The cost of capital is paramount to business expansion and meeting the investors’ expectation. The difference between the cost of capital and commercial returns determines the entity’s profitability. Given the importance of cost of capital in an organization, this study evaluates the MTR Company in light of its operation and expected operation in the debt and equity market. Some of the issues addressed are the issues that are facing the company, the cost of debt and equity of the company and calculate of its WACC.
The Key Issues Facing MTR
The first key issue facing MTR is to determine the issuing costs for new capital from debt and equity market and from the retained earnings. The company has to develop an optimal capital structure that balance between these three sources. Debt capital will attract interest charges, and more debt will affect the balance sheet of the company given that it has already issued 2 bonds totaling US $ 550 million. Equity market does not attract new financial encumbrances but will cost 6% underwriting fees. The retained earnings belongs to the shareholders and they will need return on it. Thus the company has to develop optimal capital sources balance.
The second issue is deciding on the return, lending rate, or yield against which they will benchmark the company’s equity returns. In Hong Kong, where the company is based, the have been few long term debt issues that can be used as a benchmark leaving the management to handle the issue of whether a foreign long return (US long term debt) should be used). On addition, given that Hong Kong dollar is pegged to US dollar and there are no long term debts issued in Hong Kong currently, the company is faced with a dilemma on whether to use Hanseng Index or US equity returns to determine the company’s beta.
Third, the mangers are faced with impasse on whether to use the average cost of all the forms of financing to evaluate the projects to use the cost of the next source of finance as a hurdle rate for any new project undertaken by the company. On addition the company has to decide MRR and NPV method to evaluate its projects. The major issue facing the company is determine the cost for borrowing capital or getting capital from any other source.
Cost of Capital in MTR
Cost of capital is used to refer to the cost of funds that are used to finance business. It depends on the form of financing, that is, if a business is solely financed with equity, it is referred to as the cost of equity and when it is unitarily financed by debt it is called cost of debt. Many entities use combine debt and equity to finance businesses. In this kind of company the cost of company is derived by getting the weighted average (WACC) of the sources of the capital. Cost of capital usually represents the hurdle rate which has to be overcome before the company can generate the value. Cost of capital is extensively used in during the capital budgeting process to evaluate whether a company is supposed to proceed with a given project or not (Drake & Fabozzi, 2012).
MTR can use the cost of capital to evaluate its project. The company can develop a weighted average of the costs from all the sources of capital (debt and stock) to evaluate the projects. Cost of capital can be used on NPV to discount the expected future returns. It can also be compared with IRR in order to get the net returns, that is, the difference between cost of capital and IRR to get the differential benefit to the company.
MTR’s Cost of Debt
Cost of debt can be looked as the required return on the debt instrument such as bond that is issued by an entity.
- Using net of tax formula
The cost of debt is calculated by considering the March 29th 2012 bond issue by MTR
Cost of debt = Rd (1-tc)
Debt yield to maturity = 2.175%
Hong King Tax rate = 16.5% for the companies
Cost of debt = 2.175 (1-0.165)
The yield to maturity of the bond issued in 2012 by the company is used because it reflects the interest paid by the company to the investors. The corporate tax in Hong is 126.5 and thus the net of tax rate is 83.5%.
- Using the interest expense
Using the method the cost of capital will be given by interest expense in the last fiscal year, divided by the latest two year debt
Interest expense in 2012 = 879
Debt in 2012 = HK$ 62432 million
Debt in 2011 = HK$ 63221 million
Average debt = HK$ 62827 million
Cost of debt = (879 / 62827) %
Cost of debt is obtained b…………….