an analytical analysis on weighted average cost of capital

AN ANALYTICAL STUDY ON

“WEIGHTED AVERAGE COST OF CAPITAL (WACC)”

OF

“YAAR CONSTRUCTION COMPANY”

A PROJECT REPORT SUBMITTED TO THE

SAVITRIBAI PHULE PUNE UNIVERSITY

BY

RAHMATULLAH PASHTOON

UNDER THE GUIDANCE OF

PROF. ASAD ZAFIR

IN PARTIAL FULFILLMENT OF

MASTER OF BUSINESS ADMINISTRATION

SEPTEMBER 2015

ALLANA INSTITUTE OF MANAGEMENT SCIENCES

AZAM CAMPUS, CAMP PUNE - 411001

CERTIFICATE

Certified that the Project Work entitled “AN ANALYTICAL

STUDY ON THE WEIGHTED AVERAGE COST OF

CAPITAL”, submitted by Mr. Rahmatullah Pashtoon for the

partial fulfillment of the M.B.A. Degree offered by the Savithribai

Phule Pune University during the academic year 2015-2016 is an

original work carried out by the student under my supervision, and

this work has not formed the basis for the award of any Degree,

Diploma or such other titles.

Date: Signature of the

Director

Name signature of the Guide: Prof. Asad Zafir

Institution: Allana Institute of Management Sciences

Address: Hidayatullah Road, Azam Campus, Pune - 411001

ACKNOWLEDGEMENT

It is a great pleasure to me in acknowledging my deep sense of gratitude to all

those who have helped me in completing this project successfully

I would like to thank Dr. (Prof) R. Ganesan for allotting me this project. I

would like to thank Dr. (Prof) Roshan Kazi Head of Department for his

guidance. I would like to acknowledge my gratitude towards my projects guide

Prof. Asad Zafir whose valuable guidance and encouragement at every phase

of the project has helped to prepare this project successfully.

I greatly appreciate the staff of the surveyed business unit, who responded

promptly and enthusiastically to my requests for frank comments despite their

congested schedules. I am indebted to all of them, who did their best to bring

improvements through their suggestions.

Special thanks to Mr. Mohibullah Kamawal for providing me an

opportunity to work with Yaar Construction Company, and providing me

necessary information about their company, their operations and providing

guidance in developing my project.

Finally, I would like to express my sincere thanks to my father

Habibullah Pashtoon, Chief Attorney of Kandahar province and my other

family members, all the faculties, office staff, and library staff of AIMS, Pune

and friends who helped me in some or other way in making this project.

NAME: RAHMATULLAH

PASHTOON

PLACE: PUNE

DATE:

DECLARATION

I, the undersigned, RAHMATULLAH PASHTOON student of

MBA II Year of Allana Institute of Management Sciences, Pune as

the author of this project thesis, hereby declare that the dissertation

is a result of my own Research work and the same has not been

previously submitted to any examination of SAVITHRIBAI PHULE

PUNE UNIVERSITY (SPPU), or any other University.

NAME: RAHMATULLAH

PASHTOON

PLACE: PUNE

DATE:

EXECUTIVE SUMMARY

PROJECT TITLE: - “AN ANALYTICAL STUDY ON WEIGHTED

AVERAGE COST OF CAPITAL (WACC)”

COMPANY: - YAAR CONSTRUCTION COMPANY

Yaar Construction Company began as a general construction company

in 2008. Over the years, the group has undertaken many challenging projects

and accumulated skills, know-how and experiences in design and build

solutions, project management services, building trades and related engineering

works.

The study is taken on the weighted average cost of capital of Yaar

Construction Company. The company took the 40% loan out of total capital and

the remaining 60% was its own contribution. In this study the various estimation

other than the 40% loan for finding the WACC is undertaken. I took 20% of

loan, then 60% and eventually, 80% loan.

Precisely, this study is carried out as per the requirement of MBA

curriculum. This study has significance as it takes us to the root of the subject

and increases our knowledge related to business, finance and commerce.

The main objectives are

To estimate the Weighted Average Cost of Capital of the Yaar

Construction Company.

To understand how capital structure affects owner’s value

To study the changes in the weighted average cost of capital on the

company’s financial status.

The thesis is conducted on the basis of both primary and secondary data.

The primary data is the financial statement presentations of the Yaar

Construction Company. Primary data collection begins when a researcher is not

able to find the data required for his research from secondary data, primary data

obtained by communication observation and personal interview and

questionnaire and it is collected for the first time to be original character. The

other information regarding the financial aspects of the project was collected

from YCC Accounts Manager Mr. Karimullah Totakhail.

Secondary data is taken by the researcher from secondary source internal

and external the researcher must thoroughly search secondary data sources

before commissioning any effort for collecting primary data. The secondary

data were collected from the bank websites, journals, various academic essays,

articles. Moreover, various internet media was also undertaken, viz. Internet

websites, e-magazines, Etc.

The Profits in the year 2010 was 6,245,703/-, the most profitable year. The least

was the year 2013 where only Rs. 1,807,115/- was the net profit. However, the

other years were quite good. The company’s own 60% contribution and 40%

loan was remarkable and the weighted average rate of return was 0.15024 (i.e.

15%). While finding out the weighted average rate of return we also found the

internal rate of return and the net present value of YCC Company. The NPV

@15% after finding was Rs. 9,739,653/- and the assumed NPV @70% was (Rs.

1,077,024/-).

The internal rate of return was 0.645 (i.e. 64.5%) which is very much

high and best for the company. The net profit ratio was very good. At the most

very profitable ratio was in the year 2011 (i.e. 0.447). In 2011 the net profit ratio

was slightly better than the previous year (i.e. 2010). A 0.002 or (0.2%)

difference was somehow not that much more, but still the profit has been

attained. Moreover, the company’s later years were quite shaking than the

previous as the economic and political scenario of Afghanistan brought up so

many devastative calamities. One of the essential was the declination rate of the

USAID projects and the bid rates. Indeed, the later years were of black days in

the matter of work, prosperity, profitability and gaining of income from various

kind of US constructive projects.

The year 2010 is by far better than the rest of the years by having the

GPR ratio 0.677. Later on, in the year 2011 and 2012 still did good profit and

the company was in a high rate of profitability. But as the situation became

worse this rate was also crashed with declination. The company gain a lot of

profit in the year 2010.

Briefly, the total capital of Yaar Construction Company is Rs

98,000,000/- only. In that the total capital provided by the company to

me was in two proportions. 40% of the total capital is bank loan (i.e.

3,920,000), and remaining 60% of the total capita is own contribution

(i.e. 5,880,000).

Weighted Average Cost of Capital after calculation was 15% (i.e. 0.15).

NPV @15% was 9,739,653/- and as per the internal rate of return

formula requirement we need to increase this NPV percentage in order

to find out IRR. Due to that we took 70% assumption. Therefore, NPV

@70% was (-1,077,024/-).

Now, as our analysis is about the weighted average cost of capital

(WACC), we did three assumptions of WACC respectively in order to

find out the most minimum rate of weighted average cost of capital

(WACC) among them. So, for that we took 20%, 60% and 80%.

In 20% loan the WACC was 16.5%, whereas, in 60% loan it was 13.5% and

in 80% loan it was 12%.

These are the illustrative tables for the aforementioned assumed rates for

finding the WACC:

The total equity is Rs. 9,800,000/-. We took 20%, 60% and 80% loan

estimation.

No. of Share having face value 10 each:

784,000 = 9,800,000*(100%-20%)/10

392,000 = 9,800,000*(100%-60%)/10

WACC for 20%, 60% and 80% we found was 16.5%, 13.5% and 12%. We

selected the minimum among them (i.e. 12%, which is for the 80% loan

estimation).

IRR for the 20%, 60% and 80% we found by applying the formula was

65.5%, 63.5% and 62.50%. In that we selected the maximum percentage due

to having the rule of internal rate of return. (I.e. the highest IRR is to be

considered).

Now, the Value per share is derived by dividing the Net Present Value upon

number of shares. The justification is that by taking 80% loan estimation the

value per share for the owner increases more than taking the other

estimations. In 20% it was 12.88 similarly, for 60% it was 25.29 and for

80% it was 48.85, which is the highest among them.

Therefore, the 80% loan estimation proposal is better for the company to

accept.

INDEX

Sr. No

TOPIC

Page No.

1.

Introduction 1.1. Background of the study……………………………………........

1.2. Objectives of the study………………………………………......

1.3. Significance of the study…………………………………..…….

1.4. Scope of the study……………………………………………….

1.5. Limitations of the study………………………………………….

1 - 4 2

3

3

3

4

2.

Company Profile 2.1. History and Philosophy………………………………………….

2.2. Company Information…………………………………………...

2.3. Principle Activities……………………………………….……...

2.4. Our Organization structure………………………………………

5 - 11 6

7

7

8

3.

Review of Literature 3.1. Introduction…………………………………………………......

3.2. Definition of WACC…………………………………….………

3.3. Meaning of Capital Structure……………….………………......

3.4. Guiding Principles of Capital Structure……..………………….

3.5. Factors Influencing Capital Structure Decision….……………..

3.6. Capital Structure Theories………………………………………

12 - 31 13

15

17

20

21

24

4.

Research Methodology 4.1. Research………………………………………………………...

4.2. Objective of research……………………………………………

4.3. Source of data…………………………………………………..

32 - 34 33

33

33

5.

Data Presentation, Analysis & Interpretation 5.1. Data analysis & interpretation…..………………………….

35 - 47 36

6.

Findings

48

7.

Conclusion

50

8.

Suggestions

52

9.

Managerial Implications and Scope of Future Study

54

Appendices

10.

Bibliography

57

11.

Annexure I (Foreign Exchange Rates and Their Charts)

58

12.

Annexure II (Financial Ratios and their Interpretation)

59 - 94

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CHAPTER ONE

Introduction of the Study

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1.1. Background of the study

The CIMA defines the weighted average cost of capital (WACC) “as the

average cost of the company’s finance (equity, debentures, long-term fund loans

and retained earnings) weighted according to the proportion each element bears

to the total pool of capital, which is usually based on market valuations, current

yields and costs after tax.” The term weighted average cost of capital is the

combined cost of the specific costs associated with specific source of financing.

The cost of different source of financing represents the components of the

combined cost. The use of weighted average and not the simple average is

warranted by the fact that the proportions of various sources of funds in the

capital structure of a firm are different.

The study is taken on the weighted average cost of capital of Yaar

Construction Company. The company took 40% loan out of total capital and the

remaining 60% was its own contribution. In this study the various estimation of

loan is taken for finding out the lesser WACC. The loan estimation is taken on

20%, 60% and 80% respectively.

Moreover, the EMI and the income statement is also calculated based on

the company’s relevant financial data.

This study is carried out as per the requirement of MBA curriculum. This

study has significance as it takes us to the root of the subject and increases our

knowledge related to business, finance and commerce.

I intend to undertake this project which lies towards enhancing ones knowledge

in the field of estimation for the weighted average cost of capital of Yaar

Construction Company. This project is entitled to be applied as a practical and

symbolic feature for understanding the criteria of how to project the future

scenario; this is widely recommended subject for the management students.

The study revolves around the core subject matter, “analytical study on

weighted average cost of capital WACC for Yaar Construction Company” that

comes under the broad area of Finance, but the researcher is making this project

on the basis of the financial data that is being provide by the company

accordingly which is profoundly talking about the usage of financial techniques

in order to overcome the concerned study.

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1.2. Objectives of the Study

To find the Weighted Average Cost of Capital of the Yaar Construction

Company.

To understand how capital structure affects owner’s value

To study the changes in the weighted average cost of capital on the

company’s financial status.

1.3. Significance of the Study

Helps people how to start a business

Helps how to pay the most minimum cost of debt.

Helps people how to profit by taking loans from the financial

institutions.

Helps people how to achieve the satisfactions of customer.

1.4. Scope of the Study

Investment Decisions by Company: WACC is widely used for making

investment decisions in the corporate by evaluating their projects. Let

us categorize the investments in projects in the following 2 ways:

o Evaluate of Projects with same risk

o Evaluations of Projects with different risk

Discount Rate in the Net Present Value Calculation

Valuation of Company

Important Inferences from WACC:

o Effect of leverage: Considering the Net Income Approach (NOI)

by Durand, the effect of leverage is reflected in WACC. So, the

WACC can be optimized by adjusting the debt component of the

capital structure. Lower the WACC, higher will be the valuations

of the company. Lower WACC also widens the scope of the

company by allowing it to accept low return projects and still

create value.

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o Optimal capital budgets: The increase in the magnitude of capital

tends to increase the WACC as well. With the help of WACC

schedule and project schedule, an optimal capital budget can be

worked out for the company.

WACC is an important metric used for various purposes but it has to be used

very carefully. The weights of the capital components should be expressed in

market value terms. The market values should be determined carefully and

accurately. Faulty calculations of WACC will result in faulty investment

decisions as well. There are issues such as no consideration given to floatation

cost which are not worth ignoring. The complications increase if the capital

consists of callable, puttable or convertible instruments, warrants etc.

1.5. Limitations of the study

As this project stands on the basis of both primary data and secondary

data, so the collection of data is too tough

Making notes and getting perfect idea is a complicate duty.

Shortage of time period.

In the absence of sufficient data personal judgement and

reasonable assumptions come into play.

The duration of the project work is insufficient to understand

the complete mechanism of analysis of weighted average cost

of capital in the concerned company.

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CHAPTER TWO

Company Profile

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2.1. History and Philosophy

Yaar Construction Company began as a general works contractor in

2008. Over the years, the group has undertaken many challenging projects

and accumulated skills, know-how and experiences in design and build

solutions, project management services, building trades and related

engineering works.

Today, Yaar Construction Company takes on the role of main contractor for small to medium size projects and performs project management services

to coordinates specialist trades for industrial/commercial projects. We also provide design inputs and engineering solutions as value add services to our

client

Our objective is to provide our clients with an “I am assured” experience

when we are chosen to execute their projects. Our emphasis on clear

communication and follow through procedures ensures that client’s

objectives are top priority in the planning and execution of all our processes.

Our project management and execution philosophy is:

• create detail schedule and resources plan to meet client’s project

objective, • communicate clearly with all project stakeholders, • track project progress and fine tune deviations, • supervise closely on quality of work done, • Complete and commission the project on time.

We take pride in our delivery, thus our clients can always be assured that

only the most experienced and qualified people are serving them, all the time.

Vision: To be a respectable building contractor delivering beyond expectation,

always.

Mission:

To deliver high-quality, cost-effective projects on time within budget by

employing and supporting motivated, flexible, and focused teams. We will

strive to implement a long term relationship with our clients, based on safety,

quality, timely service and an anticipation of their needs. To help fulfill this

mission, we will treat all employees fairly and involve them in the quality

improvement process to insure responsiveness and cost effective work

execution.

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We value the importance of our relationships and will continue to remain

fair and true in our dealings with all employees, clients, vendors, and partners.

Our clients count on our dependability, our drive, and our integrity. We take

great pride in our accomplishments and build on them every day.

Our reputation as a premier Afghan Contractor has been built as a result of

outstanding client relationships, supported by an experienced team of managers

and subcontractors.

2.2. Company Information

Name: Yaar Construction Company (YCC)

Address: Behind Naderia High School, Kart – e – Parwan, Kabul, Afghanistan

Email ID: [email protected]

Mobile No: +93 – 700606088

Telephone No: +93 – (0) 202210036

Registration No: 200804413R

Incorporation Date: 05/03/2008

2.3. PRINCIPLE ACTIVITIES 35212 GENERAL CONSTRACTORS (Building Construction

including Major Upgrading Works)

BCA REGISTERED CONTRACTORS Work head Description Tendering Limit

DE01 General Building F1

HJ2 Civil Engineering F2

OL06 Interior Decoration K4

LICENSED BUILDERS Licensing Code Description GB1 General Building Works (Class 1)

Director

Ahmad Yaar Kamawal

2.4. Organization Structure

mailto:[email protected]

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Management Team:

The business is driven by our 4 working directors, collectively they

accumulated more than 15 years of work experience in the building industry.

They are involved in the business development, procurement, project

management and administration of the company.

The management team proactively gathers feedback, identifies

changes in business environment, reviews work processes and communicates

key learning points and company policy to all staff at regular meetings.

People:

Our people are crucial in the delivery of our services and solution to

our clients. In order to ensure that everyone is equipped with the right skill,

knowledge and attitude, a comprehensive training programme is put in place

to constantly upgrade our people in technical and management skills.

We believe firmly in providing the right training, accredited

certification and practical knowledge for our people, in order for them to

execute their duties and responsibilities confidently. Our aim is to stay

relevant to the ever-changing market place and client’s requirement.

Management team

Commercial/Procurement Team

Project Management

Team

Planning/Design Field Operations

Admin/Finance

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2.5. Areas of Expertise:

Road, Bridge, and Culverts

Designs

Be it civil-, architectural-, structural-, mechanical-, HVAC- or electrical

design, our team of sophisticated architects and engineers masters any

challenges - our clients may face - and transcribe them into plans and schedules,

fit for realization and according to international standards.

Next to the elaboration of specialized solutions in the different areas of

design, HARIROD provides a holistic approach, applying contemporary

design- and management-software. Ranging from the elaboration of the proper

solution to a successful implementation including timely delivery on site, the

process is monitored and kept transparent. Our experience, gained in a large

number of realized projects and our client´s sustainable trust, form the base for

our corporate future.

Complex construction projects require a high level of synchronization.

Partnering our clients through all project-phases, our experience on the private-

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and public sector has shown, that next to good and innovative ideas a solid and

competent implementation is the key to success

Living Complexes and Barracks

Warehouse and Storage Facilities

Water, Irrigation, and Sanitation Facilities

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Services

YCC has the in-depth expertise to navigate any project to success - from simple

structures to more complex. Starting its history as a contracting firm, YCC today

is an organized industry that offers the best in

Main Contracting

Design-Build Services

Construction Project Management

Main Contracting

YCC is a Main Constructor undertaking all scopes of work required by the client

and coordination of any elements the client may wish to undertake directly. We

have the capability to construct any type of building be it residential,

commercial, mixed use; high rise, low rise or horizontal in nature.

Design-Build Services

Design & Build is not new, but the YCC approach is what makes the difference

and delivers results we believe to give optimum value to the client. YCC has

the capability to provide all technical design services either in-house, or

depending on the nature of the project, our relationships with external

consultants enables us to draw upon specialist design expertise if needed.

Construction Project Management

YCC assists the client in the whole construction process regardless of what

juncture we are introduced into the project organization. We have proven that

early involvement can influence and increase substantially the success of the

project. Huge value added and be gained by clients who involve us at the

beginning where design input, both from the perspective of Build ability and

Value Engineering can still be influenced.

When this is combined with the expertise of the design team and client team,

then real synergy is the result. Our integrated Project Management System sets

the path for the projects whether it is large or small to meet their goals faster,

more efficiently and with higher-quality results. We have the skill, focus and

discipline to ensure the projects are not only completed on time and within

budget but fully achieve their intended purpose.

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CHAPTER THREE

Literature Review

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3.1. Introduction

The term “business” relates to the state of being busy either as an individual or

society as a whole, doing commercially viable and profitable work. This term

has at least three usages, depending on the scope; one is to mean a particular

company or corporation, the generalized usage to refer to a particular market

sector or the broadest meaning to include all activity by the community of

suppliers of goods and services.

Business is an economic activity as it is concerned with earning money and

acquiring wealth through the production and distribution of goods and services.

Businesses are predominant in capitalist economies, most being privately

owned and formed to earn profit that will increase the wealth of its owners and

grow the business itself. The main objective of any business owner or operator

is to generate a financial return in exchange for work and acceptance of risk.

There are several common forms of business ownership like sole proprietorship,

partnership, corporation and cooperative. In order to generate a financial output,

a financial input is most important. This financial input is termed as capital in

business.

In economics, capital or capital goods or real capital refers to factors of

production used to create goods or services that are not themselves significantly

consumed in the production process. Capital goods may be acquired with money

or financial capital. In finance and accounting, capital generally refers to

financial wealth especially that used to start or maintain a business.

Financial capital represents obligation, and is liquidated as money for trade, and

owned by legal entities. It is in the form of capital assets, traded in financial

markets. Its market value is not based on the historical accumulation of money

invested but on the perception by the market of its expected revenues and of the

risk entailed.

Financial capital can refer to money used by entrepreneurs and businesses to

buy what they need to make their products or provide their services to that sector

of the economy based on its operation, i.e. retail, corporate, investment banking,

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etc.

Financial capital refers to the funds provided by lenders (and investors) to

business to purchase real capital equipment for producing goods/services. Real

capital comprises physical goods that assist in the production of other goods

and services.

The financial capital which is required by entrepreneurs can be obtained through

various sources. There are long term sources like share capital, debenture

capital, venture capital, mortgage, retained profit, etc. Financial capital can also

be obtained through medium term sources like term loans, leasing, etc. and

through short term sources like bank overdraft, trade credit, factoring, etc.

Capital contributed by the owner or entrepreneur of a business, and obtained by

means of saving or inheritance, is known as own capital or equity. This capital

that owners of business provide can be in the form of

• Preference shares/hybrid source of finance Ordinary preference shares

Cumulative preference shares Participating preference shares

• Ordinary shares

• Bonus shares

• Founder’s shares

That capital which is granted by another person or institution is called borrowed

capital, and this must usually be paid back with interest. This capital which the

business borrows from institutions or people includes debentures:

• Redeemable debentures

• Irredeemable debentures

• Debentures to bearer

• Ordinary debentures

Thus, the sources of financing will, generically, comprise some combination of

debt and equity. Financing a project through debt, results in a liability that must

be serviced and hence there are cash flow implications regardless of the

project’s success. Equity financing is less risky in the sense of cash flow

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commitments, but results in a dilution of ownership and earnings. Deciding

which source of capital should be tapped so that the entrepreneur gets a fair

return, is a type of financial decision and a part of financial management. It is a

very important component of corporate finance.

3.2. Definition of WACC

A calculation of a company's cost of capital in which every source of capital is

weighted in proportion to how much capital it contributes to the company. For

example, if 75% of a company's capital comes from stock and 25% comes from

debt, measuring the cost of capital weights these accordingly. A high WACC

indicates that a company is spending a comparatively large amount of money in

order to raise capital, which means that the company may be risky. On the other

hand, a low WACC indicates that the company acquires capital cheaply.

Approaches to estimating cost of equity

There are a number of alternatives for estimating the cost of equity capital.

These include the following approaches:

Capital Asset Pricing Model International Capital Asset Pricing Model

Dividend Discount Model Arbitrage Pricing Theory Model

Although there are alternatives available in principle, regulators in Australia,

including ORAR in previous decisions, have consistently decided that the

Capital Asset Pricing Model (CAPM) is the preferred approach.

We continue to be of the opinion that the CAPM is the best available approach.

Therefore, we have estimated the cost of equity capital using a domestic version

of the CAPM. Under the CAPM the required return on equity is expressed as a

premium over the risk free return as follows:

E(Re) = Rf + β * [E(Rm) - Rf]

Where,

Re = cost of equity capital;

Rf = risk free rate of return;

Rm = market rate of return;

E(.) = indicates the variable is an expectation; and

β = systematic risk parameter ("equity beta").

The CAPM assumes that returns are normally distributed around the mean.

Where this assumption is violated then estimating the required return on equity

using the CAPM may either over- or under-estimate the required return on

equity. Most specifically where the business is subject to regulatory or market

arrangements that limit the distribution of returns above the mean then investors

will require compensation for holding such assets.

We believe that the CAPM provides a more robust basis for estimating the cost

http://financial-dictionary.thefreedictionary.com/Cost+of+Capital

http://financial-dictionary.thefreedictionary.com/Stock

http://financial-dictionary.thefreedictionary.com/Debt

http://financial-dictionary.thefreedictionary.com/Money

http://financial-dictionary.thefreedictionary.com/Capital

http://financial-dictionary.thefreedictionary.com/Risk

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of equity capital than other available approaches. Given the well-established

support for the domestic version of the CAPM we believe there is a need to

demonstrate that alternative models have significantly improved empirical

properties before shifting from the CAPM. There have been suggestions that

an international version of the CAPM would be more consistent with the

existing conditions in Australian securities markets. We address this issue in

the following section.

Potential use of International CAPM

The most cited alternative to the CAPM is its international version (ICAPM).

ICAPM models aim to reflect the integrated nature of the world economies by

measuring the appropriate return on equity capital against the world market.

These models generally require estimation of an international market risk

premium and risk free rate, plus estimation of the systematic risk of the security

in question to the world market.

ICAPM models fail to provide benefits over the CAPM for a number of reasons:

ICAPM models fail to provide additional explanatory power over the CAPM.

For example, a recent empirical test by Koedijk, Kool, Schotman and van

Dijk15 investigates to what extent international and domestic asset pricing

models lead to different estimates of the cost of capital for an individual firm.

They find that “even though the ICAPM is theoretically preferable to the

domestic CAPM, a firm’s beta calculated using the domestic CAPM does not

necessarily provide a worse estimate of the cost of capital.” They conclude:

“the marginal contribution of all global factors is very limited, which indicates

strong country factors.” More broadly, and consistent with the above findings,

there is extensive documentation of “home bias”. Thus, although there is

opportunity for investors to hold portfolios that are fully diversified

internationally, it does not seem that investors actually hold such portfolios; the

majority of Australian listed companies have overseas operations and have

revenues and expenses that are significantly influenced by world prices.

Therefore, an investor in Australian equities will achieve a significant degree of

international diversification. This is likely to be at least a partial explanation of

the home bias mentioned above; in the single-factor ICAPM there is a need to

reliably estimate the world MRP. However, at the most we have 20 to 25 years

of data for this purpose – a period that is well accepted as being too short period

for an acceptable estimate of MRP; and to achieve a significant improvement it

is necessary to apply an ICAPM that incorporates exchange rate risk. To

achieve this we must estimate a firm’s sensitivity to exchange rate risk across

all countries in the world economy. We are far from having a reasonable basis

for this estimation.

Market risk premium

The market risk premium (MRP) is the amount an investor expects to earn from

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an investment in the market above the return earned on a risk-free investment.

The MRP in the CAPM is the term [E(Rm) – Rf]. The key difficulty in

estimating the MRP arises from it being an expectation and therefore not being

directly observable. As a result the choice of an appropriate rate is inevitably

ad hoc. Generally a range of plausible values is identified and the MRP is chosen

within the range, most commonly at the midpoint. It is important to recognize

however that in all likelihood the MRP varies over time – the difficulty is that

we have no robust means of identifying or quantifying these shifts. We believe

that this uncertainty is a material consideration in the assessment of the MRP.

In determining the appropriate MRP to apply, we consider: use of historical

data to generate a range; and the assessment of an appropriate point in that

range.

Appropriate point within the range

In considering the appropriate point for the MRP within this historical range,

we will consider the following issues: recent (short term) estimates of the MRP;

benchmarking approaches to MRP; forward-looking estimations of the MRP;

and the relevance of surveys of MRP at the present time.

3.3. MEANING OF CAPITAL STRUCTURE

The term “Financial Management” connotes that fund flows are directed

according to some plan. It connotes responsibility for obtaining and effectively

utilizing funds necessary for the efficient operation of an enterprise.

A formal definition of financial management would be the determination,

acquisition, allocation and utilization of financial resources, usually with the

aim of achieving some specific goals. To be more specific financial

management is about analyzing financial situations, making financial decisions,

setting financial objectives, formulating financial plans to attain those

objectives, and providing effective systems of financial control to ensure plans

progress towards the set objectives.

Financial decision-making includes strategic investment decisions, such as

investing in new production facilities or the acquisition of another company,

and strategic financing decisions, like the decision to raise additional long-term

loans.

Thus, a financial manager is primarily concerned with two main types of

interrelated decisions, i.e. investment decisions and financing decisions. Investment decision includes:

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• Strategic investment decision

• Tactical/operational investment decisions

Similarly financing decision also includes:

• Strategic financing decision

• Tactical/operational financing decisions.

The strategic financing decision typically involves deciding the most

appropriate mix of equity and long-term debt finance in the firm’s capital

structure, also called as the capital structure decision. The tactical financing

decision is related with ways to finance the firm’s investment in its medium and

short-term assets respectively.

Capital structure refers to the combination of debt and equity capital which a

firm uses to finance its long-term operations. Capital in this context refers to the

permanent or long-term financing arrangements of the firm. Capital is the

aggregation of the items appearing on the left hand side of the balance sheet

minus current liabilities. Corporate finance is an area of finance dealing with the financial decisions

corporations make and the tools and analysis used to make these decisions. The

primary goal of corporate finance is to maximize corporate value while

managing the firm’s financial risks.

The main concepts in the study of corporate finance are applicable to the

financial problems of all kinds of firms. The discipline can be divided into long-

term and short-term decisions and techniques. Capital investment decisions are

long-term choices about which projects receive investments, whether to finance

that investment with equity or debt, and when or whether to pay dividends to

shareholders. On the other hand, the short term decisions can be grouped under

the heading “Working capital management”.

Capital investment decisions are long-term corporate finance decisions relating

to fixed assets and capital structure. Decisions are based on several inter-related

criteria. Corporate management seeks to maximize the value of the firm by

investing in projects which yield a positive net present value when valued using

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an appropriate discount rate. These projects must also be financed appropriately.

If no such opportunities exist, maximizing shareholder value dictates that

management returns excess cash to shareholders. Capital investment decisions

thus comprise an investment decision, a financing decision, and a dividend

decision.

Achieving the goals of corporate finance requires that any corporate investment

be financed appropriately.

The ratio between debt and equity is named leverage. It has to be optimized as

high leverage can bring a higher profit but create solvency risk. As above, since

both hurdle rate and cash flows (and hence the riskiness of the firm) will be

affected, the financing mix can impact the valuation. Management must

therefore identify the “optimal mix” of financing – the capital structure that

results in maximum value.

The optimum capital structure has been expressed by Ezra Solomon in the

following words:

“Optimum leverage can be defined as that mix of debt and equity

which will maximize the value of a company, i.e., the aggregate

value of the claims and ownership interests represented on the

credit side of the balance sheet.” Capital structure policy involves a choice between risk and expected return. The

optimal capital structure strikes a balance between these risks and returns and

thus examines the price of the stock.

The pattern of capital structure of a firm has to be planned in such a way that

the owner’s interest is maximized. There may be three fundamental patterns of

capital structure in a firm:

1. Financing exclusively by equity stock.

2. Financing by equity and preferred stock.

3. Financing by equity, preferred stock and bonds.

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3.4. GUIDING PRINCIPLES OF CAPITAL STRUCTURE

Which of the above patterns would be most suited to the company can be

decided in the light of the fundamental principles. The guiding principles of

capital structure decision are:

1. Cost principle: According to this principle ideal pattern of capital

structure is one that tends to minimize cost of financing and maximize the

earnings per share. Cost of capital is subject to interest rate at which

payments have to be made to suppliers of funds and tax status of such

payments.

2. Risk principle: This principle suggests that such a pattern should be

devised so that the company does not run the risk of brining on a

receivership with all its difficulties and losses. Risk principle places

relatively greater reliance on common stock for financing capital

requirements of the corporation and forbids as far as possible the use of

fixed income bearing securities.

Control principle: While deciding appropriate capital structure the

financial manager should also keep in mind that controlling position of

residual owners remains undisturbed. The use of preferred stock and also

bonds offers a means of raising capital without jeopardizing control.

4. Flexibility principle: According to this principle, the management should

strive towards achieving such combinations of securities that the

management finds it easier to maneuver sources of funds in response to

major changes in needs for funds. Not only several alternatives are open

for assembling required funds but also bargaining position of the

corporation is strengthened while dealing with the supplier of funds.

5. Timing principle: Timing is always important in financing and more

particularly in a growing concern. Maneuverability principle is sought to be

adhered to in choosing the types of funds so as to enable the company to seize

market opportunities and minimize cost of raising capital and obtain substantial

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savings. Depending on business cycles, demand of different types of securities

oscillates. In times of boom when there is all-round business expansion and

economic prosperity and investors have strong desire to invest, it is easier to sell

equity shares. But in periods of depression bonds should be issued to attract

money because investors are afraid to risk their money in stocks which are more

or less speculative. 3.5.FACTORS INFLUENCING CAPITAL STRUCTURE DECISION

A number of factors influence the capital structure decision of a firm. These

factors can be categorized in to three categories, i.e., as per characteristics of

the economy, characteristics of the industry and characteristics of the company. Characteristic of the Economy

1. Tempo of the business activity: If the economy is to recover from

current depression and the level of business activity is expected to

expand, the management should assign greater weightage to

maneuverability so that the company may several alternative sources

available to procure additional funds to meet its growth needs and

accordingly equity stock should be given more emphasis in financing

programmes and avoid issuing bonds with restrictive covenants.

2. State of capital market: Study of the trends of capital market should be

undertaken in depth since cost and availability of different types of funds

is essentially governed by them. If stock market is going to be plunged

in bearish state and interest rates are expected to decline, the

management may provide greater weightage to maneuverability factor

in order to take advantage of cheaper debt later on.

3. Taxation: The existing tax provision makes debt more advantageous in

relation to stock. Although it is too difficult to forecast future changes

in tax rates, there is no doubt that the tax rates will not be adjusted

downwards.

4. State regulation: Decision as to the make-up of capitalization is subject

to state control. For e.g. Control of Capital Issues Act in India has

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preferred 4:1 ratio between debt and equity and 3:1 between equity and

preferred stock.

5. Policy of Term-Financing Institutions: If financial institutions adopt

harsh lending policy and prescribe highly restrictive terms, the

management must give more significance to maneuverability principle

and abstain from borrowing from those institutions so as to preserve the

company’s flexibility in capital funds.

Characteristics of the Industry

1. Cyclical variations: There are industries whose products are subject to

wider variations in sales in response to national income, whereas some

products have low income elasticity and their sales do not change in

proportion in variation in national income. The management should attach

more significance to flexibility and risk principle in choosing suitable

sources of funds in an industry dealing in products whose sales fluctuate

very markedly over a business cycle so that the company may have

freedom to expand or contract the resources used in accordance with

business requirements.

2. Degree of competition: Public utility concerns are generally free from

intra-industry competition. In such concerns the management may wish

to provide greater weightage to cost principle. But in industry which faces

neck to neck competition, risk principle should be given more

consideration.

3. Stage in life cycle: In infant industry risk principle should be the sub-

guide line in selecting sources of funds since in such industry the rate of

failure is very high. During the period of growth flexibility factor should

be given special consideration so as to leave room open for easy and rapid

expansion of funds used.

Characteristics of the Company

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1. Size of the business: Smaller companies confront tremendous problem in

assembling funds because of poor credit worthiness. In this case, special

attention should be paid to flexibility principle so as to assure that as the

company grows in size it is able to obtain funds when needed and under

acceptable terms. This is why common stock represents major portion of

the capital in smaller concerns. However, the management should also

give special consideration to the factor of control. Larger concerns have

to employ different types of securities to procure desired amount of funds

at reasonable cost. To ensure availability of large funds for financing

future expansion larger concerns may insist on flexibility principle. On the

contrary, in medium sized companies who are in a position to obtain the

entire capital from a single source, leverage principle should be given

greater consideration so as to minimize cost of capital.

2. Form of Business Organization: Control principle should be given

higher weightage in private limited companies where ownership is closely

held in a few hands. In case of public limited companies maneuverability

looms large because in view of its characteristics it finds easier to acquire

equity as well as debt capital. In proprietorship or partnership form control

is an important consideration because it is concentrated in a few hands.

3. Stability of earnings: With greater stability in sales and earnings a

company can insist on leverage principle and accordingly it can undertake

the fixed obligation debt with low risk. But a company with irregular

earnings will not choose to burden itself with fixed charges. Such

company should pay greater attention to risk principle.

Age of company: Younger companies find themselves in difficult

situation to raise capital in the initial years. It is therefore worthwhile to

give more weightage to flexibility principle so as to have as many

alternatives open as possible in future to meet the growth requirement.

Established companies should insist on cost principle.

5. Asset structure of company: A company which have invested major

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portion of funds in long lived fixed assets and demand of whose products

is assured should pay greater attention to leverage principle to take

advantage of cheaper source of fund. But risk principle is more important

in company whose assets are mostly receivables and inventory.

6. Credit standing: A company with high credit standing has greater ability

to adjust sources of funds. In such a case, the management should pay

greater attention too flexibility principle.

7. Attitude of management: Attitude of persons who are at the helm of

affairs of the company should also be analyzed in depth while assigning

weights to different factors affecting the pattern of capitalization. Where

the management has strong desire for exclusive control, preference will

have to be given to borrowing for raising capital in order to be assured of

continued control. If the principal objective of the management is to stay

in office, they would insist more on risk principle. But members of the

Board of Directors who have been in office for pretty long time feel

relatively assured and they would prefer to insist on cost principle.

3.6.CAPITAL STRUCTURE THEORIES

There are different viewpoints on the impact of the debt-equity mix on the

shareholder’s wealth. There is a viewpoint that strongly supports the argument

that the financing decision has major impact on the shareholder’s wealth, while

according to others, the decision about the financial decision is irrelevant as

regards maximization of shareholder’s wealth.

A great deal of controversy has developed over whether the capital structure of

a firm as determined by its financing decision affects its cost of capital.

Traditionalists argue that the firm can lower its cost of capital and increase the

market value per share by the judicious use of leverage. Modigliani & Miller,

on the other hand, argue that in the absence of taxes and other market

imperfections, the total value of the firm and its cost of capital are independent

of capital structure.

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There are four major theories explaining the relationship between capital

structure, cost of capital and value of the firm:

1. Net Income Approach

2. Net Operating Income Approach

3. Traditional Approach

4. Modigliani-Miller Approach

There are certain underlying assumptions made in order to present the theories

in a simple manner. The assumptions are as follows:

1. The firm employs only two types of capital- debt and equity.

2. There are no corporate taxes. This assumption is removed later.

3. The firm pays 100% of its earnings as dividend.

4. The firm’s total assets are given and they do not change, i.e. the

investment decisions are assumed to be constant.

5. The firm’s total financing remains constant.

6. The operating earnings are not expected to grow.

7. The business risk remains constant and is independent of capital

structure and financial risk.

8. All investors have the same subjective probability distribution of the

future expected operating earnings for a given firm.

9. The firm has a perpetual life.

Net Income Approach

The approach has been suggested by David Durand. According to this approach,

the capital structure decision is relevant to the valuation of the firm, i.e., a

change in the capital structure will lead to a corresponding change in the overall

cost of capital as well as the total value of the firm. If the ratio of debt to equity

is increased the weighted average cost of capital will decline, while the value of

the firm as well as the market price of ordinary shares will increase. Conversely,

a decrease in the leverage will cause an increase in cost of capital and a decline

in the value of the firm as well as the market price of equity shares.

The Net Income Approach is based on three assumptions:

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1. There are no taxes.

2. The cost of debt is less than the equity-capitalization rate or cost of

equity.

3. The use of debt does not change the risk perception of the investors.

The implication of the above assumptions is that as the degree of leverage

increases, the proportion of an inexpensive source of funds, i.e., debt in the

capital structure increases. As a result the weighted average cost of capital tends

to decline, leading to an increase in the total value of the firm. Thus, the cost of

debt and cost being constant, the increased use of debt will magnify the

shareholder’s earnings and thereby the market value of the ordinary shares.

With a judicious mixture of debt and equity, a firm can evolve an optimum

capital structure will be the one at which value of the firm is the highest and the

overall cost of capital is the lowest. At that structure the market price per share

would be maximum. If the firm uses no debt the overall cost of capital will be

equal to the equity-capitalization rate. The weighted average cost of capital will

decline and will approach the cost of debt as the degree of leverage reaches one.

We can graph the relationship between the various factors with the degree of

leverage. The degree of leverage is plotted along the X-axis while the

percentage rates for cost of debt, equity and overall cost are on the Y-axis. Due

to the assumption that cost of debt and equity are constant as the degree of

leverage changes, we find that both the curves are parallel to the X-axis. But as

the degree of leverage increases, the overall cost decreases and approaches the

cost of debt where leverage is one. At this point the firm’s overall cost of capital

would be the minimum. The significant conclusion is that the firm can employ

almost 100% debt to maximize its value.

Net Operating Income Approach

This approach is also suggested by David Durand. It is diametrically opposite

to the Net Income Approach. The essence of this approach is that the capital

structure decision of the firm is irrelevant. Any change in leverage will not lead

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to any change in the total value of the firm and the market price of shares, as the

overall cost of capital is independent of the degree of the leverage.

The Net Operating Income Approach is based on the following propositions:

1. Overall cost of capital is constant: The overall cost of capital remains

constant

for all degrees of leverage. The value of the firm, given the level of EBIT

is determined by V = EBIT/ko.

2. Residual value of equity: The value of equity is residual which is

determined by deducting the total value of debt from the total value of

the firm.

3. Changes in cost of equity capital: The cost of equity increases with the

degree of leverage. With the increase in the proportion of debt the

financial risk of the shareholders will increase. To compensate for the

increased risk, the shareholders would expect a higher rate or return.

4. Cost of debt: The cost of debt has two parts: explicit and implicit cost.

The explicit cost is represented by the rate of interest. Irrespective of the

degree of leverage the firm is assumed to be able to borrow at a given

rate of interest. This implies that the increasing proportion of debt in the

financial structure does not affect the financial risk of the lenders and

they do not penalize the firm by charging higher interest. Increase in the

degree of leverage causes an increase in the cost of equity. This increase

in cost of equity being attributable to the increase in debt is implicit part

of cost of debt. Thus the advantage associated with the use of debt

supposed to be a cheaper source of funds in terms of the explicit cost is

exactly neutralized by the implicit cost represented by the increase in

cost of equity. As a result the real cost of debt and the real cost of equity

according to Net Operating Income are the same and equal to overall

cost.

No matter what the degree of leverage is, the total value of the firm will remain

constant. The market price of shares will also not change with the change in the

debt-equity ratio. There is nothing such as an optimum capital structure. Any

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capital structure is optimum according to Net Operating Income Approach.

Traditional Approach

The Traditional Approach or the Intermediate Approach is a mid-way approach

between the Net Income and Net Operating Income approach. It partly contains

features of both the approaches.

The traditional approach accepts that the capital structure of the firm affects the

cost of capital and its valuation. However, it does not subscribe to the Net

Income approach that the value of the firm will necessarily increase with all

degrees of leverages.

It subscribes to the Net Operating Income approach that beyond a certain degree

of leverage, the overall cost of capital increases resulting in decrease in the total

value of the firm. However, it differs from Net Operating Income approach in

the sense that the overall cost of capital will not remain constant for all the

degree of leverages.

The essence of the traditional approach lies in the fact that a firm through

judicious use of debt-equity mix can increase its total value and thereby reduce

its overall cost of capital. According to this approach, up to a point, the content

of debt in the capital structure will favorably affect the value of the firm.

However, beyond that point, the use of debt will adversely affect the value of

the firm. At this level of debt-equity mix the capital structure will be optimum.7 The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton

Miller, forms the basis for modern thinking on capital structure, though it is

generally viewed as a purely theoretical result since it assumes away many

important factors in the capital structure decision. The theorem states that, in a

perfect market, the value of a firm is irrelevant to how that firm is financed. This

result provides the base with which to examine real world reasons why capital

structure is relevant, that is, a company’s value is affected by the capital

structure it employs.

If capital structure is irrelevant in a prefect market, then imperfections which

exist in the real world must be the cause of its relevance. The theories below try

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to address some of the imperfections, by relaxing assumptions made in the

M&M model.

One of the main theories of how firms make their financing decisions is the

Pecking Order Theory, which suggests that firms avoid external financing while

they have internal financing available and avoid new equity financing while

they can engage in new debt financing at reasonably low interest rates. The

pecking order theory is based on the assertion that managers have more

information about their firms than investors. This disparity of information is

referred to as asymmetric information. Other things being equal, because of

asymmetric information, managers will issue debt when they are positive about

their firms’ future prospects and will issue equity when they are unsure. Another

major theory is the Trade-Off Theory in which firms are assumed to trade-off

the tax benefits of debt with the bankruptcy costs of debt when making their

decisions. An emerging area in finance theory is right-financing whereby

investment banks and corporations can enhance investment return and company

value over time by determining the right investment objectives policy

framework, institutional structure, source of financing (debt or equity) and

expenditure framework within a given economy and under given market

conditions. One last theory about this decision is the Market timing hypothesis

which states that firms look for the cheaper type of financing regardless of their

current levels of internal resources, debt and equity. Trade-off theory allows the bankruptcy cost to exist. It states that there is an

advantage to financing with debt (namely, the tax benefit of debts) and that there

is a cost of financing with debt (the bankruptcy costs of debt). The marginal

benefit of further increases in debt declines as debt increase, while the marginal

cost increases, so that a firm that is optimizing its overall value will focus on

this trade-off when choosing how much debt and equity to use for financing.

Empirically, this theory may explain differences in D/E ratios between

industries, but it doesn’t explain differences within the same industry.12 This theory maintains that businesses adhere to a hierarchy of financing sources

and prefer internal financing when available, and debt is preferred over equity

if external financing is required. Thus, the form of debt a firm chooses can act

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as a signal of its need for external finance. The pecking order theory is

popularized by Myers(1984) when he argues that equity is a less preferred

means to raise capital because when managers (who are assumed to know better

about true condition of the firm than investors) issue new equity, investors

believe that managers think that the firm is overvalued and managers are taking

advantage of this over-valuation. As a result, investors will place a lower value

to the new equity issuance.

The determination of capital structure in practice involves considerations in

addition to the concerns about earning per share, value and cash flow. A firm

may have enough debt servicing ability but it may not have assets to offer as

collateral. Attitudes of firms with regard to financing decisions may also be

quite often influenced by their desire of not losing control, maintaining

operating flexibility and have convenient timing and cheaper means of raising

of funds.

According to Ezra Solomon and John Pringle, financial leverage affects both

the magnitude and the variability of earnings per share and return on equity. For

any given level of EBIT, the effect of increase in leverage is favorable if the

percentage rate of operating return on assets is greater than the interest on debt

and it is unfavorable if it is less. When EBIT varies over time, financial leverage

magnifies the variation in earnings per share and return on equity.13 A great deal of controversy has developed over whether the capital of a firm as

determined by its financing decision, affects its cost of capital. Traditionalists

argue that the firm can lower its cost of capital and increase market value per

share by the judicious use of leverage. Modigliani and Miller, on the other hand,

argue that in the absence of taxes and other market imperfections, the total value

of the firm and its cost of capital are independent of capital structure. This

position is based on the notion that there is a conservation of investment value.

No matter how you divide the pie between debt and equity claims, the total

investment value of the firm stays the same. Therefore, leverage is said to be

irrelevant.14 Hence, the proposed study makes a critical study of the capital structure of

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various companies over a period of a time. There are various industries like

cement, pharmaceuticals, sugar, steel, petroleum, fertilizer, automobile etc.

From among these, the proposed research shall study few companies in the

pharmaceutical and engineering industry.

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CHAPTER FOUR

Research Methodology

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4.1. RESEARCH:

Research is a systematized effort to gain new knowledge; A

movement from the known to the unknown.

Research is a method of studying, analyzing and

conceptualization social life in order to extent modify correct or verify

knowledge whether that knowledge aids in construction of theory or in

practice of an art.

Frontiers of knowledge.

4.2. OBJECTIVE OF RESEARCH

To extent knowledge of human being.

To bring out useful information.

To analysis inter relationship between variables.

To face a challenge.

To solve a problem

To get intellectual joy.

4.3. SOURCE OF DATA

Two types of Data

I. Primary data

II. Secondary data

PRIMARY DATA:-

Primary data collection begins when a researcher is not able to find the

data required for his research from secondary data, primary data obtained by

communication observation and personal interview and questionnaire and it is

collected for the first time to be original character.

In primary data collection, the information and data has been collected

through questions raised to staff members and executive personnel during the

online discussions sheering the questions about the loans taken from the

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commercial banks and moreover, some sort of questions were asked about the

targeted budgets for the current projects the company was having.

The other information regarding the financial aspects of the project was

collected from YCC Accounts Manager Mr. Karimullah Totakhail.

SECONDARY DATA:-

Secondary data is taken by the researcher from secondary source internal

and external the researcher must thoroughly search secondary data sources

before commissioning any effort for collecting primary data.

Internal data: collection of data from within the organization.

External data: collection of data from outside the organization.

The secondary data were collected from the bank websites, journals,

various academic essays, articles. Moreover, various internet media was also

undertaken, viz. Internet websites, e-magazines, Etc.

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CHAPTER FIVE

Data Analysis and Interpretation.

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5.1. Data Analysis & Interpretation:

Yaar Construction Company’s own capital is 3,920,000/- which is the 40%

stake of all the equity, and the loan contribution is 5,880,000/- (i.e. 60%). After

analyzing and calculating the essential financial ratios, WACC, NPV and IRR,

the cost of capital we found was 0.15 (i.e. 15%).

Our analysis is to assume the changes in percentage of loan in order to find out

the better rate of WACC.

The lesser WACC the more better for the company. Due to that, we will assume

and find out the WACC and other stuffs while taking 20%, 60% and 80% loan

respectively.

After finding in these three processes, the lesser will be recommended and

preferred for the Yaar Construction Company.

First we are going to assume 20% loan, and the remaining will be put on own

capital.

1. Finding of WACC by taking 20% loan:

The total amount of capital including loan is 9,800,000/- whereas loan from this

amount accounts 20% (i.e. 1,960,000/-) and the remaining is own contribution

(i.e. 7,840,000/-).

a. Weighted Average Cost of Capital (WACC)

‘

*kd = cost of debt

Kd = interest rate (1-tax rate)

Kd = 13.2% (1-20%)

Kd = 0.106

*ks = cost of equity

*Note: in Afghanistan there is no stock exchange market. Due to finding the

rate of cost of equity, we are going to apply the CAPM model [(i.e. Ki = Krf +

(KM – Krf) * betai)]

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The assumption is that Afghanistan is one of the SAARC member, and in that

mostly the construction field is resemble with that of India. Due to that the beta

of risk measurement will be taken from a similar Indian company and

accordingly are going to find the beta and the market free risk and KM.

We = weight of equity (i.e. 0.80 or 80% of the total capital)

Wd = weight of debt (i.e. 20% of the total capital)

Therefore, WdKd = 0.0211, and WeKs = 0.144. While multiplying these two

columns we get WACC which equals to 0.165 (i.e. 16.5%)

The assumption is that Afghanistan is one of the SAARC member, and in that

mostly the construction field is resemble with that of India. Due to that the beta

of risk will be taken from a similar Indian company and accordingly are going

to find the beta and the market free risk and KM. ‘Wd’ is the cost of debt (i.e. loan)

we took (i.e. 20% of the whole amount)

‘We’ is owner’s equity capital (i.e. 80% of the whole amount)

b. NPV by taking 0.165 (16.5%) and 0.70 (70%):

c. Internal Rate of Return (IRR):

Internal rate of return or IRR is the minimum discount rate that management

uses to identify what capital investments or future projects will yield an

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acceptable return and be worth pursuing. The IRR for a specific project is the

rate that equates the net present value of future cash flows from the project to

zero. In other words, if we computed the present value of future cash flows from

a potential project using the internal rate as the discount rate and subtracted out

the original investment, our net present value of the project would be zero.

This sounds a little confusing at first, but it’s pretty simple. Think of it in terms

of capital investing like the company’s management would. They want to

calculate what percentage return is required to break even on an investment

adjusted for the time value of money. You can think of the internal rate of return

as the interest percentage that company has to achieve in order to break even on

its investment in new capital. Since management wants to do better than break

even, they consider this the minimum acceptable return on an investment.

Remember, IRR is the rate at which the net present value of the costs of an

investment equals the net present value of the expected future revenues of the

investment. Management can use this return rate to compare other investments

and decide what capital projects should be funded and what ones should be

scrapped.

Going back to our machine shop example, assume Tom could purchase three

different pieces of machinery. Each would be used for a slightly different job

that brought in slightly different amounts of cash flow. Tom can calculate the

internal rate of return on each machine and compare them all. The one with the

highest IRR would be the best investment.

Since this is an investment calculation, the concept can also be applied to any

other investment. For instance, Tom can compare the return rates of investing

the company’s money in the stock market or new equipment. Now obviously

the expected future cash flows aren’t always equal to the actual cash received

in the future, but this represents a starting point for management to base their

purchase and investment decisions on.

2. Finding of WACC by taking loan of 60%:

As we are done with the 20% loan assumption, we found out weighted average

cost of capital which was 16.5%. Now, we are going to try or assume 60% loan

from the given capital (i.e. 9,800,000).

http://www.myaccountingcourse.com/accounting-dictionary/net-present-value

http://www.myaccountingcourse.com/accounting-dictionary/return

http://www.myaccountingcourse.com/accounting-dictionary/break-even-point

http://www.myaccountingcourse.com/accounting-dictionary/break-even-point

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a. Initial information:

According to 60% loan from the total capital it becomes 5,880,000/- and the

remaining 40% is assumed to be the company’s own capital (i.e. 3,920,000).

Now, by assuming 60% loan we will be going to find out the EMI and the

interest rate which is going to change the figures in the profitability statement

and the WACC along with Net Present Value and Internal Rate of Return.

b. Weighted Average Cost of Capital (WACC):

*kd = cost of debt


Kd = 13.2% (1-20%)

Kd = 0.106





The assumption is that Afghanistan is one of the SAARC countries members,

and in that mostly the construction field is resemble with that of India. Due to

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that the beta of risk will be taken from a similar Indian company and accordingly

are going to find the beta and the market free risk and KM.





Weighted average cost of capital is derived by multiplying weighted debt with

cost of debt plus weight of equity with cost of equity.

A calculation of a firm's cost of capital in which each category of capital is

proportionately weighted. All capital sources - common stock, preferred stock,

bonds and any other long-term debt - are included in a WACC calculation. All

else equal, the WACC of a firm increases as the beta and rate of return on equity

increases, as an increase in WACC notes a decrease in valuation and a higher

risk.

By assuming 60% loan the weighted average cost of capital became 0.135 (i.e.

13.5%). This rate is by far better than the previous assumption we did, which

was for the 20% loan.

The more this rate is going to ebb, the more the company is in the profit. By

WACC we means that The Weighted Cost of Capital (WACC) is used in finance

to measure a firm's cost of capital. Importantly, is not dictated by management.

Rather, it represents the minimum return that a company must earn on an

existing asset base to satisfy its creditors, owners, and other providers of capital,

or they will invest elsewhere.

c. Net Present Value (NPV):

First finding the Net Present Value @13.5% as the cost of capital was this much

we found before. Now applying the following procedure in the table in order to

find out NPV @13.5%.

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As we now found out NPV @13.5 by deducting project cost from the total

PVCIF it came a positive figure (i.e. 9,913,774). Now we in order to find out

internal rate of return (IRR) we are liable to find NPV with a negative figure.

For that we are taking NPV @70% assumption as we took this value for all the

remaining and upcoming analysis.

After applying the net present value of return at 70% we found the value in a

negative figure which is -1,828,866. It is now easy to find out Internal Rate of

Return.

d. Internal Rate of Return (IRR):

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By taking NPV at 70% assumption we got Internal Rate of Return 63.5%. This

rate is bigger and better than the previous assumption of 20% loan (i.e. 60%).

The 3.1% difference shows that the company be taking this much loan will put

in profit and the business will be in a good condition.

3. Finding of WACC by taking 80% loan:

1. Weighted Average Cost of Capital (WACC):

*kd = cost of debt*kd = cost of debt


Kd = 13.2% (1-20%)

Kd = 0.106





The assumption is that Afghanistan is one of the SAARC countries members,

and in that mostly the construction field is resemble with that of India. Due to

that the beta of risk will be taken from a similar Indian company and accordingly

are going to find the beta and the market free risk and KM.





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2. Calculating NPV @12%:

*the Net present Value at 12% after calculation is Rs. 10,096,769/-

*For finding the assumed internal rate of return (IRR) we need to increase the

percentage level this is because the figure came positive; to find IRR we need

one positive NPV figure and one negative.

*now calculating NPV @70%.

3. Internal Rate of Return (IRR):

Before analyzing why we choose the minimum rate, we need to elaborate the

essentials of WACC in brief as follows:

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Weighted Average Cost of Capital (WACC):

The weighted average cost of capital (WACC) is the rate that a company is

expected to pay on average to all its security holders to finance its assets. The

WACC is commonly referred to as the firm’s cost of capital. Importantly, it is

not dictated by management. Rather, it represents the minimum return that a

company must earn on an existing asset base to satisfy its creditors, owners, and

other providers of capital, or they will invest elsewhere.

Companies raise money from a number of sources: common stock, preferred

stock, straight debt, convertible debt, exchangeable debt, warrants, options,

pension liabilities, executive stock options, governmental subsidies, and so on.

Different securities, which represent different sources of finance, are expected

to generate different returns. The WACC is calculated taking into account the

relative weights of each component of the capital structure. The more complex

the company's capital structure, the more laborious it is to calculate the WACC.

Companies can use WACC to see if the investment projects available to them

are worthwhile to undertake.

In general there are three sources of funding available to a company to fund its

operations: retained earnings, borrowed money (debt financing), and selling

equity (stocks and bonds). If the money to support a project is obtained via a

loan (debt financing), then the cost of that money is the interest paid to the loan

provider. If all of the money is obtained via a loan than the interest rate on the

loan is set when the money a company uses is obtained and the interest rate can

simply be used to modify future cash flows as in (1.4), however, this is rarely

the case. Usually companies are funded by and fund projects via a combination

of debt and equity capital the effective cost of money is not so simple to

determine. Most engineering economics texts refer to the rate paid for money

as simply the “interest rate” and many engineers will more generally call it the

“discount rate”. Both of these terms infer the source of the money – interest

rate infers debt financing, the discount rate is defined as the interest rate charged

to commercial banks and other depository institutions for loans received from

the Federal Reserve Bank’s discount window (or the rate used by pension plans

and insurance companies for discounting their liabilities). A more general term

is the “weighted Average cost of capital” or WACC, which attempts to capture

and combine the cost of all the sources of money. This appendix describes the

general calculation and use of the WACC. It also describes how the WACC can

change over time and issues with using the WACC in long (calendar) time

calculations.

B.1 the Weighted Average Cost of Capital (WACC)

A wide variety of methods can be used to determine the rate for cost of money,

but in many cases, these calculations resemble art more than science. One

https://en.wikipedia.org/wiki/Cost_of_capital

https://en.wikipedia.org/wiki/Common_stock

https://en.wikipedia.org/wiki/Preferred_stock

https://en.wikipedia.org/wiki/Preferred_stock

https://en.wikipedia.org/wiki/Debt

https://en.wikipedia.org/wiki/Convertible_bond

https://en.wikipedia.org/wiki/Exchangeable_bond

https://en.wikipedia.org/wiki/Warrant_(finance)

https://en.wikipedia.org/wiki/Option_(finance)

https://en.wikipedia.org/wiki/Pension

https://en.wikipedia.org/wiki/Executive_stock_option

https://en.wikipedia.org/wiki/Capital_structure

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common strategy is to apply the concepts of the weighted average cost of capital

(WACC). The WACC is essentially a blend of the cost of equity and the after-

tax cost of debt.

B.1.1 Cost of Equity

Equity is a stock or any other security representing an ownership interest in a

company. Companies, weather public or private raise money by selling equity

in itself. Unlike debt, for which the company must pay at a set rate of interest,

equity does not have a set price that the company must pay. But this doesn't

mean that there is no cost of equity. Equity shareholders expect to obtain a

certain return on their equity investment in a company. From the company's

perspective, the equity holders' required rate of return is a cost, because if the

company does not deliver this expected return, shareholders may sell their

shares, causing the stock price to drop. The cost of equity is basically what it

costs the company to maintain a share price that is satisfactory (at least in

theory) to investors. The most commonly accepted method for calculating cost

of equity comes from the capital asset pricing model.

Cost of Debt

Debt is an amount of money borrowed by one party from another. Corporations

use debt as a method for making large purchases that they could not afford under

normal circumstances. A debt arrangement gives the borrowing party

permission to borrow money under the condition that it is to be paid back at a

later date, usually with interest. Compared to cost of equity, cost of debt is more

straightforward to calculate. The rate applied to determine the cost of debt (Rd)

should be the current market rate the company is paying on its debt. If the

company is not paying market rates, an appropriate market rate payable by the

company should be estimated. Since companies benefit from the tax deductions

available on interest paid on debt, the net cost of the debt is actually the interest

paid less the tax savings resulting from the tax-deductible interest payment.

Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).

Why we choose the minimum percentage of weighted average cost of

capital?

Weighted average cost of debt or simply WACC is the minimum rate the

company is going to pay to the debt owners. If the rate is high we are liable to

pay high amount from our PAT and inversely, if it is less we will pay less

amount to them. Due to that, the 80% loan where the WACC rate is 12% is quite

profitable for the company to accept and take this much loan and the remaining

of his own contribution.

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Evaluation of WACC, IRR and NPV and the decision table:

As we found out that 80% of loan estimation was a better decision for the

company to select because of the decrease in the value of weighted average cost

of capital (that was 12%). We also found out the Net present value and the

internal rate of return simultaneously. It is said that the proposal having the

highest percentage of internal rate of return which would be more than the cost

of capital, will be accepted. Looking to the IRR and Net Present Value the 20%

loan estimation is coming the correct proposal to be accepted. But, the matter

of fact, we analyzed according to the WACC therefore, we need to find out the

value of per share which is going to be given to the owner of the capital.

For that we are going to take some assumptions as follows:

1. The face value of the equity share is 10

Decision Table

Explanation:

The total equity is Rs. 9,800,000/-. We took 20%, 60% and 80% loan estimation.

No. of Share having face value 10 each:

784,000 = 9,800,000*(100%-20%)/10

392,000 = 9,800,000*(100%-60%)/10

WACC for 20%, 60% and 80% we found was 16.5%, 13.5% and 12%. We

selected the minimum among them (i.e. 12%, which is for the 80% loan

estimation).

IRR for the 20%, 60% and 80% we found by applying the formula was 65.5%,

63.5% and 62.50%. In that we selected the maximum percentage due to having

the rule of internal rate of return. (I.e. the highest IRR is to be considered).

Now, the Value per share is derived by dividing the Net Present Value upon

number of shares. The justification is that by taking 80% loan estimation the

value per share for the owner increases more than taking the other estimations.

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In 20% it was 12.88 similarly, for 60% it was 25.29 and for 80% it was 48.85,

which is the highest among them.

Therefore, the 80% loan estimation proposal is better for the company to accept.

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CHAPTER SIX

Findings

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The company’s taken loan was 40% and their shareholders’ contribution

was 60% of total capital. WACC was 15%. Net Present Value was Rs.

9,739,653/- only. Which is a very high amount. Internal Rate of Return was

64.5%. This rate is very high, and the company’s financial position is good.

After analyzing the financial data, we took first 20%, and the WACC came

16.5% and the NPV came Rs. 9,573,774/- only. Similarly, IRR we found

was 65.5%. Higher than the previous one.

For 60%, WACC came 13.5%, NPV Rs. 9,913,774/- only, and IRR =

63.5%.

For 80%, WACC came 12.0%, NPV Rs. 10,096,769/- only. Similarly, IRR

was 62.5%.

The profit after tax in the year 2010 was 6,245,703/-, (the most profitable

year). The least among them was in the year 2013 where only Rs.

1,807,115/- was the net profit.

The year 2010 is by far better than the rest of the years by having the Gross

profit ratio 0.677.

These are the illustrative tables for the aforementioned assumed rates for

finding the WACC:

a. 20% loan:

b. 40% loan (the company’s taken rate for the business):

c. 60% loan:

d. 80% loan:

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CHAPTER SEVEN

Conclusion

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The WACC is the return that investors (equity and debt providers

combined) would require to invest in a particular project, given the risk

associated with the returns to a particular project relative to that of other

projects. A WACC is not something that can be estimated in isolation – rather,

the first step in estimating a WACC is to understand the project for which the

WACC is to be estimated. Normally when a WACC is estimated, the project

for which it is to be estimated is obvious. Weighted Average Cost of Capital

after calculation for YCC is 15% (i.e. 0.15). The rate of WACC decreases when

the debt level increases. Notwithstanding, it also effects on the net present

value and internal rate of return. Now, as our analysis is about the weighted

average cost of capital (WACC), we did three assumptions of WACC

respectively in order to find out the most minimum feasible WACC among

them. For that we took 20%, 60% and 80% loan estimation.

The most feasible and efficient proposal is 20% in which the WACC

was 0.12 only.

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CHAPTER EIGHT

Suggestions

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The company’s overall business is very good. In order to make it better

and feasible, it needs to focus more not to keep cash with itself.

To make more profit, YCC needs to apply the 80% loan proposal model.

Because the value per share per shareholder is far better than the other

proposals.

The income statement of both shows the sign of positivity, but as the

loan is also going to be paid to the bank, the differentiation between the

previous percentage (i.e. 40% loan taken) and the later (80% loan taken)

has not that much difference in amount. The total net profit in the year

2010 as per the company’s original loan taken (i.e. 40%) is Rs.

6,245,703/- and for the 80% loan (assumed) came Rs. 5,858,286/- only.

The difference among them is Rs. 387,417/- only. This differentiation is

somehow variable but not in the side of loss or very much less. Indeed,

looking to the profitability ratios we found that 80% was a better choice

for the company to be tried.

WACC for the 80% came 12.0%. Due to that, the lessor among them is

to be selected as efficient and feasible in spite of having the risk.

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CHAPTER NINE

Managerial Implications and

Scope of Future Study

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We would like to conclude the process of writing this thesis with one

work’ perspective. We consider that it is worth mention this word even though

you certainly are aware of it and its implications. It was our tutor Prof. Zafir

who brought this word to our attention in the classes and it affected our way of

thinking as it increased our awareness of the wide range of possible perspectives

there are to analyze a subject from when writing a thesis. Different individuals

will probably look at one company differently if you are for say an engineer,

economist or human resource person and it is thus important to decide what you

are to write about and what you want to analyze. We would say that it is extra

important today as a lot of information is available and it is easy to analyze the

data. It is therefore from a strategic point of view important of decide what you

want to measure and to assure yourself that what you have measured is what

you intended to measure.

My thesis has taken the different estimated rates of weighted average

cost of capitals of Yaar Construction Company for finding out the best and

suitable rate of WACC for the YCC Company. The original percentage of loan

taken by the company is 40% and for the analysis we brought some assumptions

and in that we analyzed the assumed 20%, 60% and 80% of loan taken by the

company, and ultimately found out the impact of it on the company’s total

profits and income statement.

There are a lot of different assumptions made in these theories and we

chose to take a macro perspective look, which relies on the assumption that there

is an efficient market. Different economists would certainly have taken different

perspectives in this case of study but we thought that is was interesting to

analyze the chosen methods applicability. We run into various interesting areas

as the writing of this thesis and suggestions that you are about to write your

master thesis in the subject of finance and that you therefore have acquired the

necessary skills for doing that.

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Appendices

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Bibliography

References:

Harris, M, and Raviv, A 1991, ‘The Theory of capital Structure’, Journal of

Finance, 46, 1, pp.297-355, Business Source Premier, EBSCOhost, viewed 28

May 2015.

Hovakimian, A, and Titman, S 2002, ‘THE CAPITAL STRUCTURE CHOICE:

NEW EVIDENCE FOR A DYNAMIC TRADEOFF MODEL’, Journal Of

Applied Corporate Finance, 15, 1, p. 24, Business Source Premier, EBSCOhost,

viewed 17 May 2015.

Modigliani, F and Miller, M1966, ‘SOME ESTIMATES OF THE COST OF

CAPITAL TO THE ELECTRIC UTILITY INDUSTRY, 1954-57’, American

Economic Review, 56, 3, p. 333, Business Source Premier, EBSCOhost, viewed

15 July 2015.

Myers, SC 1977, Determinants of Corporate borrowing, Journal of Financial

Economics, Volume 5, Issue 2, November 1977, Pages 147-175

Myers, SC 2001, ‘Capital Structure’, Journal of Economic Perspective, 15, 2,

pp. 81-102, Business Source Premier, EBSCOhost, viewed 4 July 2015.

Books:

Berk, Jonathan, DeMarzo, Peter, 2011, ‘Corporate Finance’ Second edition,

published by Pearson Education as Prentice Hall.

Danidarabm Aswatgm 2002, ‘Investment Valuation: Second Edition’ Published

by John and Sons, Inc. New York.

Eun, Cheol S., Resnick, Bruce G., 2009, ‘International Financial Management’

Fifth edition, published by McGraw Hill/Irwin

Watson, D., Head, A., 2013, ‘Corporate Finance – Principle and Practice’,

Sixth Edition, Published by Pearson Education.

Websites:

www.google.com

www.moneycontrol.com

www.investopedia.com

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Foreign Exchange rates and their charts:

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Yaar Construction Company’s financial data:

Yaar Construction Company starts working in the year 2008. Its pro-activeness

capability and well done performance absolutely touched its benchmark they

were having in the very beginning of the incorporation.

Below is the financial data of Yaar Construction Company. The five year

balance sheet, profitability statement, expenditure usage columns, and such

other relevant financial numerical data is presented.

1. This table is belonging to the initial information of YCC Company.

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2. This table belongs to the working capital of Yaar Construction

Company. All the salary and expenditures are of monthly-wise

calculated in the below table.

3. The investment cost of capital. The biggest amount is used on the vehicle

as the company really have so active parts with the usage of vehicles.

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4. Table for the percentage change in the total amount. All the increases in

the expenditures of calculated year-wise.

5. Amount change in the total expenditure year-wise accordingly.

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6. Revenue Statement for the last five years

7. EMI calculation Statement for each year respectively.

a. EMI for the year 2010:

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b. EMI for the year 2011:

c. EMI for the year 2012:

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d. EMI for the year 2013:

e. EMI for the year 2014:

8. Depreciation statement for all the fixed assets. The percentage of

deprecation for all the fixed assets are variable (i.e. Vehicle – 15%,

Furniture – 10%, Fixtures – 30%, Computers – 28%)

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a. Depreciation statement for vehicle:

b. Depreciation statement for Computers:

c. Depreciation Statement for Furniture:

d. Depreciation Statement for Fixtures:

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e. Depreciation Total with graph illustration:

9. Profitability Statement:

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10. Balance sheet for the year 2010, 2011, 2012, 2013, 2014:

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11. Weighted Average Cost of Capital (WACC):

Kd is derived by using the following formula: interest rate (1-tax)

Ks is 0.18 as I can’t give words on it because this rate was given as the company

applied it without mentioning the core cause of it.

The loan taken by Yaar Construction Company (YCC) is 40% (i.e. 3,920,000)

and the company’s own capital is 60% (i.e. 5,880,000).

Weighted Average Cost of Capital is derived by multiplying WDKD into

WEKS (i.e. WDKD (0.0422) * WEKS (0.108) = WACC (0.15024) or 15%)

As the cost of capital is 15%, we are now going to find the Profit after Tax (i.e.

PAT) that is by adding the income with depreciation.

PVIF @ 15 is found from the following formula:

1/1.15

After calculating we found out NPV @15 is 9,739,653. (Nine Million Seven

Lakh Thirty nine thousand Six hundred and Fifty Three only/-)

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Now, to find out the internal rate of return (IRR) we need to have an assumption

rate of NPV. For that we are taking NPV @70%. The following table is made

on the assumption of 70% Net profit value:

In order to make the IRR efficient, the assumed result must be in negative

numbers.

Internal Rate of Return (IRR):

The internal rate of return (IRR) or economic rate of return (ERR) is a rate

of return used in capital budgeting to measure and compare the profitability of

investments. It is also called the discounted cash flow rate of return (DCFROR).

In the context of savings and loans, the IRR is also called the effective interest

rate. The term internal refers to the fact that its calculation does not incorporate

environmental factors (e.g., the interest rate or inflation).

Uses of IRR:

IRR calculations are commonly used to evaluate the desirability of investments

or projects. The higher a project's IRR, the more desirable it is to undertake the

project. Assuming all projects require the same amount of up-front investment,

the project with the highest IRR would be considered the best and undertaken

first.

A firm (or individual) should, in theory, undertake all projects or investments

available with IRRs that exceed the cost of capital. Investment may be limited

by availability of funds to the firm and/or by the firm's capacity or ability to

manage numerous projects.

Because the internal rate of return is a rate quantity, it is an indicator of the

efficiency, quality, or yield of an investment. This is in contrast with the net

present value, which is an indicator of the value or magnitude of an investment.

An investment is considered acceptable if its internal rate of return is greater

than an established minimum acceptable rate of return or cost of capital. In a

scenario where an investment is considered by a firm that has shareholders, this

minimum rate is the cost of capital of the investment (which may be determined

https://en.wikipedia.org/wiki/Rate_of_return


https://en.wikipedia.org/wiki/Capital_budgeting

https://en.wikipedia.org/wiki/Profit_(economics)

https://en.wikipedia.org/wiki/Investment_(macroeconomics)

https://en.wikipedia.org/wiki/Discounted_cash_flow


https://en.wikipedia.org/wiki/Effective_interest_rate

https://en.wikipedia.org/wiki/Effective_interest_rate

https://en.wikipedia.org/wiki/Interest_rate


https://en.wikipedia.org/wiki/Rate_(mathematics)

https://en.wikipedia.org/wiki/Yield_(finance)

https://en.wikipedia.org/wiki/Magnitude_(mathematics)

https://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_return


https://en.wikipedia.org/wiki/Shareholder


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by the risk-adjusted cost of capital of alternative investments). This ensures that

the investment is supported by equity holders since, in general, an investment

whose IRR exceeds its cost of capital adds value for the company (i.e., it is

economically profitable).

One of the uses of IRR is by corporations that wish to compare capital projects.

For example, a corporation will evaluate an investment in a new plant versus an

extension of an existing plant based on the IRR of each project. In such a case,

each new capital project must produce an IRR that is higher than the company's

cost of capital. Once this hurdle is surpassed, the project with the highest IRR

would be the wiser investment, all other things being equal (including risk).

IRR is also useful for corporations in evaluating stock buyback programs.

Clearly, if a company allocates a substantial amount to a stock buyback, the

analysis must show that the company's own stock is a better investment (has a

higher IRR) than any other use of the funds for other capital projects, or than

any acquisition candidate at current market prices.

Decision criterion:

If the IRR is greater than the cost of capital, accept the projects.

If the IRR is less than the cost of capital, reject the projects.

Now the Internal Rate of Return formula is:

Implication:

As the cost of capital is 15% and the internal rate of return is 64.5%, there is a

huge difference in the rate. Due to the decision criterion of IRR, if the rate of

return is more than the cost of capital, we usually accept the project rather to

reject. Nevertheless, if it supposedly came lower than the cost of capital, the

company surely would reject the proposal. But as the profit is immense the

company is in a very good position. They accepted the proposals.

Finding of WACC by taking 20% loan:

https://en.wikipedia.org/wiki/Value_(economics)

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a. Initial information:

*The amount depreciation, expenditure changes amount is the same as it is

mention in the before pages. We don’t need to bring changes in the balance

sheet as our work is with the profitability statement. We mostly need the

Weighted Average Cost of Capital to show how much variation is there with

the company’s taken loan. The lesser will be selected.

a. EMI calculation for each year along with their graphs:

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a. Profitability Statement along with graph illustration

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1. Initial Information:

e. Calculation of EMI for each year on the basis of assumed value

(60%):

After using the EMI formula the per month interest amount was 134,539/- only.

1. EMI for the year 2010:

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f. Profitability Statement:

*The interest rate is changed because of the loan proportion. In the first year the

interest amount is 726,408. Moreover, the interest amount goes down year after

year.

*The tax rate is 20% as it was. No changes are added in this part.

The income statement, also called the profit and loss statement, is a report that

shows the income, expenses, and resulting profits or losses of a company during

a specific time period. The income statement is the first financial statement

typically prepared during the accounting cycle because the net income or loss

must be calculated and carried over to the statement of owner's equity before

other financial statements can be prepared.

http://www.myaccountingcourse.com/accounting-dictionary/financial-statements

http://www.myaccountingcourse.com/accounting-cycle/

http://www.myaccountingcourse.com/financial-statements/statement-of-stockholders-equity

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The income statement calculates the net income of a company by subtracting

total expenses from total income. This calculation shows investors and creditors

the overall profitability of the company as well as how efficiently the company

is at generating profits from total revenues.

The income and expense accounts can also be subdivided to calculate gross

profit and the income or loss from operations. These two calculations are best

shown on a multi-step income statement. Gross profit is calculated by

subtracting cost of goods sold from net sales. Operating income is calculated by

subtracting operating expenses from the gross profit.

Unlike the balance sheet, the income statement calculates net income or loss

over a range of time. For example annual statements use revenues and expenses

over a 12-month period, while quarterly statements focus on revenues and

expenses incurred during a 3-month period.

http://www.myaccountingcourse.com/accounting-dictionary/net-income

http://www.myaccountingcourse.com/accounting-basics/expense-account

http://www.myaccountingcourse.com/accounting-basics/revenue-accounts

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2. EMI calculation for 80% loan:

a. EMI calculation for the year 2010:

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b. EMI calculation for the year 2011:

c. EMI calculation for the year 2012:

d. EMI calculation for the year 2013

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e. EMI calculation for the year 2014:

3. Profitability Statement:

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Financial Ratios and Their Interpretations

A financial ratio or accounting ratio is a relative magnitude of two selected

numerical values taken from an enterprise's financial statements. Often used in

accounting, there are many standard ratios used to try to evaluate the overall

financial condition of a corporation or other organization. Financial ratios may

be used by managers within a firm, by current and potential shareholders

(owners) of a firm, and by a firm's creditors. Financial analysts use financial

ratios to compare the strengths and weaknesses in various companies. If shares

in a company are traded in a financial market, the market price of the shares is

used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an

equivalent percent value, such as 10%. Some ratios are usually quoted as

percentages, especially ratios that are usually or always less than 1, such as

earnings yield, while others are usually quoted as decimal numbers, especially

ratios that are usually more than 1, such as P/E ratio; these latter are also called

multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1,

the reciprocal will be below 1, and conversely. The reciprocal expresses the

same information, but may be more understandable: for instance, the earnings

yield can be compared with bond yields, while the P/E ratio cannot be: for

example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Purpose and types of ratios:

Financial ratios quantify many aspects of a business and are an integral part of

the financial statement analysis. Financial ratios are categorized according to

the financial aspect of the business which the ratio measures. Liquidity ratios

measure the availability of cash to pay debt. Activity ratios measure how

quickly a firm converts non-cash assets to cash assets. Debt ratios measure the

firm's ability to repay long-term debt. Profitability ratios measure the firm's

use of its assets and control of its expenses to generate an acceptable rate of

return. Market ratios measure investor response to owning a company's stock

and also the cost of issuing stock. These are concerned with the return on

investment for shareholders, and with the relationship between return and the

value of an investment in company’s shares.

Financial ratios allow for comparisons

between companies

between industries

between different time periods for one company

between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something

else, like past performance or another company. Thus, the ratios of firms in

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different industries, which face different risks, capital requirements, and

competition are usually hard to compare.

1. Net profit ratio:

Net profit ratio (NP ratio) is a popular profitability ratio that shows

relationship between net profit after tax and net sales. It is computed by dividing

the net profit (after tax) by net sales.

Formula of Net Profit Ratio:

For the purpose of this ratio, net profit is equal to gross profit minus operating

expenses and income tax. All non-operating revenues and expenses are not

taken into account because the purpose of this ratio is to evaluate the

profitability of the business from its primary operations. Examples of non-

operating revenues include interest on investments and income from sale of

fixed assets. Examples of non-operating expenses include interest on loan and

loss on sale of assets.

We calculated YCC Company’s net profit ratio as follows:

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Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the

business. A high ratio indicates the efficient management of the affairs of

business.

There is no norm to interpret this ratio. To see whether the business is constantly

improving its profitability or not, the analyst should compare the ratio with the

previous years’ ratio, the industry’s average and the budgeted net profit ratio.

The use of net profit ratio in conjunction with the assets turnover ratio helps in

ascertaining how profitably the assets have been used during the period.

In 2011 the net profit ratio was slightly better than the previous year (i.e. 2010).

A 0.002 or (0.2%) difference was somehow not that much more, but still the

profit has been attained. Moreover, the company’s later years were quite

shaking than the previous as the economic and political scenario of Afghanistan

brought up so many devastative calamities. One of the essential was the

declination rate of the USAID projects and the bid rates. Indeed, the later years

were of black days in the matter of work, prosperity, profitability and gaining

of income from various kind of US constructive projects.

As we can see in 2012 it was somehow good; the ratio was 0.420 (40.2%)

comparing with the later years (i.e. 2013 and 2014). A big shrink was in 2014

due to the US Army forces being expelled from Afghanistan and their duration

came to end. With that so many biggest projects were stopped to nil all around

Afghanistan, and their huge impact was on the Construction and logistic

companies.

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2. Gross Profit Ratio:

Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship

between gross profit and total net sales revenue. It is a popular tool to evaluate

the operational performance of the business. The ratio is computed by dividing

the gross profit figure by net sales.

Significance and interpretation:

Gross profit is very important for any business. It should be sufficient to cover

all expenses and provide for profit.

There is no norm or standard to interpret gross profit ratio (GP ratio). Generally,

a higher ratio is considered better.

The ratio can be used to test the business condition by comparing it with past

years’ ratio and with the ratio of other companies in the industry. A consistent

improvement in gross profit ratio over the past years is the indication of

continuous improvement. When the ratio is compared with that of others in the

industry, the analyst must see whether they use the same accounting systems

and practices.

The year 2010 is by far better than the rest of the years by having the GPR ratio

0.677. Later on, in the year 2011 and 2012 still did good profit and the company

was in a high rate of profitability. But as the situation became worse this rate

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was also crashed with declination. The company gain a lot of profit in the year

2010.

3. Debt Service Coverage Ratio:

The debt service coverage ratio (DSCR), also known as "debt coverage ratio,"

(DCR) is the ratio of cash available for debt servicing to interest, principal and

lease payments. It is a popular benchmark used in the measurement of an entity's

(person or corporation) ability to produce enough cash to cover its debt

(including lease) payments. The higher this ratio is, the easier it is to obtain a

loan. The phrase is also used in commercial banking and may be expressed as a

minimum ratio that is acceptable to a lender; it may be a loan condition.

Breaching a DSCR covenant can, in some circumstances, be an act of default.

In corporate finance, DSCR refers to the amount of cash flow available to meet

annual interest and principal payments on debt, including sinking fund

payments.

In personal finance, DSCR refers to a ratio used by bank loan officers in

determining debt servicing ability.

Net operating income is the income or cash flows that are left over after all of

the operating expenses have been paid. This is often called earnings before

interest and taxes or EBIT. Net operating income is usually stated separately on

the income statement.

Total debt service refers to all costs related to servicing a company's debt. This

often includes interest payments, principle payments, and other obligations. The

debt service amount is rarely given in a set of financial statements. Many times

this is mentioned in the financial statement notes, however.

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Significance and interpretation:

The debt service coverage ratio measures a firm's ability to maintain its current

debt levels. This is why a higher ratio is always more favorable than a lower

ratio. A higher ratio indicates that there is more income available to pay for debt

servicing.

For example, if a company had a ratio of 1, that would mean that the company's

net operating profits equals its debt service obligations. In other words, the

company generates just enough revenues to pay for its debt servicing. A ratio of

less than one means that the company doesn't generate enough operating profits

to pay its debt service and must use some of its savings.

Generally, companies with higher service ratios tend to have more cash and are

better able to pay their debt obligations on time. Therefore, Yaar Construction

Company did very well in the beginning years of the balance sheet (i.e. 2010

and 2011). However, the ratio of 2010 is 8.83 the next year is also not being ebb

to the required ratio as it attained the ratio of 8.49 which is quite better than the

later three years (i.e. 2012, 2013 and 2014).

The better year where YCC was in a good condition is 2010. As we said the

bigger the value of the ratio the easier it becomes for the company to pay the

loan services. So the best year is 2010 and the worst year among them is 2013

where the ratio slightly gone down to 2.96.

4. Return on Assets (RoA):

The return on assets ratio, often called the return on total assets, is a profitability

ratio that measures the net income produced by total assets during a period by

comparing net income to the average total assets. In other words, the return on

assets ratio or ROA measures how efficiently a company can manage its assets

to produce profits during a period.

Since company assets' sole purpose is to generate revenues and produce profits,

this ratio helps both management and investors see how well the company can

convert its investments in assets into profits. You can look at ROA as a return

on investment for the company since capital assets are often the biggest

investment for most companies. In this case, the company invests money into

capital assets and the return is measured in profits.

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In short, this ratio measures how profitable a company's assets are.

Analysis:

The return on assets ratio measures how effectively a company can turn earn a

return on its investment in assets. In other words, ROA shows how efficiently a

company can covert the money used to purchase assets into net income or

profits.

Since all assets are either funded by equity or debt, some investors try to

disregard the costs of acquiring the assets in the return calculation by adding

back interest expense in the formula.

It only makes sense that a higher ratio is more favorable to investors because it

shows that the company is more effectively managing its assets to produce

greater amounts of net income. A positive ROA ratio usually indicates an

upward profit trend as well. ROA is most useful for comparing companies in

the same industry as different industries use assets differently. For instance,

construction companies use large, expensive equipment while software

companies use computers and servers.

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In 2010, the ROA ratio was 0.33 which is the biggest in all the years of the

balance sheet. The company earn more on investing all the fixed assets.

However, it profited less in the year 2013 where the ratio is the lowest in all (i.e.

0.04).

5. Accounts Receivable Turnover Ratio:

What is accounts receivable? It's an efficiency ratio or activity ratio that

measures how many times a business can turn its accounts receivable into cash

during a period. In other words, the accounts receivable turnover ratio measures

how many times a business can collect its average accounts receivable during

the year.

A turn refers to each time a company collects its average receivables. If a

company had $20,000 of average receivables during the year and collected

$40,000 of receivables during the year, the company would have turned its

accounts receivable twice because it collected twice the amount of average

receivables.

This ratio shows how efficient a company is at collecting its credit sales from

customers. Some companies collect their receivables from customers in 90 days

while other take up to 6 months to collect from customers.

In some ways the receivables turnover ratio can be viewed as a liquidity ratio as

well. Companies are more liquid the faster they can convert their receivables

into cash.

Interpretation:

Since the receivables turnover ratio measures a business' ability to efficiently

collect its receivables, it only makes sense that a higher ratio would be more

favorable. Higher ratios mean that companies are collecting their receivables

more frequently throughout the year. For instance, a ratio of 2 means that the

company collected its average receivables twice during the year. In other words,

this company is collecting its money from customers every six months.

Higher efficiency is favorable from a cash flow standpoint as well. If a company

can collect cash from customers sooner, it will be able to use that cash to pay

bills and other obligations sooner.

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Accounts receivable turnover also is an indication of the quality of credit sales

and receivables. A company with a higher ratio shows that credit sales are more

likely to be collected than a company with a lower ratio. Since accounts

receivable are often posted as collateral for loans, quality of receivables is

important.

In 2010, the

Receivables

Turnover

Ratio is

6.92

whereas, in

2011, it

slightly

increased

which

reached

8.82. The highest ratio is in 2011. It means that the company is more in a good

condition of collecting their receivables more frequently throughout the year.

The worst is in the year 2012, which touched 4.21. It means in this year the

collection for the receivables were quite slow than the other years calculated.

6. Payable Turnover Ratio:

The accounts payable turnover ratio is a liquidity ratio that shows a company's

ability to pay off its accounts payable by comparing net credit purchases to the

average accounts payable during a period. In other words, the accounts payable

turnover ratio is how many times a company can pay off its average accounts

payable balance during the course of a year.

This ratio helps creditors analyze the liquidity of a company by gauging how

easily a company can pay off its current suppliers and vendors. Companies that

can pay off supplies frequently throughout the year indicate to creditor that they

will be able to make regular interest and principle payments as well.

Vendors also use this ratio when they consider establishing a new line of credit

or floor plan for a new customer. For instance, car dealerships and music stores

often pay for their inventory with floor plan financing from their vendors.

Vendors want to make sure they will be paid on time, so they often analyze the

company's payable turnover ratio.

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Interpretation:

Since the accounts payable turnover ratio indicates how quickly a company pays

off its vendors, it is used by supplies and creditors to help decide whether or not

to grant credit to a business. As with most liquidity ratios, a higher ratio is

almost always more favorable than a lower ratio.

A higher ratio shows suppliers and creditors that the company pays its bills

frequently and regularly. It also implies that new vendors will get paid back

quickly. A high turnover ratio can be used to negotiate favorable credit terms in

the future.

As with all ratios, the accounts payable turnover is specific to different

industries. Every industry has a slightly different standard. This ratio is best

used to compare similar companies in the same industry.

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As the highest ratio is favorable, the YCC Company in 2011 with a very high

rate of difference that is 12.75 brought up the company to pay the accounts

payable faster than the other years. The least rate where the company wasn’t in

a good condition paid lately during the year. That year is 2012. Similarly the

Accounts receivable was a bit changes. It was for the year 2011 respectively.

7. Current Ratio:

The current ratio is a liquidity and efficiency ratio that measures a firm's ability

to pay off its short-term liabilities with its current assets. The current ratio is an

important measure of liquidity because short-term liabilities are due within the

next year.

This means that a company has a limited amount of time in order to raise the

funds to pay for these liabilities. Current assets like cash, cash equivalents, and

marketable securities can easily be converted into cash in the short term. This

means that companies with larger amounts of current assets will more easily be

able to pay off current liabilities when they become due without having to sell

off long-term, revenue generating assets.

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Interpretation:

The current ratio helps investors and creditors understand the liquidity of a

company and how easily that company will be able to pay off its current

liabilities. This ratio expresses a firm's current debt in terms of current assets.

So a current ratio of 4 would mean that the company has 4 times more current

assets than current liabilities.

A higher current ratio is always more favorable than a lower current ratio

because it shows the company can more easily make current debt payments.

If a company has to sell of fixed assets to pay for its current liabilities, this

usually means the company isn't making enough from operations to support

activities. In other words, the company is losing money. Sometimes this is the

result of poor collections of accounts receivable.

The current ratio also sheds light on the overall debt burden of the company. If

a company is weighted down with a current debt, its cash flow will suffer.

In 2011, the current ratio pertaining to other years is quite high and this is a

good sign for the YCC Company. The 44.73 ratio is the highest which is the

best selected year for a company that can more easily make current debt

payments. The most less is in 2010 which is showing 3.17 only. This is by far

the lowest in all. It means that the company was not being so much effective to

make current debt payments.

8. Quick Ratio:

The quick ratio is a financial liquidity ratio that compares quick assets to current

liabilities. Quick assets generally include cash, cash equivalents, and accounts

receivable.

The quick ratio is calculated by adding all the quick assets together and dividing

by the total current liabilities. Here is the quick ratio equation.

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Interpretation:

The quick ratio is designed to show investors and creditors how quickly a

company can pay off its short-term debt. Assets like cash, marketable securities,

and accounts receivable can quickly be converted into cash and used to pay off

current liabilities. This also shows analysts that the company has healthy cash

flow and can meet its short-term debt obligations with its operations. In other

words, the company is making enough profit to pay off its current liabilities

without having to sell long-term assets

Yaar Construction Company had made very well in the year 2011 to convert its

assets like accounts receivable, cash, cash equivalents, etc. To pay its short term

debt obligations. Meanwhile, the lowest possibility where the company can’t

that much was ready to pay its short term debt payments was the year 2010,

because the rate was quite low than the others. It was just 2.68 only.

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