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# WetSuits PLC

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WetSuits PLC

Introduction

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Question 1

A calculation of WetSuits equity beta, cost of equity and WACC. Why is the cost of equity so high? A discussion regarding the suggestion of the junior finance manager and the argument put forward from one of the directors.

Beta= (Stocks rate of return-Risk free rate)/ (market of return-risk free rate)

= (8%-4%) / (12%-4%) = 4/8=0.5%

Cost of Equity = Risk Free rate + Beta × Market Risk Premium

Hence; 4 + (0.5*3) = 5.5%

WACC= (Weight of Equity x Cost of Equity) + (Weight of Debt x Cost of Debt)

Market Value of Equity = 1,000,000 × 10 = 10,000,000
Market Value of Debt = 2,000,000

Total Market Value of Debt and Equity = 12,000,000
Weight of Equity = 10,000,000 / 12,000,000 = 83.

3%
Weight of Debt = 2,000,000 / 12,000,000 = 16.7%

Cost of debt=before tax rate*(1-marginal tax) = 8*(1-0.3%)

Hence cost of debt=5.6%

Therefore the WACC of Wetsuits will be= (83.3%*5.5%) + (16.7%*5.6%)

= (458.15/100) + (93.52/100)=5.53%

Assumptions:

It is assumed that the corporate tax that is charged on companies is at 30% in the calculation of the WACC. In the calculation of the Beta, it is assumed that stock rate of return is similar to interest on bonds the company pays.

It is also assumed that the market value of the debt is 2,000,000 and does not change.

The cost of Equity at 5.5% is too high due to high risk-free rate which is at about 4% and also due to the high market risk premium of 3%.  Whenever companies recapitalise at high rates, the cost of equity of a company always becomes quite higher and makes the use of equity for financing quite expensive since the interests or dividends involved are higher. Suggestion by the junior officer to increase the leverage of the company may be short-lived in case of the down fall in the economy which will increase the debt levels of the company hence quite risky (Ryan, 2007).

Question 2

A discussion as to why the negative prospects regarding the future of the economy have a more critical impact on the debt commitments rather than equity for WetSuits.

Companies always have various commitments in relation to what financing alternatives they use in obtaining finances for their operations.

In the case of Wetsuits PLC, the negative prospects regarding the future of the economy have a more critical impact on the debt commitments rather than equity due to various reasons (Yescombe, 2007). When considering debt commitments of any form of company or organization, there are always interests which are t be paid towards the debt commitments. Whenever there are negative future prospects which are expected to occur, a business stands at risk of losing a lot in terms of the interests it is required to pay (Yescombe, 2007). The interests are always expected to be paid at specific dates hence negative prospects may mean that the company may not be able to pay the interests hence risks losing its properties which were used as collateral.

On the other hand, equity does not pose a great risk to the company since it involves the owners of the company (Yescombe, 2007). The owners will do everything possible to save the company and help it to with stand the negative future prospects. Equity in most cases is not paid on demand as compared to the debt commitments.

Question 3

A discussion of the statement in the financial press regarding the low debt levels and efficiency of WetSuits. Is there any real reason for concern regarding efficiency’s? Is Jack right to think that low debt levels give WetSuits flexibility that a fast growing company must have? What other reason might be behind the low levels of debt employed by WetSuits?

With regard to efficiency, there is no real reason for the concern regarding the efficiency of Wetsuits because the company is able to meet the demands of its customers as well as manage the competition within the industry within which exists (Donegan, 2002). The only issue that may be is thought to be a reason to cause concern about the efficiency of the company is the low debt levels, which should not be a major concern. In regard to the opinion that Jack holds that the low debt levels help to give the much needed flexibility for Wetsuits which is still a growing company is right. Companies that are still in the stages of growth do not need higher debt levels because this will put them at greater risks as a result of a lot of debts which it may not be able to handle in the long run (Donegan, 2002).

The other reason that might be behind the low debt levels employed by Wetsuits is because of the image of the company. A company that has low debt levels is capable of attracting more shareholders as this makes their securities or shares in the stock market to be of great value hence attractive to potential investors. Many investors do not prefer high risk investments which in most cases is associated with high debt levels (Donegan, 2002). Therefore, the low debt levels employed by Wetsuits are to attract investors to buy the shares of the company.

Question 4

A discussion of the cost of capital minimisation and firm maximisation objectives. Under what conditions are they equivalent for Wetsuits? Support your answer with theoretical arguments.

Cost of capital minimisation simply refers to the reduction in the expenses which are related to the amount of capital invested in any business. This is always done to ensure lower unit costs, increase the profit margin of the company, increase the operating profits of the company, and improve the cash flow of the company (Mayo, 2011).

Costs always affects the profits of any company even the cash flow hence cost of capital minimisation will help to improve the profits. The maximisation objective is to maximise the profits of the company which are directly affected by the costs involved in the company (Duffhues, & Renneboog, 2006). The cost of capital minimisation and the firm maximisation objectives will be equivalent when the amount of products supplied by this company is higher while the unit cost of the production is lower, or simply when the marginal costs of Wetsuits is equivalent to the marginal revenue (Mayo, 2011). According to the standard theory, it is assumed that company will always have the sufficient information about the market as well as the market power that will enable it to set its prices, reduce its capital costs hence maximise its objectives and minimise its capital costs.

Question 5

A discussion as to why financing by retained earnings is the most preferred source of funds.  Please include academic references as necessary.

Is Noel right to think that borrowing short term and rolling it over to invest in long term fixed assets and a marketing campaign is the right strategy? Why Jack thinks equity is safer than debt when interest payments are guaranteed but dividends are not?

Retained earnings simply refer to the percentage of the total net earnings of a given company which are not issued out to shareholders as form of dividends. These are earnings which the company retains so that it can be able to reinvest in other projects of the company to generate more income for the company. Furthermore, retained earnings may be used to pay debts instead of reinvesting in other projects.

From research which has been previous conducted, it is observed that retained earnings as a source of funds for any business are of great advantage and preferred by many companies because for one, the retained earnings do not increase or add up the debt levels of the company. This is because the company does not have to borrow funds from any institution or shareholders hence reduce its debt levels which are quite important for any company. In case of any problems, the company will not have a lot of debts to settle since it was using retained earnings to finance its projects (Duffhues, & Renneboog, 2006).

The other reason why retained earnings are preferred choice of the source of funding for the projects of the company is because retained earnings do not deplete the profits of the company in terms of the interests to be paid out as in the case of borrowed funds. This is important because it allows full control of the business rather than having creditors, new partners or even outside investors to be involved in the operations of the business. In the case of Noel, he is not right because short term borrowing always comes with higher interest rates which must be paid on due dates.

Purchasing long term assets with short term borrowing will not generate any cash that may be used in repaying the interests involved in the short term debts (Mayo, 2011). On marketing strategy, that may be advisable because every company needs to market itself and its products so that it can be able to reach the market which it has not yet obtained. Marketing strategies help to increase the market share of any company hence it is a good idea. In the case of Jack, equity is safer because the dividends are only payable when the company makes profits unlike the funds from debts which involve interests (Ryan, 2007). Interests are always payable whether a company makes profits or not hence it is quite risky to have finances from sources where interest is involved.

Question 6

A discussion of the reasons why they think equity is safer then debt when interest payments are guaranteed but dividend is not. A discussion of the options Wetsuits has to make the interest payments affordable if it decides to finance this project by debt

Equity is thought to be safer for Wetsuits because when the company finances its projects using equity it does not have to repay the equity. Dividends under equity are not a must to be paid out especially when the company does not make profit hence it does not face the risk of closer as a result of creditors demanding for their payments (Damodaran, 2011).

The other reason is that since the cash generated may not be necessarily used to make repayments, the cash can be reinvested in the company to grow or invest in other new projects that will generate more cash for the company. When the company is able to maintain a low debt-to-equity ratio, it stands a greater chance of obtaining loans at a future date when the need arises (Mayo, 2011).

In the case of debt, the interests must be paid whenever they are due.  Failure to repay the debt and the interest involved puts the company at risk of losing its assets as a result of repossession by the financial institution. Debt involves borrowing funds against the future earnings of the company. This means that instead of using the realized profits for growth, the company will be forced to use it to repay debts which should not be the case. Debts also limit the cash flow of the company in addition to preventing or minimising the growth of the company to higher levels (Mayo, 2011).

To make the interests affordable in case the company decides to use debts for financing, Wetsuits needs to borrow long term loans instead of short term so that it can have a lot of time to repay as well as pay interests at reduced rates. Short term loans hold higher interest rates since they have to be repaid within a short period unlike long term.

Question 7

What is the impact on the WACC depending on the type of finance they decide and why? A discussion on Jacks opinion that WetSuits share price will decrease if they go ahead with the rights issue.

In case the company opts to finance its operations using debt borrowing, the higher the cost of debt the lower the WACC of the company. This means that when the company increases its cost of debt, then the WACC of the company will decrease. Furthermore, financing the company using debt affects the WACC and increases the value f the company more than when the company is financed through equity.

Calculation of WACC

The formula for estimating WACC:

WACC = (1-t) * Kd * D/(E+D) + Ke * E/(E+D)

Where:

t – Tax rate

Kd – cost of debt financing

Ke – cost of equity

D – Value of debt financing

E – Value of equity

Kd =5%; Ke=8%; D=6,000,000; E=12,000,000; t=30%

WACC= (1-0.3)*5.6*6,000,000/ (12,000,000+6,000,000) + 5.5*12,000,000/ (12,000,000+6,000,000) hence the WACC=4.98%.

This shows that with increase or higher cost of debt, the WACC of the company increases. It is assumed that the corporate tax rate is 30%, while all the other factors remain constant.

References

Damodaran, A. (2011). Applied corporate finance. Hoboken, NJ: John Wiley & Sons.

Donegan, M. C. (2002). Growth and Profitability: Optimizing the Finance Function for Small   and Emerging Businesses. New York, NY: John Wiley & Sons.

Duffhues, P., & Renneboog, L. (2006). Advances in corporate finance and asset pricing:            [this book is in the honour of Professor Dr. Piet Duffhues]. Amsterdam [u.a.:       Elsevier.

Mayo, H. B. (2011). Investments: An introduction. Mason, OH: South-Western, Cengage         Learning.

Ryan, B. (2007). Corporate finance and valuation. London: Thomson Learning.

Yescombe, E. R. (2007). Public-private partnerships: Principles of policy and finance.     Amsterdam: Elsevier.

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