Cost of Capital, Risk and Returns

QUESTION: You are considering two investment options. In option A, you have to invest………..

SOLUTION>>>>>

Introduction

According to Ismal (2010), the risks and returns are highly related. It has always been argued that there is no promise of high returns with low risks. However, measuring the risk may be challenging. In most cases, the financial experts have equated risks with the volatility of the market. However, others also measure the risks with the cost of capital since it is directly linked to the expected returns. For example, the interest rate the company offers in the bond market on its bonds constitute the company’s cost of capital and the bond buyers expected return. Therefore, the higher the risk, the higher the cost of capital, and subsequently the higher the expected returns (Rashid, 2014). This relationship also applies when comparing stocks and the expected returns from such stocks. The amount of capital raised from the issuance of bonds comes at a lower cost for the organization than the capital raised by issuing stocks. This happens because the investors usually demand greater expected returns from stocks than from bonds with the aim of compensating for uncertainty of payoff. The startups companied are usually at high risk than big companies and properly established companies. The expected returns also differ from the value companies and the growth companies. In order to attract the needed capital, value companies are forced to offer more attractive expected returns.

According to Sadique (2015), the tradeoff usually exists between the risk and the returns. Investors would not take additional risks, unless they expect to be compensated with additional returns from the risk they are taking. The low levels of certainty translate to low levels or risks. On the other hand, high levels or uncertainty are linked with high expected results. Therefore, the rational investors have to choose from the risk-return tradeoff between any available investment options. It follows than an investor will take on increased risk provided it has high returns.

Description of Terms

Equity: In simple terms, equity is described as the value of assets less the value of total liabilities on the asset. This is mathematically represented as: Equity = Assets – Liabilities (Zhu & Wang, 2013). However, a company can own several types of assets and this may somehow alter the meaning of equity. In terms of stocks, equity may be represented by a stock or other security that represents an ownership of interest. In the company’s balance sheet or statement of financial position, equity may be represented by the funds contributed by the owners in addition to the retained earnings (losses). This is also known as the shareholders’ equity. The financial experts consider equity to be important since it represents the value of one’s stake in an investment. Royal bank of Scotland is one of the known banks that successfully financed their expansion through equity financing.

Preference shares: The people who hold preference shares are known to hold the preferred stock (Zhu & Wang, 2013). They represent the shares of the company’s stock with dividends that are first issued before the issuance of the common stock dividends. In this regard, the shareholders with preferred shares are entitled to be paid first from the company’s assets before other shareholders are paid. Unlike the common stocks, the preference shares are associated with a fixed dividend.

The preference shares are of great significance to investors as they provide an alternative for risk-averse equity investors. Compared to the common shares, the preference shares are less volatile and they provide the risk-averse investors with a steady flow of dividends. On the same note, the preference shares are callable as they can easily be redeemed any time.

Convertible loan stock: These are unique type of debt and equity that provide the investors with the opportunity to convert a debt instrument into shares at a set price and a set date (Zhu & Wang, 2013). The company’s share price performance may trigger the shareholders to convert their debt instrument into shares. The convertible bondholders get new stocks in the form of securities, leading to possible dilutions of the ownership percentage of the current shareholders.

Redeemable debentures: This is basically the agreement that a company issues as an agreement to repay the borrowed amount after a certain period of time. After the completion of the stated time, the principal amount borrowed will be paid to the debenture holders through the redemption of the debentures. 

Capitalization issue: This is the issue of new shares to the existing shareholders of the company in relation to their existing shareholding (Ariffin, Kassim, & Razak, 2015). Under this arrangement, the shareholders do not need to pay for the new shares received.

Earnings per Share (EPS): It represents the amount of company’s profit that that can be allocated to one share of its stock (Ariffin, Kassim, & Razak, 2015). The basic EPS takes care of the net income minus the preferred dividends divided by the weighted average number of shares of common stock for the said period (Marciukaityte & Szewczyk, 2011). On the other hand, the diluted number of shares does not utilize the number of shares outstanding. Instead, it uses the number of possible shares outstanding because most companies have issued convertible securities such as the stock options.

Usually, the stocks trade on multiple earnings per share such that the rise in the basic EPS can cause the prices of the stocks to appreciate in line with the company’s increased earnings per share basis. However, the increased basic EPS does not necessarily imply that the company is generating more earning on a gross basis. It is possible for companies to buy back shares, decrease their share counts and spread their net income over a few common shares.

The number and the value of shares matter so much for the shareholders of the company. If the company decides to issue more shares, then proportional claim on the company’s earnings would eventually shrinks. Issuing a lot of stock options can have a dilutive effect on the shares when the options are explored. However, it may not be that bad if the shares being issued are used to explore more lucrative investment opportunities.

Case Study

The directors of the Euro-American Corporation decided to replace most of their existing plant and machinery that are obsolete. An automated plant has been proposed and the cost of removing the existing plant and acquiring and installing a new automated plant is estimated at $60,000,000. There are two options for financing the acquisition: Proposal A and Proposal B.

Consideration of the options  

Option A

Amount of cash raised

1st January; 40,000,000 x 0.5 = £20,000,000

1st July; 6/12 x 40,000,000 x 0.5 = £10,000,000

Capitalization issue = 1/8 x 75,000,000 = £9,375,000

Total raised = £39,375,000

 

Earnings per share

                                                                        £

Profit before tax                                              25,100,000

Less income tax expense                                 (7,530,000)

Profit for the year                                           17,570,000

Less preference dividends                              (10,000,000)

Earnings                                                          7,570,000

Earnings per share                                           7,570,000/40,000,000

                                                                        = 18.9c

Option B

Cash raised

1st April, ¾ x 20,000,000 x 0.5 = £7,500,000

Convertible loan = £30,000,000

Total raised =£37,500,000

 

The max number of shares in which the loan stock could be converted is 94% x 30,000,000 = 28,200,000.

The shares in issue 20,000,000 + 28,200,000 = 48,200,000

The revised earnings would be:

                                                                                                £                      £

Earnings per share                                                                                           7,570,000

Interest saved by conversion (6% x 30,000,000)                    1,800,000

Less attributable tax (1,800,000 x 30%)                                 (540,000)

                                                                                                            1,260,000

                                                                                                            6,310,000

 

Diluted EPS =                                     6,310,000/48,200,000 = 0. 131 or 13.1c        

EPS;                            7,570,000/48,200,000 = 0.157 or 15.7c

 

Analysis

Based on the above report, it is evident that the Euro-American Corporation will raise different levels of capital from the two options. In option A, they will raise a total of £39,375,000. In option B, the company will raise a total of £37,500,000. Therefore, the company is likely to raise more capital under option A, than option B. In terms of equity, Option A will enable the Euro-American Corporation to have more equity than option B. More equity is for the company, considering that they plan to acquire new component that is worth millions of euros.

In terms of earning per share, option A gives more EPS than option B. Therefore, the shareholders are likely to benefit from option A. More EPS is beneficial for both the management and the shareholders. More EPS gives the shares the value it deserves and this makes the shareholders to earn more for every shareholding in the company. Option B gives a relatively low EPS and this will imply that the investors will have to earn a relatively low amount of money from their investment. On the same note, option B tends to dilute the EPS of the shareholders. When the EPS is diluted, it implies that the worth of shareholding in the company is reduced. Therefore, it will be a bad news for the shareholders if they learn that the process of obtaining the new equipment acquisition has diluted their shareholding.

The shareholders with preferred stock are likely to benefit with option A since their stocks will face less dilution. In addition, the acquisition of the new equipment will give them more advantage during the issuance of the common stock dividends. The preferred stock holders will have a better alternative for risk-averse equity investors with option A than option B.

On the other hand, the 6% convertible loan stock for option B is likely to dilute the ownership percentage of the current shareholders. Option B opens more opportunity for more shareholdings in the company. However, this will dilute the shareholding of the current investments. The shareholders will not be happy with any option that dilutes their shareholdings. On the same note, the 1 for 8 capitalization issue for the existing members will not have a profound effect of the value of their shareholding. Therefore, Option A stands out as the best option that Euro-American Corporation should use to fund their acquisition.

References

Ariffin, N.M., Kassim, S.H. & Razak, D.A. 2015, “Exploring Application of Equity-Based Financing Through Musharakah Mutanaqisah in Islamic Banks In Malaysia: Perspective From The Industry Players”, International Journal of Economics, Management and Accounting, vol. 23, no. 2, pp. 241-261.

Ismal, R. 2010, “Volatility of the returns and expected losses of Islamic bank financing”, International Journal of Islamic and Middle Eastern Finance and Management, vol. 3, no. 3, pp. 267-279.

Marciukaityte, D. & Szewczyk, S.H. 2011, “Financing Decisions and Discretionary Accruals: Managerial Manipulation or Managerial Overoptimism”, Review of Behavioral Finance, vol. 3, no. 2, pp. 91-114.

Rashid, A. 2014, “Firm external financing decisions: explaining the role of risks”, Managerial Finance, vol. 40, no. 1, pp. 97-116.

Sadique, M.A. 2015, “Application of Profit and Loss Sharing Modes In Trade Financing For Small-Scale Businesses: An Alternative To Debt Based Financing”, IIUM Law Journal, vol. 23, no. 1, pp. 175-189.

Zhu, W. & Wang, Z. 2013, “Equity financing constraints and corporate capital structure: a model”, China Finance Review International, vol. 3, no. 4, pp. 322-339.