Sample Weighted Average Cost of Capital (WACC) and Capital Structure Analysis Altium Ltd
WACC and Capital Structure Analysis 1
II. Weighted Average Cost of Capital 3
(i) Computation of cost of equity 4
(iii) Calculation of weights 6
IV. Findings with reference to capital structure theory 10
Introduction
Altium Ltd is a software company which designs PCbased softwares for the electronic items. It was established in 1985 in Australia and was known as Protel International. In 1999 the company got listed in Australian Stock Exchange (ASX). In 2001 its name was changed to Altium Ltd. Over a period of 30 years, the company has become one of the market leaders in designing PC based software.
The present report aims to calculate and evaluate the weighted average cost of capital of Altium Ltd followed by discussion on steps involved and the judgments made while calculating it.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) is a widely used approach used by companies to estimate the expected rate of return on the company investment (Queensland Government Treasury, 2006). It is the minimum rate of return expected by shareholders of the company. It computes the total cost of company by considering the after tax cost of debt and cost of equity and weighing these costs either on the basis of their book value or market value. It is an important tool which is used by companies at the time of selection of viable projects (Davis, 2002). It is used as benchmark against which the return of projects is compared. The formula for calculating WACC is as follows:
WACC = R_{e}* E/V + R_{d}*(1T)*(D/V)
Where:
R_{e} = Cost of equity
R_{d }= Cost of debt
D = Value of Debt
E = Value of Equity
V = Total capital employed
T = Corporate Tax rate
The steps involved in the computation of weighted average cost capital of Altium Ltd. along with the assumptions made are given below:
Computation of cost of equity
It is the first step in WACC computation. Cost of equity is the minimum rate of return expected by the shareholders for the risk taken by making investment in shares of the company. There are number of methods to compute cost of equity but Capital Asset Pricing Method (CAPM) is the widely used method. The CAPM method is based on the assumption that by making investment in shares of company, an investor takes risk. So he must get an additional return as a compensation for the additional risk undertaken. The cost of equity is a function of risk free return rate plus risk premium scaled by the beta of concerned security.
R_{e }= R_{f} + β*MRP
Where Re = Cost of equity
Rf = Risk free return rate
MRP= Market risk premium
Β = Beta of security.
 Risk free rate: It is the rate of return which is earned on the investments with zero risk. The investment in government bonds is totally risk free therefore the return on such bonds is used as a proxy for risk free return rate (KPMG, 2004). For determining the cost of equity of Altium Ltd., the rate of yield on 10 years’s government bond has been used as risk free return rate which was 2.01% as on 30^{th} June 2016 and 3.06% as 0n 30^{th} June 2015 (Reserve Bank of Australia, 2016).
 Market risk premium: It is one of the important inputs of CAPM model used for calculating the cost of equity. Being a future oriented model, CAPM suggests what equity investors should be paid as a compensation for the risk taken by them. The past analysis depicts that the market risk premium ranges from 6%8%. The Australian regulatory authorities have recommended using 6% market return for the calculation of WACC (Queensland Government Treasury, 2006). One of the recent Australian studies has considered 6% MRP as too low and has recommended using 7% as MRP (Australia Post, 2015). For the purpose of computation of WACC of Altium Ltd. 7% MRP has been used.
 Beta: It represents the proportionate change in market price of equity as a result of change in Index. The Beta of Altium Ltd is 0.51 as on 30^{th} June 2016 and 0.235 as on 30^{th} June 2015 (Yahoo Finance, 2017). It has been calculated after establishing historical relationship between stock returns and market returns also shows the same value (Details given in excel sheet). It shows that for every change in market index, there is 51% variation in share price of Altium Ltd in 2016 and 24% in 2015.
The computation of cost of equity is given in table 1.
Table1: Cost of Equity
Cost of Equity (CAPM Model)  2016  2015 
Risk free rate  2.01%  3.06% 
Beta  0.515  0.235 
Market Premium  7.00%  7.00% 
Cost of Equity  5.62%  4.70% 
The cost of equity is high in 2016 as compared to 2015. The reason is obviously high beta in 2016. High beta means high risk and therefore equity shareholders need to be compensated more in 2016 as compared to 2015.
Cost of Debt
The next step is computation of cost of debt. It is computed by dividing the interest paid on borrowings with the value of interest bearing borrowings. In case of Altium Ltd., the cost of debt is mentioned in annual report so this rate has been taken as it is. It is 7.31% in 2016 and 9.16% in 2015 (Altium Ltd, 2016). It is the before tax cost of debt. Since interest paid on debts is allowed as tax deduction so it reduces the overall cost of debt. So this interest rate has been adjusted with corporate tax rate which is 30%.
2016 R_{d }(after tax) = 7.31% * (130%) = 5.12%
2015 R_{d }(after tax)= 9.16%*(130%)= 6.41%
Calculation of weights
The cost of debt and equity is multiplied with their respective weights to compute WACC. These weights can be taken either on the basis of market value or book value. In case of Altium Ltd., weights have been calculated on the basis of book value as given below table 2 and 3.
Table 2: Calculation of Weights (2016)  
W1  Book Value of Equity  130795000  99.95% 
W2  Book Value of Debt  71000  0.05% 
Total Book Value of Firm  130866000  100% 
Table 3: Calculation of Weights (2015)  
W1  Book Value of Equity  121602000  99.91% 
W2  Book Value of Debt  113000  0.09% 
Total Book Value of Firm  121715000  100% 
Calculation of WACC
The WACC of Altium Ltd is given as below in table 4 and 5.
Table 4: Calculation of WACC (2016)  
Weights  Cost (%)  Weighted Cost  
Debt  0.05%  5.12%  0.003% 
Equity  99.95%  5.62%  5.613% 
WACC  5.616% 
Table 5: Calculation of WACC (2015)  
Weights  Cost (%)  Weighted Cost  
Debt  0.09%  6.40%  0.006% 
Equity  99.91%  4.70%  4.696% 
WACC  4.702% 
The above tables show that in 2016, cost of debt of Altium Ltd is 5.12% and cost of equity is 5.62%. The WACC is 5.61% and in 2015, cost of debt is 6.4%, cost of equity is 4.7% and WACC is 4.70%.
Gearing Ratios
Gearing, also known as leverage, measures the degree of funding of operations of an organizations by borrowed funds and owned capital. It is calculated by dividing the borrowed funds of company with the total capitalization. This ratio is an indicator of financial risk to which an organization is subject to (Davis, 2002). High ratio means the proportion of debt is more in the total capitalization and low ratio means low debt proportion in total capitalization. High leverage poses high level of financial risk as excessive debt can put an organization into the financial problems due to obligations of periodic interest payment and repayment of principle amount. Low gearing ratio indicates conservative policy of management who is trying to avoid financial risk and is also not able to take the benefit of trading on equity. Sometimes low gearing ratio is advisable in certain situations or industries like in case of cyclical industry where revenues are high during the times of economic prosperity and low when there is downturn. The companies in such case can’t take the risk of raising debt as during their business contraction; they may be unable to fulfill their obligations related to interest payment and principle. The formula for calculating gearing ratio is
Gearing Ratio = Borrowed funds
Borrowed funds + Equity
The Gearing ratio of Altium Ltd. on the basis of book value and market value is given as below:
Based on Book Values Capital Structure is  
Jun16  Jun15  
Debt to Total Assets  0.05%  0.09% 
1 Debt to Total Assets  99.95%  99.91% 
Based on Market Values Capital Structure is  
Jun16  Jun15  
Debt to Value Ratio  0.01%  0.02% 
1Debt to Value Ratio  99.99%  99.98% 
Another approach of computing gearing ratio is the interest coverage ratio which provides information regarding capacity of an organization to generate enough profits to provide coverage for interest payments.
Interest coverage ratio = Earnings before interest and tax
Interest Charges
Interest Coverage Ratio  
Jun16  Jun15  
Interest Coverage Ratio  4757  2067 
Difficulties in computation of gearing ratio
 The gearing ratio of company calculated on the basis of market value has one limitation. The market value of shares was possible to calculate as market value of share was available but debts have been taken at book value as the market value of borrowings is not available. So market value of debt has been assumed to be equal to book value.
 The weighted average interest rate of debt has been taken from the annual report of company. It is 7.31% in 2016 and 9.16% in 2015 (Altium Ltd, 2016). The interest rates have been multiplied with the total borrowings (current as well as noncurrent leases) to arrive at the value of interest charges since the individual interest rates are not given.
Findings with reference to capital structure theory
The computation of WACC and gearing ratio as given above exhibit the following points related to capital structure of Altium Ltd.
 The company is almost debt free in both years as the amount of debt is almost negligible. The policy of company is to maintain clean balance sheet. The proportion of debt in the total capital employed is ranging from 0.05% to 0.09% in 2015 and 2016. The company is not taking the benefit of leverage or trading on equity.
 Due to low amount of debts, the financial risk is almost equal to nil value and it increases the scope of borrowing funds whenever company needs to exploit the profitable opportunity.
 The debt is 0.01% of the firm value in 2016 and 0.02% of firm value in 2015 while the benchmark of the industry is 25% (Capitalcube, 2016). The interest coverage ratio is 2067 times in 2015 which has increased to 4757 times in 2016. The company can borrow funds quickly. The company can be classified as quick and able in terms of its financial and operating capacity to raise funds whenever required.
 The WACC is high in 2016 as compared to 2015. The obvious reason for this is the beta value which is high in 2016 as compared to 2015. High beta denotes high risk and therefore the shareholders need to be compensated more for taking the more risk. Though the debt level is high in 2015 but it has not been able to have any impact upon the WACC of company due to its very low proportion.
Recommendations
Though the company is doing well in terms of its operating position, financial position and profitability position but the board of directors should adopt an optimal capital structure and include debts in it. Since the interest paid upon debts is a tax deductible expense, so company can increase its earnings per share by increasing its gearing ratio. It should take the benefits of trading on equity and improve its position further.
References
Altium Ltd. (2016). Annual Report . New South Wales: Altium Ltd.
Australia Post. (2015). Assessment of WACC Parameters for Australian Post and Reserved Letters Business as at 23rd July 2015. Melbourne.
Capitalcube. (2016, December 6). http://www.capitalcube.com. Retrieved January 22, 2017, from http://www.capitalcube.com: http://www.capitalcube.com/blog/index.php/altiumltdvalueanalysisasxaludecember62016/
Davis, K. (2002). Measuring the Cost of Capital Some Lessons from Access Pricing Regulation. Melbourne: Finance and Treasury Association.
Kaplan Financial Knowledge Bank. (2012). http://kfknowledgebank.kaplan.co.uk. Retrieved January 2017, from http://kfknowledgebank.kaplan.co.uk: http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Acca%20F3%20Chapter%2020v2.aspx
KPMG. (2004). WACC of Alinta networks. Perth.
Queensland Government Treasury. (2006, February). https://www.treasury.qld.gov.au. Retrieved January 2017, from https://www.treasury.qld.gov.au: https://www.treasury.qld.gov.au/publicationsresources/services/governmentownedbusinesses/documents/costofcapitalprinciplespaper.pdf
Reserve Bank of Australia. (2016). http://www.rba.gov.au. Retrieved 2017, from http://www.rba.gov.au: http://www.rba.gov.au/chartpack/interestrates.html
Yahoo Finance. (2017). https://au.finance.yahoo.com. Retrieved January 22, 2017, from https://au.finance.yahoo.com: https://au.finance.yahoo.com/q?s=ALU.AX
Appendices

 Beta Computation
2016
Regression Statistics  
Multiple R  0.258226  
R Square  0.066681  
Adjusted R Square  0.063063  
Standard Error  0.022054  
Observations  260  
ANOVA  
Df  SS  MS  F  Significance F  
Regression  1  0.008965  0.008965  18.43274  2.49E05  
Residual  258  0.125483  0.000486  
Total  259  0.134448  
Coefficients  Standard Error  t Stat  Pvalue  Lower 95%  Upper 95%  Lower 95.0%  Upper 95.0%  
Intercept  0.001913  0.001368  1.398308  0.163221  0.00078  0.004606  0.00078  0.004606 
X Variable 1  0.515459  0.12006  4.293336  2.49E05  0.279036  0.751882  0.279036  0.751882 
2015
Regression Statistics  
Multiple R  0.08805283  
R Square  0.007753301  
Adjusted R Square  0.003907383  
Standard Error  0.020543955  
Observations  260  
ANOVA  
df  SS  MS  F  Significance F  
Regression  1  0.000851  0.000851  2.015982  0.156857704  
Residual  258  0.10889  0.000422  
Total  259  0.109741  
Coefficients  Standard Error  t Stat  Pvalue  Lower 95%  Upper 95%  Lower 95.0%  Upper 95.0%  
Intercept  0.002546886  0.001274  1.998864  0.046672  3.77954E05  0.005055976  3.77954E05  0.005056 
X Variable 1  0.234905687  0.165444  1.419853  0.156858  0.090886244  0.560697618  0.090886244  0.560698 

 Calculations related to Capital Structure Analysis
Jun16  Jun15  
EBIT  24688000  21396000 
Interest  5190  10351 
Cost of Debt  7.31%  9.16% 
Cost of Debt (after Tax)  5.12%  6.41% 
Interest Bearing Debts  71000  113000 
Total Assets  196372000  171572000 
Total Liabilities  65577000  49970000 
Total Equity  130795000  121602000 
Number of Shares  130215813  129272762 
Share price  6.46  4.64 
Market Capitalization  841194152  599825616 