ICT80008 Professional Issues In IT Oz Assignment
Delivery in day(s): 5
This assignment relates to ten analyses of financial sources and investment proposals for business using the capital budgeting techniques and models for estimating cost of capital such as Dividend Discount Model and Capital Asset Pricing Model. The first part of the assignment relates to the assessment of the financial viability of an investment project with the life of five years for a company namely Emu electronics by calculating the decision making tools such as Net present value of the project, it’s payback period, Internal Rate of Return, Profitability Index, sensitivity analysis etc. The decision for the investment project by the company is recommended on the basis of these calculations. The second part of ten assignments relates to ten estimation of cost of equity, cost of debt and weighted average cost of capital using the information extracted from the ASX website and Annual Report of a listed company. These calculations are used to estimate the cost of capital of non listed company Hubbard Computers Limited using pure play approach.
Emu Electronics is a 50 years old company which indulged in the repairing of radios and household appliances originally. The company expanded over the years and is now a leading manufacturer of electronic items including various smart phones with variety of colours and preprogrammed features. However with the changing technology in the recent times the smart phones manufactured by the company contained limited features as compared to the newer models available in the market. As a result the company planned to manufacture new smart phone with additional features such as Wife tethering. For this project the company spent $750,000 in developing the prototype of the new smart phone along with $200,000 for advertisement to predict the expected sales figures as initial investment. Also it purchased an equipment of $34,500,000. The other details related to the sales and profit from the expected sales of new smart phone for the next five years has also been estimated by the company. In order to assess the viability of the project the calculations have been made as follows to assist in deciding that whether Emu Electronics shall manufacture the new smart phone or not:
Calculation of profit and NPV

Year0 
Year1 
Year2 
Year3 
Year4 
Year 5 
Total 
Units 

64000 
106,000 
87000 
78000 
54000 

Sales 

31040000 
51410000 
42195000 
37830000 
26190000 

Less: Variable cost 

13120000 
21730000 
17835000 
15990000 
11070000 

Contribution 

17920000 
29680000 
24360000 
21840000 
15120000 

Less Fixed Cost 

5100000 
5100000 
5100000 
5100000 
5100000 

Less: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Profit 

7020000 
18780000 
13460000 
10940000 
4220000 

Less: Tax 

2106000 
5634000 
4038000 
3282000 
1266000 

Profit after tax 

4914000 
13146000 
9422000 
7658000 
2954000 

Add: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Add: Working capital recovery 





19268781 

Add: Salvage value after tax 





3850000 

Net cash inflow 

10714000 
18946000 
15222000 
13458000 
31872781 

Present Value Factor @12% 

0.892857143 
0.797194 
0.71178 
0.635518 
0.567427 

Present value of cash inflows 

9566071.429 
15103635 
10834719 
8552802 
18085472 
62142699.67 
Cash Outflow 







Prototype development cost 
750000 





750000 
Marketing cost 
200000 





200000 
Equipment cost 
34500000 





34500000 
Net working capital after tax 

4345600 
7197400 
5907300 
5296200 
3666600 

Present Value Factor @12% 

0.892857143 
0.797194 
0.71178 
0.635518 
0.567427 

Present value of cash outflows 

3880000 
5737723 
4204699 
3365831 
2080527 
19268780.83 
Net Present Value 






7423918.844 
(Jarrow, 2014)
Payback period of the project is the duration or the time period which is required by the project to generate the cash inflows equal to the initial cash investment into the project. It is the period which represents the duration of payback of the initial investment into the project. If the payback period of the project is less than the life of project then it means that the initial investment will be recovered within the life of the project after which the project will become profitable and therefore shall be accepted. The lesser the payback period, the better is the project for investment (Saxena, 2015). The payback period of the project can be calculated as follows:
Payback period = A+ B/C
Where,
A = Last period having negative cumulative cash flows
B = Absolute value of cumulative cash flow at the end of period A
C = Total cash flow during the period after A
Calculation of cumulative cash flows

Cash Inflows 
Cumulative cash inflows 
Year 0 
35450000 
35450000 
Year1 
5686071.429 
29763928.57 
Year2 
9365911.99 
20398016.58 
Year3 
6630019.474 
13767997.11 
Year4 
5186971.452 
8581025.655 
Year5 
16004944.5 
7423918.844 
Payback period of project = 4 + $8581025.66/$16004944.5
= 4 + 0.54
= 4.54 years
Thus the payback period of the project is 4.54 years.
Profitability Index of a project refers to as the factor which represents the ratio of payoff to the amount of investment in relation to a specific project. It is also known as Profit Investment Ratio or Value Investment ratio. This factor is used to make decisions about ten projects by ranking the projects since it is able to determine the quantity or value created per amount of investment into the project. The profitability index of ten projects is calculated as follows:
Profitability Index = Present value of cash inflows/ Present value of cash outflows
= $62142700/$54718780.83
= 1.14
Thus, the profitability index of the project is 1.14
Internal Rate of return of the project is the rate of discounting which is applied to make the present value of cash outflows from the project equal to the present value of cash inflows from the project. If the internal rate of return from the project is higher than it is desirable to undertake the project (Rogers, 2014). Thus the internal rate of return from the project shall be higher than its cost of capital to enable the acceptance of the project. The IRR of the project can be calculated using the spreadsheet software as follows:

Amount($) 
Year 0 
35450000 
Year1 
5686071.429 
Year2 
9365911.99 
Year3 
6630019.474 
Year4 
5186971.452 
Year5 
16004944.5 
IRR 
6% 
Thus the internal rate of return from the project is 6%.
Net present value is the value which represents the difference between present value of cash inflows from the project and present value of cash outflows from the project discounted at same rate. It represents the net cash flows that can be generated from the project during its life. The net present value from the project can be calculated using the following formula:
Where,
Ct = net cash flow during the period t,
Co = total investment cost,
r = rate of discount,
t = number of time periods
The net present value of the project calculated above using the spreadsheet software is $7,423,918.84.
Sensitivity of the project refers to as the change that may take place in the Net Present Value of ten projects if any of the elements used in the estimation of Net present value is changed such as sales price, quantity sold, variable cost or fixed cost, discount rate or life of project. The new NPV as a result of changes in the price of smart phone by increasing the price of smart phone by 1% to $489.85 per unit can be calculated as follows:

Year0 
Year1 
Year2 
Year3 
Year4 
Year 5 
Total 
Units 

64000 
106,000 
87000 
78000 
54000 

Sales 

31350400 
51924100 
42616950 
38208300 
26451900 

Less: Variable cost 

13120000 
21730000 
17835000 
15990000 
11070000 

Contribution 

18230400 
30194100 
24781950 
22218300 
15381900 

Less Fixed Cost 

5100000 
5100000 
5100000 
5100000 
5100000 

Less: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Profit 

7330400 
19294100 
13881950 
11318300 
4481900 

Less: Tax 

2199120 
5788230 
4164585 
3395490 
1344570 

Profit after tax 

5131280 
13505870 
9717365 
7922810 
3137330 

Add: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Add: Working capital recovery 





19461469 

ADD: Salvage value after tax 





3850000 

Net cash inflow 

10931280 
19305870 
15517365 
13722810 
32248799 

Present Value Factor @12% 

0.892857 
0.797194 
0.797194 
0.797194 
0.797194 

Present value of cash inflows 

9760071 
15390521 
12370348 
10939740 
25708545 
74169226.1 
Cash Outflow 







Prototype development cost 
750000 





750000 
Marketing cost 
200000 





200000 
Equipment cost 
34500000 





34500000 
Net working capital 

4389056 
7269374 
5966373 
5349162 
3703266 

Present Value Factor @12% 

0.892857 
0.797194 
0.71178 
0.635518 
0.567427 

Present value of cash outflows 

3918800 
5795100 
4246746 
3399489 
2101333 
62127231 
Net Present Value 






12041995.1 
Change in NPV due to change in price of new smart phone = $12041995.1  $7423918.84 = $4618076
% change in NPV = $4618076/$7423918.84*100 = 62.21%
Thus if the price of new smart phone is increased by 1% keeping other things constant, the NPV will also increase by 62.21%. This means that NPV is highly sensitive to the changes in price of new smart phone.
The new NPV after changes in the quantity sold of new smart phone can be calculated as follows where the quantity of new smart phones sold each year is increased by 1%:

Year0 
Year1 
Year2 
Year3 
Year4 
Year 5 
Total 
Units 

64640 
107,060 
87870 
78780 
54540 

Sales 

31350400 
51924100 
42616950 
38208300 
26451900 

Less: Variable cost 

13251200 
21947300 
18013350 
16149900 
11180700 

Contribution 

18099200 
29976800 
24603600 
22058400 
15271200 

Less Fixed Cost 

5100000 
5100000 
5100000 
5100000 
5100000 

Less: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Profit 

7199200 
19076800 
13703600 
11158400 
4371200 

Less: Tax 

2159760 
5723040 
4111080 
3347520 
1311360 

Profit after tax 

5039440 
13353760 
9592520 
7810880 
3059840 

Add: Depreciation 

5800000 
5800000 
5800000 
5800000 
5800000 

Add: Working capital recovery 





19461469 

ADD: Salvage value after tax 





3850000 

Net cash inflow 

10839440 
19153760 
15392520 
13610880 
32171309 

Present Value Factor @12% 

0.892857 
0.797194 
0.797194 
0.797194 
0.797194 

Present value of cash inflows 

9678071 
15269260 
12270823 
10850510 
25646770 
73715434.8 
Cash Outflow 







Retype development cost 
750000 





750000 
Marketing cost 
200000 





200000 
Equipment cost 
34500000 





34500000 
Net working capital 

4389056 
7269374 
5966373 
5349162 
3703266 

Present Value Factor @12% 

0.892857 
0.797194 
0.71178 
0.635518 
0.567427 

Present value of cash outflows 

3918800 
5795100 
4246746 
3399489 
2101333 
62127231 
Net Present Value 






11588203.8 
Changes in NPV = $11588203.8  $ 7423918.84= $4164285
% change in NPV = $4164285/$ 7423918.84 = 56.10%
If the quantity of new smart phones each year is increased by 1%, the NPV will also increase by 56.10%. Thus NPV is highly sensitive to changes in quantity of smart phones sold every year during the life of the project.
The net present value of the project is positive which means that the project will be able to generate cash inflows from the investment. The Internal rate of return from the project is 6% which is less than its discounting rate or cost of capital. However the payback period from the project is less than its life. Also the NPV is highly sensitive to the price of new smart phone and quantity sold. Thus Emu Electronics shall invest in the project since it has positive NPV and NPV can also be increased after making changes in the price and quantity of expected sales of new smart phones.
Due to ten sales of new smart phones the sales of other models produced by the company will be affected. The amount of loss from decrease in sales of other models shall be estimated by emu Electronics. If ten amount of loss exceeds the net present value from the project then the project shall be accepted otherwise not since it will result in an overall loss for the company. Thus, the analysis of project will be affected to the extent the loss from sales of other models do not exceed the profit from the project (Davies, 2011).
In the given case Hubbard Computers Limited is a privately owned company owned by Bob Hubbard and his family. The company is indulged in the sales of computers through 14 stores operated by it in the South Island of New Zealand. The growth of ten companies is financed by its profits and sufficiency of capital. The company plans to open a new store on the basis of analysis using the capital budgeting techniques. However it is difficult for the company to estimate its cost of capital since it is privately owned therefore the company proposes to use Harvey Norman as pure play company to estimate its cost of capital.
Details 
Amount ($) 
Book value of debt

290,000,000 
Book Value of Equity Contributed equity $380,328,000 Reserves $113,290,000 Retained profits $2,043,463,000 
2,537,081,000 
Most recent listed stock price per share 
5.12 
Market capitalization/Market value of equity 
57 billion 
Shares outstanding 
1112.56 million 
Most recent annual dividend 
17 cents 
This is the method or procedure which is used to calculate the value of stock of a company on the basis of predicted dividends for future years and then discounting them back at the current year to estimate the actual worth of share in terms of dividend. It is the present value of all future dividends to be payable by ten company in coming years. If the value of shares of company calculated using the Dividend Discount Model is higher than the value at which the stock of company is currently trading then the share of ten company is undervalued (Baker, 2011). However in this case the cost of equity has to be estimated and the price of company’s share is given. The cost of equity of Harvey Norman can be calculated as follows:
P = D1/rg
Where
P is the current stock price,
D1 is the value of dividend of next year,
r is the cost of equity,
g is the growth rate in perpetuity which is expected for the dividends.
P = $5.12 per share
D0 = $ 0.17
g = 14.30%
Applying these values to the above formula,
5.12 = 0.17 (1 + 0.1430)/ r – 0.1430
r – 0.1430 = 0.1943/5.12
r = 0.0380 + 0.1430
r = 18.1%
Thus the cost of equity of Harvey Norman estimated using the Dividend Discount Model is 18.1%.
Capital Asset Pricing model is the method which is used to calculate the cost of equity on the basis of beta of the company and risk premium of market in comparison to the risk free rate of return prevailing in the market. The value of beta multiplied by market risk premium which is assumed as the cost of risk for the company is added to the risk free rate of return to calculate the cost of equity of company.
Beta of Harvey Norman is 0.76. The 5 year yield on government debt is 1.75%. The historical market risk premium is 4.5%.
As per CAPM
Cost of Equity = Risk free rate + Beta x Market risk premium
= 1.75% + 0.76*4.5%
= 5.17%
Thus the estimated cost of equity of Harvey Norman using the Capital Asset Pricing model is 5.17%.
Cost of debt is the rate of cost incurred by the company for its capital which was sourced as finance in the form of debts. The value of debts presented or reported by the company in its books is different from the value of debts prevailing in the market. Thus the weighted average cost of all the debts of the company can be calculated using either book value weights or market value weights for the debts to which each element of finance cost relates.
The weighted average cost of debts of Harvey Norman can be calculated as follows:

Market value (Amount $000) 
Book value (Amount $000) 
Rate 
Market value weights 
Book value weights 
Borrowings 
561,808 
290,000 
5.93% 
33,315.21 
17197 
Financial lease 
139 
0 
9.50% 
13.21 
 
Total 
561,947 
290,000 

33,328.21 
17,197 
Using market value weights
Cost of debt = 33,328.21/561,947*100
= 5.93%
Using book value weights
Cost of debt = 17,197/290,000
= 5.93%
Hence the cost of debt of Harvey Norman under both the methods is same which is calculated to be 5.93%.
Using book value weights
WACC = Cost of equity * Weight of equity + Cost of debt*Weight of debt
Weight of debt = Debt/ Equity + Debt
= 290,000/ 2537,081 + 290,000
= 0.1026
Weight of Equity = Equity/ Debt + Equity
= 2537, 081/ 2537,081 + 290,000
= 0.8974
WACC = 5.17% * 0.8974 + 5.93% (10.30)*0.1026
= 5.07%
Using market value weights
WACC = Cost of equity * Weight of equity + Cost of debt*Weight of debt
Weight of debt = Debt/ Equity + Debt
= 561,947/ 2537,081 + 561,947
= 0.1813
Weight of Equity = Equity/ Debt + Equity
= 2537, 081/ 2537,081 + 561,947
= 0.8187
WACC = 5.17% * 0.8187 + 5.93% (10.30)*0.1813
= 4.99%
The weighted average cost of capital of Harvey Norman calculated using the market value weights represent the current market value of debts and cost to company in relation to those debts, therefore the cost of debt calculated using the market value weights is more reliable cost which shall be considered as more relevant weighted average cost of capital (Barth, 2013).
Pure play approach is the method which is used to estimate the coast of capital of a company which is not publicly listed by taking some listed company as a pure play company on the basis of which the estimation of the cost of capital of non listed company can be made. This method is used since the beta of a non listed company cannot be estimated which can be applied in CAPM or other valuation models to calculate the cost of capital. Since Hubbard Computers Limited is a non listed company therefore Harvey Norman which is an ASX listed company can be used as a pure play company to estimate the cost of capital of HCL. This can be done as follows:
Formula for pure play approach
Unlevered Beta of B = (Equity) Beta coefficient of B/ 1 + Debt Equity Ratio of B X (1Tax rate of B)
Equity Beta of A = Unlevered Beta of B X {1 + Debt Equity Ratio of A (1Tax rate of A)}
Where, A is the nonlisted company and B is the publicly traded company.
Applying Harvey Norman as a pure play company to HCL
Unlevered Beta of Harvey Norman = 0.76 / 1 + 561,947/ 2537,081 (1 – 30%)
= 0.76/ 1+ 0.155
= 0.658
Cost of equity of HCL
Cost of Equity = 1.75% + 0.658*4.5%
= 1.75% + 2.96%
= 4.71%
In absence of availability of debt equity ratio of HCL the unlevered Beta of HCL is assumed as the Equity beta.
The potential problems that arise with the pure play approach is that the useful information that is needed to calculate the unlevered beta and equity beta of nonlisted company using the beta of listed company might also not be available along with the nonavailability of beta and other risk factors (Keef, 2012).
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