Business sustainability performance cost of capital †Free Samples

Question: Discuss about theBusiness sustainability performance and cost of equity capital. Answer: Introduction With the changes in economic and complex business structure, each and every organization has been using financial analysis tools to evaluate the financial performance, availability of the sources of finance and use of capital budgeting tools. In this report, Petronas Gas Berhad Company has been taken into consideration. This is the natural gas distribution company which has been running its business on a domestic and international level. This report has been prepared to evaluate the objective of Petronas Gas Berhad Company related to wealth maximization and source of external finance available for the company. In addition to this, weighted average cost of capital and other capital budgeting technique has also been used to evaluate the available project for the company. This report emphasizes upon the financial analysis for the effective welfare of stakeholders, raise funds from the external sources and evaluating the same by using a weighted average cost of capital. Brief description of company The Petronas Gas Berhad Company is natural gas distribution company headquartered in Malaysia. It has several subsidiaries- Kimanis power sdn. Bhd. It was incorporated in 1983 and was listed on the main market of Bursa Malaysia security stock exchange. This company has the strong brand image in market. Initially the company was wholly owned subsidiary of Petronas and the biggest oil selling company in Malaysia. The company is performing well in the oil and petroleum industry. However, the sales revenue of the company has increased to MYR 4.58 billion in 2016 which is 5% higher than the last four year data. The gross income of the company has also increased to MYR 2.07Billion in 2016. This amount reflects that company has been performing well in the market and increasing the return on capital employed. Group structure of Petronas Gas Berhad Compan It is a listed company in which CEO and managers take all the important decisions of the organization. It is observed that company has been following decentralized business functioning in which all the decisions are taken by the process manager and line mangers (Hrisch, Freeman and Schaltegger, 2014). Stakeholders wealth maximization Shareholders are the key promoters and owners of company who provide capital to the company. There are several stakeholders of the company such as employees, shareholders, management, staff members, suppliers, and vendors and government who may influence or get influenced by the activities of an organization. It is evaluated that the company are providing high amount of return to its shareholders with the increase in its earning. However, strategic alliances with the suppliers are also increasing the revenue returns (Baker and Wurgler, 2015). Importance of wealth maximization It is observed that shareholders are the key investors of the company. It is evaluated that if a company does not offer the proper return to shareholder then the brand image of company and efficiency to raise funds from the market wil be effected. There are several ways to establish wealth maximization of shareholders such as setting profit based dividend policy, issue of bonus and other incentive plans. The importance of wealth maximization is related to creating value of the invested capital of the shareholders for their long-term benefits. If this wealth maximization process is not undertaken then it may destruct the value of the shareholders (Hrisch, Freeman and Schaltegger, 2014). Risk minimization model The risk model is implemented to minimize the risk associated with the business of the company. It helps in mitigating the financial and business risk in determined approach. The standard risk model is implemented to identify the risk, develop an action plan and implement proper business activities to mitigate the issues. It also helps in identification of the best course of action which company could take to increase the overall outcomes (Denis, 2016). Analysis of Stakeholders model The wealth maximization of the stakeholders is highly dependent upon the nexus established by the management department for the organizational development and company's welfare. The company has issued bonus shares, contribution in employees provident funds and adequate dip points to suppliers and vendors. In the recent years the company has increased its dividend payment amount to its shareholders with the increase in its profit. It reflects that company adopted profit based dividend policy (Mitchell, et al., 2016). Importance of stakeholders The main important thing about the stakeholders is related to the contributed capital of a company. It is observed that there is several importance of stakeholders (Tantalo and Priem, 2016). Established proper nexus between company's developments with the stakeholder's development. Use of capital to expand the business. Formulation of clients oriented policies and frameworks. Local support and new business functioning. Problems of reconciling the two models This business model reflects that these two models have different objects and approaches. It is observed that if these models are reconciled together then it may destruct the existing business operations of the company. It is evaluated that the company needs to evaluate whether the existing business functions has been offering best results to stakeholders and also complying with the fundamental perspectives. The below-given chart reflects how the stakeholder's models could be reconciled with the risk events of the company. It may increase the overall quality of the business but also reduce the risk of the company. Source: (Kacperczyk, et al., 2015) Sources of finance available There are several sources of finance available to such as an issue of equity shares, debentures, applying for loans in banks and securitization of assets with the assets securitization company (Schwarzmller, et al. 2017). Equity shares- the company could issue share through an initial public offer and further public offer. It is observed that company could opt this option if by raising funds from equity shares holders gives more return on capital employed. However, the cost of the equity covers all the expenses incurred to issues of shares in market and return and dividend given to shareholders. Debentures- It is observed that debentures could be defined as bonds and documents offer by the the company to investors for their capital. It has fixed interest payment which is charged on the profit. If a company fails to pay this interest amount to debenture holders then it may result to wind up or dissolution of a company (Cox and Nguyen, 2018). Securitisation- It is the process which could be used by the company to covert its long-term assets into liquid assets. For instance, company could sales it's fixed assets and machines to other companies for the temporary basis and take finance from them (West and Bogers, 2014). Banks loans- It is observed that the company has strong brand image in the market. It could raise capital from the banks and financial institutions after applying for loans. However, banks may charge high interest from the company which results to increase the cost of capital of the company (Rostamkalaei and Freel, 2016). Distinguished for the Petronas Gas Berhad Company It is observed that the company is listed company and having a strong brand image. After evaluating all the details and information regarding the company, it is inferred that the company should raise funds from different sources of methods. For instance, 60% capital could be raised by issue of equity shares in the market. The issues of equity shares have zero financial leverage nor does company pay fixed amount to shareholders. On the other hand, issues of debentures may increase the financial leverage and the interest payment is the charge on the profit. It may decrease the value of the investment and put negative impact on the business functioning of an organization if a company fails to have adequate gearing ratio. However, in case, if a company is having strong profitability then the company could opt for the issues of debentures in a market. This option not only decreases the cost of capital but also increase the financial leverage of company (Cuevas?Rodrguez, Cabello?Medina and Carmona?Lavado, 2014). Possible consideration was undertaken by management These above-given sources of finance are opted by the company for raising funds on the basis of cost associated with the business and return on capital employed. Company could use proper analysis tools such as capital budgeting tools, net present value methods, cash flow methods to determine whether the particular source of finance would increase the net present value of investment of company (Queen, 2015). Cost of the capital- It is amount of total money which is required to be paid by company to the persons who have deployed their capital in the business of the company. However, it includes the cost of equity, debentures and the bank loan financial risk- It is the risk which reflects companys sustainability and business risk. It is observed that if company is having low profitability then it will have high financial risk and vice-versa. This risk is also known financial leverage which may put company in danger for its sustainable business (Kacperczyk Beckman and Moliterno, 2015). It is observed that raising funds from market may be complicated for the company. It is analyzed that company could select the particular source of funding. The selecting of particular source of funds depends upon the two important factors such as financial leverage and cost of capital. After evaluating the annual report of the company, it is analysed that company is having low financial leverage. The total assets of the company are MYR 16554 million in 2017. The total liability of the company is MYR 4587 million in 2017. On the other hand, the profitability of company is also very high and increased its profit by 22% since last two years. The net profit of company is MYR 1739 million in 2017 (Ng, and Rezaee, 2015). This data reflects that the company has very low financial leverage in the market. It is observed that company should raise more funds from the market by using debt funding process. It will help company to reduce the overall cost of capital and increase the return on capi tal employed of company. There are main two advantages of raising funds from the market first is related to the low cost of capital and another is related to decrease in the financial leverage of the company. Therefore, it could be inferred that the company could use debt funding to raise funds from the market (Montmartin, and Herrera, 2015). Now, in the end, it could be inferred that company could raise funds from the market by issue of debentures in market. It will reduce the overall cost of the capital and increase the overall return on capital employed of company. The management of the company needs to evaluate whether the issue of debts in market would be expensive for the organization or not. It will also reduce the overall cost of capital and create value of the investment (Frank, and Shen, T., 2016). Discussion of weighted average cost of capital and computation of the same It is the amount of overall cost of capital which pays to its internal and external factors. This weighted average cost of capital assist organizations to determine whether the particular project should be accepted or not. If the return on capital employed is positive then management of the company could accept that project and vice-versa. The weighted average cost of capital could be computed as below. Cost of equity (calculated through CAPM) = This is the amount cost which is computed by following capital assets pricing model. Cost of Debt = 3% Interest payment= MYR 103 Million Total liabilities= 3548 Cost of debt before deducting tax benefits= Computation of the cost of debt Interest payment 103 Debt 3548 Interest rate 3% Cost of debt 2.03% Cost of debt after deducting the tax= 2.03% Computation of the cost of equity The cost of equity is the amount of return paid to equity shareholders. However, cost of equity is determined on the basis of using proper CAPM model (Krger, Landier and Thesmar, 2015). Computation of the cost of equity RF 4% RM 10% Beta 0.99 CAPM (Re) 9.9400% WACC = Cost of debt (interest rate after tax) + cost of equity WACC Capital Amount Cost of capital % of portion WACC Equity 11967 9.94% 77.1318% 7.67% Debt 3548 2.03% 22.87% 0.46% Total capital 15515 WACC 8.13% After evaluating all the details from the annual report of company such as total debt amount, equity share portion and interest payment, the WACC of the company has been computed as above. The weighted average cost of capital of company is 8.13%. (Petronas Gas Berhad Company, 2016). Implication of higher weighted average cost of capital on the investment decision It is observed that the weighted average cost of capital is the total amount of cost of capital which company requires paying to internal external investors for the use of their capital in organization. The implication of higher WACC on the investment decision would be negative on the business. If company has low WACC then it could easily accept any project. In case, the company has higher WACC then the return on capital employed would be low. Therefore, lower WACC reflects the positive indication to the company as it could easily accept any project (Dagher, 2016). The main problem which may arise while computing weighted average cost of capital in general firms The main problem which arises in computing the WACC is related to identifying the right beta of company, risk-free rate of return and tax deduction available on the interest expenses. Beta- It reflects the risk of company based on the marketing factors. However, it could be computed on the basis of the share price of company and market capitalization. It becomes cumbersome to compute in case when there are high differences between share price fluctuation and share price of all ordinary indexes Risk free rate of return- It is hard to determine which risk free rate of return should be chosen to compute the cost of equity in the absence of proper information. It may also deviate the results of calculation. Tax deduction- It is evaluated that in case of international transactions, company may face problem while determining the tax-deductible expenses. Therefore, it may create problem while computing the cost of debt of company (Ortiz-Molina and Phillips, 2014). Problem which may arise while computing weighted average cost of capital It is observed that the company has two types of capital such as debt capital and equity capital. It is evaluated that in order to compute the cost of equity of company, the company could use capital assets pricing model. The main difficulty which may arise could be related to identifying the right beta, Risk-free rate of return and the market premium of company. The trade-off theory of capital structure The the company is having good amount equity capital which reflects that company should establish the proper capital structure. It is observed that company is managing debt portion of 22% and 68% equity portion. It is observed that the company may have to face high financial cost due to high equity portion and less debt portion. The Company needs to increase the overall its deb portion in its business. It will not only reduce the overall cost of capital but also increase the financial leverage of company ( Birn, 2017). Recommendations After evaluating the annual report and other details of company, it is inferred that The the company is having low financial leverage but a high cost of capital. In addition to this, company is also having good profitability in its business. Therefore, company should increase the debt to equity portion by increasing the overall debt funding in business. Particular (MYR in Million) Capital Amount Equity 11967 Debt 3548 Total capital 15515 The total capital of company is MYR million 15515 which is accompanied by the 78% equity portion and 22% debt portion. It has increased its revenue by 22% in 2017 as compared to last four years data. Therefore, company should also increase its debt portion to reduce the overall cost of capital. The existing capital structure of company is managing debt portion of 22% and 68% equity portion which reflects low financial leverage and high cost of capital. the company should be more inclined towards increasing the debt portion and increasing the return on capital employed. The gearing ratio of the company is 10% which is very low and clearly indicates that company could charge more interest amount on its profit (Wang. et al. 2015). Conclusion The capital structure of the company is accompanied by the debt and equity portion. The company has strong brand image and high profitability in its business. The company should be less worried about the financial leverage and market risk. After analyzing the financial details, it could be inferred that company has moderate cost of capital and has increased its return on capital employed throughout the time. Nonetheless, the debt portion should be increased to 30% to keep the balance between risk and cost of capital. It is easy to understand that increase in the debt portion will surely decrease the overall cost of capital of company (Cerutti, Dagher and Dell'Ariccia, 2017). References Baker, M. and Wurgler, J., 2015. Do strict capital requirements raise the cost of capital? Bank regulation, capital structure, and the low-risk anomaly.American Economic Review,105(5), pp.315-20. Birn, E., 2017.Taxation, technology, and the user cost of capital(Vol. 182). Elsevier. Cerutti, E., Dagher, J. and Dell'Ariccia, G., 2017. Housing finance and real-estate booms: a cross-country perspective.Journal of Housing Economics,38, pp.1-13. Cox, J. and Nguyen, T., 2018. Does the crowd mean business? An analysis of rewards-based crowdfunding as a source of finance for start-ups and small businesses.Journal of Small Business and Enterprise Development,25(1), pp.147-162. Cuevas?Rodrguez, G., Cabello?Medina, C. and Carmona?Lavado, A., 2014. Internal and external social capital for radical product innovation: Do they always work well together?.British Journal of Management,25(2), pp.266-284 Denis, D., 2016. Corporate Governance and the Goal of the Firm: In Defense of Shareholder Wealth Maximization.Financial Review,51(4), pp.467-480. Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital.Journal of Financial Economics,119(2), pp.300-315. Hrisch, J., Freeman, R.E. and Schaltegger, S., 2014. Applying stakeholder theory in sustainability management: Links, similarities, dissimilarities, and a conceptual framework.Organization Environment,27(4), pp.328-346. Kacperczyk, A., Beckman, C.M., and Moliterno, T.P., 2015. Disentangling risk and change: stake holder model and risk model comparison in the mutual fund industry.Administrative Science Quarterly,60(2), pp.228-262. Krger, P., Landier, A. and Thesmar, D., 2015. The WACC fallacy: The real effects of using a unique discount rate.The Journal of Finance,70(3), pp.1253-1285. Mitchell, R.K., Weaver, G.R., Agle, B.R., Bailey, A.D. and Carlson, J., 2016. Stakeholder agency and social welfare: Pluralism and decision making in the multi-objective corporation.Academy of Management Review,41(2), pp.252-275. Montmartin, B. and Herrera, M., 2015. Internal and external effects of RD subsidies and fiscal incentives: Empirical evidence using spatial dynamic panel models.Research Policy,44(5), pp.1065-1079. Ng, A.C. and Rezaee, Z., 2015. Business sustainability performance and cost of equity capital.Journal of Corporate Finance,34, pp.128-149. Ortiz-Molina, H. and Phillips, G.M., 2014. Real asset illiquidity and the cost of capital.Journal of Financial and Quantitative Analysis,49(1), pp.1-32. Petronas Gas Berhad Company 2017, annual report, retrieved on 22nd February 2017 from https://www.petronasgas.com/IR/Pages/Timeline.aspx Queen, P.E., 2015. Enlightened shareholder maximization: is this strategy achievable?.Journal of Business Ethics,127(3), pp.683-694. Rostamkalaei, A. and Freel, M., 2016. The cost of growth: small firms and the pricing of bank loans.Small Business Economics,46(2), pp.255-272. Schwarzmller, T., Brosi, P., Stelkens, V., Sprrle, M. and Welpe, I.M., 2017. Investors reactions to companies stakeholder management: the crucial role of assumed costs and perceived sustainability.Business Research,10(1), pp.79-96. Tantalo, C. and Priem, R.L., 2016. Value creation through stakeholder synergy.Strategic Management Journal,37(2), pp.314-329. Wang, D.H.M., Chen, P.H., Yu, T.H.K. and Hsiao, C.Y., 2015. The effects of corporate social responsibility on brand equity and firm performance.Journal of business research,68(11), pp.2232-2236. West, J. and Bogers, M., 2014. Leveraging external sources of innovation: a review of research on open innovation.Journal of Product Innovation Management,31(4), pp.814-831. Yahoo finance, 2018 retrieved on 19h January from https://in.finance.yahoo.com/