the cost of capital estimation

The cost of capital is the fee levied on the sum of money (debt and capital) used to operate a company. The cost of capital is determined by the type of borrowing used by a business; it corresponds to the cost of debt if the company is entirely funded by debt, or the cost of equity if the company is entirely financed by equity (Alexander & Nobes, 2016, p. 21). Many institutions use a blend of equity and debt. The main reason why institutions raise any form of capital is to invest in various projects with the intention of generating profits. Also, out of the generated funds, the firm ends up incurring dividends and interest to the source of capital. The sum of money that is paid as either dividend or interest is regarded as the cost of capital. All the business investments for instance in equipment, machinery, and factor require capital. The funds can be generated internally through equity or from the owner’s financial resources.

The computation of takes into account various sources of funds: the cost of debt, cost of preference shareholder, the cost of equity share capital. The preferential shareholders are entitled to a fixed rate of dividends on the invested capital (Armitage, 2005, p. 11). The cost of equity is the gain that ordinary shareholders expect to receive after investing in a particular company. Equity owners invest money with the hope that they will receive dividend after a certain period. The number of dividends received can be earning per share and dividend per share. The weighted average cost of capital is usually the overall charge of capital that entailed different sources of funds.

Method of Estimating Cost of Capital

The cost of capital can be appraised expending two distinct methods: the capital asset pricing model (CAPM) and the fundamental analysis theory (Pandey, 2015, p. 16). Model is used to estimate the return for any risky asset. The capital asset pricing model (CAMP) depends on various assumptions. The model assumes that the quantities of financial assets that are given are fixed, the investor's activities can be influenced but the market, there are no tax rates, and the market includes no transaction costs. The CAPM model also assumes that investors can borrow or lend out money at zero risk rate, the main objective of investors is to maximise the rate of return they receive. Investments projects are usually selected based on the expected return as well as the standard deviation (Pandey, 2015, p. 37). It’s obvious that all the stated assumption are not valid in the real world, but CAPM is an effective method because the estimated cost can be adjusted to incorporate some of the assumptions. The CAPM method assumes that investors are to be compensated based on time value of money concept. The risk-free rate the yield that bonds are expected to generates while the time value of money is the difference between the current investment and the future investment (Alexander & Nobes, 2016, p. 23). If the required return is greater than the expected return, then the investment should be abandoned. CAPM is primarily used in calculating the cost of capital, generating the returns on a specific asset given a specific risk and in the pricing of the risky securities.

The fundamental analysis theory is another method that is used to estimate the cost of capital. The fundamental analysis method attempts to measure the intrinsic value by examining the quantitative, qualitative, financial, and economic related factors (MacLean & Ziemba, 2013, p. 14). The method determines the health performance of a particular firm by looking at the economic indicators and key numbers. The fundamental analysis theory aims at finding the fundamentally weak and strong companies within the industry. The most significant part of the model is delving into the financial statement; this looks at the liabilities, assets, expenses and revenue and all other financial aspects of the company. The model looks at the insight of the company’s future performance. The fundamentals include the quantitative and qualitative information that contributes to the well-being and subsequent valuation of the firm’s currency, security, and company (Towler & Sinnott, 2013, p. 32). The investors and analysts rely on the model to determine whether a particular asset worth their investments. For example, a company’s information such as growth, liabilities, assets, and earning are some of the fundamentals. The fundamental analysis is performed using the present and the historical data, but its primary goal is usually to make financial forecast (Turf, 2014, p. 26). There are numerous objectives of fundamental analysis that includes finding out the intrinsic value of the share, to evaluate the management and make viable business decisions, to make projections on its business performance, to predict the probable price evolution and conduct company’s stock valuation. When analysing stock using this model there are two methods: the top-down approach and the bottom-up analysis (MacLean & Ziemba, 2013, p. 21). The method is easier to calculate, provide the minimum value and is readily available.

Cost of Equity

B&M European Value Retail AS’s is the weighted cost of capital is missing. The financial information doesn’t have the beta factor making it impossible to estimate the cost of equity.

The cost of debt

The cost of debt

2017

2016

Interest on debt and borrowing

(17446)

(19325)

The ongoing amortization

(1381)

(1384)

The finance charges

(23)

(14)

Cost incurred in raising the debt equity

(3687)

(1573)



(723)

The total cost of debt

(24110)

(21573)

From the above calculation, there was a rise in the total cost of raising debt from 21,573 to 24110 million euros. The rising cost of debt was either caused the company’s excessive reliance on the external borrowing.

Business Valuation Methods

Business valuation is the process of estimating the economic worth of a company. The method is often used to estimate the fair value of the business. Businesses are valued based on a variety of motives such as their capital gain computation, inheritance tax, sales and purchase and obtaining a listing. In many cases the valuation difficulties are restricted to unlisted firms because they have the quoted share price (Pandey, 2015, p. 19). At times it can be a challenge to value the listed companies for instance when trying to predict the effect of the takeover on the share (Pratt, 2013, p. 54). Whenever a firm is sold, the new owners have rights based on the shares they hold: the minority holders tend to have access to the dividends that majority shareholders decide to pay, and in case the company is wound up they are entitled to a share of the net profits. The minority shareholders have access to the share that the minority decide to pay, they also receive a percentage of assets in case the company winds up. The minority shareholders have access to the earning per share, and they are also entitled to a portion of the assets in case a company winds up. Minority shareholders have no control or little power. 80 percent of share in a firm has more than 80 percent of the total value of the company. Conversely, a 20 percent share of a firm is less than 20 percent of the company’s overall value (Pratt & Grabowski, 2011, p. 7). The majority shareholders in any business should always be prepared to pay a premium for the control.

Three key methods are utilized in valuing the share: the cash flow based, the income based, and the asset based. In the cash flow based approach the market value of a stock is reinforced by the present worth of the future dividend (Mercer, Harms, & Mercer, 2008, p. 8). The method involves making a comparison between similar companies existing in the industry and then doing a valuation based on the findings. The share price of the target form can be estimated using that relationship as a model (Pandey, 2015, p. 21). The price-earning ration shows the number of years that earning are paid for the share price; the ratio is usually price per share divided by the earning per share.

The asset-based approach is a broader approach that can be used to value a company. The business is taken to be equal to the value of its assets. There are three methods of valuing a firm based on this approach: the replacement values, the net realizable, and the book values. The replace net value estimates what it would cost to set up a company if it was being started now. The value of a successful business under the replacement value is usually undervalued unless adjustments are made for the intangible such as brand and goodwill. Estimating the replacement costs of various assets can also prove to be difficult (Armitage, 2015, p. 37). The net realizable value estimates the exact amount of money that will be left for the shareholders is the assets of the business are sold and all the liabilities sold. The formulae are usually the net realizable value of a particular asset less the liabilities. If a company is successful it is expected that shareholders will receive more than the net realizable value because such business has intangible assets such customer’s lists, brands, know-how and goodwill as well as the net tangible assets (Madura, 2018, p. 8). The net book value approach practically values a company based relatively arbitrary depreciation and the historical sunk costs. The net book value method uses simple figures that are obtained from the balance sheet and might not represent the true asset value.

When estimating the book value of an asset, all the accumulated impairment, accumulated amortization, accumulated depletion, and accumulated depreciation are subtracted from the original cost of an asset. The initial or acquisition cost is the original cost, which is the cost required not only to purchase the asset but bring it to the condition and intended use for it by the management. The initial cost of an asset can include such items as the setup costs, customs duties, delivery charges, sales taxes, and the purchases price off the assets (Drake & Fabozzi, 2012, p. 71). The amortization, depletion, and depreciation associated with an asset is the process by which the initial cost of any particular asset is charged at the expense. The book value of any asset tends to decline in a predictable and continues rate over the useful life of that asset. The net book value is a method that is widely used when valuing companies because it is used about a whole business or it can be used about the specific asset ("Introduction to International Financial Reporting Standards," 2014, p. 45).

Net Book Value Approach

Net Book Value approach

2017

2016

Intangible assets

103693

101174

Goodwill

(841691)

(837450)

Property, plant, and equipment

165,748

138,050

Investments in associates

5669

39995

Other receivable

2413

2771

Deferred tax asset

824

473

Cash and cash equivalent

155551

91148

Inventories

462119

356312

Trade and other receivables

35398

28761

Other financial assets

410

4769

Netbook value

931825

1463729

The net book value of the company declined from 1463729 in 2016 to 931825 in 2017 (B&M Annual Report, 2017, p. 70). The value of the net asset of the company declined to mean that the shareholder's stake in the company also declined.

Limitation of the method

The valuation of the intangible assets, for instance, the goodwill and the intangible asset is usually tricky. Failure to account for goodwill means that the company is undervalued. The method also ignores the future earnings (Barker & Kasim, 2016, p. 13). The value of a company can be undervalued because the method fails to account for the intangible assets, for instance, the goodwill.

Net Realizable Value

Net Realizable Value

2017

2016

Inventory

462,119

356,312

Les provision for impairment

(17)

(48)

Provision for impairment

(51)

(9)

Provision for impairment

(18)

(51)



462033

356204

The company expects to raise 462033 thousand euros after the sale of stock. This is an increase from 356204 in the previous year (Reports and Presentations, 2018). The ratio is a positive indicator for the company because it shows that the shareholder's return on investment rose.

Limitation of the Method

The net realizable value tends to allocate the costs on the net value of each commodity. The method takes into account the selling costs and the additional processing costs that are incurred in the process of production (Scott, 2017, p. 22). The limitation of net realizable costs is that it requires the higher amount of data that needs the physical measurement method. The net realizable value is the amount of money that the company will receive once all costs have been paid (Shah, 2017).

B &M Issue of Senior Secured Debt

The Capital Gearing Ratio

The gearing measures the extent by the ongoing operation operations are funded by the short term or long term debt or which a firm acquires assets are financed by debt (Garrett & James III, 2013, p. 13). The capital gearing ratio changes over time, and it differs from industry to industry. Before extending any form of credit, the lender might consider the gearing ratio. A higher ratio is an indicator that the business is highly geared (Alexander & Nobes, 2016, p. 39). A company is deemed to be highly geared if the ratio is geared than 50 percent. A highly geared company is quite risky and therefore not a good avenue for investments.

Gearing ratio= long-term debt/capital employed*100

The capital employed is calculating by subtracting the current liabilities from the total assets.

2017 Gearing ratio= 664,808/ (1,773,516- 295,087) =0.4497

From the above gearing ratio the company is financed by more capital employed relative to the long-term, this is an indicator that the company is least geared. The ratio which is 44.97 percent is less than 50 percent indicating that the company relies more on capital to fund its internal projects.

Debt to Equity Ratio

The ratio measures the proportion of the funds that contributed by the owner to that one contributed by debt. A company with a debt-equity ratio above 100 percent is taken to be geared (Erturk & Nejadmalayeri, 2012, p. 19). The debt to equity ratio indicates how a corporation is using the debt to finance internal operations. A higher ratio shows that companies rely on external funding relative to the debt-equity a scenario that is quite dangerous. Excessive external funds imply that the organization will use more funds in debt servicing. A higher ratio means that the company is riskier since it is geared and leveraged.

Long-term debt/ Net worth or Equity=2017 Debt equity ratio

2017 debt-equity ratio= 664,808/ 813,621*100=81.71%

From the above debt to equity ratio B&M Company is financed by more equity when compared to debt because the ratio which is 80.71 percent fall below the minimum requirement of 100 percent. Despite the fact the debt-equity ratio is below 100 percent B&M is still leveraged because the ratio is 80 percent indicating that it is riskier.



References

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Reports and Presentations. (2018). 2018. Retrieved from http://www.bandmretail.com/investors/reports-and-presentations/financial-reports/fr-2018.aspx

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Shah, O. (2017, July 23). Asda Eyes £4.4bn Bid for B&M. Retrieved from https://www.thetimes.co.uk/article/asda-eyes-4-4bn-bid-for-b-m-qqp7f0lpf

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