by government must be followed while making capital structure decisions. For example compulsory requirement of the company to maintain debt equity ratio while raising capital
Weighted Average cost of capital is the rate offered by the company for making payments to security holders for financing the assets of the company.The assets are financed through debt & equity. & WACC which is also called as cost of capital of firm is calculated by using following formula.(Annon, 2015) It will also help in determining the interest paying capacity of the company against its finances. Following is the formula for calculating WACC:
WACC= E/ (E+D)*Cost of equity/ (E+D)* cost of debt* (1-Tax rate)
Coca Cola co.’s returns are higher than its costs as its cost of capital is approximately 8.32 % as compared to ROI which is 14.45%. The continuity in higher returns will increase the value & the growth prospects of the business.(William, 2013)
As we know that debt & equity are used to finance the assets of the company, thus it is necessary to calculate the weights of equity & debt. The market capitalization of coca cola is approx. $ 176085.6 million which is denoted by ‘E’. The book value of debt is used to calculate market value of debt by adding latest two year average of short term & long term debt in order to simplify the calculation.
For the year ending 2015 the two year average of coca cola Company’s short term debt is $20310.4 million while long term debt is $19110.4 million. The book value is $39408 million.
Weights of equity = E/E+D
=176085.6/ (176085.6+39408)
= .817
Weights of debt= D/ (E+D)
= 39408/ (176085.6+39408)
= .183
CAPM model is used to calculate cost of equity as per following formoula:
Cost of equity = Risk free rate of return+ Beta of asset* (expected return of market- risk free rate of return.(Franklin, 1996)
Risk free rate of Coca Cola Company is 2.44%, Beta is 1.04, Expected return of market less risk free rate of return is 8%
Cost of equity = 2.44+1.04 *(8) = 10.76%
Cost of Debt
The co.’s interest expense amounting to $ 479 million & book value was $39408 million. Hence cost of debt will be 1.23% (483/39408)
WACC = .8171*10.76%+.183*1.23*(1-24%)
=.0879+.171
=.259
It can be concluded from the above that return on investments are high as compared to its cost incurred to raise the capital. However if the returns on investment is lower as compared to its cost it may badly affect the value & growth of business.(Scott, 2007) But on the other hand excess returns on investment will increase the value as well as growth prospects of business. Therefore it is recommended that while making investment decisions above mentioned factors must be considered. So, that it can be ensured that investment will yield a higher return. WACC appears to be simple theoretically but it is difficult to calculate from practical point of view. WACC tool is used by many investors to take decisions regarding making investments.
Annon, 2008. https://www.dineshbakshi.com/igcse-gcse-economics/private-firm-as-producer-and-employer/revision-notes/1296-external-sources-of-finance. External sources of finance .
Annon, 2015. https://www.gurufocus.com/term/wacc/KO/Weighted%2BAverage%2BCost%2BOf%2BCapital%2B%2528WACC%2529/Coca-Cola%2BCo. Coca-Cola Co (NYSE:KO)WACC.
Cleveland, P. S., 1995. The cost of capital : theory & estimation. USA: greenwood publishing group.
Ehsan, N., 2006. Finance. Newyork: s.n.
Franklin, P. J., 1996. Understanding Return on Investment. Canada: John Wiley & SOns.
H, B. K., 2011. Capital structure & corporate financian decision. s.l.:s.n.
Mike, B., 1996. accounting & Finance in Business. s.l.:s.n.
Natalie, P., 2012. A Critical analysis of efficacy of law as a tool. USA: University Press of america.
Saritha, P., 2009. https://www.yourarticlelibrary.com/stock-exchange/14-important-factors-affecting-the-choice-of-capital-structure/1042/. Important Factors Affecting the Choice of Capital Structure.
Scott, B., 2007. Essentials of managerial finance. s.l.:Cengage Learning.
William, L. R., 2013. Practical Financial Management. Canada: s.n.
Zane, S., 2003. Capital structure paradigm. USA: Praeger Publishers.
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