The prime provider for the integrated financial services in Australia is the Commonwealth Bank Australia. Besides Australia, the bank has other branches in regions and countries such as North America, Europe, Asia, and New Zealand.
AMP’s current common share price is trading at 3.22
|
Table 1. AMP’s financial summary as at 21st September, 2019. |
|
|
Daily change |
0.01 – 0.312% |
|
Daily volume |
15,620,435 |
|
Market capital |
9.37 billion |
|
Bid |
3.19 |
|
Offer |
3.23 |
|
No of Shares |
2.92 billion |
|
CBA’s c current common share price stands at 71.94 Table 2. CBA financial summary as at 21st September |
|
|
Daily change |
0.06 – 0.083% |
|
Daily volume |
4,091,895 |
|
Market capital |
126.5 billion |
|
Bid |
71.61 |
|
Offer |
71.64 |
|
No of Shares |
1.76 billion |
The table below summarizes AMP’s share price evolution for the period between 2013 and 2017.
|
Table 3. AMP share price evolution 2013 – 2017 |
|||||
|
2017 |
2016 |
2015 |
2014 |
2013 |
|
|
Share Price as at the end of the financial year (AUD) |
5.25 |
5.00 |
5.37 |
5.77 |
4.27 |
(Source: Yahoo Finance)
It can be seen that the AMP’s share price has been growing for the past five years. 2014 posted an all-time high of AUD 5.77 and the price stabilized to AUD 5.25 as at the end of financial year 2017. The graph below shows AMP’s year-to-year evolution of share price.
The table below summarizes CBA’s evolution of share price for the period between 2013 and 2017.
Table 4: CBA’s share price evolution 2013 – 2017
|
2017 |
2016 |
2015 |
2014 |
2013 |
|
|
Share Price as at the end of the financial year (AUD) |
74.46 |
73.18 |
66.62 |
71.62 |
56.51 |
(Source: Yahoo Finance)
It can be seen that the company’s share price has been growing for the last five years with 2017 reporting the highest share price. The graph below shows the evolution of CBA’s share price from 2013 – 2017.
The objective of the Royal commission was the restoration of trust and confidence, and the maintenance of theexisting stability of the economic sector. It is worth noting that the reliance on higher financial leverage led to the vulnerability to economic fluctuations in the banking sector. Nevertheless, banks suffer loss of confidence from royal commission as a result of being opaque to their clients and this leads to a reduced amount of deposits. The reason for the loss of confidence from the royal commission is as a result of the matters discussed below.
First, the misconduct among the financial service providers is the leading cause of the loss of confidence. Second is any practice by the service provider that is considered to be below the expectation of the public.
According to the royal commission’s observation on matters concerning systematic and unsystematic risk, the following conclusions can be made:
First, there is a misalignment between the client and the financial service provider and this is detrimental to both parties. Secondly, the public does not trust the financial system because it lacks the muscle to tackle the malpractices and illegal behaviors arising out of the engagement of the system. Finally, there is the potential or risk arising out of the negative sentiments from small engagements that are likely to spill over into the financial system as a whole.
Hence, the main purpose of the royal commission is to handle and tackle misconduct and also the fulfillment of the expectations of the public. In retrospect, complaints that arise from wills such as the insurance claims will and the financial counsel will lead to compensations that will eventually result in the elevation of Australian Securities and Investments Commission (ASIC).
The significant role played by the royal commission includes but is not limited to competition among the financial systems, financial stability of the system, and the costs remitted to the consumers by the financial system. Thus, these roles are critical in providing counsel on financial and insurance matters.
Findings of the royal commission concerning Hayne could lead to AMP’s permanent damage. Essentially, AMPs stock is likely to fall to $4.45 representing a 4.4% decline
The findings also indicate that close to $4million was used in the remediation of the firm’s customers. Nevertheless, the company also faced a major problem when close to 15,000 of its clients were charged for their failure to observe the required procedure with regards to giving counsel on financial and insurance matters. AMP is likely to suffer from a long-term scar on its image as a result of the findings by Hayne.
The royal commission has also come up with substantial evidence which indicates that over the last ten years, CBA has been charging dead clients for counsel on financial and insurance matters.Nevertheless, the executive general manager also confessed that the financial planning department at CBA still kept receiving commissions from clients who registered after July 2013 even though the Future of Financial Advice (FOFA) laws prohibiting the same had been instituted.
Further findings by the royal commission also indicated that complaints by clients with regards to services not rendered had been ignored and were still being charged for the past six years. This complaint was also coupled with the admission by CBA that they had been charging clients for financial advice that was not given. From the above revelations, it is evident that the corporate image for both AMP and CBA has been tarnished and this is likely to cause their share prices to tumble in the coming days.
Part B
According to Robson (2017), both internal rate of return (IRR) and the required rate of return (RRR) are metrics used to determine the performance of a certain investment over time.
The RRR is theleast return that a certain firm targets on its investments or projects that compensates them for a particular level of risk before pursuing such investments. The RRR is also called the hurdle rate. In essence, RRR is an arbitrary figure that differs from one firm to the other because different companies have different risk appetites. On the other hand, the IRR a discount rate that translates the net present value (NPV) of all cash flows from a certain project to be equal to zero.
Decision Rule of RRR and IRR
When the resulting internal rate of return is greater than the cost of capital, then the company should proceed with the project and if the IRR is the same to the cost of capital, then the firm should be indifferent and hence conduct further analysis, and if the IRR is less than the cost of capital, then the project should be discarded. Hence, while selecting two mutually exclusive projects then the one with the highest internal rate of return ought to be chosen as long as the computed rate is more than the cost of capital. On the other hand, the decision rule in the required rate of return is such that if the NPV of the required rate of return is greater than zero for a given project, then it ought to be pursued and evaluated further, if the RRR is a lesser amount than zero then the project is discarded.
The NPV formula is as shown below:
Where: CFt = the cash flow at time t and r = the cost of capital.
Computing NPV for project X at r = 12%
|
Year |
Cash Inflows (A) |
Discounting Factor @12% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.8928 |
71,424 |
|
2 |
140,000 |
0.7971 |
111,594 |
|
3 |
130,000 |
0.7118 |
92,534 |
|
4 |
160,000 |
0.6355 |
101,680 |
|
Resulting NPV |
$77,232 |
Computing NPV for project Y at r = 12%
|
Year |
Cash Inflows (A) |
Discounting Factor @12% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.8928 |
142,848 |
|
2 |
160,000 |
0.7971 |
127,536 |
|
3 |
160,000 |
0.7118 |
113,888 |
|
4 |
160,000 |
0.6355 |
101,680 |
|
5 |
160,000 |
0.5674 |
90,784 |
|
6 |
160,000 |
0.5066 |
81,056 |
|
NPV |
$357,792 |
Decision Rule of NPV:
From the above results, both project X and Y should be pursued because they yield positive NPVs.
Calculation of IRR
The IRR formula is such that:
IRR = lower rate + [(NPV at the lower rate) / (Absolute sum of NPVs)] x Difference in the rates
In this case, the NPV of both projects at r = 12% is present. there. Hence, we can calculate the NPV at a lower rate of 7% and also NPV at a higher rate of 16%.
NPV at a lower rate of 7%
PROJECT X:
|
Year |
Cash Inflows (A) |
Discounting Factor @7% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.9346 |
74,768 |
|
2 |
140,000 |
0.8734 |
122,276 |
|
3 |
130,000 |
0.8163 |
106,119 |
|
4 |
160,000 |
0.7629 |
122,064 |
|
Resulting NPV |
$125,227 |
PROJECT Y
|
Year |
Cash Inflows (A) |
Discounting Factor @7% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.9346 |
149,536 |
|
2 |
160,000 |
0.8734 |
139,744 |
|
3 |
160,000 |
0.8163 |
130,608 |
|
4 |
160,000 |
0.7629 |
122,064 |
|
5 |
160,000 |
0.7129 |
114,064 |
|
6 |
160,000 |
0.6663 |
106,608 |
|
NPV |
$462,624 |
Higher rate of NPV @ 16%
PROJECT X
|
Year |
Cash Inflows (A) |
Discounting Factor @16% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.8621 |
68,968 |
|
2 |
140,000 |
0.7431 |
104,034 |
|
3 |
130,000 |
0.6407 |
83,291 |
|
4 |
160,000 |
0.5523 |
88,368 |
|
Resulting NPV |
$44,661 |
PROJECT Y
|
Year |
Cash Inflows (A) |
Discounting Factor @16% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.8621 |
137,936 |
|
2 |
160,000 |
0.7431 |
118,896 |
|
3 |
160,000 |
0.6407 |
102,512 |
|
4 |
160,000 |
0.5523 |
88,368 |
|
5 |
160,000 |
0.4761 |
76,176 |
|
6 |
160,000 |
0.4104 |
65,664 |
|
NPV |
$289,552 |
Determination of IRR for PROJECT X is as follows:
IRR = lower rate + [(NPV at the lower rate) / (Absolute sum of NPVs)] x Difference in the rates
I.R.R = 7% + [(125,227) / (125,227 + 44,661)] x (16 – 7)
I.R.R = 7% + 6.63%
I.R.R = 13.63%
Determination of IRR for PROJECT Y is as follows:
IRR = lower rate + [(NPV at the lower rate) / (Absolute sum of NPVs)] x Difference in the rates
I.R.R = 7% + [(462,624) / (462,624 + 289,552)] x (16 – 7)
I.R.R = 7% + 5.54%
I.R.R = 12.54%
Decision Rule:
In this case, both project X and Y should be accepted because their IRRs are greater than the cost of capital of 12%. However, in the case of project Y, the managers ought to conduct a further analysis because the computed IRR is more or less the same as 12%.
Basically, any change made to the RRR will have an impact on the final conclusion to be arrived at when determining which project to be pursued or not. However, IRR would be unaffected. In this case, computing the NPV of the projects using the required rate of return of 10% would be as follows:
PROJECT X
|
Year |
Cash Inflows (A) |
Discounting Factor @10% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.9091 |
72,728 |
|
2 |
140,000 |
0.8264 |
115,696 |
|
3 |
130,000 |
0.7513 |
97,669 |
|
4 |
160,000 |
0.6830 |
109,280 |
|
Resulting NPV |
$95,373 |
PROJECT Y
|
Year |
Cash Inflows (A) |
Discounting Factor @10% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.9091 |
145,456 |
|
2 |
160,000 |
0.8264 |
132,224 |
|
3 |
160,000 |
0.7513 |
120,208 |
|
4 |
160,000 |
0.6830 |
109,280 |
|
5 |
160,000 |
0.6209 |
99,344 |
|
6 |
160,000 |
0.5645 |
90,320 |
|
NPV |
$396,832 |
In this case, if both project X and Y had the same economic life, then the change in RRR would have an impact in the financial decision with regards to the NPV criterion.
If the same RRR of 10% is used in the calculation of IRR, then the IRR of the two projects would not be altered. However, the final decision would be influenced to some extent and in that case, the computation of IRR would be as shown below:
First compute the NPV at a lower rate of 6% and NPV at a higher rate of 13%
NPV at a lower rate of 6% for PROJECT X is:
|
Year |
Cash Inflows (A) |
Discounting Factor @6% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.9434 |
75,472 |
|
2 |
140,000 |
0.8899 |
124,586 |
|
3 |
130,000 |
0.8396 |
109,148 |
|
4 |
160,000 |
0.7921 |
126,736 |
|
Resulting NPV |
$135,942 |
NPV of PROJECT Y at a lower rate of 6% is:
|
Year |
Cash Inflows (A) |
Discounting Factor @6% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.9434 |
150,944 |
|
2 |
160,000 |
0.8899 |
142,384 |
|
3 |
160,000 |
0.8396 |
134,336 |
|
4 |
160,000 |
0.7921 |
126,736 |
|
5 |
160,000 |
0.7473 |
119,568 |
|
6 |
160,000 |
0.7050 |
112,800 |
|
NPV |
$486,768 |
NPV of PROJECT X at a higher rate of 13%
|
Year |
Cash Inflows (A) |
Discounting Factor @13% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
80,000 |
0.8850 |
70,800 |
|
2 |
140,000 |
0.7831 |
109,634 |
|
3 |
130,000 |
0.6931 |
90,103 |
|
4 |
160,000 |
0.6133 |
98,128 |
|
Resulting NPV |
$68,665 |
NPV of PROJECT Y at a higher rate of 13%
|
Year |
Cash Inflows (A) |
Discounting Factor @13% 1/(1+r)n (B) |
Cash Flows (A x B) |
|
0 |
-300,000 |
– |
-300,000 |
|
1 |
160,000 |
0.8850 |
141,600 |
|
2 |
160,000 |
0.7831 |
125,296 |
|
3 |
160,000 |
0.6931 |
110,896 |
|
4 |
160,000 |
0.6133 |
98,128 |
|
5 |
160,000 |
0.5428 |
86,848 |
|
6 |
160,000 |
0.4803 |
76,848 |
|
NPV |
$339.616 |
Determination of IRR for PROJECT X is as follows:
IRR = lower rate + [(NPV at the lower rate) / (Absolute sum of NPVs)] x Difference in the rates
I.R.R = 6% + [(135,942) / (135,942 + 68,665)] x (13 – 6)
I.R.R = 6% + 4.65%
I.R.R = 10.65%
Determination of IRR for PROJECT Y is as follows:
IRR = lower rate + [(NPV at the lower rate) / (Absolute sum of NPVs)] x Difference in the rates
I.R.R = 6% + [(486,768) / (486,768 + 339,616)] x (13 – 6)
I.R.R = 6% + 4.12%
I.R.R = 10.12%
Conclusion:
It is clear that the criteria for making a decision based on IRR has been altered due to the use of a discounting factor rate that is equal to the RRR, that is, 10% hence resulting in a situation where both scenarios resulting in an IRR that is indifferent. In this case, the project managers ought to analyze the projects further with the intention of determining whether they are feasible or not.
The conflict between NPV and IRR occurs in the following scenarios:
When the two projects under review are of different sizes, it is likely that the IRR will result in the same kind of result in matters concerning the acceptance or rejection of the project hence resulting in a conflict.
This is seen where the project has both positive and negative cash flows during its lifetime.
There are situations when a company may be pursuing two projects with differing durations to completion and this will result in differing NPV and IRR. For instance, in the case in the previous section where one project has 4 years and the other 6 years, it is evident that the NPV and IRR computed are different.
At times two mutually exclusive projects may have different cash flows. For instance in the case in the previous section, project X has random cash flows while project Y has a constant cash inflow of $160,000. In this case, it is evident that the NPV and IRR are in conflict.
Preferred Recommendation:
According to Viney and Phillips (2015), when both NPV and IRR are different hence causing a conflict in the decision, NPV shall prevail because NPV is all about the ultimate goal of the existence of the firm, that is, the growth of a firm’s financial wealth.
Reference
Chanticleer R, 2018, April 17. Financial review: Banking royal commission,
Christian G, 2018. May 16. What does royal commission tell us?.
Decker, F. and McCracken, S., 2018. Central banking in Australia and New Zealand: historical
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foundations and modern legislative frameworks. Research Handbook on Central Banking.
Harris, T.R., 2017. Incorporating risk in analysis of tax policies for solar power investments.
Niblock, S.J., 2017. Flight of the condors: evidence on the performance of condor option spreads in Australia. Applied Finance Letters.
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