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Cost Of Capital And Capital Structure, Australian Catholic University, Australia

BAFN200 Principles of Finance

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Question: Cost of capital and capital structure

Determine the cost of capital for each source of finance as well as the weighted average cost of capital for 2018. What does the WACC suggest for the company? Provide an evaluation of the company's capital structure policy and recommend an appropriate capital structure policy for the company. Do you find the capital structure risky for the company? Justify your answer.

Answer: Cost Of Capital & Capital Structure: The cost of capital is the cost that the company incurs to finance its capital. It is the cost of funding of capital from different sources like equity and debt.

The cost of capital and the WACC of the Qantas Airways Ltd has been calculated below using the details from Guru focus.

Cost of debt= Interest expense/Total book value of debt

= 172.413793103 / 3609.41352319

= 4.78%

The tax rate as per Guru focus= 28.66%

Therefore, Cost of debt after tax= 4.78%*(1-28.66%)

= 3.41%

Calculation of cost of equity using the CAPM model-

Qantas Airways Ltd.'s beta - 0.29

Market Risk premium- 6%

Current Rf- 1.96%

Cost of equity= Rf +(Rm-Rf) *beta

= 1.96% + 0.29 * 6%

= 3.700%

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Calculation of weights of debt and equity-

 

Book value(million)

Weights

Debt

                      3,609.41

0.374328096

Equity/market capitalization

                      6,032.96

0.625671904

Total capital structure

                      9,642.37

 

Calculation of WACC-

 

Weightage

Cost of Capital

WACC

Long Term Debt

37.43%

3.41%

1.28%

Common Stock

62.57%

3.70%

2.31%

WACC

 

 

3.59%

The WACC tells us about the return that the shareholders of a company can expect and the opportunity cost that the investors of a company bear in return for investing in the capital of the company. The WACC of the has been calculated based on the June 2018 data. The WACC of Qantas Airways Ltd comes to 3.59%. This means that the company is low at risk from the investors and the company, Qantas Airways Ltd, bears the low cost of financing its capital. 

The capital structure of the company consists of debt and equity.The equity portion of the company is more than the debt portion. The weight of debt comes to 37.43%, and that of equity is 62.57%. This means that the risk portion or the debt of the company is relatively low as compared to the equity value of the company. The owners of the shareholders of the company are more secured.

An idle capital structure of any company should have a higher portion of equity and a lower amount of debts. Debt represents more amount of future obligations to be paid by the company, and so it should be as low as possible. I believe that the capital structure of Qantas Airways Ltdis appropriate. However, the target capital structure of the company should be a 100% equity financed firm. The organization should aim at having no debt in its capital structure. This would be best for the company. This would tend to reduce the interest obligations of the company that the company with debt has to pay in future. This will also decrease the outlay of cash. The cost of debt of the company is 4.78% which is more than the cost of equityof the company. The company should aim at reducing this cost. This would also keep the shareholders of the company satisfied and would reduce their opportunity cost as well as boost their confidencein the company.

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