Capital Budgeting Method

Question: Discuss about the Capital Budgeting Method. Answer: Introduction: A huge multinational organization, Harvey Norman is located in Australia. It sells furniture, electronics, computers, peripherals and other communication products to retail customers. The main operating model of Harvey Norman is franchise based, although it does operate some stores itself in Australia and overseas. Started in 1961, Gerry Harvey and Ian Norman opened their first store selling only electrical goods and appliances. Expansion happened when the store became successful which led to Gerry and Ian establishing the retail chain Norman Ross. However, the chain was discontinued in 1992 and Gerry and Ian were sacked for unknown reasons. They started another store in Sydney in 1982, which also gained much popularity. Harvey Norman Holdings limited was finally listed in 1987 on the Australian Stock Exchange. Except acquiring Joyce Mayne in 1998, Harvey Norman has mostly seen an organic growth. Joyce Maine also offers similar products as that of Harvey Norman. The products include computers and accessories, mobiles and other small appliances. Harvey Norman has recently opened an online store to reach more customers directly and jump onto the e-commerce bandwagon. The company however has traditionally been strong in its physical store presence. Its partners include big brands like HP, Dell, Compaq, Lenovo etc. which whom it has enjoyed long time relationships. The operating structure of Harvey Norman is peculiar and a bit complicated than traditional retail chains. It is operated as a grouping of four distinct businesses furniture, bedding, electrical appliances and IT. It has recently stared a home and renovation business. Harvey Norman Design and Renovations takes care of all the design and renovation related projects. Its unique selling point is its kitchen, bathroom and home office renovations. Domayne is the independent furniture, bedding and homewares chain of Harvey Norman. It focusses on fashion and design with contemporary, Australian made furniture its more popular product. Although very small in quantity, some of these keep electrical and consumer goods also for customers. Harvey Norman acquired Megamart and Retravision- both stationary giants, in order to rival Officeworls in the stationary business. It set-up 5 stores across Australia. It registered the name OFIS for its stationary business. Harvey Norman however closed all the stores by 2009 as the business did not prove profitable. Harvey Norman has had a close relationship with Flexirent, which has allegedly been involved in wrongful lending practices. These lending practice were predatory in nature due to which Harvey Norman faced heavy criticism. HCL HCL was founded by Bob Hubbard in 2008 and is a relatively small company. It is completely privately owned and run business, with the Hubbard family the sole owners and operators. It mainly sells computers and accessories to retail customers. It only operates based on a brick and mortar store model. A customers enters an HCL store and has a chat with the sales rep., explaining his requirements. The sales rep. then helps the customers according to his needs and desires. HCL is completely self-finances and hasnt raised any kind of capital till now- either equity or debt. It has mostly seen organic growth and it ploughs all its profits back into the company. It opened a new store whenever it felt that it had enough cash to do so. It has now expanded to 14 stores across Australia. Weighted Average Cost of Capital: A company can raise capital in two ways either through debt or through equity in order to finance its capital investments and operating activities. In order to calculate the effective cost of financing a company, a weighted average of cost of debt and cost of equity needs to be calculated. This weighted average where debt and equity contribute proportionately to the companys value is known as Weighted Average Cost of Capital or WACC. For investors, it is essentially an opportunity for bearing the risk to invest in the company. Many capital budgeting decisions are made by the top management internally using WACC. While calculating the net present value to make go/no-go decisions on projects, it uses WACC as a discount rate for all its calculations. A companys WACC is a measure of desirability of an investor to invest in the company. It is the minimum return that a company should provide the investor who invests in the company. A lot of company information is required to calculate WACC for a company and this calculation is often extremely complicated. Harvey Norman Latest Stock Price 5.19 Assets 4430000000 Liabilities 1740000000 Market Capitalization 5774000000 Book value of equity (Calculated) 2690000000 Total number of outstanding shares 1113000000 Recent dividend announced by the company 0.17 Beta 0.75 Government Bond yield (3 month) 2.45% Market risk premium 5% Cost of equity (calculated) 6.200% Book value of long-term debt 290000000 Tax Rate for the company 30% Total interest Expense (Calculated) 32080000 Cost of debt (Calculated) 11.06% Using Book Value Using market Value Total Value 2980000000 Total Value 6064000000 Weighted Average Cost of Capital 6.35% Weighted Average Cost of Capital 6.27% All values are in Australian Dollars. As included in the 2015 annual report of Harvey Norman Holdings. Long-term debt = 290000000 (Here current liabilities and other short term debt is not considered) Total assets of Harvey Norman = 4430000000 Total liabilities for Harvey Norman = 1740000000 Equity (book value) = Assets Liabilities = 2690000000 Latest Stock Price of Harvey Norman Holdings Ltd. = 5.19 Market cap (market value of equity) = 5.77 billion Total number of outstanding shares = 1.113 billion Most recent dividend announced = 0.17 per share Beta = 0.75 Yield on government bond (3-month maturity) = 2.45% Market Risk Premium for the company = 5% Using CAPM, Cost of equity = 2.45 + 0.75* 5 = 6.2% Since there is no particular dividend policy of the company, dividend discount model cannot be used.(Beath, 2016) According to the annual report 2016, Interest expense of Harvey Norman = 32080000 Long-term debt (Book Value) = 290000000 Cost of debt = total interest expense/ long term debt (book value) = 32080000/290000000 = 11.06% Harvey Norman hasnt issues any bonds in 2015. Since there is no data available about bonds, book value of debt is presumed to be equal to market value of debt.(Anne, 2012) Weighted Average Cost of Capital Using Book-values for calculating WACC, Total value = equity (book-value) + long-term debt (book value) = 2690000000 + 290000000 = 2980000000 WACC = (Equity (Book-value) /total value)*Cost of equity + (Debt (Book-value))*Cost of debt*(1-tax rate) = 6.35% Using the market values of debt and equity, we get WACC = 6.27% The Weighted Average Cost of Capital Using market value is more relevant as it is measures the actual value of the company which the buyers are ready to pay in the market.(Gallo , 2015) There is a problem in using Harvey Norman as a representative company for HCL as both the companies are very different in terms of size, ownership and operational structure.(Patient Value, 2013) Size: Harvey Norman has a market cap of over 5 billion dollars, making it a huge company. HCL only has sales of merely $9.7 million. Harvey Norman has huge reserves of liquid cash, making it too big to fail. Hence the risk associated with Harvey Norman is very low as compared to a company like HCL. Ownership: Harvey Norman is a publicly listed company, listed on the Australian Stock Exchange. Its financials are completely public and it is accountable to its shareholders. Therefore, Harvey Norman has an easier access to capital. HCL, on the other hand, is completely privately owned and funded. It is family-run and its financials are also not visible to the public. It is difficult for HCL to raise capital--both debt and equity- when in need. Operational Structure: There are stark differences in the operations of HCL and Harvey Norman. Firstly, there is a slight difference in the product portfolio of the two companies. While Harvey Norman sells all kinds of electronic goods besides bedding and furniture, HCL is only a retail seller of computers and peripherals. While Harvey Normans strength lies in its brick and mortar stores, it also sells its products through its online channel. The customer visits the company websites and browses through the various products- classified into various categories and subcategories. The customer can also customize the product according to his needs. Whereas HCL only has in-store sales where the customer enters an HCL store and has a chat with the sales rep., explaining his requirements. The sales rep. then helps the customers according to his needs and desires hardware, software, and other computer accessories. Customers are now slowly but surely moving to ecommerce as there are more opti ons and greater convenience of door step delivery. Having only physical store sales can be a risk for HCL. (Peavler, 2011) The operating structure of Harvey Norman is also one of its kind and quite unique as compared to other traditional retail chains. Most of the Harvey Norman stores follow a franchisee based approach and are a group of three or four separate entities electrical, bedding, furniture and computers. These entities are managed separately and independently from each other and contribute to the parent company- Harvey Norman through rent and lease payments. Harvey Norman follows such a model to enjoy a lower effective tax rate as the different businesses will now be separately taxed. On the other hand, the family-run HCL operates all its stores on its own without any franchisees. It would thus pay normal rate of taxes levied by the Australian government. Harvey Norman, would therefore, have an overall better weighted average cost of capital. (Goedhart, 2015) References Anne, C., 2012. Winning dividend stocks. Morning Star. viewed September 24, 2016 https://www.morningstar.com.au/1/categories/harvey-norman-holdings-ltd-hvn-articles.html Beath, L., 2016. Bear hasn't run its course. morning star. viewed September 24, 2016 https://www.morningstar.com.au/1/categories/harvey-norman-holdings-ltd-hvn-articles.html Goedhart, M., 2015, A better way to understand internal rate of return, Mckinsey. viewed September 24, 2016 https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/internal-rate-of-return-a-cautionary-tale Harold Bierman, J., 2016, Comparing Net Present Value and Internal Rate of Return, Finance Practitioner. viewed September 24, 2016 https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-better-way-to-understand-internal-rate-of-return Peavler, R., 2011, Net Present Value (NPV) as a Capital Budgeting Method, The Balance. viewed September 24, 2016 https://www.financepractitioner.com/cash-flow-management-best-practice/comparing-net-present-value-and-internal-rate-of-return?full Winkle, L., 2011. Harvey Norman shares: Should you really buy them?. Financial Review. viewed September 24, 2016 https://www.bofaml.com/content/dam/boamlimages/documents/articles/D3_014/bro-04-15-1256_f_singlepages.pdf