Cost of Capital for Hubbard Computer Ltd - Finance Assessment Answers
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Solution:
Part A
Background of the Company
| Particulars | Amount in AUD |
| Prototype | 750,000.00 |
| Marketing Study | 200,000.00 |
| Variable cost | 205 |
| Fixed cost | 5,100,000.00 |
| Equipments | 34,500,000.00 |
| Salvage Value | 5,500,000.00 |
| Depreciation | 4,928,571.43 |
| Unit Price | 485 |
| Particulars | % |
| corporate tax | 30% |
| ROR | 12% |
- Payback Period
Payback period is the span of time needed for the capital invested in assets to be repaying by the money outflow produce by the asset. It is an easiest way to assess the risk linked with a future project.1. The shorter is the time of payback period, the better is the project.
Payback Period:
Payback Period=Initial InvestmentCash inflow per period
=19885000.00/35450000 (Please refer to Annexure 1 for further details)
= 2.7 years
In this case, company should go further with the project taking other financial techniques into account like NPV, IRR etc. As the payback period is just only 2.7 years. It means they can recover all the invested money within 3 yrs of time.
- Profitability Index: It is the ration of future profits and investment made into a particular project. It is also known as Profit Investment Ratio. If the profitability index is greater than 1 then project is acceptable and vice versa.2
Profitability Index=Total Discounted cash InflowInitial Investment
Profitability index = 60267585.19/35450000= 1.70 (please refer to Annexure 1 for further details)
Here, as per thumb rule, an entity should accept the project if the profitability index is greater than 1 and reject if it is less than 1. Here the project shows the profitability index is greater than 1, it means the project is profitable and company should go further with this project taking other factor like NPV, IRR into account.
- IRR (Internal rate of Return)
It is used in comparative appraisal of investment proposals where the cash inflows vary with the time. It is the average rate of return in the span of life of the investment. As per decision rule, If IRR >ROR then required rate of return (ROR) the project is desirable e and if IRR< ROR than we should reject the project. 3
NPV=t=1TCt1+r- C0
Here Ct = net Cash Inflow during the period t
C0 = Total investment
R = discount rate (IRR)
T= number of time period.
IRR is the rate of Return where NPV = 0, to calculate IRR (r) we should the NPV to zero.
Using the above formula, we found that
0=7,814,571.43/(1+r )1+ 18,180,571.43/(1+r )2 +14,165,571.43/(1+r )3
+13,565,571.43/(1+r )4 +35,410,571.43 /(1+r )5
IRR = 27.65% (please refer to Annexure 1 further details)
Since IRR is greater than ROR, project is desirable and we can go forward with the same but we should also consider NPV.
- NPV (Net present Value):
Whenever any company takes any project first they will see whether that is profitable or Not. NPV is the best way to find the cash inflows from the project is positive or negative.It is method of comparing the current value of all the future cash inflows from the project with the cash outflow or investment done on the project. To covert the future cash inflow into the present value we need to discount the cash flow with the specified rate of return.4
If the project NPV is greater than 0 than we should accept the project and if NPV<0 then we should the reject the same.
NPV=t=1TCt1+r- C0
Here Ct = net Cash Inflow during the period t
C0 = Total investment
R = discount rate (IRR)
T= number of time period.
NPV = 60267585.19-35450000= 24,817585 AUD (Please to annexure 1 for further details).
Here NPV is showing positive value of 24,817585 AUD. Hence project is desirable and we should go forward with this proposal.
- Here we want to examine the sensitivity of the changes in price to the NPV. It is necessary to check the sensitivity of the prices on NPV because the product is new and it is hard to determine the future cash flow perfectly. So here is this case, using the goal seek function in excel, keeping the NPV = 0 (which is the breakeven point) we find out that till 355 AUD the NPV >= 0, where as we the given price is 485 AUD. It shows that we have a buffer of 130 AUD to absorb the 10 to 20% of variation in the price changes. Hence we can go ahead with the project.
- Here we want to examine the sensitivity of the changes to NPV to quantity sold using the scenario analysis i.e. best, Worst case. Assuming that there can be variation of 20% of up and down in the quantity sold.
| Scenario Summary | ||||||||||||
| Year | Current Values: | Normal | Best +20% | Worst -20% | ||||||||
| 1 | 64000 | 64000 | 76800 | 51200 | ||||||||
| 2 | 106000 | 106000 | 127200 | 84800 | ||||||||
| 3 | 87000 | 87000 | 104400 | 69600 | ||||||||
| 4 | 78000 | 78000 | 93600 | 62400 | ||||||||
| 5 | 54000 | 54000 | 64800 | 43200 | ||||||||
| Result | ||||||||||||
| NPV | 24,817,585 | 24,817,585 | 35,180,949 | 14,454,222 | ||||||||
| Profitability Index | 1.70 | 1.70 | 1.99 | 1.41 | ||||||||
| IRR | 27.65% | 27.65% | 32.87% | 22.12% | ||||||||
| Total Discounted cashflow | 389000 | 389000 | 466800 | 311200 | ||||||||
By above method we have found that for every additional unit sold, NPV goes up or down by 133.21 AUD. It shows that for every units changes in quantity sold there is changes of 0.27 % in price changes. We should go ahead with the project since in both the worst and best scenario (assuming 205 of variation) NPV, IRR and Profitability index is positive.
- Yes EMU Electronics should produce the new smart phone to stay competitive in the market. If the company does not go for production of new model with new features than in the long run the company will not be able to sustain in the market and will loss all its market share. Company like Nokia and Blackberry has already faced this problem they have lost its entire market share to company Samsung and Lenovo as they have not upgrade their phone features as per the technology changes demanded by the customer.
- As said earlier that EMU electronics should go ahead with the introduction of the new models to sustain in the market with the changing technology rapidly for e.g. Nokia and Blackberry has to come out from the smart phone market because they have not change their product as per the technology changes. Anyway old model has become absolute and it will not go long as it does not contain the new features which the market demands. Though it might affect the overall sales volume and profit of the company but company should g ahead with the new project as in long run, losses on sales on other old models will not affect the company and its new project.
Part 2
1 a) Book Value of Debt
The book value of debt is consist of Long term debt, short term debt and notes payable. All these itemsis available on an entity’s balance sheet. IT does not include accounts payable or accrued liabilities as these does not considered to be interest-bearing liabilities.The book value of debt is mainly used in liquidity ratios to compare cash flows to find out whether company is capable of supporting its debt or not.5
As per June 2015, Statement of Financial Statement mentioned in Annual Report
Book Value of Debt=longtermdebt+shorttermdebt+notespayables
Long term debt:
Interest–bearing loans and borrowings: - 290000
Current debt:
Interest–bearing loans and borrowings:-408,438
Trade and other payables: - 813,474
Book Value of Debt =1511912
- b) Book value of Equity
It is also known as Owner’s Equity. It can be calculated as Total Assets minus Total Liabilities. It will include the paid- in capital, retained earnings, treasury income, and accumulated income.6It helps investors to understand the financial health of a company.
Book Value of Equity= Company's Total Assests-Company's Total Liabilties
Total Assets: 4358544
Total Liabilities: 1801684
Book Value of Equity = 4358544-18011684
Book Value of Equity=2556860
2a) Current Stock Price
It is the highest price or lowest price at which a single number of share can be purchase or sale. It the prevailing prices of the security of a particular company on the exchange market.7recent stock price of Harvey Norman 5.19 AUD on 28th Sep’15
- b) Market Value of equity or Market capitalization
It is the current value of the Company’s total outstanding shares. Owner’s equity is normally stated in book value. But by calculating value of Equity using market price, we can determine whether owner’s share is undervalued or overvalued currently. 8
Market Value of Equity :Current price of Equity*Total Outstanding Shares
Current price = 5.19 AUD
Total Outstanding Shares: 1113000000
Market Value of equity = 5.19*1113000000
Market Value of equity = 5776470000 AUD
- c) Harvey Norman has total 1113000000 Number of shares outstanding.
- d) Recently On 31st Aug 2015, HVN has announced the total 0.11000000 per security.
- e) Dividend discount Model: It is the model where stock price is calculated based on the predicted or future dividends discounted by the help of cost of capital to find out the current value. 9Here we can’t use discount dividend model since we don’t have growth rate of dividends.
- f) Beta is the measure of volatility of share price in relation to the movement of the share market. Beta represent systematic risk which cannot be get away for e.g the it may be different depending on the market movement i.e. beta is generally high when the share market goes down and is low when the market goes up. 10 As per yahoo finance, the beta of the HVN is 0.75.
- g) As per Bloomberg.com, the yield or coupon rate on 10 yr yield bond is 4.25 %.11
- h) The Historical Market risk premium of Australia is 7.2 % 12
Cost of Equity: It is the rate of return which the shareholders get to compensate the risk which they taken by investing their money in the company. 13
Ra=RF+a (Rm-rf )
Where rf = Risk free rate
?a = beta of the security
R m = Expected market return
Cost of equity = 4.25%+.75(7.2%-4.25%)
= 6.4625%
- Cost of Debt
Cost of Debt is the rate which the company pays for borrowing long term and short term loans. It helps to understand that how much is the overall interest which company has to pay for borrowings and whether company can repay its debt. 14
Cost of Debt=Interest rate ( 1-Tax)
| Interest bearing loans and borrowings | ||||
| Particulars | Amount | % Rate of interest | Tax Rate | Cost of Debt |
| Less Than 1 year | 485,582 | 5.19% | 30% | 0.03633 |
| 1- 2 year | 7,254 | 5.06% | 30% | 0.03542 |
| 2-5 year | 232,478 | 5.33% | 30% | 0.03731 |
| Total | 725,314 | 30% | 0.10906 | |
*https://www.westpac.com.au/business-banking/business-loans/business-loans-interest-rate/
- b) Weighted average cost of Debt:
It is the average minimum rate of return which the company has to earn to pay interest for the capital. It is one of the most important techniques in Cost of capital. It is shows how much actually company is going to pay as interest 15
| Interest bearing loans and borrowings | ||||||
| Particulars | Amount | Weight age | % Rate of interest | Tax Rate | Cost of Debt | WACD |
| Less Than 1 year | 485,582 | 0.669478 | 5.19% | 30% | 0.03633 | 0.024322 |
| 1- 2 year | 7,254 | 0.010001 | 5.06% | 30% | 0.03542 | 0.000354 |
| 2-5 year | 232,478 | 0.320520 | 5.33% | 30% | 0.03731 | 0.011959 |
| Total | 725,314 | 30% | 0.10906 | 0.036635 | ||
WACD is calculated by finding out weight age as per the amount invested multiply by the cost of Debt
Here WACD is 0.036635. It shows that actually company at the end of the year it is going to pay an 0.036635% instead of 0.1096 which we have calculated as overall the cost of the debt. It shows that as per market value WACD i.e. 0.036, company is going to less than book value of WACD i.e. 0.1096.
3)Cost of capital
It is the one the most important techniques to evaluate any firm’s financial position. It helps in calculating the average rate of return which the company provides to all the investors for taking risk by investing their money.15
- WACC using the Market Value:
WACC= ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E =Market valueof the company'sequity
D =Market valueof the company'sdebt
V = TotalMarket Valueof the company (E + D)
Re=Cost of Equity
Rd= Cost of Debt
T=Tax Rate
WACC using the Market Value: 5776470000/( 5776470000+1511912)*6.4625%+ 1511912/( 5776470000+1511912)*0.001089892 *(1-30%)=0.000885063
- WACC using the Book Value:
WACC= ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E =Book valueof the company'sequity
D =Book valueof the company'sdebt
V = TotalBook Valueof the company (E + D)
Re=Cost of Equity
Rd= Cost of Debt
T=Tax Rate
WACC using the Book Value:
Using the above formula WACC ( Book Value) is 4.069464163
Cost of Debt is core relevant as it the cost of debt is high in comparison to cost the equity.
Annexure 1
| No. Of Year | Quantity | Sales Value | Varibale | Contribution |
| 0 | ||||
| 1 | 64000 | 31,040,000.00 | 13,120,000.00 | 17,920,000.00 |
| 2 | 106000 | 51,410,000.00 | 21,730,000.00 | 29,680,000.00 |
| 3 | 87000 | 42,195,000.00 | 17,835,000.00 | 24,360,000.00 |
| 4 | 78000 | 37,830,000.00 | 15,990,000.00 | 21,840,000.00 |
| 5 | 54000 | 26,190,000.00 | 11,070,000.00 | 15,120,000.00 |
| 5 | ||||
| 5 |
| No. Of Year | Working Capital | Investment in WC | Depreciation | Gross | Tax | Net Income | ||||
| 0 | ||||||||||
| 1 | 6,208,000.00 | 6,208,000.00 | 4,928,571.43 | 12,991,428.57 | 3,897,428.57 | 9,094,000.00 | ||||
| 2 | 10,282,000.00 | 4,074,000.00 | 4,928,571.43 | 24,751,428.57 | 7,425,428.57 | 17,326,000.00 | ||||
| 3 | 8,439,000.00 | 4,365,000.00 | 4,928,571.43 | 19,431,428.57 | 5,829,428.57 | 13,602,000.00 | ||||
| 4 | 7,566,000.00 | 3,201,000.00 | 4,928,571.43 | 16,911,428.57 | 5,073,428.57 | 11,838,000.00 | ||||
| 5 | 5,238,000.00 | 2,037,000.00 | 4,928,571.43 | 10,191,428.57 | 3,057,428.57 | 7,134,000.00 | ||||
| 5 | 19,885,000.00 | |||||||||
| 5 | ||||||||||
| No. Of Year | Fixed cost | Cash Flow | DCF | Cumlative CF | ||||||
| 0 | -35,450,000 | -35,450,000 | ||||||||
| 1 | 5,100,000.00 | 7,814,571.43 | 6,977,295.92 | 7,814,571.43 | ||||||
| 2 | 5,100,000.00 | 18,180,571.43 | 14,493,440.23 | 25,995,142.86 | ||||||
| 3 | 5,100,000.00 | 14,165,571.43 | 10,082,773.94 | 40,160,714.29 | ||||||
| 4 | 5,100,000.00 | 13,565,571.43 | 8,621,165.89 | 53,726,285.71 | ||||||
| 5 | 5,100,000.00 | 10,025,571.43 | 5,688,778.47 | 63,751,857.14 | ||||||
| 5 | Salvage Value Equipment | 5,500,000.00 | 3,120,847.71 | 69,251,857.14 | ||||||
| 5 | NWC | 19,885,000.00 | 11,283,283.03 | |||||||
| Total DCF | 60,267,585.19 | |||||||||
| NPV | 24,817,585 | |||||||||
| Payback period | 2.67 | years | ||||||||
| Profitability Index | 1.70 | |||||||||
| IRR | 27.65% | |||||||||
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