Finance For Business: Investment Or Initial Outflow - An Essay.

Payback period is used to analyze that how much time is required to recover the initial cost of investment or initial outflow. If payback period is shorter, the project is more desirable (Chandra, 2015). Whether in discounted payback period, the concept of time value of money is applicable.

Pay Back period = Initial Investment / Cash flow of per period

If cash flow of every year is same, then above formula will apply. For example, asset purchase costing $100000 and cash flow every year is $25000, then pay back period will be 4 years ($100000 / $25000). And if cash flow is different in every year, then discounted payback period calculated. 

In the given project required rate of return is 12% and cash flow is different every year, so discounted payback period will be calculated.

Depreciation = (cost - salvage value) / life of asset  

                      = (34500000 - 5500000) / 5     

                      = 5800000

Expenditures for adding new features and expenditures for market study both considered as initial cash outflow.

Payback period of the project is 2.79 years means cost of assets can be recovered in 2.79 years. It is beneficial for the Emu electronics to investment in manufacturing equipments.

Profitability index used to identify the relations between cost and benefits by calculated ratio. It is used for ranking projects. While calculating profitability index, time value of money is also applicable. It is a tool of finance to taking decision, whether the project will be accepted or not (Damodaran, 2010).

The project will be accepted if profitability index will more than 1 (>1) and the project will be rejected if profitability index falls below 1 (<1).

And if, profitability index is equal to 1 (=1), then it will be situation of indifferent means projected will be accepted or rejected.

Profitability Index = Present Value of Inflow / Present Value of Outflow

                              = 52205510.12 / 35,450,000

                              = 1.47

As per above calculation profitability index is more than 1, so the project is acceptable. Emu electronics should have accepted the project.

It is the rate of return which is used to calculate profitability of investment. IRR is the rate of interest. The net present value should be equals to zero of all cash flows at internal rate of return (Gallagher & Andrew, 2007).

Calculation of Internal Rate of Return by Trial & Error method:

IRR = 30 + (35570884.83 - $35,450,000) / (35570884.83 - 34908659.88)

        = 30.18254345

Internal Rate of Return of the project is 30.18% on which net present value will be zero.

It refers to divergence between present value of cash inflows and present value of cash outflows.

The criteria of acceptance the project is net present value (NPV) will be positive and the criteria of rejection of project is net present value (NPV) will be negative.

And if, net present value (NPV) is zero, it will be condition of indifference.

Formula:

Net Present Value = Present Value of cash Inflows – Present Value of cash Outflows

Calculation of Net Present Value:

While calculating present value of inflows, present value of residual value/salvage (i.e. 5500000) also included (Needles, Powers & Crosson, 2010). Here, net present value of project is $16,755,510 which is positive so, project will be accepted.

Changes in cash flow directly impacts to NPV and cash flow changes if there is variation in price of product. Net present value changes with change in the price of the product. If price of the smart phones will be increases then net present value will increases and remains positive. And if, price of the smart phones will be decreases then net present value will decreases or falls negative. So, it can be said that net present value is highly sensitive with changes in the price of the new smart phone (Moyer, McGuigan & Rao, 2014).

If selling quantity of any product changes, it directly impacts to net present value. If selling quantity of smart phones will be increases, net present value will increases. And if, selling quantity of smart phones will be decreases, net present value decreases. So it can be said that sensitivity of net present value (NPV) is depends on change in number of units sold or quantity sold.

Net present value is more sensitive with changes in the quantity sold (Gill, 2015).

Emu Electronics should have to produce the new smart phone because it is profitable as per calculations made under net present value, payback period and profitability index.

The payback period of Emu Electronics is 2.79 years. If Emu Electronics invested in manufacturing equipments of new smart phone then they can recover their investment cost in the period of 2.79 years.

Profitability index of Emu Electronics is 1.47 which is more than 1, so new project is suitable for them.

Net present value of Emu Electronics is positive, so new project is acceptable. 

If Emu Electronics introduce new model of smart phone, it will be carried more specifications. So customers will prefer to buy it. Hence, automatically sales of other models will be decreased. It impacts the profitability and net present value of company.

As per market general scenario, if any new product launched in market then it will be successful or not depends on its specifications or customers need. If such product is more useful or have special characteristics then customers will prefer to buy it because they got more satisfaction. If there is no specifications in new product then customers will not buy it.

Introduction of new product always effects to the sale of other products. Same with Emu Electronics, they got loss of sales on other models because of introduction of the new model. It happens because customers divert to purchase new model and sales decreases of other models. Due to change in sale, cash flow of company changes and it effects directly to net present value, profitability index and payback period. So it affects on complete analysis of company.      

From the ASX website annual report of Harvey Norman of 2015 downloaded. The annual report of any company shows the complete outlay of that company. As per balance sheet or statement of financial position as at 30 June 2015, on page number 59 book value of debt and book value of equity found. Book value of debt included notes payable, current portion of long term debt and long term debt.

As per annual report of Harvey Norman, the book value of debt is $698,438,000 as at 30 June 2015 is:

Current portion of Interest bearing loans and borrowings              $408,438,000

Non-current portion of Interest bearing loans and borrowings        $290,000,000

Book Value of Debt                                                                 $698,438,000

Book value of equity includes share capital or contributed equity, reserves & surplus and retained profits. As per annual report of Harvey Norman, the book value of equity is $2,556,860 as at 30 June 2015 is:

Contributed equity                                                                           $380,328

Reserves                                                                                           $113,290

Retained profits                                                                                $ 2,043,463

Non-controlling interest                                                                   $19,779

Book Value of Equity                                                                      $2,556,860

(Source: Annual report of Harvey Norman, 2015)

As per title ‘Interest Rate Risk Management’ in annual report of Harvey Norman at page number 120, breakdown of Harvey Norman’s long-term debt is as follows:

(Source: Annual report of Harvey Norman, 2015)

Average interest rate (floating) of long-term debt is 0.47% to 5.93% provided in annual report of Harvey Norman. There is no other categorization of debts as per group of years.

Most recent stock price listed for Harvey Norman         5.18

Market value of equity, or market capitalization            5.76B

Outstanding shares of Harvey Norman                           2,066,523

Most recent annual dividend (pay date 01 Dec 2015)    11 cent

As per annual report dividend per share                         20.0 cent

As per annual report special dividend per share             14.0 cent

Dividend discount model can use in this case as all relevant information are available.                                   

Beta for Harvey Norman                                                 0.70

Note: All the amounts given above are in Australian Dollar (AUD).

(Source: aufinance.yahoo.com, 2016)

Yield on government debt is 1.86% as per ‘Bonds’ link at aufinance.yahoo.com.

Cost of equity for Harvey Norman by Capital Asset Pricing Model (CAPM):

Cost of equity = Risk free rate of return + Premium expected for risk

Cost of equity = Risk free rate of return + Beta * (market rate of return – risk free rate of return)

                        = 1.86% + 0.70 * (3% - 1.86%)

                        = 0.02658

                        = 2.658%

Here, government bonds yield value taken as risk free rate of return. Cost of equity is interest rate of equity capital (Pratt & Grabowski, 2010). Under capital asset pricing model, risk factor of capital invested is considered. Risk free rate of return is a rate of government bonds, which are free from market risk. Value of beta is taken from Harvey Norman’s site. And market rate of return is calculated, it is shown in appendix.

Business loan rate is 5.34% p.a. as per provided site of Westpac.

Weighted average cost of debt for Harvey Norman

By book value weights:

Weighted average cost of debt = total of weighted rate / total of weight

                                                  = 3.738 / 1

                                                  = 3.738%

Here one type of debt (i.e. interest bearing loans and borrowings) available as per annual report of Harvey Norman. Cost of debt is 3.73% for both, current and non- current interest bearing loans and borrowings. So there is no dissimilarity between cost of debt and weighted average cost of debt. It can be understand by above calculation of weighted average cost of capital.

Weighted average cost of debt cannot be determined by market value basis because loans and borrowings do not have market value. The market value and book value are same in case of loans and borrowings. So, cost of debt by market value weights will be same as cost of debt by book value.

Cost of debt = borrowing rate * (1-tax rate)

= 5.34 * (1-.30)

= 5.34 * .70

= 3.738 %

Cost of debt is a rate of interest, by which rate, company paid interest to money lenders. The cost of debt of  Harvey Norman is 3.738%. Company will pay interest on loans and borrowings at 3.738%. Cost of debt calculated by making interest rate after tax because company got tax benefit on debts.

(Source: Westpac.com, 2016)

Weighted average cost of capital of Harvey Norman:

In weighted average cost of capital, weight provides to amount. Then multiply cost and weight to find weighted cost / rate. Under weighted average cost of capital, equity share capital, preference share capital, debentures and long term loans are included.

While calculating weighted average cost of capital by book value weights, book value take given under financial statement.

By book value weights

Weighted average cost of capital (WACC) = total of weighted rate / total of weight * 100

= (0.0373 / 1) *100

= 3.73%

By market value weights

Weighted average cost of capital (WACC) = total of weighted rate / total of weight * 100

= (0.0278 / 1) *100

= 2.78%

Market value of equity is taken 5.76B as per point 2. Relevancy of weighted average cost of capital liable with market value weights. Lower the cost of capital, it will be less risky for company. So 2.78% is less, hence it is more relevant for Harvey Norman.

Harvey Norman is a representative company of HCL to estimate the cost of capital. If both companies have same nature of work and same debt & equity structure, then there will no problem in calculating cost of capital. But if, debt & equity structure and nature of work is different then it will be potential problem with this approach. In that situation, cost of capital will be different and Harvey Norman will not be considered as representative company of HCL to estimate the cost of capital.

Chandra, P. 2015. Financial Management: Theory and Practice. McGraw-Hill Education

Needles, B. E., Powers, M. & Crosson, S. V. 2010. Principles of Accounting. (Ed. 11). Cengage Learning

Damodaran, A. 2010. Applied Corporate Finance. (Ed. 3). John Wiley & Sons

Gallagher, T. J. & Andrew, J. D. 2007. Financial Management; Principles and Practice. (Ed. 4). Freeload Press, Inc.

Moyer, R. C., McGuigan, J. R. & Rao, R. P. 2014. Contemporary Financial Management. (e.d. 13): Cengage Learning

Gill, S. 2015. Cost and Management Accounting: Fundamentals and its Applications. (e.d. 1): Vikas Publishing House 

Australia Government Bond 10Y. 2016. https://www.tradingeconomics.com/australia/government-bond-yield

Intelligent Investor. Dividends. https://www.intelligentinvestor.com.au/company/harvey-norman-11766/dividends

Pratt, S. P. & Grabowski, R. J. 2010. Cost of Capital in Litigation: Applications and Examples. (e.d. 4). Volume (647 of Wiley Finance): John Wiley & Sons

Westpac. 2016. Business loans interest rates. Retrieved on 19 Aug 2016 from: https://www.westpac.com.au/business-banking/business-loans/business-loans-interest-rate/