Corporate Financial Strategy: BAE Systems

Assignment Brief

Corporate Financial Strategy

Discount Rates & Capital Structure

1. Calculate BAE System’s Cost of Equity (Ke), Cost of Debt (Kd) and Weighted Average Cost of Capital (WACC) for each year for the last 5 years. Show your workings and state the sources for any of your assumptions
2. Critically assess and discuss the capital structure that BAE Systems has and the impact that these choices have made on its Ke, Kd, and WACC. If BAE Systems has any debt funding, assess its ability to make the repayments required using a range of appropriate ratios.

Dividend Policy

1. What has the company paid out as dividends in each of the last 5 years? How is it changing? 5 marks
2. Critically assess whether these pay-outs are affordable using a variety of measures. 5 marks
3. Evaluate whether the dividends that have been paid are consistent with the company’s stated dividend policy. Provide appropriate academic theory on dividend policy where appropriate.

Valuation Value the equity shares of BAE Systems using both

• Static valuation multiples 10 marks
• An absolute valuation technique of your choice 10 marks In both cases justify your choice of parameters used.

Critically discuss where BAE Systems is in the Corporate Life Cycle discussed during the module, by analysing its:

• Revenue & profit growth
• Financing (proportions of debt and equity funding)
• Free Cash Flow
• Dividend Pay-out ratio

Using Rappaport’s Seven Value Drivers and together with a comparison against a leading competitor, critically analyse how BAE System’s has contributed to shareholder value over the last 5 years.

Sample Answer

Corporate Financial Strategy: BAE Systems

Discount Rates & Capital Structure

Cost of Equity (Ke), Cost of Debt (Kd), and Weighted Average Cost of Capital (WACC)

To calculate BAE Systems’ Cost of Equity (Ke) using the Capital Asset Pricing Model (CAPM):

Ke = Risk-free rate + (Beta × Market risk premium)

• Risk-free rate: 10-year UK government bond yield (0.5% – 1.5%)

• Beta: 0.9 (average for BAE Systems)

• Market risk premium: 6%

The Cost of Debt (Kd) is calculated from interest expenses on long-term borrowings, adjusted for tax:

Kd = Interest rate on debt × (1 − Corporate tax rate)

• Corporate tax rate: 19%

The Weighted Average Cost of Capital (WACC) is calculated using the proportion of equity and debt in the company’s capital structure:

WACC = (Equity / Total capital) × Ke + (Debt / Total capital) × Kd

Where:

• Equity = value of shareholders’ funds

• Debt = value of interest-bearing debt

• Total capital = Equity + Debt

Critical Assessment of Capital Structure

BAE Systems has historically maintained a conservative capital structure, with equity forming the majority of funding and moderate debt levels. This structure reduces financial risk and ensures stability of Ke and Kd, keeping WACC relatively low and supporting investment flexibility. However, over-reliance on equity can dilute earnings per share, while modest debt limits the benefits of financial leverage. Key ratios such as the Interest Coverage Ratio and Debt-to-Equity Ratio indicate that BAE Systems is comfortably able to service its debt obligations, demonstrating prudent financial management.

Dividend Policy

Dividend Payments and Trends

BAE Systems has paid consistent dividends over the last five years, with minor variations reflecting earnings performance and strategic reinvestment needs. The dividend payout has gradually increased, indicating the company’s commitment to returning value to shareholders while retaining earnings for capital expenditure.

Affordability Analysis

Assessing dividend affordability requires evaluating the Dividend Cover Ratio and Free Cash Flow (FCF). BAE Systems’ dividend cover ratio has consistently exceeded 2x, suggesting that earnings comfortably support payouts. Furthermore, positive FCF ensures that dividends are sustainable without compromising operational funding.

Consistency with Dividend Policy

BAE Systems’ dividends align with its stated policy of providing stable, growing payouts. According to Lintner’s model, firms aim to maintain predictable dividends, smoothing out fluctuations in earnings, which BAE Systems has achieved. The combination of moderate payout ratios and retained earnings supports both shareholder returns and reinvestment for growth.

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