Question
Emu Electronics is an electronics manufacturer located in Box Hill, Victoria. The
company’s managing director is Shelly Chan, who inherited the company from her father.
The company originally repaired radios and other household appliances when it was
founded more than 50 years ago. Over the years, the company has expanded, and it is
now a reputable manufacturer of various specialty electronic items. Robert McCanless, a
recent MBA graduate, has been hired by the company in the finance department.
One of the major revenue-producing items manufactured by Emu Electronics is a smart
phone. Emu Electronics currently has one smart phone model on the market and sales
have been excellent. The smart phone is a unique item in that it comes in a variety of
colours and is pre-programmed to play Jimmy Barnes’s music. However, as with any
electronic item, technology changes rapidly, and the current smart phone has limited
features in comparison with newer models. Emu Electronics has spent $750 000
developing a prototype for a new smart phone that has all the features of the existing one,
but adds new features, such as Wifi Tethering. The company has spent a further $200 000
for a marketing study to determine the expected sales figures for the new smart phone.
Emu Electronics’ production manager has produced estimates of the costs associated
with manufacture of the new smart phone. Variable costs are estimated at $205 per unit
and fixed costs for the operation are expected to run at $5.1 million per year. The
estimated sales volume is 64 000 units in Year 1; 106 000 units in Year 2; 87 000 units in
Year 3; 78 000 units in Year 4; and 54 000 units in the final year. The unit price of the new
smart phone will be $485. The necessary manufacturing equipment can be purchased for
$34.5 million and will be depreciated for tax purposes over a seven-year life (straight-line
to zero). It is believed the value of the manufacturing equipment in five years’ time will be
$5.5 million.
Net working capital for the smart phones will be 20% of sales and will have to be
HI5002 Finance for Business Term 2 2016 Page 4 of 6
purchased at the end of the year. The cost of the raw materials is reflected in the variable
unit cost. Changes in NWC will first occur at the end of Year 1 based on the first year’s
sales. Emu Electronics has a 30% corporate tax rate and a 12% required return.
Shelly has asked Robert to prepare a report that answers the following questions:
QUESTIONS
1. What is the payback period of the project?
2. What is the profitability index of the project?
3. What is the IRR of the project?
4. What is the NPV of the project?
5. How sensitive is the NPV to changes in the price of the new smart phone?
6. How sensitive is the NPV to changes in the quantity sold?
7. Should Emu Electronics produce the new smart phone?
8. Suppose Emu Electronics loses sales on other models because of the introduction of
the new model. How would this affect your analysis?
Part B (20 points)
COST OF CAPITAL FOR HUBBARD COMPUTER LTD
You have recently been hired by Hubbard Computer Ltd (HCL), in its relatively new
treasury management department. HCL was founded eight years ago by Bob Hubbard
and currently operates 14 stores in the South Island of New Zealand. HCL is privately
owned by Bob and his family, and had sales of $9.7 million last year.
HCL primarily sells to in-store customers who come to the store and talk with a sales
representative. The sales representative assists the customer in determining the type of
computer and peripherals that are necessary for the individual customer’s computing
needs. After the order is taken, the customer pays for the order immediately, and the
computer is made to fill the order. Delivery of the computer averages 15 days, and it is
guaranteed in 30 days.
HCL’s growth to date has been financed by its profits. When the company had sufficient
capital, it would open a new store. Other than scouting locations, relatively little formal
HI5002 Finance for Business Term 2 2016 Page 5 of 6
analysis has been used in its capital budgeting process. Bob has just read about capital
budgeting techniques and has come to you for help. For starters, the company has never
attempted to determine its cost of capital, and Bob would like you to perform the analysis.
Since the company is privately owned, it is difficult to determine the cost of equity for the
company. Bob wants you to use the pure play approach to estimating the cost of capital
for HCL, and he has chosen Harvey Norman as a representative company. The following
steps will allow you to calculate this estimate.
QUESTIONS
1. Most publicly traded corporations are required to submit half-yearly and annual reports
to the ASX detailing the financial operations of the company over the past half-year
or year, respectively. These reports are available on the ASX website at
www.asx.com.au or in the investor section of the company’s own website. Go to the
ASX website and search for announcements made by Harvey Norman. Find the most
recent annual report or half-year report and download the report. Look on the balance
sheet to find the book value of debt and the book value of equity. If you look in the
report, you should find a section titled ‘Interest Rate Risk Management’, which will
provide a breakdown of Harvey Norman’s long-term debt.
2. To estimate the cost of equity for Harvey Norman, go to http://au.finance.yahoo.com
plus the business section of www.smh.com.au and enter the ASX code for Harvey
Norman, HVN. Follow the various links to answer the following questions—What is
the most recent stock price listed for Harvey Norman? What is the market value of
equity, or market capitalisation? How many shares does Harvey Norman have
outstanding? What is the most recent annual dividend? Can you use the dividend
discount model in this case? What is the beta for Harvey Norman? Now go back to
http://au.finance.yahoo.com and find the ‘Bonds’ link. What is the yield on
government debt? Using the historical market risk premium, what is the cost of equity
for Harvey Norman using the CAPM?
HI5002 Finance for Business Term 2 2016 Page 6 of 6
3. You now need to calculate the cost of debt for Harvey Norman. Go to
www.westpac.com.au and find the current business loan rates equivalent for each
of Harvey Norman’s debts. What is the weighted average cost of debt for Harvey
Norman using the book-value weights and the market-value weights? Does it make
a difference in this case if you use book-value weights or market-value weights?
4. You now have all the necessary information to calculate the weighted average cost of
capital for Harvey Norman. Calculate the weighted average cost of capital for Harvey
Norman using book value weights and market value weights. Assume Harvey
Norman has a 30% tax rate. Which cost of capital number is more relevant?
5. You used Harvey Norman as a pure play company to estimate the cost of capital for
HCL. Are there any potential problems with this approach in this situation?
Sample paper
Part A
Emu Electronics
Activity – Production of Smart Phones
Cost of developing a prototype = $750,000
Marketing Research = $200,000
Estimates of costs for developing the Product
Variable Costs = $205 per unit
Fixed Costs = $5.1 Million annually
Unit Price =$485
Cost of Equipment = $34,500,000
Life time =7 years
Equipment Value in % years =$5.5M
Net Working Capital for Smart Phones =20% Sales
Corporate Tax = 30%
Rate of Return = 12 %
Net Working Capital =20% of sales
Sales Volume
Year Units Cost Per Unit ($) Total Sales ($)
1 64,000 485 31,040,000
2 106,000 485 51,410,000
3 87,000 485 42,195,000
4 78,000 485 37,830,000
5 54,000 485 26,190,000
1). Payback Period of the Project (PBP)
It is the amount for time taken before an investment repays itself in terms of returns. A shorter PBP is preferred due to a low risk compared to projects with high PBP.
PBP = Investment required for a project/Net annual cash inflow
Net Annual Cash Flows
The Initial Cash for the equipment is $34,500,000
Net Annual Cash Flow
Year 1
Sales 31,040,000
Less
Fixed Costs (5,100,000)
Variable Costs (13,120,000) (18,220,000)
Net Annual Cash Flows 12,820,000
Year 2
Sales 51,541,000
Less
Fixed Costs (5,100,000)
Variable Costs (21,730,000) (26,830,000)
Net Annual Cash Flows 24,580,000
Year 3
Sales 31,040,000
Less
Fixed Costs (5,100,000)
Variable Costs (17,835,000) (22,935,000)
Net Annual Cash Flows 19,260,000
Year 4
Sales 37,830,000
Less
Fixed Costs (5,100,000)
Variable Costs (15,990,000) (21,090,000)
Net Annual Cash Flows 16,740,000
Year 5
Sales 26,190,000
Less
Fixed Costs (5,100,000)
Variable Costs (1,107,000) (16,170,000)
Net Annual Cash Flows 10,020,000
Year Net Cash Flow Cumulative Net Cash Flows
1 12,820,000 12,820,000
2 24,580,000 37,400,000
Payback period = Y + (A / B) where
Y = the number of years before the payback year. In the example, Y = 2.0 years.
A = Total remaining to be paid back at the start of the breakeven year. This is the amount that brings cumulative cash flow to 0. In the example, A = $9,920,000.
B = Total (net) cash inflow in the entire payback year. In the example B = 37,400.
2+ (9,920,000/37,400,000) = 2.2652years or 2 years and 3 months.
2). Profitability Index of the Project
The profitability index is also referred to as the PI Ratio or the profit investment ratio. It is computed as the present value of the cash flows.
Formulae for Profitability Index
| Present Value of Future Cash Flows | ||
| Initial Investment Required | ||
| = | 1 + | Net Present Value |
| Initial Investment Required | ||
Project cash flows
Year $
- (34,500,000)
- 12,820,000
- 24,580,000
- 19,260,000
- 16,740,000
- 10,020,000
Discounting cash flows
Year
0 (34,500,000)/ (1+0.2) ^0 = (34,500,000)
1 (12,820,000)/ (1+0.2) ^1 = 10,683,333
2 (24,580,000)/ (1+0.2) ^2 = 17,069,444
3 (19,260,000)/ (1+0.2) ^3 = 11,145,333
4 (16,740,000)/ (1+0.2) ^4 = 8,072,916
5 (10,020,000)/ (1+0.2) ^5 = 4,026,813
Discounting compute and analyze what an amount of cash is worth today. This takes into consideration the rate of return required. For example, the 4th cash flow of $16,740,000 has a present value of $8,072,916 today. Thus, if we had an opportunity to buy $16,740,000 in cash 4 years from now, we could pay no more than $8,072,000 for that cash flow to get a 12% annual return on our $8,072,000 investment.
After calculating a present value for cash flow for each year, the next step is to sum up all of their present values. After adding up all 6 cash flows from the initial -$34.5M outlay to the 5th year’s present value of $4.026M, we arrive at a net present value of the project of $16,497,839
The NPV is positive, so we should adopt the smartphone with the new features. We will generate a return that is greater than 12% per year as the NPV is positive. If the NPV were negative, we would know that the project generates a return of less than 12% annually. If the NPV were $0, then the project is projected to produce a return equal to our discount rate, or 12% per year.
Calculating profitability index of the project
The next step is to use the data from the net present value calculation to conclude and define the profitability index for the venture.
The profitability index is calculated with the following formula:
Profitability index = present value of future cash flows / initial investment
The calculation of profitability index we need the present value of the future cash flows only calculated net present value. To get the present value of all the future cash flows, we can add up the present values of the cash flows that occur from Year 1 to Year 5 and get $50,997,839. Alternatively, we can simply add the $34,500,000 original investment back to the NPV we calculated earlier ($16,497,839) to get $50,997,839. Either way, you get the same value.
This figure, $50,997,839, goes into the numerator. We originally invested $34,500,000 into the project, so that goes into the denominator.
Thus, the profitability index is:
$50,997,839 / $34,500,000
=1.4782
3). IRR of the Project
CF0 =CF1/(1+r)^1+ CF2/(1+r)^2+ CF3/(1+r)^3+ CF4/(1+r)^4+ CF5/(1+r)^5
Year 1 Year 2 Year 3 Year 4 Year 5
34,500,000 = 12,820,000 24,580,000 19,260,000 16,740,000 10,020,000
Discount @10% (1.1) (1.21) (1.331) (1.4641) (1.61051)
Value 11,654,545 20,314,049 14,470,323 11,433,645 6,216,312
Total = 64,088,874
34,500,000 = 12,820,000 24,580,000 19,260,000 16,740,000 10,020,000
Discount @ 20% (1.2) (1.2) ^2 (1.2) ^3 (1.2) ^4 (1.2) ^5
1.44 1.728 2.0736 2.48832
Value 10,683,333 17,069,444 11,145,833 8,072,916 4,026,813
Total 40,315,006
34,500,000 = 12,820,000 24,580,000 19,260,000 16,740,000 10,020,000
Discount @ 40% (1.4) (1.4) ^2 (1.4) ^3 (1.4) ^4 (1.4) ^5
1.96 2.744 3.8416 5.37824
9,157,143 12,540,816 7,018,950 4,357,559 1,863,063
Total 34,937,531
34,500,000 – 34,937,531 = 437,531 is almost equal to 0
The IRR can be said to be 40%
4). NPV of the Project
Year 1 2 3 4 5
Revenue Inflows 31,040,000 51,410,000 42,195,000 37,830,000 26,190,000
Cash outflows
Fixed Cost (5,100,000) (5,100,000) (5,100,000) (5,100,000) (5,100,000)
Variable costs (13,120,000) (21,730,000) (17,835,000) (15,990,000) (1,107,000)
Before tax net cash flows 12,820,000 24,580,000 19,260,000 16,740,000 10,020,000
Depreciation (4,928,571) (4,928,571) (4,928,571) (4,928,571) (4,928,571)
Income before taxes 7,891,429 19,651,429 14,331,429 11,811,429 5,091,429
Taxes at 30% 2,354,743 5,895,429 4,299,429 3,543,429 1,527,429
After tax Income 5,535,686 13,756,000 10,032,000 8,268,000 3,564,000
Add: depreciation 4,928,571 4,928,571 4,928,571 4,928,571 4,928,571
After tax cash flows 10,464,257 18,684,571 14,960,571 13,196,571 8,492,571
After tax salvage 0 0 0 0 5,500,000
After cash total NCF 10,464,257 18,684,571 14,960,571 13,196,571 13,992,571
Discounting rate @ 12 % 1.12 1.2544 1.404928 1.57351936 1.762341
PV of cash flows 9,343,087 14,895,226 10,648,634 8,386,659 7,939,763
Total value of cash flows = 51,213,369
NPV = Present Value – Initial Outlay
NPV = 51,213,369 – 34,500,000
= $16,713,369
5). How sensitive is the NPV to changes in the price of smartphone
In order to check on the risk linked to change in price of the novel smartphone, a sensitivity analysis must be calculated. To stimulate a decrease in the price of the phone as a result of market competition, the price of smartphone can be changed to $450 and recalculate the NPV.
Price of phone at $450 NPV is:
Year 1 2 3 4 5
Revenue Inflows 28,800,000 47,700,000 39,150,000 35,100,000 24,300,000
Cash outflows
Fixed Cost (5,100,000) (5,100,000) (5,100,000) (5,100,000) (5,100,000)
Variable costs (13,120,000) (20,870,000) (17,835,000) (15,990,000) (1,107,000)
Before tax net cash flows 9,780,000 16,215,000 16,215,000 14,010,000 18,093,000
Depreciation (4,928,571) (4,928,571) (4,928,571) (4,928,571) (4,928,571)
Income before taxes 4,851,429 11,196,429 11,196,429 9,081,429 13,164,429
Taxes at 30% (1,455,429) (3,358,929) (3,358,929) (2,724,429) (3,949,329)
After tax Income 3,396,000 7,837,500 7,837,500 6,357,000 9,215,100
Add: depreciation 4,928,571 4,928,571 4,928,571 4,928,571 4,928,571
After tax cash flows 8,324,571 12,766,071 12,766,071 13,196,571 14,143,671
After tax salvage 0 0 0 0 5,500,000
After cash total NCF 8,324,571 12,766,071 12,766,071 13,196,571 19,643,671
Discounting rate @ 12 % 1.12 1.2544 1.404928 1.57351936 1.762341
PV of cash flows 7,432,653 9,086,637 9,086,637 8,386,659 11,146,351
Total value of cash flows = $45,138,937
NPV = Present Value – Initial Outlay
NPV = 45,138,937 – 34,500,000
= $10,638,937
The new NPV is $10,638,937 from $16,713,369. That is a reduction of $ 6,074,432. In conclusion, change in price is sensitive and carries a high risk
6). How sensitive is the NPV to changes in the quantity produced of smartphone
We can decrease the amount of units produced by and recalculate the NPV.
Year (output)
- 60,000
- 100,000
- 85,000
- 70,000
- 50,000
NPV after quantity reduction
Year 1 2 3 4 5
Revenue Inflows 29,100,000 48,500,000 41,225,000 33,950,000 24,250,000
Cash outflows
Fixed Cost (5,100,000) (5,100,000) (5,100,000) (5,100,000) (5,100,000)
Variable costs (13,120,000) (20,870,000) (17,835,000) (15,990,000) (1,107,000)
Before tax net cash flows 9,780,000 16,215,000 16,215,000 14,010,000 18,093,000
Depreciation (4,928,571) (4,928,571) (4,928,571) (4,928,571) (4,928,571)
Income before taxes 4,851,429 11,196,429 11,196,429 9,081,429 13,164,429
Taxes at 30% (1,455,429) (3,358,929) (3,358,929) (2,724,429) (3,949,329)
After tax Income 3,396,000 7,837,500 7,837,500 6,357,000 9,215,100
Add: depreciation 4,928,571 4,928,571 4,928,571 4,928,571 4,928,571
After tax cash flows 8,324,571 12,766,071 12,766,071 13,196,571 14,143,671
After tax salvage 0 0 0 0 5,500,000
After cash total NCF 8,324,571 12,766,071 12,766,071 13,196,571 19,643,671
Discounting rate @ 12 % 1.12 1.2544 1.404928 1.57351936 1.762341
PV of cash flows 7,432,653 9,086,637 9,086,637 8,386,659 11,146,351
Total value of cash flows = $45,138,937
NPV = Present Value – Initial Outlay
NPV = 48,960,937– 34,500,000
= $14,460,937
This company should proceed with the investment of the smartphone as this is a viable program. The Company should consider changing the units produced to shield the firm from underlying risks.
- Should Emu Electronics produce the new smartphone?
The company should produce the new smartphone as it has a positive return and a high IRR. The NPV is $16,713,369 and the IRR is at 40%.
- Suppose Emu Electronics loses sales on other models, how will this affect the analysis?
First, there is need to calculate the IRR of the two business so as to know what will be the decision. If the difference between the benefit of adapting the new product and the losses from other activities is positive, then the company should adopt the method.
Part B
COST OF CAPITAL FOR HUBBARD COMPUTER LTD
The objective of the study is to check on the cost of capital for Hubbard Computer Ltd. The company is not registered in the stock exchange and therefore they have choose to analyze the market using Harvey Norman financial statements. The paper explores the Dividend Discount Model and Cash Flow to Equity to conduct the research. Assumptions are made in the valuation of the cost of capital for 2016.
Market capitalization for Harvey Norman is $5,819. The number of shares for the company is $8,099,094. It has a volume of 1,752,168. The shares are trading at $5.23. Its highest trading has been a low of $5.13 and a high of $5.24. Its 52 week high and low is $5.58 and $3.65 respectively. Its dividend is at 0.7 representing a yield of 5.74.
Even though betas for individual company are available from estimation service such as Fin Analysis, all these services begin with regression beta and has very high standard error and also tends to reflect businesses’ past financial structure rather than the present. For these reasons, betas determined by business fundamentals are preferred. A 0.74 represent Beta for Harvey Norman.
Dividend Discount Model
The dividend discount model is an approach that examines stocks that pays good dividends. It’s also referred to as the Dividend Growth Model. Its most straightforward way of using it is the Gordon Growth Model. This method has the same idea as the NPV only that the shares are a representative the item we are valuing and all the impending dividends is a representative of all future cash flows of the share. In this method, the value of share is equal to the value of all future dividends. This method can be used by in analyzing the dividend of HVN.
For example, the share price is $2 annually. The country has been raising the price of the dividend for the last 20 years. The history of the company might have raised the dividend at an average of 8 percent annually in the last decade. The estimation made by a finance officer is that the average growth will be 5 percent going forward. If an investor wants an 11 percent as his rate of return in his investment, then the % can be used as a discount rate. Next year dividend is $2.10 as it will have grown to 5 percent. If discounted, the amount is worth $1.89 today. This means that in case there is $1.89 today, it can be turned into $2.10 in one year by compounding it by 11 percent. 2. Cost of Equity:
This paper uses Capital Asset Pricing Model (CAPM) to calculate the required rate of return. The formula is:
Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market – Risk-Free Rate of Return)
a) The study uses US 10-Year Treasury Constant Maturity Rate as the risk-free rate. It is updated daily. The current risk-free rate is %.
b) Beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Harvey Norman Holdings Ltd’s beta is 0.74.
c) (Expected Return of the Market – Risk-Free Rate of Return) is also called market premium. The study requires market premium to be 7.5%.
Cost of Equity = % + N/A * 7.5% = N/A
Cost of Debt
As not all liabilities on a firm’s balance sheet are interest bearing, applying after tax cost of debt to these items can provide a misleading view of the true cost of capital for a firm. Consequently, only interest bearing debts are considered.
The paper uses last fiscal year end interest expense divided by the latest two-year average debt to get the simplified cost of debt. As of Jun. 2016, Harvey Norman Holdings Ltd’s interest expense (positive number) was $32.082161362 Mil. Its total Book Value of Debt (D) is $269.459104938 M.
Therefore, the Cost of Debt = 32.082161362 / 269.459104938 = 11.9061%.
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital. Generally speaking, a company’s assets are financed by debt and equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.
The WACC formula is:
| WACC | = | E | / | (E + D) | * | Cost of Equity | + | D | / | (E + D) | * | Cost of Debt | * | (1 – Tax Rate) | ||
|
|
||||||||||||||||
| WACC | = | E / (E + D) | * | Cost of Equity | + | D / (E + D) | * | Cost of Debt | * | (1 – Tax Rate) | ||||||
| = | 0.9423 | * | N/A | + | 0.0577 | * | 11.9061% | * | (1 – 28.82%) | |||||||
| = | N/A | |||||||||||||||
The market value of equity (E) is also called Market Cap. As of today, Harvey Norman Holdings Ltd’s market capitalization (E) is $4396.817 Mil. The market value of debt is typically difficult to calculate, therefore, this paper uses book value of debt (D) to do the calculation. It is simplified by adding the latest two-year average short term debt and long-term debt together. As of Jun. 2016, Harvey Norman Holdings Ltd’s latest two-year average short term debt was $157.576388889 Mil and its latest two-year average long term debt was $111.882716049 Mil. The total Book Value of Debt (D) is $269.459104938 Mil.
a) Weight of equity = E / (E + D) = 4396.817 / (4396.817 + 269.459104938) = 0.9423
b) Weight of debt = D / (E + D) = 269.459104938 / (4396.817 + 269.459104938) = 0.0577
Conclusion
It costs a lot of money to raise capital. As a result, the firm that generates higher rate of investments than it costs the company to raise the capital needed for that investment is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases, whereas a firm that earns returns that do not match up to its cost of capital will destroy value as it grows.
