Goals prioritization for Debenhams Plc.

Debenhams Plc. operates as a multinational organisation in the international market. The company is British based. The operation of the entity is carried out in from of several departmental stores and franchisee model throughout the United Kingdom. Multi-fold client provisioning has resulted in enormous success for the company in recent years. The current report has laid out the goals except wealth maximisation that can be prioritised for the organisation. An analysis is made into the capital structure of the company to figure out the various sources that the company is funding its requirements from.  The management motive behind the company’s selection of the certain external financing sources has been tried to be understood.  A study of the concept of the weighted average cost of capital is made to gather knowledge regarding the different problems that the company might have faced while using the costing model. However, the industry of entity’s operations also affects the operating and financing pattern that the entity follows. No matter what kind of external financing the firm resorts to, there is always a weighted average capital cost computed for the company. The report is summed up with a theoretical discussion of the weighted average cost of capital and the practical conditions that revolve while applying the model. The company chosen for the preparation of report is Debenhams Plc.  Various complex topics are conceptualised in a smooth manner with the use of the given company. The capital structure is the main key point for determining the cost of capital and financial leverage of business (Debenhams Plc., 2018).

The aim behind adoption of this model is to increase value that the shareholders shall receive. The increment in the value shall be made only when the market capitalisation increases. The increase in the market capitalisation can be achieved when the market price of the shares can be incremented. As per this model all the decisions should be taken by the management with a view to increase the return that the shareholders shall get. This maximization of shareholders value is increased when company align the interest of the stakeholder’s with the organization development (Smith, Russell, and Tennent, 2017). The justification of this model is that the shareholders signify the real owners that the company have. They shall add to the investment which can sustain the company in the longer run. To keep the investors stay in the entity and add their investments it’s important to add to the value that they shall receive (Kilroy, and Schneider, 2017).

Capital structure and funding sources of Debenhams Plc.

This model asks for providing the shareholders with certain and reasonable return but does not strive for some maximum return. The aim is to make such investments that provide the entity with certain and stable cash flows. The risk is the main thing to be eliminated from the business transactions and outcomes (Delen, Kuzey, and  Uyar,  2013). This model can be placed in priority to all the other models as the focus of this model is to balance out different factors. Along with returns the risk is also strived to be managed. The sustainability of business strengthening in future is tried to be worked on (Nyeland, Laursen, and Callréusc, 2107).

The business does not run only for the benefit of shareholders. The needs of all the stakeholders need to be kept in mind and ultimately fulfilled. These stakeholders are necessary to be satisfied if the company wants to get successful in the longer run and sustain the roots of success.  The stakeholder models strengthen the business value and align the business values with the stakeholder’s interest (Robb, and Robinson, 2014). The model can be debated to be prioritised over the wealth maximisation model because for having successful in a social placement, the entity is legitimately required to fulfil the needs of all the stakeholders that include, society; government; employees, and etc. (Smith, Russell, and Tennent, 2017).

These are the certain objectives that help the company in laying its vision and objectives for the longer run. To set its roots stably in the environment the entity has to adopt them and keep them in mind as the time passes (Yan, 2017).

There comes a serious problem in reconciling these models as the stakeholders demand good quality services at a lower price, while the shareholders seek for increasing profits by charging higher prices. This amounts to an expectation gap between the two parties. However, the bigger picture suggests settlement of stakeholder demand that shall ultimately satisfy the shareholders.

Debenhams Plc. has raised money for its operations from some external sources. It is practically not possible for the company to use completely retained funds and grow the business. The different sources from which the company has raised funds externally include the following (Ehiedu, V.C., (2014) such as Issue of common stock, short term borrowings, long term debt through debenture (Debenhams Plc., 2018).

The explanation of these different sources has been laid as follows:

Issue Of Common Stock: this is the most common way to raise funds by any organisation. Herein the company raises funds and make the fund providers real owners of the entity by providing them with ownership share in proportion with shareholding pattern they have. These fund providers get voting rights in the company’s general meetings. The return that is provided to the shareholders in this financing form is the value addition when the market price rises and any dividend if declared by the company. However, it is not necessary for the company to pay dividends regularly; however a regular dividend payment consolidates faith in shareholders’ minds. This is less risky for the company’s part in comparison with the debentures (Lashgari. 2015).

Weighted average cost of capital

Rights Issues:  this is the way in which the company invites the existing shareholders to purchase new shares that the company is issuing in the ratio they already hold shares. This is mandatory to be followed by the company to provide the existing shareholders at the same position and least impacted by further issue (Ogada, and Kalunda, 2017). It is the primitive right of the shareholders which allow existing shareholders to buy more shares of the company.

Short Term Borrowings: This debt borrowing includes short term financing tools such as trade payables, notes payable, and bank overdraft. This genre of funding is required to meet the fund requirements that are generated in day to day operations of the entity. The working capital requirements are fulfilled by this borrowing technique.

Debentures: Debenture borrowing is a long term fund raising technique which is pertaining to be the most popular nowadays. The debentures are issues in the public market and potential holders are invited to buy them. The holders of debentures get interest on a periodic basis which acts as a financing burden for the entity. But this pattern of borrowing is somehow secure as far the view of the holders is concerned. For the company a regular burden is fixed for the payment of interests. These debentures are issued at fixed interest rate.  Organizations which have low financial leverage must issue debentures. This will help organization to raise capital at cheapest cost and strengthen the business outcomes.

Loan Stock: This comprises of fixed interest bearing bonds that are unsecured and cannot be transferred.

Redeemable Preference Shares: these are those preference shares that have been issued by the company with a certainty to get redeemed or repaid after a certain fixed term.

The main area of difference between both kinds of external fund raising areas is depicted here. When funds are raised through issuance of common stock or right shares, the fund gathered is counted as company’s owned fund as the fund providers are considered to be the actual owners of the company. Whereas, when debt funds are rescued by, the funds are always borrowed and charge company with a periodic interest for the loaned amount. There is no ownership and it has to be returned in priority in case the company falls in the clutches of liquidation.

Further, the debt holders get no right to take part in the controlling operations of the organisation. While when the shareholders of common stock are considered they all get to have power to vote and take controlling positions. The tax benefit is not offered on the dividend which is paid to the owners, but the interest payment made as the financing cost is mostly the operating expense and the company is offered with tax benefit for the same.

Shareholder value maximization vs stakeholder models

Further, the investors that invest in the company’s common stock do not directly ask for any security, which in the case of debt fund is collateral. The investors just look for the company’s financial position to take the investment decision (Baker, and Wurgler, 2015).

Debenhams Plc. as discussed is a multinational brand having retail business across United Kingdom. The company shows a vibrant profile of profiteering and is working well. The revenues of the company are filling well in the company’s objectives. The revenues have shown a stark rise of 12% as compared to the statistics of company’s presented for last three years. The company works in diversified product range since its establishment. The company product category includes a wide range of products from widely famous brands and some of the company’s owned brands. The company’s performance statistic is presented below:

Particulars	Formula	DEBENHAMS PLC ADR  (DBHSY)
		2013-08	2014-08	2015-08	2016-08	2017-08
Net profit Margin	Net profit revenues	6%	4%	4%	4%	2%
Return on equity	Net profit Equity	17%	11%	11%	10%	5%
Earnings per share	Net profit Share outstanding	0.50	0.25	.1.5	0.65	0.45

The increased business profitability and high return on capital employed is the positive indicator for the future growth of the organization. Since last three years, the profitability have gone down and resulted to high risk for the business sustainability.

As already discussed the company has made in its financing both the equity financing and debt financing. The table presented below shall throw light on the financing division into debt equity for the company:

CAPITAL STRUCTURE	AMOUNT (GBP IN MILLION)
	2013	2014	2015	2016	2017
Equity	744	767	853	884	918
Debt	1388	1381	1289	1307	1,292
Total capital	2133	2148	2143	2191	2,210

The above table shows the clear inclination of the company towards the equity funds as compared to the debt funds. A close look and study of the balance sheet tells that the main rise for inclination comes to be the rise in the retained earnings for the company.

These factors are determined on the basis of the internal and external factors which may directly and indirectly influence the cost of capital and return on capital employed of the company. The underlying factors that have motivated the company to choose the external financing pattern in the manner depicting above are explained as follows:

Fulfilment of debt covenants relating to existing debt: The most important internal factor that might have laid the company to finance with the help of more equity is the already taken debt by the company. The debt providers might have laid certain restrictions on the company to prevent from raising further debt and may require fulfilment of certain other requirements to get the new debt raised (Debenhams Plc., 2018).

Historical performance: Before raising the level of either of debt or equity the company needs to look into the way it has performed in the near past. A trend analysis is required to be made to analyse whether the company is able to successfully exploit the benefits of using larger debt in its capital structure, or whether it has just been adding to the cost of the company.

External financing sources of Debenhams Plc.

Maintenance of certain working ratios: The trend analysis that the company performs may require it to maintain a certain gearing level or keep the debt equity ratio to a certain point, or to work out some other ratios relating to capital structure within acceptable limit. To fulfil that certain requirement a selection between either debt or equity can be made by the company (Öztekin, 2015).

Economic conditions of market: sometimes the market scenario proves to be the prominent factor that affects the choice of external finance. The market may at times show a boom that makes the company require urgent funds to cater the business operations. The fund is not that readily available when it comes to equity borrowing as the formalities are bit more as compared to raising debt. This way the company may end up choosing debt.

Interest rate effect: if the interest rate on debt is such that the company is offered with more benefits in terms of tax reductions and increased overall return on capital employed, the company must choose debt over equity.

Movement in tax rates: the tax rate fluctuations are a major area to be analysed. Higher rate of tax can promote debt financing as it shall help the company to take the benefit of reduction of tax amount with the help of interest expense. Vice versa can be observed in case when the tax rates are low (Graham, Harvey, and Puri, 2015). 

MEANING: weighted average cost of capital (WACC) helps the company to compute the minimum and reasonable rate that its investor should expect out of any investment that the company wants to invest their money into. This rate is calculated as an average cost rate that averages the cost rate for both equity and debt. Any investment project whose rate of return is analysed needs a comparison to be made with the weighted average cost of capital (Frank, and Shen, 2016).

FORMULA:  The WACC can be calculated in the following manner:

WACC = ((E/V) * Re) + [((D/V) * Rd) * (1-T)]

Where,

 E = company’s equity market value

D = company’s debt market value

 V = overall market value of both debt and equity

Re = Cost of Equity

Rd = Cost of Debt

T = prevailing Tax Rate

Process to compute the WACCC by using the CAPM model

Step-1

By using the CAPM model, beta firstly would be computed by using the regression analysis.

	df	SS	MS	F	Significance F
Regression	1	0.005802	0.005802	4.919688	0.03718544
Residual	22	0.025944	0.001179
Total	23	0.031746
	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Lower 95.0%	Upper 95.0%
Intercept	-0.008492084	0.007562	-1.12293	0.273571	-0.024175555	0.007191	-0.02418	0.007191
X Variable 1	-0.130042533	0.05863	-2.21804	0.037185	-0.2516328	-0.00845	-0.25163	-0.00845

Financial performance statistics of Debenhams Plc.

Beta= -.013 (Debenhams Plc., 2018).

Step-2

After that cost of equity would be computed

Computation of the cost of equity-17
Rf	1.75%
RM	-19.66%
beta	-0.130042533
Cost of equity	4.5349%

Cost of equity= RF+ (Rm- Rf) Beta

Cost of equity = 4.5%

Step-3

After that cost of debt would be computed.

Particular	GBP amount in million.
Interest-2017	11
Cost of debt	0.85%
tax	30%
KD	0.60%

The weighted average cost of capital is used to determine the cost of capital and the payment which would be paid by the company to pay off the amount of investment taken by it from the investors (Debenhams Plc., 2018).

Step-4

The WACC calculation for the Debenhams Plc. for the financial year 2017 is shown by the table presented below (Debenhams Plc., 2018).

CAPITAL STRUCTURE	AMOUNT (GBP MILLION)	Re/Rd	% of portion (E/V or D/V)	WACC [(E/V)* Re] or [D/V)* Rd]
Equity	918	1.72%	42%	0.713%
Debt	1,292	0.60%	58%	0.348%
Total capital	2,210	WACC		1.062%

WACC would be =1.06%

The weighted average cost of capital is computed on the proportionate basis of the equity capital and debt portion. Cost allocated to the all types of funding of the business is divided on their proportionate basis to determine the weighted average cost of capital. If the interest rate on debt is low then company would be offered with more benefits in terms of tax reductions and increased overall return on capital employed, the company must choose debt over equity. Ideally, company uses the debt funding to lower down the cost of capital but in case of low profitability or sluggish market condition, company might face sustainability risk in the business (Debenhams Plc., 2018).

Issues:

 The given information is available from the company’s statement of financial position, i.e. the balance sheet. The use of the provided formula requires the company to compute the cost of equity and the cost of debt also.

The cost of equity can be calculated using either of the dividend valuation model or the capital asset pricing model. Both the formulae use their own assumptions and certain of them are not practical too. Similarly, the cost of debt may be calculate dafter tax or before tax (Barberis, et. al 2015).

The financial leverage and cost of capital are the core factor to determine the capital structure of company.

Further, while calculation the WACC for the company, the weights that have been used are the balance sheet weights and not the real time market values of the company’s capital structure. This does not provide the exact weighted position of the company’s capital structure composition.  The weighted average cost of capital is computed to determine the overall costing of the raised capital and return on capital employed of company.

Conclusion and recommendation of capital structure for Debenhams Plc

Cost of capital and financial leverage are the two main bases to determine the overall financial capital structure of company. The capital structure of any organisation provides details regarding the use of the level of debt and equity by the entity in its financing pattern. Company should determine the equilibrium point at which company would have balanced financial leverage and cost of capital. The overall analysis that have been performed on the company over the years should be used a main power tool to decide on whether the equity financing or the debt financing is more beneficial for the company. The tax rates must be looked to evaluate the benefit that shall be provided if the company uses more debt. However, a comparison is also required to make by calculating WACC using different levels of debt and equity to obtain an optimised debt and equity level, at which the cost is least and benefits are at their best. The following graph use of an optimum debt and equity level that shall help in providing maximum value at the least cost.

As per this graph, it is evident that the company can achieve maximum value for its shares at a certain point on which there is a balance between both debt and equity. At that point the firm is appropriately levered and that helps the organisation to reach a point where the cost of debt, cost of equity and the resultant weighted average cost of capital is most optimal. The cost cannot be said to be the least on that level as the firm’s value is also to be seen for the optimal level.

References

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