FIRM VALUE AND THE COST OF CAPITAL

ASSIGNMENT BRIEF: FIRM VALUE and THE COST OF CAPITAL

ProGliders plc is formed and owned by Abel Cain, a recently retired professional paraglider who has decided to further pursue his aspiration of being involved in this sector as an ex-professional. The firm is a producer of paragliding equipment. The company is in its third year of operation and provides both professional (i.e. competitive) and amateur (i.e. recreational) paragliding equipment. The owner runs the company together with his friend and general manager Bruno Bellagio who is also in his second-year as a business finance student and is an avid fan and supporter of paragliding. The company has been gaining recognition and as a reward of its quality equipment it has been approached as a bidding nominee for producing and providing full-gear paragliding equipment for the UK National Paragliding Association Championships for the next two years. This is a one-off, two-year project only. In terms of the risk of this project, it is the same with all other projects that the company currently undertakes. The firm’s engineering team has designed 3 types of alternative equipment along with their supplementary gear for the bidding; BoldMuscleWings (BMW), BoldBubbleWings (BBW) and OzoneLayerWings (OLW). The capital invested in the company so far is shown in Exhibit 1. The cash flow projections relating to these projects are provided in Exhibit 2. The company pays tax of 20%.

The company following the decision of Abel has also bought a few shares in other related-industry suppliers. The reason is that the owner believes this is an effective way to: (i) demonstrate its commitment to maintaining long-term relationships with them (ii) as a way to invest and diversify in the wider sector and (iii) keep an eye on competition. To this end, the firm has invested in the following companies: Air-V-Wings (AVW) which provides the variometers, Safe-H-Fly (SHF) which provides the harnesses and company Para-T-Build (PTB) which supplies the parachutes. Information regarding these companies is provided in Exhibit 3. Lastly, some more generic information regarding the conditions of the specific sector in which the company finds itself is further provided in Exhibit 4.

Abel has asked Bruno to provide him with some help regarding the data at hand as well as provide some recommendations as to whether the company should undertake such a project. He has also asked Bruno to consider the risks the company has given its current investment in the other companies. Bruno is very keen to help and support Abel knowing also that this is a first major test for him in finance analysis. Bruno quickly searched for all data at hand and necessary for the analysis and quickly moved on spending a week gathering the data and estimating the project values for the company as well as the risks from the company’s investments. He then submitted an analysis via an e-mail memo to Abel explaining his calculations and assumptions fed into the models on Exhibit 5.

 

a. What is the company’s cost of capital? Based on your assessment of the company’s cost of capital advice which product(s) (should ProGliders plc invest in and why? (7 marks)

b. Which (if any) any of the products be accepted under both the internal rate of return rule (IRR) and Payback rule? Explain why and whether this confirms your findings in part a above. (5 marks)

c. Use an appropriate model in order to calculate and comment upon the risk-return profile of the shares, AVW, SHF and PTB and on an equally weighted portfolio made up of securities AVW, SHF and PTB. (10 marks)

d. Critically review the use of the cost of capital concept for investment appraisal.

Answer:

Part 1: Calculate the company’s Weighted Average Cost of Capital
 
a)
 
Calculate the before tax cost of bank loans, mortgage loans and corporate bonds.
Cost of Bank loans = Interest/Market Value *100
=19.6/240*100=8.2%
Cost of Mortgage loans= Interest/Market Value* 100
31.27/530 *100 = 5.9%
Cost of bonds= Interest/m+ (Face Value-Market value/n*m)/ (Face Value + Market Value/2)
=70/4 + (1000-300)/2*4 / ((1000+300)/2) = 17.5+87.5/650=0.1615=16.15%
 
 
b)
 
 
Calculate the (market) value of bank loans, mortgage loans, and corporate bonds
Market Value of loan= Interest/ Cost of capital of loan = 19.68/0.082= 240
Market Value of Mortgage= Interest/ Cost of capital of mortgage= 31.27/0.059= 530
Market Value of bonds= Interest*PVIFA+ RP*PVIF= 17.5*7.4+1000*0.870= 999.5
•PVIFA=1- (1+r/m)-n*m/ (r/m) = 1- (1+0.07/4)-8/ (0.07/4) =0.1295/0.0175=7.4
•PVIF= 1/ (1+0.07/4)8= 0.70
 
 
c)
 
Calculate the cost of ordinary shares and preference shares
Cost of Ordinary Shares= Rf+B1(Market Risk Premium) = 0.114+1.2*0.08=0.21=21%
Cost of Preference shares= Dividend/Market value*100=0.10/1.2*100=0.0833=8.33%
 
 
d)
 
Calculate the market prices of ordinary shares and preference shares
 
 
 
 
Ordinary share=D1/(1+Ke)1+D2/(1+Ke)2+D3/(1+Ke)3+P3/(1+Ke)4
=0.0749/1.021*1+0.0801/1.021*2+0.057/1.21*3+0.49/1.21*4
=0.0619+0.0547+0.0483+0.225=0.3934
•D1=0.07(1.07) = 0.0749
•D2=0.0749(1.07) =0.0801
•D3=0.0801(1.07) =0.0857
•D4=0.0857(1.07) =0.0882
•P3=0.0882/0.21-0.03=0.49
 
 
e)
 
Calculate the total market values of ordinary shares and preference shares
Market Value of Ordinary share=430*0.49=210.7
Market value of Preference share=250*1.2=300
 
 
f)
 
Calculate the company’s WACC
Weights= Value of debt of equity/Total Value of debt and equity
Bonds=0.1371, Mortgage=0.3028, Bonds= 0.1714, Ordinary share=0.2457, Preference share= 0.1428
WACC= We*Ke+ Wp* Kp+ Wl* Kl+ Wm*Km+ Wb* Kb
= (0.2457*0.21) + (0.1428*0.0833) + (0.1371*0.0574) +(0.3028*0.0413) + (0.1714*0.1130) = 0.1032= 10.32%
•After tax:
Cost of loan= 0.082 (1-0.3) =0.0574
Cost of Mortgage = 0.059 (1-0.3) = 0.0413
Cost of bond = 0.1615 (1-0.3) = 0.1130
 
 
Ordinary share=D1/(1+Ke)1+D2/(1+Ke)2+D3/(1+Ke)3+P3/(1+Ke)4
=0.0749/1.021*1+0.0801/1.021*2+0.057/1.21*3+0.49/1.21*4
=0.0619+0.0547+0.0483+0.225=0.3934
•D1=0.07(1.07) = 0.0749
•D2=0.0749(1.07) =0.0801
•D3=0.0801(1.07) =0.0857
•D4=0.0857(1.07) =0.0882
•P3=0.0882/0.21-0.03=0.49
e)Calculate the total market values of ordinary shares and preference shares
Market Value of Ordinary share=430*0.49=210.7
Market value of Preference share=250*1.2=300
f)Calculate the company’s WACC
Weights= Value of debt of equity/Total Value of debt and equity
Bonds=0.1371, Mortgage=0.3028, Bonds= 0.1714, Ordinary share=0.2457, Preference share= 0.1428
WACC= We*Ke+ Wp* Kp+ Wl* Kl+ Wm*Km+ Wb* Kb
= (0.2457*0.21) + (0.1428*0.0833) + (0.1371*0.0574) +(0.3028*0.0413) + (0.1714*0.1130) = 0.1032= 10.32%
•After tax:
Cost of loan= 0.082 (1-0.3) =0.0574
Cost of Mortgage = 0.059 (1-0.3) = 0.0413
Cost of bond = 0.1615 (1-0.3) = 0.1130
 
 
Part 2: Estimate the project’s incremental free cash flows
 
a) Prepare the depreciation table of the equipment (see examples in Topic 7 seminar). Round up to whole numbers