Predict the effects of the time value of money on potential investments:
The time value of money is a basic
fundamental of finance. The underlying
principle is that a dollar presently in possession is worth more than a dollar
received in the future owing to its earning potential. The money today can be invested which has the
possibility of growing into more money in the future.
Building on this premise when
researching a company’s potential, it would be beneficial to know the present
value of said company. The discounted
cash flow (DCF) analysis can assist with this calculation. The DCF “analysis uses future free cash
flow (FCF) projections and discounts them to estimate the
present value, which is then used to evaluate the investment potential.” This essentially endeavors to assess a
company based on its projected future value.
The FCF is not specifically stated
in any one financial statement. Instead,
it can be calculated by using both the income statement and balance sheet. This
will provide the cash flow from operating activities (CFO) and can be computed by
adding the Net Income, Depreciation, Amortization and Non-Cash Income then
subtracting the Net Working Capital (NWC is essentially the current assets
minus the current liabilities).
Present Value Calculations
In the case of Home Depot as
presented in the Commission File Number 1-8207, if a 35% corporate tax rate and
8% interest rate is assumed, the present value can be calculated for years one
through five as:
Year 1 $(104.63) million
Year 2 $(95.16) million
Year 3 $(85.73) million
Year 4 $(74.24) million
Year 5 $(66.02) million
This translates to a present value
of negative $425.78 (million). Future
years can be forecasted utilizing this figure and a projected 5% sales increase
for each consecutive year.
Since the net present value is
based upon projected future returns correct risk assessment is a vital piece of
information in the calculations and as such has a direct correlation to the
implications of NPV. Analyzing the NPV
incorporates present cash outflow, future cash inflows and weighted average
cost of capital or discount rate. Since
both future cash inflows and the discount rate are estimated figures there is
risk associated with two of the three elements used in NPV.
Recalculation of PV When Company Risk
Changes Due to an Internal Event
Any changes in the present cash
outflow, future cash inflows or discount rate based upon an internal event also
affect the NPV. In the current
technology driven society, Home Depot relies heavily on information technology
as an integral part of running a successful business. “A failure of a key information technology
system or process could adversely affect” the business. If Home Depot itself or one of its service
providers encounter a massive system failure this could adversely affect the
company’s risk or WACC. If a 4% increase
in the associated risk, from 8% to 12% is assumed the NPV of the company would
decrease by $40.3 (million); reduced from negative 425.78 to negative $385.48.
Potential Buyer Scenario
Along with the present value the
future value should be determined which will assist in the decision to purchase
or not to purchase a business. This can
be established using the following formula; FV = PV (1+i)^n. The future value of Home Depot, therefore can
be calculated as (385.48)*(1+.12)^5 or negative $679.38 million.
Effect on Shareholder Value
Investors use a variety of reports
and calculations to ascertain the worthiness of an investment. The DCF is one such tool as it takes into
consideration the time value of money.
Since DCF makes some assumptions in its calculations there are certain
risks involved. “Even a small change in
a single assumption can result in very different valuation results.” As a result, if the risk increases the
present value decreases. The decline of
the present value and higher risk associated with the company will have
investors wanting a greater rate of return to compensate for the elevated
risk. Conversely, a decrease in risk for
the company will increase the present value.
Investors in this case would encounter a lower rate of return since the
risk is lower.
Purchasing Company Based on Future
Purchasing this company based upon
the calculated future value would depend upon the investor’s risk tolerance as
well as appetite. With that stated,
based upon the FCF calculated, it would be recommended that if the business
sold in five years it not be purchased for the calculated future value. FCF analysis indicates a decreasing trend in
the next five years which if continued would correlate to a future value less
Assess the stock valuation process as a viable financial option and
Capital markets are used by
companies as a source of financing.
Stock and bond markets are two of the most widely utilized. These markets are vital to the business world
as they provide a secure arena for investors with capital and companies looking
for capital through either equity (stock) or debt (bond) instruments. Companies
issue stock to increase cash flow whereby they are essentially offering
investors a partial ownership in the business.
A dividend which is a distribution of a company’s earnings is decided
upon by the company’s board of directors and paid to the company’s
shareholders. Dividends can be issued in
the form of cash payments, shares of stock or even other property.
Bonds however, are basically loans
from which the investor will receive repayment of the bond amount plus interest
at a specified future date. The company
issuing the bond receives the funds needed while the investor receives the promise
of recompense. However, the investor may
decide the bonds are no longer a desired instrument for investment. The investor would then have the option of
selling to another investor in the bond market.
In this case, the company’s promise of repayment simply transfers to the
new bond holder.
Stock Valuation Calculations:
One task set forth is to calculate
the new dividend yield if the company increased its dividend per share by
$1.75. Company financial statements
indicate as of February 2015, the dividend per share is $1.88. An increase of the per share dividend will
affect the yield. The cash dividend per
share increases from 1.88 to 3.63 which results in increase in the dividend
yield from 2.30% to 4.44%.
The company’s financial statements
can 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 identifying
trends in yield. Investors whose intent
is to receive dividends would use this to assist in the selection process. However, investors should realize a lower
dividend yield does not necessarily indicate lower dividends as the price might
have significantly increased.
The next task is to compute the
dividend yield if the company doubles its outstanding shares. Stock splits essentially increase the number
of outstanding shares to the company’s current stockholders. A with a 2 for 1 split a stock holder holding
10,000 shares would increase the amount to 20,000. Although the total outstanding shares
increase, the market capitalization remains constant. Assuming the stock prices remain unchanged,
the dividend yield decreases since this is calculated as dividend per share
divided by stock price
The final task is to determine the
rate 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 by
100. The new rate of return based on the
increased dividend share is 3.78%.
Effects to Shareholder’s Value
The effect to the shareholder’s
value in each scenario depends upon how shareholder wealth maximization is
being defined. For instance, if the
shareholder’s main concern is to receive increasing dividends, then the
increased yield in the first scenario will accomplish this goal. However, if the shareholder’s goal is to
increase wealth based upon stock price then the second scenario of the stock
split would ultimately incur the maximum wealth. An increased number of stocks provide
increased ownership in the company which results in higher rate of return of
A dividend policy is one which
involves the financial policies regarding the payout of current cash dividends
or paying increased cash dividends at a later date. According to Home Depot’s 10-K Form, along
with disciplined decisions about capital allocation, focus on expense control
increased returns on invested capital.
This allowed Home Depot to ‘return value to shareholders through $7
billion in share repurchases and $2.5 billion in dividends in fiscal
2014.” This would indicate the company’s
dividend policies support both an increasing growth rate and dividend
Assess the bond issuance process as a viable financial option and
As discussed previously, the
issuance of bonds is another avenue companies investigate when funds are needed
to finance operations. Bonds or
fixed-income securities are an alternative for companies to acquire funds rather
than obtaining loans from banks.
Assuming Home Depot already has
outstanding bonds, calculate the new value of the bond if overall rates in the
market increase by 5%. This would be
calculated 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 the
new value of the bond if overall rates decrease by 5%. Working with the same formula, the future
value is $24,634.03. This result is
calculated as $2,963*(1+0.054375)40.
If the overall rates in the market
stayed the same, the value of the bond will remain unchanged.
When considering bonds as a viable
option for raising capital, it is important to recognize that market interest
rates 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 interest
payments. This then would be a viable
scenario for Home Depot to raise capital as the bonds were issued prior to the
increase in market rates.
If the overall market rates
decrease, Home Depot may decide the financially sound decision would be to call
back the bonds. The company would be
paying a higher interest rate than is currently dictated by the market.
Raising capital by issuing bonds in
a market that remains the same as reviewed in the third scenario would be a
viable option for Home Depot. In this
case, the outstanding bonds are valued at the price Home Depot intended with
the projected interest payments.
Bond Issuance Policies
Home Depot has stated in the Form
10-K that “current cash position, access to the long-term debt capital markets
and cash flow generated from operations should be sufficient not only for
operating requirements but also to enable us to complete our capital
expenditure programs and fund dividend payments, share repurchases, obligations
incurred…and any required long-term debt payments through the next several
fiscal years”. Issuing of bonds as an
avenue for Home Depot to raise capital has enabled the company to: repurchase
Common Stock worth 7 billion dollars as of February 1, 2015, repay $39 billion
in long term debt and distribute $2.53 billion dividends to stock holders. Considering these figures and future plans as
outlined in the Form 10-K regarding contractual obligations, it appears that
Home Depot’s bond issuance policies are sound and support the company’s
strategies for sustainability as well as expansion.
Appraise corporate investment opportunities using capital budgeting
Capital investments are an
important aspect of a company’s growth initiative. Capital budgeting provides management a way
to ensure the project and investment opportunities which best suit the
company’s needs are pursued while rejecting those not meeting the
criteria. It is a step by step process
which creates accountability and measurability for the project or investment
being considered. Management can rank
the projects or investments resulting in the highest return on the invested
funds being the optimal choice. There
are several methods management uses for capital budgeting; throughput analysis,
net present value, internal rate of return, discounted cash flow or payback
period. Management must also consider
whether those projects under consideration are independent or mutually
exclusive. Independent projects and
investments are those whose cash flows are not affected by the acceptance or
rejection of other projects or investments.
Whereas mutually exclusive projects are a group of projects or
investments under consideration for which at most only one would be accepted.
Consideration for Potential
Investment NPV Calculation
Net Present Value allows for
management to estimate the profitability of a project or investment. Co is representative of the
initial investment, shown as a negative cash flow as the funds are
outgoing. A positive NPV indicates the
projected earnings exceed the anticipated costs.
In the case of Home Depot, the NPV
of the project being considered is $9,785,570.71.
Consideration for Potential
Investment IRR Calculation
The internal rate of return also
measures the profitability of an investment or project. In general, the higher the rate of return the
more desirable the investment or project is.
The formula for which is
0 = P0 + P1/(1+IRR) +
P2/(1+IRR)2 + P3/(1+IRR)3 +
In this, Po, P1…P5
equals the cash flows in periods one through five respectively; while IRR
represents the internal rate of return.
For Home Depot’s project under
consideration, the IRR is 50%.
Implications of the calculations
The NPV of Home Depot’s project is
$9,785,570.71. NPV represents the
difference between the present value of cash inflows and the present value of
cash outflows. Therefore, a positive NPV
would indicate the projected earnings of a project or investment exceeds the
anticipated costs. Conversely, a
negative NPV would indicate a net loss.
Calculations for the Home Depot project under consideration denote a
positive 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 the
discount rate or IRR. Theoretically, projects
or 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 is
50%. Therefore, the company should
accept this project.
Difference between NPV and IRR
Both the NPV and IRR measure profitability
often with similar results. However,
there are projects and investments for which using one computation rather than
the other will provide a more accurate calculation.
An advantage of using NPV is that
it is an absolute measure. It represents
the value of money gained or lost by undertaking a particular project or
investment. NPV can also be used when
evaluating projects or investments when changes in cash flow are expected. Changes in discount rates will also produce
differing results for the same project.
IRR is representative of the yield
a particular project or investment will provide. Since the IRR utilizes WACC it is a
relatively easy measure to calculate and provides a way to compare the worth of
projects or investments under consideration regardless of the size of the
Unlike IRR, NPV lacks the ability
to compare projects of differing sizes.
NPV can indicate which projects should provide a return on investment
but cannot indicate which projects would provide the best return. Although IRR considers projects of varying
sizes, it cannot incorporate any changes in cash flow and provides the same
results even if the discount rate alters.
Based upon the various advantages
and disadvantages of both NPV and IRR, NPV would be the suggested method of
measurement for the project under consideration by Home Depot. This method provides a more accurate
measurement of the expected return on investment. With this said, the NPV indicates a positive
figure which correlates into an acceptable project for Home Depot to pursue.
Analyze macroeconomic variables for their impact on financial decision
Macroeconomics is defined as the
study 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 broad
field, it may be loosely broken down into two disciplines; the business cycle
and economic growth. The business cycle
involves the examination of cause and effect of short term fluctuations. Whereas economic growth examines the factors
which help determine long term growth.
In the case of Home Depot, the CEO
is convinced that financial analysis should hinge only on what is happening
internally. The task set forth is to provide
a substantive argument to persuade him otherwise.
Analysis of the Implications of
Interest Rate Changes
Changes in interest rates, an
external factor for which the company has no control, provide a convincing case
as to why the CEO should not focus solely upon internal factors regarding
financial analysis. Interest rates are
incorporated in determining the company’s weighted average cost of capital
(WACC). This figure is utilized in
several financial analyses. For example,
WACC is applied when calculating the present value of estimated future cash
Previous analysis of the FCF
indicates a negative present value when the interest rate is 8%. This is calculated by using the formula
PV=FVN/1+I)^N where I is the interest rate and N is the number of years. Changes in the WACC would therefore cause a
change in the present value (PV). For
example, if interest rates decline from 8% to 5% the present value would change
from negative $425.78 million to negative $460.69 million. However, if the interest rate were to
increase from 8% to 15% the effect would be an increase in the PV to a negative
$359.18 million. This is due to future
cash flows being discounted by the WACC rate.
Stock Market Impact
Another outside influence the CEO
should consider when reviewing company financials is the stock market. The condition of the market as a whole as
well as the company’s own stock value will provide additional insight into Home
Depot’s financial health. In a bull
market investors are encouraged to invest due to increasing share prices and
high rates of return. A strong economy
promotes increased demand and spending contributing to the company’s welfare.
However, in a bear market when
businesses are not able to maintain large profit margins, investors balk and
begin to sell their stock. This in turn
leads to lower stock prices which, adversely affects the company’s value.
As previously stated WACC is used
in 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 the
firm’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 on
existing debt), and T is the tax rate.
The formula alone assures any change in rate will alter the result.
For instance, in the capital
budgeting problem WACC is assumed to be 8% resulting in a NPV of $9.785 million
and 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 million
resulting in a rejection of the proposed project.
Impact of External Factors
To promote economic growth
companies must identify and analyze external factors which might affect its
goals or strategies; whether adversely or not.
One such tool Home Depot may utilize is the PESTEL/PESTLE analysis which
identifies political, economic, social, technological, legal and environmental
factors. Other analysis tools are
available such as SWOT (strength, weakness, opportunities and threats) or
variations of the PEST model.
As the acronym suggests, there are
various external factors Home Depot should review. One such factor would be political. Due to international trade agreements Home
Depot 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 large
role in the financial health of Home Depot.
As stated in Home Depot’s Form 10-K, “The Home
Depot stores sell a wide assortment of building materials, home improvement
products and lawn and garden products and provide a number of services.”
Therefore, it stands to reason environmental factors would play a part in
decision making and strategic planning.
Storms, fires and other catastrophic events would ensure the demand for
product increase; thereby, increasing the company’s and investors’ financial
Considering all of these factors,
it would seem evident that a financial analysis which only included internal
factors would be detrimental.
Incorporating external factors such as political, economic and
environmental will provide Home Depot a more accurate outlook on the company’s
financial health in relation to the market and industry as a whole. It would also provide a more strategic
platform for the company to launch future projects or investments.