Evaluating alternative methods to calculate the cost of capital

• Develop the necessary analytical skills to make financial decisions

Prepare a business report for presentation to the Board of the company.

E) Discuss the advantages and disadvantages of the payback, accounting rate of return and net present value techniques.

Answer:

Introduction

The financial management is a dynamic and the most crucial component of the overall management in any organization. The success of the business largely depends upon the effectiveness of the financial management of the firm. As part of the decision making process, the financial management domain is concerned with analyzing the financial viability of the projects (Brigham and Daves, 2014). The capital budgeting process plays an important role in assessing the financial viability of the projects and the most crucial aspect of capital budgeting is the evaluation of risk and returns associated with the projects being considered for analysis. The process of risk and return assessment brings in the concept of weighted average cost of capital. This report provides discussion on the computation of weighted average cost of capital in relation Pearson plc, which is a listed company engaged in the business of providing educational materials and learning technologies (Yahoo Finance, 2017).      

Weighted Average Cost of Capital (WACC): Meaning and Significance

Computation of Cost of Equity: Pearson plc

Method-1: Capital Asset Pricing Model (CAPM)

In this formula, this “Rf” is risk free rate of return and “Rm” is market rate of return. The beta refers to volatility of the stock and “Rm-Rf” refers to the market risk premium (Baker and Martin, 2011). Applying the above formula, the cost of equity of Pearson Plc has been arrived as under:

Method-2: Dividend Discount Model (DDM)

The dividend discount model works as an alternative to the CAPM model in determining the cost of equity. This model assumes that the dividend payout is the only cost that the company incurs against the use of equity funds. The formula used for computation of cost of equity in this model is given below:

Computation of Cost of Debt: Pearson plc

Method-1: Taking Interest Cost as Base

Method-2: Referring to External Market

In this method, the cost of debt of the firm is determined by referring to the bond yield in the prevailing in the market (Baker and Martin, 2011). For instance, the bond yield of the similar company operating in the same industry can also be taken. In the current case of Pearson Plc, the cost of debt has been computed with reference to the bond issue of University of Liverpool as detailed below:

WACC of Pearson plc

The computation of the weighted average cost of capital of Pearson plc has been given below:

Evaluating the use of WACC as an Approach to the Calculation of the Cost of Capital 

Further, there is one more consideration in regards to use of WACC in analyzing the project’s financial viability. Before using WACC for the purpose of analysis, it is to be ensured that the project is financed by using a mix of debt and equity. This is because the computation of WACC takes debt and equity both the factors in computing the cost of equity (Campani, 2015). Thus, if the project is financed entirely through equity or debt then the use of WACC will not be proper. In that case if the project is financed entirely through equity and WACC is used for analysis, the incorporation of risk would be less. The use of equity only to finance the project increases the risk of the project and thus, in that case, the cost of capital should be only the cost of equity rather than the WACC (Campani, 2015).

Further, the WACC may sometimes become computationally cumbersome making its use less desirable. Commonly, the difficulties arise in the computation of cost of equity because there is no standard set for this. There are different methods to compute cost of equity and the results of different methods may at times deviate significantly (Campani, 2015). Further, the computation of the market weights may also pose problems in case of unlisted entities. The securities of the unlisted companies are not listed on the stock exchange; therefore, the estimation of market value of shares becomes very subjective in those cases (Campani, 2015).

Evaluating Alternative Methods to Calculate the Cost of Capital

Conclusion

The discussion carried out in this report relates to determination of the cost of capital. In this regards, it has been observed that the cost of capital plays an essential role in the analysis of financial viability of the project. The cost of capital is computed by applying the weighted average cost of capital method which involves the use of cost of debt and cost of equity. However, in certain situations the use of weighted average cost of capital may not be suitable; thus, alternative methods should be applied in those situations to compute the cost of capital. Further, it has been observed that the primary methods of determination of the cost of equity are CAPM and dividend discount model. The cost of debt can be computed by taking the finance cost as the basis or taking the proxy rate of similar company having same credit ratings.              

References 

Baker, H.K. and Martin, G.S. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons.

Fernandez, P. 2011. WACC: Definition, Misconceptions, and error. [Online]. Available at: https://www.iese.edu/research/pdfs/DI-0914-E.pdf [Accessed on: 19 March 2017].

Madura, J. 2007. International Financial Management. Cengage Learning.

Yahoo Finance. 2017. Pearson Plc: Market Cap. [Online]. Available at: https://in.finance.yahoo.com/quote/PSO?p=PSO [Accessed on: 19 March 2017].

Yahoo Finance. 2017. Pearson Plc: Profile. [Online]. Available at: https://finance.yahoo.com/quote/PSO/profile?p=PSO [Accessed on: 19 March 2017].