Sample Answer
Discount Rates, Capital Structure, Dividend Policy and Valuation
Introduction
Corporate financial strategy focuses on how firms raise finance, allocate capital, reward shareholders, and create long-term value. This assignment evaluates BAE Systems’ financial strategy by analysing its cost of capital, capital structure, dividend policy, valuation, and shareholder value creation. The analysis uses established corporate finance theory and applies it to BAE Systems’ financial performance over the last five years. The aim is to assess how effectively BAE Systems has managed its financing decisions and whether these decisions have supported sustainable shareholder value.
Discount Rates and Cost of Capital
Cost of Equity
The cost of equity represents the return required by shareholders for investing in BAE Systems. It is estimated using the Capital Asset Pricing Model, which links expected returns to systematic market risk.
Cost of equity is calculated as:
Cost of Equity (Ke) = Risk-free rate + Beta × (Market return − Risk-free rate)
For example, using a UK government bond yield of 3.5 percent as the risk-free rate, a market return of 8 percent, and a beta of 0.80:
Ke = 3.5% + 0.80 × (8% − 3.5%)
Ke = 3.5% + 0.80 × 4.5%
Ke = 3.5% + 3.6%
Ke = 7.1%
Across the last five years, BAE Systems’ cost of equity has remained relatively stable, reflecting its defensive industry position and predictable earnings from long-term government contracts. However, changes in interest rates and market risk premiums have caused moderate fluctuations year to year.
Cost of Debt
The cost of debt reflects the effective interest rate paid on borrowings. It is calculated using interest expense divided by total interest-bearing debt and adjusted for tax.
Cost of debt before tax = Interest expense ÷ Total debt
Cost of debt after tax = Cost of debt × (1 − Corporate tax rate)
For example, if BAE Systems’ average borrowing cost is 4.5 percent and the UK corporate tax rate is 19 percent:
Cost of debt after tax = 4.5% × (1 − 0.19)
Cost of debt after tax = 3.65%
BAE Systems benefits from relatively low borrowing costs due to its strong credit profile and stable cash flows. The tax deductibility of interest further reduces the effective cost of debt.
Weighted Average Cost of Capital
The weighted average cost of capital represents the blended cost of financing from both equity and debt.
WACC is calculated as:
WACC = (Equity ÷ Total capital × Cost of equity) + (Debt ÷ Total capital × Cost of debt × (1 − Tax rate))
Assuming equity represents 60 percent of total capital and debt represents 40 percent:
WACC = (0.60 × 7.1%) + (0.40 × 4.5% × (1 − 0.19))
WACC = 4.26% + 1.46%
WACC = 5.72%
Over the last five years, BAE Systems’ WACC has remained relatively low, reflecting a balanced mix of debt and equity and disciplined financial management.
Capital Structure and Financial Risk
BAE Systems operates with a moderate level of leverage, which is common in capital-intensive industries. The company uses debt strategically to benefit from lower financing costs while maintaining financial flexibility.
The debt to equity ratio is calculated as:
Debt to equity ratio = Total debt ÷ Total equity
An illustrative ratio of 0.86 indicates that debt is significant but not excessive.
BAE Systems’ ability to service its debt can be assessed using the interest coverage ratio:
Interest coverage ratio = Operating profit ÷ Interest expense
For example:
Interest coverage = 3,600 million ÷ 800 million
Interest coverage = 4.5 times
This suggests that operating profits comfortably cover interest payments, indicating low default risk. However, higher leverage increases financial risk and raises the cost of equity, as shareholders demand compensation for increased volatility.
