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com Cost of capital of UK companies

Select two companies from each of two different industries; collect relevant financial data and estimate the cost of capital for each company (more than one estimation technique may be used for each company). Synthesize your findings to form a conclusion.

Solution

The cost of capital is a key risk metric for the investment and financial decisions of professional investors and corporate financial managers In other words; it is an indicator of the market perception about the risk associated with a particular companys cash flows and thus the return the providers of debt and equity capital demand in compensation for assuming that risk.

Tesco Plc and Unilever Plc are the two companies for which we would compute the Weighted Average Cost of Capital (WACC). While Tesco Plc is a leading supermarket in Great Britain, Unilever Plc is a key player in the fast moving consumer goods (FMCG space)

Methodology adopted

The formula for WACC is the weighted average of the cost of equity and debt for the two companies.

WACC = Cost of Debt* Relative Proportion of Debt in the Capital Structure of the company + Cost of Equity* Relative Proportion of Equity in the Capital Structure of the company and

Cost of Debt is obtained by dividing the post tax finance costs for the year ending February 28, 2009 for Tesco Plc and year ending December 31, 2008 for Uniliver Plc(as taken from their annual reports), by the average outstanding debt for the year.

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www.solvemyassignment.com Cost of Equity is obtained by applying the Capital Asset Pricing Model (CAPM) which is as follows:

Cost of Equity for a company = Risk free Rate of Return +Beta for the company*(Expected Market Rate of Return-Risk Free Rate of Return)

The 10 year yield on UK Government Treasury Bonds is taken as a proxy for the risk free rate of return. Currently it stands as 4.5% p.a.

Beta is a measure of the systematic risk associated with a company i.e. it indicate the relative movement of the stock price of a particular company in comparison to the benchmark index, which we have taken as FTSE 100.

From our computation, we take the Beta for Tesco Plc as 0.79 and for Unilever is 0.84

For our calculation purposes, we can approximate the Expected Market Rate of Return to be the reciprocal of the P/E Ratio of the broader market. The Price/Earnings Ratio for FTSE 100 at the end of Q3 of 2009 was 16.6 times. (Article titled We are still in recession. Yahoo Finance ) Thus the Market Rate of Return will be 100/16.6= 6.02%.

Tesco Plc (For Year ended 28.02.09)

Since we require the post tax cost of debt, we need to find out the effective tax rate for Tesco Plc

Calculation of Effective Tax rate (ETR) Particulars Amt mn) Provision for Taxation (A) Profit Before Taxes (B) 788 2954 (GBP

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www.solvemyassignment.com Effective Tax Rate (%) (A/B) 26.7%

Calculation of Average Debt Particulars Amt mn) Opening Borrowings (01.03.08) Closing Borrowings (28.02.09) Average Debt 5972 12391 9182 (GBP

Post Tax Finance Costs are calculated as Pre Tax Cost*(1-Effective Tax Rate). This divided by average debt gives us the average post tax cost of debt

Calculation of Cost of Debt Particulars Amt mn) Finance Costs Effective Tax Rate Post Tax Finance Costs [A} Average Debt[B] Average Cost of Debt [A/B] 478 26.70% 350 9182 3.8% (GBP

As discussed earlier, we apply the CAPM Model to calculate Cost of Equity for Tesco Plc

Calculation of Cost of Equity Particulars Amt mn) (GBP

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www.solvemyassignment.com Risk Free Rate of Return [a] Beta [b} Expected Market Return [c] Expected Market Return-Risk Free Return d=[c-a] Cost of Equity [a+b*d] 4.5% 0.79 6.0% 1.5% 5.7%

We now compute the relative proportion of debt and equity in the capital structure of the company. Calculation of Proportion of Debt & Equity Particulars Amt mn) Book Value of Debt (28.02.09) Book Value of Equity (28.02.09) Total Funds Employed in the company 12391 12938 25329 48.9% 51.1% 100.0% (GBP Proportion (%)

Finally we compute the WACC for Tesco Plc ,which works out to be 4.8%

Calculation of Weighted Average Cost of Capital Particulars Cost (%) [a] Proportion [b] Debt Equity WACC 3.8% 5.7% 48.9% 51.1% 1.9% 2.9% 4.8% (%) [a*b]

Thus the weighted average cost of capital for Tesco Plc works out to be 4.8%.

Unilever Plc (For Year ended 31.12.08) contact@solvemyassignment.com

www.solvemyassignment.com We computed Weighted Average Cost of capital for Unilever Plc in a similar fashion as above

Calculation of Effective Tax rate (ETR) Particulars Amt mn) Provision for Taxation (A) Profit Before Taxes (B) Effective Tax Rate(%) (A/B) 1844 7129 25.9% (GBP

Calculation of Average Debt Particulars Amt mn) Opening Borrowings (01.01.08) Closing Borrowings (31.12.08) Average Debt 9649 11205 10427 (GBP

Calculation of Cost of Debt Particulars Amt mn) Finance Costs Effective Tax Rate Post Tax Finance Costs [A} Average Debt[B] Average Cost of Debt [A/B] 506 26.70% 371 10427 3.6% (GBP

Calculation of Cost of Equity Particulars Amt mn) (GBP

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www.solvemyassignment.com Risk Free Rate of Return [a] Beta [b} Expected Market Return [c] Expected Market Return-Risk Free Return d=[c-a] Cost of Equity [a+b*d] 4.5% 0.84 6.0% 1.5% 5.8%

Calculation of Proportion of Debt & Equity Particulars Amt mn) Book Value of Debt (28.02.09) Book Value of Equity (28.02.09) Total Funds Employed in the company 11205 9948 21153 53.0% 47.0% 100.0% (GBP Proportion(%)

Calculation of Weighted Average Cost of Capital Particulars Cost (%) [a] Proportion [b] Debt Equity WACC 3.6% 5.8% 53.0% 47.0% 1.9% 2.7% 4.6% (%) [a*b]

Thus the weighted average cost of capital for Unilever Plc works out to be 4.6%. Conclusion Comparative Analysis Tesco Plc Particulars Cost (%) [a] Unilever Plc Cost (%) [a]

Proportion (%) [b]

Proportion (%) [b]

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www.solvemyassignment.com Debt Equity WACC Unilever Plc (4.6%). 3.8% 5.7% 4.8% 48.9% 51.1% 3.6% 5.8% 4.6% 53.0% 47.0%

Thus we find that the WACC for Tesco Plc (4.8%) is higher by 20 basis points as compared to

As we can easily observe from the above data, the post tax cost of debt for the two companies is significantly lower than the cost of equity. WACC for Tesco Plc is higher because of the two reasons: a) The post tax cost of debt for Tesco at 3.8% is higher as compared to 3.6% for Unilever b) Also because the capital structure of Tesco is skewed more in favour of costly equity (51.1%) with only 49% of debt as compared to Unilever which has a larger component of debt (53%) and only 47% of reliance on equity as a source of fund.

(1040 words) References

1) Tesco Plc Annual Report and Financial Statements (2009) [Online] Available from: http://www.investis.com/tesco/pdf/repp2009.pdf [Accessed: 13th November 2009]

2) Unilever Plc Annual Report and Accounts 2008 [Online] Available from: http://www.unilever.com/images/ir_ar08_annual-report_tcm13-163124.pdf [Accessed: 13th November 2009]

3) Risk free rate of return obtained from Bloomberg data for U.K. GOVERNMENT BONDS. Available from: http://www.bloomberg.com/markets/rates/uk.html [Accessed 13th November 2009]

4) P/E Ratio for FTSE 100 obtained from article titled We are still in recession. Yahoo Finance Available from: http://uk.finance.yahoo.com/news/we-re-still-in-recession-foolcouk-

54fc9dfbb849.html contact@solvemyassignment.com

www.solvemyassignment.com [Accessed 13th November 2009]

5) Beta for Tesco PLC obtained from Stock Quote for Tesco PLC (TSCO.L) (London Stock Exchange) Available from:http://www.reuters.com/finance/stocks/overview?symbol=TSCO.L [Accessed 13th November 2009]

6) Beta for Unilever Plc obtained from Stock Quote for Unilever plc (ADR) (Public, NYSE:UL) Available from: http://www.google.com/finance?q=NYSE:UL [Accessed 13th November 2009]

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