Finance of Business - Emu Electronics - Case Study Example

FINANCE OF BUSINESS Name Course Tutor Date Finance of Business PART A Emu Electronics is an electronics manufacturer located in Box Hill. 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 additional $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 cost 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 $45. 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 purchased at the end of the year. The cost of the raw materials is reflected in the variable cost unit. 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. Required Payback Period This is the amount of time it takes for a business entity to recover the invested amount. The payback period is an important factor to consider when thinking on whether to invest in a project or not. Projects with longer payback periods are not desirable. When using the payback period to determine the desirability of a project, one tends to ignore the time value of money. Other methods like internal rate of return, net present value and discounted cash flow turn out to be better since they all consider the time value of money. Since most corporate finance is about capital budgeting, it is important to give consideration to the time value of money. The concept of time value of money is that cash at hand today is not worth the same in the future, say after one year. It is therefore necessary to consider the time value of money when thinking about an investment. The payback period calculations are however more interested on the number of years an investor will have to wait until the amount invested is recovered. The best thing with the payback period method is that it is easier to calculate compared to the other methods. Calculations; Total Invested amount; Prototype development amount = $750,000 Marketing study = $200,000 Manufacturing equipment = $34,500,000 Total Investment = $ 35,450,000 Sale volume Year 1 =$31,040,000 Year 2 =$51,410,000 Year 3 =$42,195,000 Year 4 =$37,830,000 Year 5 =$26,190,000 Therefore; Payback Period = 1+ (4,410,000/51,410,000) = 1.09 years Profitability Index This is a ratio that identifies the relationship between the costs and benefits of a proposed project. The lowest acceptable ratio is 1. Ratios lower than 1 indicates that the invested amount is higher than the future PV of the project. This makes the project unattractive. The higher the ratio, the more attractive the project, since the project would be more profitable. In this technique, the projected capital inflow is divided by the projected capital outflow. The profitability of the project can then be determined. This technique does not discriminate between small and large projects. It is therefore possible not to get the desired outcome as projects with larger cash inflows may not have as high profit margin and this results to lower profitability index. The present value of future cash flows involves the calculations of time value of money. The cash income is discounted to the required number of periods to make the future cash flows equal to the present value of money. The discounting is necessary since the value of money does not remain the same. An amount invested can gain value. Profitability Index = Year Cash Flow ($’000) Discounted Cash Flows ($) 0 -35,450 1 31,040 25,866,666.67 2 51,410 35,701,388.89 3 42,195 24,418,402.78 4 37,830 18,243,634.26 5 26,190 10,525,173.61 Total PV 114,755,266.2 Initial Investment = $35,450,000 PI =114,755,266.2/35,450,000 =3.237 The value of profitability index must be a positive value for it to be useful. A value less than 1 indicate that the future cash flows will create a deficit of outflows greater than the inflows discounted. This situation makes the project unattractive and should be rejected. A figure greater than 1 indicates the expected cash inflows are greater than the expected discounted cash outflows. Such a project should be accepted since it indicates profitability. A figure equal to 1 indicates a situation where the project would have minimal profits or losses. The project in the case of Emu Electronics displays a ratio of 3.this is an attractive project and thus its implementation is what would determine the level of success. Internal Rate of Return Internal Rate of Return (IRR) is a calculation that is used in capital budgeting. This calculation is employed to rate the level of profitability of the project at hand. This technique equates all calculated NPV to zero. The calculation of IRR employs the same formula as that of the NPV. The value for NPV must be equated to zero for the formula to work. Net Present Value Where; Ct = net cash inflow during period, t Co = total investment capital r = discount rate t = number of time periods Therefore; The NPV = $66,087,721.84 The IRR = 104% The internal rate of return is also known as the economic rate of return (ERR). A higher rate of return indicates the attractiveness of the project. The calculated internal rate of return for the manufacture of the smart phone is quite high. The project is thus rewarding enough to warrant investing in. Any changes on the price of the smart phone would impact on the NPV. An increase of the price of the smart phone would result to an increase of the NPV. A decrease on the price of the phone would impact negatively on the NPV. Slight changes on the quantity sold would affect the sales income of the company. Therefore, any decrease in the quantity sold would result to a decrease on the NPV. The NPV would otherwise increase if the quantity sold was to increase. Putting considerations on the above calculated figures, the project appears lucrative and the management should adopt the project. Firstly, profitability index greater than one signifies the worthiness of the project. Otherwise profitability index of less than one would lead to automatic rejection of the project. Secondly, the project has a relatively shorter payback period. This shows that the company will be able to recover the invested capital in less than two years. It is thus a risk worth taking. If Emu Electronics was to lose sales on other models, the management will have to take a whole new approach on the investment. Adjustments will have to be done on the operating capital which include fixed and variable costs. This would so as to reduce the net operating cost to boost the profits. The reduction in sales would translate to longer payback period. Analysis may have to be done again and new analyses ratios calculated. PART B You have recently been hired by Hubbard Computer Limited (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 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 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 pure play approach is usually a publicly traded company which deals with a single program, or one that has its focus on one industry. The investors in the pure play company are interested in betting on specific products or industry segments. Such investors are afraid to invest in diversified companies since they perceive them to have risks that they are not ready to take. The ease of following cash flows makes it very attractive for investors. Pure play companies are quite rare, but they provide analysts with the opportunity to develop more accurate valuations through the application of relative and precedent transactions. Pure play is significantly important as business analysts are able to obtain and use data for peer comparisons in order to relate how a business competes with the rest in the same industry. The reports developed by analysts using the pure play approach provide crucial information that can be used for investment analysis and the base for relative analysis. By use of the information obtained through the pure play method, an investor is able to derive the relative value of the company. Such valuations help the investor know if the company is undervalued or overvalued. The right selection of peer group is key to obtaining accurate information. The wrong choice of peer group can lead to one obtaining misleading information and possible loss of funds. The selection of Harvey Norman as the peer for HCL is particularly important as the information obtained will help analyze the correct financial position of HCL. Analysis will take the approaches as discussed below: Net Book Value at 30 June 2010 Leasehold Improvements = $8,864,000 Plant and Equipment = $4,007,000 Computer Equipment = $21,432,000 Total = $34,303,000 Total Payables (Debt) = $2,990,208,000 Most recent stock price for Harvey Norman = $5.23 Market Capitalization = $5.82B Outstanding Shares = 2,842,960 Most recent annual dividend = $0.31 Beta for Harvey Norman = 0.7460 Yield on Government Debt = 4.31 Cost of Equity The cost of equity is the amount (in returns) that a company needs in order to get convinced that the invested meets capital returns requirements. The cost of equity of a company is the amount demanded by the market as an exchange for owning the asset, and bearing the risk that comes with the ownership of the asset. Cost of Equity = Risk Free Rate of Return + Beta * (Market Rate of Return – Risk Free Rate of Return) Risk Free rate of Return = 6.71% Market Rate of Return = 5.58% Beta = 0.7460 Therefore; Cost of equity = 6.71 + 0.7460 * (5.58 – 6.71) = 6.71 + (-0.84298) = 5.8670 The cost of debt for Harvey Norman = 5% The weighted average cost of capital for Norman Harvey The weighted average cost of capital (WACC) is the where the cost of capital of a company is calculated, and all the categories of the capital are weighted proportionately. The calculation takes in to account all sources of capital of a company. The increase in the WACC of a company is directly proportional to its beta and the rate of return on equity. A high WACC indicates a decrease in value of the company and an increase in risk. The WACC is calculated as below: WACC = ((E/V) * Re) + [((D/V) * Rd) * (1 – T)] Where; E = Market value of the company’s equity D = Market value of the company’s debt V = Total market value of the company (E + D) Re = Cost of equity Rd = Cost of debt T = Tax rate WACC = (($150,000/$250,000) * 0.05867) + [(($100,000/$250,000) * 0.05) * (1 – 0.3))] = 0.0352 + 0.14 = 0.1752 = 17.5% Conclusion Pure play has its own demerits. These demerits may be caused by the following factor: It is only suitable for companies with its resources invested in one line of business. Diversified companies may not perform well with this method. Furthermore, this method is associated with buying and selling over the internet. A decline in internet buying can highly affect these companies. The pure play method can also be affected by the investing style that targets it. The pure play method is mostly associated with high risk. This is because pure play highly depends on one sector of the economy, a single product or one strategy of investment. However, positive conditions can bring in very high rewards for the pure play investing style. The pure play technique is the most popular aid in the use of peer firms for the appraisal of another firm. This approach employs the various calculations to determine the valuation of a certain company. It is however limited to companies which deal with one product or focused on a specific industry. Use of this approach in a highly diversified company would be misleading and inappropriate. It is also important to identify the right peer in order to obtain the correct results. Slight mistake in the picking of the peer company to be used may lead to unforeseen loss of funds. References Inc. (n.d) Discounted Cash Flow. Retrieved from: http://www.inc.com/encyclopedia/discounted-cash-flow.html [Accessed 30 September 2016] Peavler R, (2016) Payback Period in Capital Budgeting. Retrieved from https://www.thebalance.com/payback-period-in-capital-budgeting-392916 [Accessed: 30 September 2016] Investopedia (n.d) Internal Rate of Return. Retrieved from http://www.investopedia.com/terms/i/irr.asp [Accessed: 30 September 2016] ASX (2016) Search ASX. Retrieved from http://search.asx.com.au/s/search.html?query=hvn&collection=asx-meta&profile=web [Accessed: 30 September 2016] Yahoo Finance (2016) S&P/ASX 200 (^AXJO). Retrieved from https://au.finance.yahoo.com/q?s=^axjo [Accessed: 30 September 2016] Read More