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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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