HI5002 Finance for Business Proof Reading Services

HI5002 Finance for Business Proof Reading Services

Executive Summary

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.

Part A

Analysis of Investment project

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 pre-programmed 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

(Jarrow, 2014)

Payback period of project

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

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 the project

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

IRR of the project

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:

Thus the internal rate of return from the project is 6%.

NPV of the project

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 NPV to changes in price of smart phone

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:

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.

Sensitivity of NPV to changes in quantity sold

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%:

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.

Decision about producing the new smart phone

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.

Effect of loss of sales of other models

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).

Part B

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 of Harvey Norman extracted from Annual Report

Estimation of Cost of equity of Harvey Norman

Using Dividend Discount Model

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/r-g

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%.  

Using Capital Asset Pricing Model

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%.

Calculation of cost of debt of Harvey Norman

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:

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%.

Calculation of weighted average cost of capital of Harvey Norman

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% (1-0.30)*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% (1-0.30)*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 to estimate cost of capital of HCL

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 (1-Tax rate of B)

Equity Beta of A = Unlevered Beta of B X {1 + Debt Equity Ratio of A (1-Tax rate of    A)}

Where, A is the non-listed 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 non-listed company using the beta of listed company might also not be available along with the non-availability of beta and other risk factors (Keef, 2012).

References

Baker, H.K. & English, P. 2011, Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects, 1. Aufl.;1; edn, Wiley, Hoboken.

Barth, M.E., Konchitchki, Y. & Landsman, W.R. 2013, "Cost of capital and earnings transparency", Journal of Accounting and Economics, vol. 55, no. 2-3, pp. 206-224.

Davies, T. & Crawford, I. 2011, Business accounting and finance, 3rd edn, Pearson/Financial Times Prentice Hall, New York;Harlow, England;.

Halbert, L., Henneberry, J. & Mouzakis, F. 2014, "Finance, Business Property and Urban and Regional Development", Regional Studies, vol. 48, no. 3, pp. 421-424.

Jarrow, R. 2014, "Computing Present Values: Capital Budgeting Done Correctly", Finance Research Letters, vol. 11, no. 3, pp. 183.

Keef, S.P., Khaled, M.S. & Roush, M.L. 2012, "A note resolving the debate on “The weighted average cost of capital is not quite right”", Quarterly Review of Economics and Finance, vol. 52, no. 4, pp. 438-442.

Mendes-da-Silva, W. & Saito, R. 2014, "STOCK EXCHANGE LISTING INDUCES SOPHISTICATION OF CAPITAL BUDGETING", RAE : Revista de Administração de Empresas, vol. 54, no. 5, pp. 560-574.

Ong, T.S. &Thum, C.H. 2013, "Net Present Value and Payback Period for Building Integrated Photovoltaic Projects in Malaysia", International Journal of Academic Research in Business and Social Sciences, vol. 3, no. 2, pp. 153-171.

Rigopoulos, G. 2015, "A review on Real Options utilization in Capital Budgeting practice",International Journal of Information, Business and Management, vol. 7, no. 2, pp. 1.

Rogers, S. & Makonnen, R. 2014, Entrepreneurial finance: finance and business strategies for the serious entrepreneur, Third;3rd; edn, McGraw-Hill Education, New York.

Saxena, A.K. 2015, "Capital budgeting principles: bridging theory and practice", Academy of Accounting and Financial Studies Journal, vol. 19, no. 3, pp. 283.

University of Wollongong "Australasian accounting, business and finance journal",Australasian accounting, business and finance journal, [Online], .