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

Value

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

than calculated.

Assess the stock valuation process as a viable financial option and

application:

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

investment.

Dividend Policies

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

yield.

Assess the bond issuance process as a viable financial option and

application:

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.

Bond Calculations

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.

Raising Capital

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

estimates:

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 +

P4/(1+IRR)4+P5/(1+IRR)5

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

projects.

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

making:

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

flows (FCF).

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

well-being.

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.