FINANCE

Finance

Finance

1.The UK Base Interest Rate is at present 0.50%. Suppose that in the future the Monetary Policy Committee of the Bank of England decides to raise this to 1.50%. Explain the impact of the rise in the UK Base Interest Rate on the UK Sterling Exchange Rate with the US$ and Euro.

“In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share”.

The PEG ratio of Lowe's is 0.44, implying that the share price of the Lowe's does not take into considerations the full account of expected growth. In another words, Lowe's is undervalued.

“'Value in use' is computed by discounting the asset or income-generating unit's expected cash flows at a rate of return that the market would expect from an equally risky asset. This rate of return is a post-tax interest rate which might equate to the rate implicit in market transactions of similar assets or the weighted average cost of capital (WACC) of a listed company (with similar risk profile)”

WACC = E/V X r + D/V X i X (1-t)

Where, E = Equity

D = Debt

V = Value of the Firm (E + D)

r = Required return on Equity

i = Interest on Debt

t = Rate of Corporate Taxation

Risk free rate :2,85 % ; Return on the market :12,01 % ; ßeta of stock : 0,90 ;D/E ratio : 0,47 Interest rate (Cost of debt) of the company : 10,48 % ; Tax rate : 30 %

Long Term Debt

1'050

Equity

2'244

Total (V)

3'294

(CAPM) Return on stock (Rs) = Rf + ß.(Rm - Rf)

Rs = 2,85 % + 0,90.(12,01% - 2,85 %) = 11,09 %

WACC = Rs(Ke) . E/V + Kd . D/V

WACC = 11,09 % . (2'244 / 3'294) + (10,48 % - 30 %) . (1'050 / 3'294) = 9.89 %

Many companies estimate the rate of return required by investors in their securities and use the company WACC to discount the Free Cash Flows on all new projects. But the company WACC rule can also get the firm into trouble if the new projects are more or less risky than its existing business. Each project should be evaluated at its own Opportunity Cost of Capital (OCC). The true OCC depends on the use of capital.

If a firm uses the company cost of capital rule, it would reject many good low-risk projects and accept many poor high-risk projects.

CAPM model is widely used by large corporations to estimate the discount rate.

To calculate this formula, we have to estimate the project beta. This can be achieved by looking at an average of similar companies.

Cost of capital and capital structure

The Cost of capital is the norm to be respected for capital budgeting decisions. It depends on the business risk of the firm's investment opportunities. The risk of a common stock reflects the business risk of the real assets held by the firm. But shareholders also bear financial risk to the extent that the firm issues debt to finance its ...