Predict the effects of the time value of money on potential investments: The time value of money is a basicfundamental of finance. The underlyingprinciple is that a dollar presently in possession is worth more than a dollarreceived in the future owing to its earning potential. The money today can be invested which has thepossibility of growing into more money in the future. Building on this premise whenresearching a company’s potential, it would be beneficial to know the presentvalue of said company. The discountedcash flow (DCF) analysis can assist with this calculation.
The DCF “analysis uses future free cashflow (FCF) projections and discounts them to estimate thepresent value, which is then used to evaluate the investment potential.” This essentially endeavors to assess acompany based on its projected future value. The FCF is not specifically statedin any one financial statement. Instead,it can be calculated by using both the income statement and balance sheet. Thiswill provide the cash flow from operating activities (CFO) and can be computed byadding the Net Income, Depreciation, Amortization and Non-Cash Income thensubtracting the Net Working Capital (NWC is essentially the current assetsminus the current liabilities). Present Value Calculations In the case of Home Depot aspresented in the Commission File Number 1-8207, if a 35% corporate tax rate and8% interest rate is assumed, the present value can be calculated for years onethrough five as:Year 1 $(104.63) millionYear 2 $(95.
16) millionYear 3 $(85.73) millionYear 4 $(74.24) millionYear 5 $(66.02) millionThis translates to a present valueof negative $425.78 (million). Futureyears can be forecasted utilizing this figure and a projected 5% sales increasefor each consecutive year. Since the net present value isbased upon projected future returns correct risk assessment is a vital piece ofinformation in the calculations and as such has a direct correlation to theimplications of NPV. Analyzing the NPVincorporates present cash outflow, future cash inflows and weighted averagecost of capital or discount rate.
Sinceboth future cash inflows and the discount rate are estimated figures there isrisk associated with two of the three elements used in NPV. Recalculation of PV When Company RiskChanges Due to an Internal EventAny changes in the present cashoutflow, future cash inflows or discount rate based upon an internal event alsoaffect the NPV. In the currenttechnology driven society, Home Depot relies heavily on information technologyas an integral part of running a successful business. “A failure of a key information technologysystem or process could adversely affect” the business. If Home Depot itself or one of its serviceproviders encounter a massive system failure this could adversely affect thecompany’s risk or WACC.
If a 4% increasein the associated risk, from 8% to 12% is assumed the NPV of the company woulddecrease by $40.3 (million); reduced from negative 425.78 to negative $385.48.
Potential Buyer ScenarioAlong with the present value thefuture value should be determined which will assist in the decision to purchaseor not to purchase a business. This canbe established using the following formula; FV = PV (1+i)^n. The future value of Home Depot, therefore canbe calculated as (385.
48)*(1+.12)^5 or negative $679.38 million. Effect on Shareholder ValueInvestors use a variety of reportsand calculations to ascertain the worthiness of an investment. The DCF is one such tool as it takes intoconsideration the time value of money. Since DCF makes some assumptions in its calculations there are certainrisks involved. “Even a small change ina single assumption can result in very different valuation results.” As a result, if the risk increases thepresent value decreases.
The decline ofthe present value and higher risk associated with the company will haveinvestors wanting a greater rate of return to compensate for the elevatedrisk. Conversely, a decrease in risk forthe company will increase the present value. Investors in this case would encounter a lower rate of return since therisk is lower.Purchasing Company Based on FutureValuePurchasing this company based uponthe calculated future value would depend upon the investor’s risk tolerance aswell as appetite.
With that stated,based upon the FCF calculated, it would be recommended that if the businesssold in five years it not be purchased for the calculated future value. FCF analysis indicates a decreasing trend inthe next five years which if continued would correlate to a future value lessthan calculated. Assess the stock valuation process as a viable financial option andapplication: Capital markets are used bycompanies as a source of financing. Stock and bond markets are two of the most widely utilized. These markets are vital to the business worldas they provide a secure arena for investors with capital and companies lookingfor capital through either equity (stock) or debt (bond) instruments. Companiesissue stock to increase cash flow whereby they are essentially offeringinvestors a partial ownership in the business. A dividend which is a distribution of a company’s earnings is decidedupon by the company’s board of directors and paid to the company’sshareholders.
Dividends can be issued inthe form of cash payments, shares of stock or even other property. Bonds however, are basically loansfrom which the investor will receive repayment of the bond amount plus interestat a specified future date. The companyissuing the bond receives the funds needed while the investor receives the promiseof recompense. However, the investor maydecide the bonds are no longer a desired instrument for investment. The investor would then have the option ofselling to another investor in the bond market. In this case, the company’s promise of repayment simply transfers to thenew bond holder.Stock Valuation Calculations:One task set forth is to calculatethe new dividend yield if the company increased its dividend per share by$1.
75. Company financial statementsindicate as of February 2015, the dividend per share is $1.88. An increase of the per share dividend willaffect the yield. The cash dividend pershare increases from 1.88 to 3.63 which results in increase in the dividendyield from 2.30% to 4.
44%.The company’s financial statementscan be used to project dividend yields and rate of return. The dividend yield formula (Dividend Yield =dividends for the period/initial price for the period) can assist identifyingtrends in yield.
Investors whose intentis to receive dividends would use this to assist in the selection process. However, investors should realize a lowerdividend yield does not necessarily indicate lower dividends as the price mighthave significantly increased.The next task is to compute thedividend yield if the company doubles its outstanding shares. Stock splits essentially increase the numberof outstanding shares to the company’s current stockholders. A with a 2 for 1 split a stock holder holding10,000 shares would increase the amount to 20,000. Although the total outstanding sharesincrease, the market capitalization remains constant.
Assuming the stock prices remain unchanged,the dividend yield decreases since this is calculated as dividend per sharedivided by stock priceThe final task is to determine therate of return on equity based on the new dividend yield. The rate of return formula can be stated as(current value less original value) divided by original value) multiplied by100. The new rate of return based on theincreased dividend share is 3.78%. Effects to Shareholder’s ValueThe effect to the shareholder’svalue in each scenario depends upon how shareholder wealth maximization isbeing defined.
For instance, if theshareholder’s main concern is to receive increasing dividends, then theincreased yield in the first scenario will accomplish this goal. However, if the shareholder’s goal is toincrease wealth based upon stock price then the second scenario of the stocksplit would ultimately incur the maximum wealth. An increased number of stocks provideincreased ownership in the company which results in higher rate of return ofinvestment.
Dividend PoliciesA dividend policy is one whichinvolves the financial policies regarding the payout of current cash dividendsor paying increased cash dividends at a later date. According to Home Depot’s 10-K Form, alongwith disciplined decisions about capital allocation, focus on expense controlincreased returns on invested capital. This allowed Home Depot to ‘return value to shareholders through $7billion in share repurchases and $2.5 billion in dividends in fiscal2014.” This would indicate the company’sdividend policies support both an increasing growth rate and dividendyield.
Assess the bond issuance process as a viable financial option andapplication: As discussed previously, theissuance of bonds is another avenue companies investigate when funds are neededto finance operations. Bonds orfixed-income securities are an alternative for companies to acquire funds ratherthan obtaining loans from banks.Bond CalculationsAssuming Home Depot already hasoutstanding bonds, calculate the new value of the bond if overall rates in themarket increase by 5%. This would becalculated as FV = PV*(1+i)n or $2,963 * (1+0.029375)40. Therefore, the future value is $9,433.57.
The next computation assumes thenew value of the bond if overall rates decrease by 5%. Working with the same formula, the futurevalue is $24,634.03. This result iscalculated as $2,963*(1+0.054375)40. If the overall rates in the marketstayed the same, the value of the bond will remain unchanged.
Raising CapitalWhen considering bonds as a viableoption for raising capital, it is important to recognize that market interestrates and bond prices have an inverse relationship. Therefore, when the market increased by 5%the bond is priced at a discounted amount. Bonds issued prior to a market rate increase would incur lower interestpayments. This then would be a viablescenario for Home Depot to raise capital as the bonds were issued prior to theincrease in market rates.
If the overall market ratesdecrease, Home Depot may decide the financially sound decision would be to callback the bonds. The company would bepaying a higher interest rate than is currently dictated by the market. Raising capital by issuing bonds ina market that remains the same as reviewed in the third scenario would be aviable option for Home Depot. In thiscase, the outstanding bonds are valued at the price Home Depot intended withthe projected interest payments.Bond Issuance PoliciesHome Depot has stated in the Form10-K that “current cash position, access to the long-term debt capital marketsand cash flow generated from operations should be sufficient not only foroperating requirements but also to enable us to complete our capitalexpenditure programs and fund dividend payments, share repurchases, obligationsincurred…and any required long-term debt payments through the next severalfiscal years”. Issuing of bonds as anavenue for Home Depot to raise capital has enabled the company to: repurchaseCommon Stock worth 7 billion dollars as of February 1, 2015, repay $39 billionin long term debt and distribute $2.53 billion dividends to stock holders. Considering these figures and future plans asoutlined in the Form 10-K regarding contractual obligations, it appears thatHome Depot’s bond issuance policies are sound and support the company’sstrategies for sustainability as well as expansion.
Appraise corporate investment opportunities using capital budgetingestimates: Capital investments are animportant aspect of a company’s growth initiative. Capital budgeting provides management a wayto ensure the project and investment opportunities which best suit thecompany’s needs are pursued while rejecting those not meeting thecriteria. It is a step by step processwhich creates accountability and measurability for the project or investmentbeing considered. Management can rankthe projects or investments resulting in the highest return on the investedfunds being the optimal choice.
Thereare several methods management uses for capital budgeting; throughput analysis,net present value, internal rate of return, discounted cash flow or paybackperiod. Management must also considerwhether those projects under consideration are independent or mutuallyexclusive. Independent projects andinvestments are those whose cash flows are not affected by the acceptance orrejection of other projects or investments. Whereas mutually exclusive projects are a group of projects orinvestments under consideration for which at most only one would be accepted.
Consideration for PotentialInvestment NPV CalculationNet Present Value allows formanagement to estimate the profitability of a project or investment. Co is representative of theinitial investment, shown as a negative cash flow as the funds areoutgoing. A positive NPV indicates theprojected earnings exceed the anticipated costs.In the case of Home Depot, the NPVof the project being considered is $9,785,570.71. Consideration for PotentialInvestment IRR CalculationThe internal rate of return alsomeasures the profitability of an investment or project. In general, the higher the rate of return themore desirable the investment or project is.
The formula for which is0 = P0 + P1/(1+IRR) +P2/(1+IRR)2 + P3/(1+IRR)3 +P4/(1+IRR)4+P5/(1+IRR)5In this, Po, P1…P5equals the cash flows in periods one through five respectively; while IRRrepresents the internal rate of return. For Home Depot’s project underconsideration, the IRR is 50%.Implications of the calculationsThe NPV of Home Depot’s project is$9,785,570.71. NPV represents thedifference between the present value of cash inflows and the present value ofcash outflows. Therefore, a positive NPVwould indicate the projected earnings of a project or investment exceeds theanticipated costs.
Conversely, anegative NPV would indicate a net loss. Calculations for the Home Depot project under consideration denote apositive NPV thereby indicating the project is acceptable.The Internal Rate of Return (IRR)also utilizes the net present value. However, the NPV is set to zero with the formula solving for thediscount rate or IRR. Theoretically, projectsor investments with an IRR greater than its weighted average cost of capital(WACC) would be a profitable one of which the company should undertake. IRR calculation for Home Depot’s project is50%. Therefore, the company shouldaccept this project.
Difference between NPV and IRRBoth the NPV and IRR measure profitabilityoften with similar results. However,there are projects and investments for which using one computation rather thanthe other will provide a more accurate calculation.An advantage of using NPV is thatit is an absolute measure. It representsthe value of money gained or lost by undertaking a particular project orinvestment. NPV can also be used whenevaluating projects or investments when changes in cash flow are expected. Changes in discount rates will also producediffering results for the same project.
IRR is representative of the yielda particular project or investment will provide. Since the IRR utilizes WACC it is arelatively easy measure to calculate and provides a way to compare the worth ofprojects or investments under consideration regardless of the size of theprojects. Unlike IRR, NPV lacks the abilityto compare projects of differing sizes. NPV can indicate which projects should provide a return on investmentbut cannot indicate which projects would provide the best return. Although IRR considers projects of varyingsizes, it cannot incorporate any changes in cash flow and provides the sameresults even if the discount rate alters. Based upon the various advantagesand disadvantages of both NPV and IRR, NPV would be the suggested method ofmeasurement for the project under consideration by Home Depot. This method provides a more accuratemeasurement of the expected return on investment.
With this said, the NPV indicates a positivefigure which correlates into an acceptable project for Home Depot to pursue.Analyze macroeconomic variables for their impact on financial decisionmaking: Macroeconomics is defined as thestudy of economics in relation to the whole, exploring a variety of factors.Unlike Microeconomics which places its focus on aggregated sectors. Although macroeconomics encompasses a broadfield, it may be loosely broken down into two disciplines; the business cycleand economic growth. The business cycleinvolves the examination of cause and effect of short term fluctuations. Whereas economic growth examines the factorswhich help determine long term growth.In the case of Home Depot, the CEOis convinced that financial analysis should hinge only on what is happeninginternally.
The task set forth is to providea substantive argument to persuade him otherwise.Analysis of the Implications ofInterest Rate ChangesChanges in interest rates, anexternal factor for which the company has no control, provide a convincing caseas to why the CEO should not focus solely upon internal factors regardingfinancial analysis. Interest rates areincorporated in determining the company’s weighted average cost of capital(WACC). This figure is utilized inseveral financial analyses. For example,WACC is applied when calculating the present value of estimated future cashflows (FCF). Previous analysis of the FCFindicates a negative present value when the interest rate is 8%. This is calculated by using the formulaPV=FVN/1+I)^N where I is the interest rate and N is the number of years. Changes in the WACC would therefore cause achange in the present value (PV).
Forexample, if interest rates decline from 8% to 5% the present value would changefrom negative $425.78 million to negative $460.69 million. However, if the interest rate were toincrease from 8% to 15% the effect would be an increase in the PV to a negative$359.18 million. This is due to futurecash flows being discounted by the WACC rate. Stock Market ImpactAnother outside influence the CEOshould consider when reviewing company financials is the stock market. The condition of the market as a whole aswell as the company’s own stock value will provide additional insight into HomeDepot’s financial health.
In a bullmarket investors are encouraged to invest due to increasing share prices andhigh rates of return. A strong economypromotes increased demand and spending contributing to the company’s welfare.However, in a bear market whenbusinesses are not able to maintain large profit margins, investors balk andbegin to sell their stock.
This in turnleads to lower stock prices which, adversely affects the company’s value.As previously stated WACC is usedin a multitude of financial formulas. The WACC formula is (E/V x Re) + ((D/V x Rd) x (1 – T));where E is the market value of the firm’s equity, D is the market value of thefirm’s debt, V is the total value of capital, Re is the cost of equity(required rate of return), Rd is the cost of debt (yield to maturity onexisting debt), and T is the tax rate. The formula alone assures any change in rate will alter the result. For instance, in the capitalbudgeting problem WACC is assumed to be 8% resulting in a NPV of $9.785 millionand an acceptance of the proposed project. If, the WACC decreases to 5% the NVP increases to $23.
105 million.However, increasing the WACC to 15% decreases the NPV to $14.362 millionresulting in a rejection of the proposed project.
Impact of External FactorsTo promote economic growthcompanies must identify and analyze external factors which might affect itsgoals or strategies; whether adversely or not. One such tool Home Depot may utilize is the PESTEL/PESTLE analysis whichidentifies political, economic, social, technological, legal and environmentalfactors. Other analysis tools areavailable such as SWOT (strength, weakness, opportunities and threats) orvariations of the PEST model.
As the acronym suggests, there arevarious external factors Home Depot should review. One such factor would be political. Due to international trade agreements HomeDepot has the opportunity to expand the international arena. However, unpredictable government spending,political stability and exchange rates pose a threat to that opportunity.Environmental factors play a largerole in the financial health of Home Depot. As stated in Home Depot’s Form 10-K, “The HomeDepot stores sell a wide assortment of building materials, home improvementproducts and lawn and garden products and provide a number of services.”Therefore, it stands to reason environmental factors would play a part indecision making and strategic planning. Storms, fires and other catastrophic events would ensure the demand forproduct increase; thereby, increasing the company’s and investors’ financialwell-being.
Considering all of these factors,it would seem evident that a financial analysis which only included internalfactors would be detrimental. Incorporating external factors such as political, economic andenvironmental will provide Home Depot a more accurate outlook on the company’sfinancial health in relation to the market and industry as a whole. It would also provide a more strategicplatform for the company to launch future projects or investments.
