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Sample Weighted Average Cost of Capital (WACC) and Capital Structure Analysis Altium Ltd

Contents

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WACC and Capital Structure Analysis 1

Contents 2

I. Introduction 3

II. Weighted Average Cost of Capital 3

(i) Computation of cost of equity 4

(ii) Cost of Debt 6

(iii) Calculation of weights 6

(iv) Calculation of WACC 7

III. Gearing Ratios 8

IV. Findings with reference to capital structure theory 10

V. Recommendations 11

References 11

Appendices 12

# Introduction

Altium Ltd is a software company which designs PC-based 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 = Re* E/V + Rd*(1-T)*(D/V)

Where:

Re = Cost of equity

Rd = 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.

Re = Rf + β*MRP

Where Re = Cost of equity

Rf = Risk free return rate

Β = Beta of security.

1. 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 30th June 2016 and 3.06% as 0n 30th June 2015 (Reserve Bank of Australia, 2016).
2. 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.
3. 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 30th June 2016 and 0.235 as on 30th 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- Rd (after tax) = 7.31% * (1-30%) = 5.12%

2015- Rd (after tax)= 9.16%*(1-30%)= 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 Jun-16 Jun-15 Debt to Total Assets 0.05% 0.09% 1- Debt to Total Assets 99.95% 99.91% Based on Market Values Capital Structure is Jun-16 Jun-15 Debt to Value Ratio 0.01% 0.02% 1-Debt 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 Jun-16 Jun-15 Interest Coverage Ratio 4757 2067

Difficulties in computation of gearing ratio

1. 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.
2. 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 non-current 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.