Section C

AquaGrid Networks

AquaGrid Networks is a public utility company planning to build a new desalination plant. The board is reviewing both its working capital policy and its overall cost of capital.

Part 1: Working Capital Policy
AquaGrid currently adopts a conservative working capital financing policy. The new CFO is proposing a shift to an aggressive working capital financing policy to improve profitability.

Part 2: Cost of Capital
To fund the desalination plant, AquaGrid will issue new 'Green Bonds'. The current capital structure (by market value) is:

• Equity: $60 million
• Debt: $40 million

The current cost of equity is 12%, and the current post-tax cost of debt is 5%.

The new Green Bond issue will raise $20 million. The post-tax cost of this new debt will be 4%.
Because of the increased gearing, the cost of equity is expected to rise to 14%. The existing debt's cost will remain at 5%.

Required:

(a) Explain the difference between a conservative and an aggressive working capital financing policy. Discuss the impact this shift will have on AquaGrid's profitability and liquidity risk. (8 marks)

(b) Calculate AquaGrid's current Weighted Average Cost of Capital (WACC) before the new bond issue. (4 marks)

(c) Calculate AquaGrid's revised WACC after the $20 million Green Bond issue. (4 marks)

(d) Based on your calculations in (b) and (c), explain whether the new bond issue has maximized shareholder wealth according to the traditional view of capital structure. (4 marks)

**Part (a) Working Capital Financing Policy** - **Conservative Policy:** A conservative policy uses long-term finance (equity and long-term debt) to fund all permanent current assets and a portion of fluctuating current assets. Short-term finance is only used for the peak of fluctuating current assets. - **Aggressive Policy:** An aggressive policy uses short-term finance (e.g., overdrafts) to fund all fluctuating current assets and a portion of permanent current assets. Long-term finance is only used for fixed assets and the remaining permanent current assets. - **Impact on Profitability:** Short-term debt is generally cheaper than long-term debt (due to the normal yield curve). Therefore, shifting to an aggressive policy will reduce interest expenses, thereby increasing profitability. - **Impact on Liquidity Risk:** An aggressive policy significantly increases liquidity risk. The company relies heavily on short-term debt, which must be constantly renewed. If the bank withdraws the overdraft facility, AquaGrid could face insolvency. It also exposes the company to short-term interest rate fluctuations. **Part (b) Current WACC** Total Market Value = $60m (Equity) + $40m (Debt) = $100m. Weight of Equity = 60/100 = 0.60 Weight of Debt = 40/100 = 0.40 WACC = (0.60 × 12%) + (0.40 × 5%) WACC = 7.2% + 2.0% = 9.2%. **Part (c) Revised WACC** New Total Market Value = $60m (Eq) + $40m (Old Debt) + $20m (New Debt) = $120m. Weight of Equity = 60/120 = 0.50 Weight of Old Debt = 40/120 = 0.333 Weight of New Debt = 20/120 = 0.167 Revised WACC = (0.50 × 14%) + (0.333 × 5%) + (0.167 × 4%) Revised WACC = 7.00% + 1.67% + 0.67% = 9.34%. **Part (d) Shareholder Wealth and Traditional View** According to the traditional view of capital structure, there is an optimal level of gearing where the WACC is minimized, thereby maximizing the total value of the firm and shareholder wealth. In this scenario, the WACC has increased from 9.2% to 9.34%. Although the new debt is cheap (4%), the increased financial risk has caused equity investors to demand a significantly higher return (from 12% to 14%). The cost of this more expensive equity outweighs the benefit of the cheap debt. Therefore, the new bond issue has not maximized shareholder wealth; it has destroyed value by increasing the overall discount rate applied to the firm's cash flows.