Cost Of Capital Structure In H. J Heinz Case Study (Case Study Sample)

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Cost of Capital Structure in H.J Heinz Case Study
Q1a
The weighted Average Cost of Capital refers to the average price of return that a firm should pay to creditors and shareholders. Financial analysts normally focus on a company’s total capitalization, which is the capital structure or mix of long- run sources of finance used by the company. Firm’s capitalization consists of bonds, preference shares and common stock. To estimate the WACC, one need to identify the capital constitution mix and the cost of all the sources of fund utilized. The vital assumption in any system of weighting is that the company will definitely increase capital in the specified proportions. These firms hike funds marginally to make incremental investments in latest projects. Thus the capital cost of the marginal is used wholly in the firm instead of using the firm’s capital in general.
The Heinz case assumptions incorporates that the firm managers have to leave their own desires and concentrate on maximizing the wealth of stockholder (Brynjolfsson, McAfee, and Cummings p12). This might happen due to the fear of being replaced by stockholders during their annual gathering or board of directors meetings or because they hold sufficient stock in the company thus maximizing wealth of stockholder becomes their core as well. Secondly, it’s assumed that the lenders to the company are totally protected by stockholders from expropriation. This can happen due to the effect of reputation. The stockholder will not take any step which hurts their lenders when borrowing funds in future (Brynjolfsson, McAfee, and Cummings p18). Lenders have also the right to fully protect themselves through writing agreements forbidding the company from taking any hurting steps on their end.
The scenario assumption is that managers of the company do not try to lie or mislead to financial markets on the company’s future vision. This is due to enough ideas for the markets to do judgments about the impacts of actions on long run value and cash flow (Christian). In conclusion, the social benefits or social costs are absent (Christian). All costs made by the company in its effort of maximizing the wealth of stockholder can be charged and traced to the company. With these mentioned assumptions, there is lack of side costs in maximization of stock price. Therefore, managers can focus on stock prices maximization. In the practice, wealth of stockholder and company value will be utilized and community will be well again.
Q1b

calculation of WACC





WACC=Cost of debt + cost of equity



Year

cost of debt

cost of equity

WACC


2009

0.341*10

2.51*1.2




3.41

3.012

6.422







2010

0.441*10

30.1*0.1




4.41

3.o1

7.42







Q2
WACC is a weighted standard cost of debt, equity and shares of preference. Weights are the capital percentage sourced from every element correspondingly in value terms of the market. It is mostly called the overall capital cost for the firm as a whole. The WACC can also operate as a hurdle rate in calculating the new projects given the assumptions for those projects are correct. The structure or capital mix of the new scheme investment should be similar as the structure of the existing firm (David). When the firm has a ratio of 70:30 of debt to balance in their latest balance sheet, involvement of the new scheme will retain the same. In addition the risk accompanied with the new scheme will be similar to the existing schemes. Example a textile production increases and expands the supply of looms from 60 looms to 100. Due to similar business and industry, there will be no difference in the profile risk of current production and the new development.
The major advantage of WACC is its simplicity. When calculating, it does not require complications. The manager will just apply weights of every finance source with its cost and total the result. Also, a single rate of hurdle for schemes saves managers’ time in calculating the new projects (David). If the schemes are of similar profile risk and there is no difference in the structure of proposed capital, the latest WACC can be instituted and effectively applied. Another advantage is that accurate decisions have to be applied at the accurate time (Gleißner and Femerling p8). Since all new schemes use single rate, the decisions can be reached quickly and new opportunity grabbed and benefits taken.
The disadvantages can be traced from the applicability assumptions of WACC. The limitations and practicability of the assumptions are difficulty in the capital structure maintenance. The unreasonable assumptions of no difference in capital organization has exceptional possibilities of persisting all the time (Gleißner and Femerling p19). It shows similar capital organization for new schemes. This process has two possibilities for its funding. First, one requires funding using the retained earnings (Paul). In the case assumption, the new scheme is funded using similar capital organization. There is lack of free cash with the firm. Even if free cash is present, it will create a cap on the investment size (Paul). Example if the new scheme needs US D.100 million the firm can only raise USD. 70 Million. What about the USD. 30 Million? Secondly increasing fund in similar capital mix. The main concern of company management is to reduce the capital cost as low as needed to enable them achieve the profits of shareholders and maximization of wealth. Another disadvantage is taking poor projects and rejecting the quality ones. The assumption can be considered right if the firm is growing its own company and similar business. Example the textile company, it can be false due to the risk accompanied with putting looms being different since the past. The technology may be complicated and different. The cost and quality methods may differ. In the concept of firm growing in different industry, the case might prove malicious due the heavy machineries and FMCG lacking similar risk profile. In this case, the WACC should be corrected to take the difference in risk effectively.
The WACC disadvantage in the case of difficulty in obtaining latest market capital cost is used for calculation of new schemes. Knowing such sums and the latest day of capital cost is hard. The WACC focuses mainly on preferred, debt and equity. The interest debt cost changes in the market due to economic differences. Also another disadvantage is that the significant capital sources are avoided. When carrying out WACC evaluations, only preference, debt and equity shares are preferred in place of simplicity in assumption that they take major part of the capital. The reason for errors is complexity. The short run borrowings and the credit trade cost is also not considered. If such factors are instituted, WACC will definitely be transformed.
Q3
The decision of financing has a direct impact on WACC. The WACC can be the simple average weighted debt cost or the equity cost. The weightings are in magnitudes to the values of market debt and equity variation thus WACC.As a firm changes its capital organization, it will definitely effect in a WACC change. Wealth is viewed as present value of prospect cash flows reduced at depositors’ needed return, the value of the market of a firm is similar to the current value of its prospect cash flows reduced by WACC. The lesser the WACC the higher the value market of the firm. By changing the capital organization to lower the WACC, we grow the value of the market of the firm thus growing the wealth of shareholder.
It is the task of all finance directors to seek the optimal capital organization that will effect in lowering WACC (Shapiro and Sarin p5). The debt cost is cheaper compared to the equity cost as debt is termed as less hazardous than equity, the returns needed to compensate the depositors of debt is less than compensating equity depositors. In debt interest payment is mostly fixed quantity and obligatory in nature and paid in precedence to the dividends payment which are flexible in nature. In the liquidation process, holders of debt get their repayment capital before depositors getting their repayment capital as debt holders are ranked above in the hierarchy of creditor. Debt is low-priced than equity from a firms perspective due to different tax corporate treatment of dividends and interest. Issuing extra debt implies that additional interest is earned out of profits before depositors receive their dividends. This increase is known as rise in financial risk to depositors (Shapiro and Sarin p23). If financial risk rises, a superior return will be needed to compensate them thus increase in cost equity results in the WACC increase. When seeking the lowest WACC, one should give more debt to substitute expensive equity thus lowering WACC. More debt enhances the WACC as keg, Beta equity, financial risk and gearing. In considering capital structure theories, the M+ M theory of the WACC reduction effected by cheaper debt increases financial risk. The cheaper M+M theory in application of tax also raises the financial risk. In the traditional theory, the U shaped WACC is an optimal ratio gearing (Tracy p45). The pecking order theory has no process, just a row of least rejections generated internally funds, followed by debts and in conclusion the issue of equity.
In Miller and Modigliani models, assumption of a perfect market capital and disregarding taxation, the WACC remains same at all gearing levels. As a firm gears up, the WACC’s decrease effect by having a superior number of cheaper debts is definitely characterized by the rise in the WACC caused...