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Weighted Average Cost of Capital

1 – Introduction Cadbury Schweppes plc, was formed by two different people in charge of different companies coming together. John Cadbury was in charge of making confectionery and Jacob Schweppes was producing and distributing beverages. Both of these came together in 1969 to form Cadbury Schweppes plc. This company is engaged in the manufacturing, distributing and sale of branded beverages and confectionery. It supplies its products through whole sale and retail outlets in almost 200 countries. The company make focus is on two things confectionery and beverages.

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Cadbury Schweppes has manufacturing facilities in 25 countries with a range of products on sales in over 170 countries. These products are sold everywhere convenience stores, grocery stores and kiosks. 2 – Cost of Capital A company’s capital is consists of mostly debt or equity. Equity and debt are external sources of financing and financing from external sources is not without cost. The cost of capital is the cost to raise capital through equity and debt. It can be defined as the weighted sum of the cots of equity and the cost of debt.

It determines the rate of return that a firm would receive if it invested its money in another option with a similar risk. A risky business will have a higher cost of capital than one involving less risk as the investors expect to be compensated for the greater risk. It is easy to determine the cost of debt. Cost of debt is simply the weighted rates of interest paid by the company on its debts. However, cost is equity is not so straightforward. The cost of equity is based on an estimate of a reasonable rate of return on the shareholders’ investment. The term ‘reasonable’ is what makes all the difference.

There are various models which are used to estimate this reasonable rate of return which will satisfy the shareholders. One such model is Capital Asset Pricing Model (CAPM). 3 – Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model (CAPM) was first developed by Harry Markowitz in 1959 and after a decade more work was done by William Sharp, John Lintner and Jack Treynor. CAPM describes the relationship between risk and return and it is used as a model for the pricing of risky securities. The model says the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. Answers Corporation, 2007) The investment should only take place if the expected return does meet or is higher then the required return. The model according to Brealey et al, 2004 assumes that the expected return depends on compensation for the time value of money (risk free rate) and a risk premium that depends on beta and market risk premium. Therefore it can be said that Capital Asset Pricing Model is a theory of the relationship between risk and return which states that the expected risk premium on nay security equals its beta times the market risk premium. (Will, 2007)

The model is based on two types of risks an investment is subject to: • Risks that can be removed through diversification or unsystematic or specific risks. These risks are not correlated to market moves. • Risks that cannot be removed through diversification or systematic or market risk. These include risks like interest rate fluctuations. CAPM takes into account an investment’s sensitivity to systematic risk. (Wikipedia, 2007) 3. 1 – The CAPM Formula This systemmatic risk is referred to as beta (? ). The equation to determine the required rate of return (k) under the CAPM is as follows: r = Rf +(? RM-Rf) )(12manage, 2007) The above formula can be translated to: Expected return = Risk free + (Beta (Market Return – Risk free)) 3. 1. a – The risk free rate of return – Rf This tends to be about rate of return where there is zero risk. In order words the risk free rate of return is the interest expected by investors in a certain time period, it reflects the time value of money. In the real world this would not exist since the safest investments carry a very small amount of risks. Due to this the interest rate on a three month U. S. Treasury bill is often used as the risk free rate. Investopedia, 2007) 3. 1. b – The risk premium – ? (RM-Rf) The market risk premium is the difference between the expected return on a market portfolio and the risk free rate. (Investopedia, 2007) The market risk is converted to risk premium by multiplying it by the share’s beta. So the market risk premium is more return on top of the risk free rate return which is in general equal to the amount of risk the investors are willing to take. Therefore it is equal to the slope of the security market line (SML). (Investopedia, 2007) 3. 1. c – Beta – ?

This is a Greek alphabet which measures the sensitivity of an assets return. Beta with more then 1 will tend to be more sensitive therefore will be higher risk. On the other hand it will be the quite the opposite if the beat was less than 1. (Brealey et al, 2004) In theory beta can be negative if a stock’s returns are negatively correlated with the market. However, in the real world negative beta stocks do not exists. (Greekshares,2007) If for whatever reason the beta was negative then the risk premium would be negative and the expected return would be less than the risk free rate. . 2 – The CAPM in relation to Cadbury Schweppes The risk free rate in connection to Cadbury Schweppes is between 4 -5 according to (Office of Communications,www. ofcom. org, but for this valuation the 5 will be used. Also from the same website it states that the market rate is between 7 and 11. 4. On the other hand according to Brealey the average if about 9, so this will be used for the market rate. In order to complete the CAPM formula beta is required and this is 0. 8 (www. todays. reuters. com)

Therefore applying the above figures into the formula will look like: Expected return = Risk free + (Beta (Market Return – Risk free)) 5 + (0. 8 * ( 9 – 5)) The estimate of the potential return shareholders will receive is 8. 2%. 3. 3 – Advantages of CAPM The advantage of CAPM is that it is an easy model which can be implemented and interpreted very quickly. Another thing is that it is focused only on systematic risk which is the relevant risk in an investor’s well diversified portfolio.

The main advantage is summed in Civil Aviation Authority report ,2001 which state that CAPM enable a statistically more accurate measurement of a firm’s expected return and this done by first estimating the risk and then using the risk estimate as an argument in the CAPM expected return equation. Advantages also include having beta since it relates to individual stock return to overall market return. A full list of the advantages of beta like stock has greater systematic risk, systematic risk the same as overall market, stock lower systematic risk etc can be found on a report by the UWF, 2007. . 4 – Disadvantages and issues in CAPM The disadvantage/issue of CAPM is that it makes many unrealistic assumptions about markets, returns and investor behaviour. For example all investors have the access to the same information and agree about the risk and expected return of all assets and no taxes or transaction costs. It is difficult to estimate the beta and all aspects of risk can not be summed up in a beta. Also related to beta is that it might shift over time and that the calculation of this are sensitive to historical time period used. UWF,2007) Similar to this is that estimation of risk free rate as well is not easy and to avoid this many people use the rate on a long term government bond. 3. 5 – CAPM describes the real world They have been many empirical test carried out on CAPM and many of them show that CAPM does work. In CAPM if the beta is known then the prediction of the return can take place. Stocks with high risk will tend to have a higher return. A famous test conducted which shows that what CAPM was designed to do it did that. The test was about dividing stocks in the NYSE into 10 portfolios.

The first portfolio contained 105 of the securities with the lowest betas; the second portfolio contained 10% with the next lowest betas and so on. The tests showed over a 35 period that there was an almost exactly straight line relationship between portfolios beta and average return. The CAPM did not predict that stocks with zero beta will have higher return than risk free investments. Mr Roll suggested that the trouble with test was that they used bad proxy for this market portfolio. (Jacoby, 2007) Mr Roll showed that CAPM would look true if the market proxy is efficient.

He also showed that little changes in the market proxy can completely alter the expected the returns of a stocks as predicted by the CAPM. (Jacoby, 2007) Since no body knows what the true market portfolio is , it cannot be Said if CAPM is right or wrong. Despite this CAPM does show a connection between beta and the expected return. Empirical tests have been carried out and it does prove that there is a relationship between beta and expected return. In will help economists attain a better understanding of risk and return which will in turn help predict better results. 4 – Strategy of the firm and forecasted performance

Cadbury Schweppes, which has evolved from a Commonwealth focused food and beverage business into a leading international confectionery and beverages group is defining all its strategies to maximise shareholders value. This approach will make investing in Cadbury’s an attractive option. Cadbury Schweppes future cash flow strategy is based on concept of free cash flow. Free cash flow is the primary cash flow measure proposed to be used by the management. Free cash flow shows the amount of cash flow remaining after the company’s cash from operations has been used to meet taxation and interest costs or capital expenditure and dividends.

Free cash flow therefore represents the amount of cash generated in the year by the underlying business and provides investors with an indication of the net cash flows generated which may be used for, or are required to be funded by. This approach will help the company improve its forecasted performance. Besides, the existence of free cash flows will provide additional security to prospective investors and reduces their investment risks. (Cadbury Schweppes Interim Report 2006) 5 – Weighted Average Cost of Capital (WACC) The assets of a company are financed by either debt or equity or both.

In the case of Cadbury Schweppes PLC it is funded by both debt and equity therefore the calculation of WACC is needed. The WACC enable a company to calculate the company’s capital. This is important in theory since all capital does have a cost but one writer believes that it is easy to do by following textbooks but it just has no application when it comes to determining intrinsic value in the real world. (Kenyon, 2007) WACC is the average of the cost of each of these sources of financing weighted by their usage in the situation. This allows investors to see how much interest the company has to pay for every pound it borrows.

The main advantage of using WACC is that it is very easy to understand and if necessary can be explained to another person without any difficulties. Another advantage of this is that less computations needed. (Jenter, 2005) Along with advantages there are disadvantages has well. One disadvantage is that with WACC it mixes up effects of assets and liabilities and those errors and approximations in effect of liabilities contaminate the whole valuation. (Jenter, 2005) Another problem is that it is not flexible therefore if a debt is risky then it may affect a number of things.

When calculating this, the calculation of risk premium is one thing which makes the whole calculation of WACC complicated. So overall WACC is a minimum return that is needed on an investment within a firm that will be needed to satisfy the lenders and will leave just enough to give shareholders their return. It has a strong foundation in theory and provides a return target specifically to the market risk of the business and its borrowing costs. In order to calculate this more data is needed and more understanding of theory is required. Despite the value of WACC is it more illusory than real.

In relation to Cadbury Schweppes Plc the WACC is an indication of its future stock price. A low WACC would mean that Cadbury Schweppes can perform at a lower rate to maintain its stock price. In order to calculate the WACC for Cadbury Schweppes a number of figures will be needed. Most of the figures are taken from Cadbury Schweppes 2005 report. The following are need: • CAPM- 8. 2% • Value of shareholders • Value of debt • Interest and tax Shareholder value = 2072*587p = 12162. 54 Value of debt = 4137+ 630 = 4767 The tax will be at 30% The formula for the model is: Value of shareholder/value of shareholders+ debt*CAPM) + (Debt/value of shareholders + debt*interest*tax) The calculation would be: (12162. 54/16929. 54*8. 2) + (4767/16929. 54*6*0. 7) Therefore 5. 89 + 1. 11 So the WACC for Cadbury Schweppes Plc is 6. 99 Cadbury Schweppes with a WACC of 6. 99% means that only and all investments should be made that give a return higher than the WACC of 6. 99%. 6 – Return On Invested Capital (ROIC) ROIC is a measure of how a company is effectively using the money which was borrowed or owned invested in its operations. Investorwords, 2007) In terms of Cadbury Schweppes Plc it allows them to see how much profit they are going to make so that any money that needs to be return to shareholders/ investors can be done without any problems. Just like mention above about WACC, ROIC also has some advantages and disadvantages of being used. If the ROIC is high then it can be seen as proof of a strong company or solid company management. (12manage, 2007) This is a good thing however, by having high ROIC may be an indication of poor management that could be caused by ignoring growth possibilities and by long term value destruction.

The problem with this is that it can be manipulated very easily by management. The ROIC is affected by inflation and currency exchange movements and it is influenced by accountings convection. The ROIC for Cadbury Schweppes can be calculated in the following way: Total capital employed (shareholders)3088 Non current liabilities4137 Current liabilities – Borrowings603 Goodwill1749 Total capital invested9604 Profit on ordinary activities1159 before interest Less tax (estimated @ 30%)(348) Estimated profit 811 Therefore the calculation would be 811/ 9604 = 0. 8 So ROIC = 8% 7 – Interaction of Growth, ROIC and Reinvestment From looking at the financial data of Cadbury Schweppes the growth is expected to be between the ranges 3 – 5%. (Cadbury Schweppes, 2006) For the assignment the assumption is made that the growth should be about 4% because looking at the past figures this seems reasonable. However, from the growth a small percentage would need to be kept by Cadbury Schweppes just in case of an emergency like the investors want their money back or more investment is needed in technology to speed up production etc.

Due to this about 1% from growth would be needed to facilitate any problems. Therefore the new growth rate would be 3%. So the following calculation would be done to determine the percentage of reinvestment: Growth/ ROIC = Reinvestment 0. 03/0. 08 = 37. 5% Using the growth of 4% would enable Cadbury Schweppes to see how much money will be available for investors. The calculation below allows Cadbury Schweppes Plc to see this: Estimate profit * Growth 811 * 0. 04 = 843 Net profit 843 Reinvestment at 35. 7% (316) Available for investors next year527 – Valuation Now all the figures above have been calculated now the valuation of Cadbury Schweppes Plc can take place. To calculate the value the money which is available to investors will be divided by the WACC which takes away growth. Money available for investors/ (WACC – Growth) 527 / (0. 07 – 0. 04) = 17,566 The valuation after accounting for debt is: Non current liabilities + current liabilities borrowings 4137 + 630 = 4767 Valuation – Debt 17,566 – 4767 = ? 12,799 Valuation of Cadbury Schweppes = ? 12,799bn

The simple way to calculate the valuation of Cadbury Schweppes Plc would be to do the following: Number of shares * share price = Valuation 2072 * 587p = ? 12,799bn (Share price is taken at 07/03/06). 9 – Conclusion The current market capitalization of Cadbury Schweppes Plc on 1st April 2007 is ? 13. 68 billion. (Yahoo Finance, 2007) The valuation is have from the above calculation is correct bearing in mind it a month old. The rise is valuation is due to the fact that Cadbury Schweppes Plc is dividing the business into two parts; first part selling chocolate and second part selling drinks.

This here would increase the about of money needed from external sources which in turn would affect the valuation. It has been mentioned above that a higher risk would result in higher return. Due to this it could affect the cost of debt and beta would increase, resulting in Cadbury Schweppes Plc rethinking its capital structure. Similar to this, is that if beta was increased the whole valuation of Cadbury Schweppes would be affected since it would decrease and if other calculation like the cost of debt/equity changed as well the effect would be huge.

Overall using the above process to do a valuation is good because many things are considered in the valuation calculation. The values however need to be accurate otherwise the whole valuation would be inaccurate. The main advantage of using the above process is that it allows buyers to think before buying and is best used when firms cash flow are positive and estimated with some reliability for future periods. On the other hand the disadvantage is that it is hard to calculate since requires more inputs and information which can be misleading. 0 – Bibliography Arkwright, T (2007) – Corporate Financial Management, Lecture notes, Manchester. Answers Corporation, (2007) – Capital asset pricing model at http://www. answers. com/topic/capital-asset-pricing-model Brealey, Myers and Macus (2004) – Fundamentals of Corporate Finance, 4th Edition Greekshares, (2007) – Learn to Invest- Stocks and the Beta Coefficient, at http://www. greekshares. com/beta. php Cadbury Schweppes Interim Report 2006, accessed from http://www. investis. com/reports/cbry_ir_2006_en/accessible/index. php? page=19

Civil Aviation Authority, (2001) – Economic regulation and the cost of capital, London, pp6, at http://www. caa. co. uk/docs/5/ergdocs/annexcc. pdf 12manage, (2007)- Capital Asset Pricing Model (CAPM) at http://www. 12manage. com/methods_capm. html Investopedia, (2007) – Risk – Free Rate of Return at http://www. investopedia. com/terms/r/risk-freerate. asp Investopedia (2007) – Market Risk Premium at http://www. investopedia. com/terms/m/marketriskpremium. asp Jacoby,G (2007) – The Capital Asset Pricing Model at http://home. cc. umanitoba. ca/~jacobyg/invest/4. %20CAPM. pdf UWF, ( 2007) – CAPM – Risk Review, at http://www. uwf. edu/rconstand/5994content2003/T4-RiskReturn/CAPM%20APM. pdf Wikipedia, (2007) – Capital Asset Pricing Model at http://en. wikipedia. org/wiki/Capital_asset_pricing_model Will, M. (2007) – Fundamentals of Corporate Finance, 5th Edition, McGraw – Hill Companies, London, Chapter 11, at http://www3. uta. edu/faculty/stephen/Docs/FINA%203313/chap011. ppt Yahoo Finance (2007) – Cadbury Schweppes Plc, at http://uk. finance. yahoo. com/q? s=CBRY. L Website www. todays. reuters. com www. ofcom. org

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