Cost of Capital Estimation Electrocomponents and James Fisher & Sons Plcs

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Equation 3.0: Cost of Debt Electrocomponents PLC

Before taxes, the cost of debt would have been 3.6% (calculations for follow in 3.2.2). According to UK GAAP, Electrocomponents’ interest payments were tax deductible therefore we considered the after tax cost of debt of 2.26% more suitable for estimating the project’s WACC. 4[pic 13]

3.2.2 Corporate Tax Rate

Effective tax rate, = 37.25%[pic 14]

Tax was found to be a subjective matter, especially because firm A paid taxes in several jurisdictions. Considering information in its Annual Report, Electrocomponents had sales in countries across all continents; each with their own tax treatments. Therefore we used the ‘effective tax rate’ as calculated by Equation 4.0. This figure gave a more effective representation of all the different types of taxes paid.

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Equation 4.0 Effective Tax Rate

On its 2016 Annual Report, Electrocomponents PLC actually reported a tax charge of £21.4m. However, there was a tax-credit of £8.4m added during the 2015-16 reporting period. This in effect reduced their paid tax-charges to just £13m. The profit before tax of £34m was a top-line figure, which could be taken as inspected. The overall future tax liability may however be different to the present, and consequently the effective tax rate would be affected. Several possibilities arise to such matter, one of which is transfer pricing rules and regulations. Recently in 2015, the emergence of FRS102 has implemented a major restructuring of financial reporting standards.

4 Notes

a) The £208.1m value for average interest bearing obligations was the average total amount of loans from 31/4/2015 to 31/4/2016. This was the period that the total interest payments at 31/4/2016 (balance sheet) related to. It was calculated as followed: (£210.8m+£205.4m)/2=£208.1m.

b) Figures sourced from p84, Electrocomponents’ 2016 Annual Report.

3.3 UK Rate Estimations

3.3.1 Risk-free Rate, [pic 17]

Selected Customized 6-Year UK-Gilt Index = 0.16%[pic 18]

Because we are assessing UK headquartered and listed, firms; we chose the UK Gilt as a suitable risk-free investment. Typically, the 3-month-Treasury is used as the because it has the shortest investment horizon and lowest risk. However, as we are estimating the cost of capital on a 6-year project, this was deemed to short-term therefore an alternative measure was required.[pic 19]

The Debt Management Office (DMO), a function of HM Treasury, regularly releases information on the UK’s bond market. Although the data was plentiful, we faced challenges in the sense that there was no such security as a 6-year Gilt to be auctioned in the near future. Additionally there were no gilts, already issued, that expired exactly when we expected our project to complete. Consequently, we decided that a more accurate approach of estimating would be through synthesizing it, by engineering a portfolio of gilts with similar expiry profiles. The constituents of our bond portfolio were illustrated in Table 2.0. [pic 20]

Gilt

Coupon (%)

Maturity Date

Yield (%)

RIC

A

1.75

09-July-22

0.84

GB00B7L9SL19

B

0.5

22-July-22

0.876

GB00BD0PCK97

C

2.25

07-Sep-23

1.023

GB00BD0PCK97

Table 2.0: Gilt Portfolio Constituents

Our project completion target was June-2023. Bonds A, and B expired approximately 9 months, and bond C, just three months from this date. Consequently, C was given more weight in our portfolio; see Equation 5.0.

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Equation 5.0 Rf Portfolio

This portfolio represented a risk-free redemption yield of 0.968% assuming an investment horizon of 6-years, holding all bonds until redemption. Because the WACC required an estimation of over a single year, an adjustment to this figure was required and calculated in Equation 6.0.[pic 22]

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Equation 6.0: Calculation of Rf

When calculating all values used where checked to take into account inflation, and the time value of money. This was to ensure that our estimate reflected ‘real’ terms as closely as possible. Although, it could be argued that government bond yields changed often. For this a sensitivity analysis was conducted in 5.0.[pic 25]

3.3.2 Equity Premium

Selected Equity Premium: Geometric mean of market returns- = 6.95%[pic 26]

The equity premium was defined and calculated in Equation 6.0. This value represented part of the CAPM (4.0), and was required to calculate the required return on equity for Electrocomponents’ investment project.

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Equation 7.0: Equity premium

Note that the estimated market return required estimation in itself. For this, the yearly returns of the FTSE250 index were subjected to further analysis in Microsoft Excel. The average yearly returns were calculated and then their geometric mean