Discuss about the Guide to Valuation and Risk Management.
Harvey Norman is the multi-national retailer of furniture, bedding, computers and customer electrical products. The company operates its business in Australia and is known as a leading retailer in the country. It is listed on ASX and is traded with a ticker ASX: HVN. This report contains the calculation of weighted average cost of capital and gearing ratios of Harvey Norman, which reflects the capital structure of the firm. Later on the analysis and recommendations are also provided as per the capital structure theory.
The calculation of WACC includes the determination of cost of equity and cost of debt of a company. Once, they are determined then they are been calculated according to their portion in the capital structure of the company. Weighted average cost of capital is then the result of their summation.
The below table shows the calculation of WACC for Harvey Norman.
|
Risk free rate (A) |
2.70% |
|
Market return (B) |
5.80% |
|
Beta (C) |
0.52 |
|
Risk premium (D = B-A) |
3.10% |
|
Cost of equity (A+C*D) |
4.23% |
|
Calculation of cost of debt |
|
|
Interest rate |
5.78% |
|
Tax rate |
29.20% |
|
Cost of Debt |
4.09% |
|
Calculation of WACC |
||
|
Amount |
Weights |
|
|
Debt |
715 |
0.20 |
|
Equity |
2790 |
0.80 |
|
Total |
3505 |
1 |
|
WACC |
|||
|
Value |
Weights |
weighted average |
|
|
Cost of equity |
4.23% |
0.80 |
0.03 |
|
Cost of debt |
4.09% |
0.20 |
0.01 |
|
Total |
4.20% |
The company has 80% equity financing and 20% debt financing. Its WACC is calculated as 4.20% by applying appropriate formula.
It is the average rate of return which is expected by the company to compensate to all its investors. Under this, fractions of weights are used to determine the company’s expected capital structure. The company generally raises funds from two sources named as equity and debt. The combination of these two forms a capital structure of a company. Sometimes, the organization raises more funds from one source only (Harris, 2017). In such situation, calculation of WACC becomes very important. It eventually helps in figuring out the amount of expense a company is required to pay for acquiring funds for the purpose of purchasing inventory, equipment and many more (Lakshmi, Khan &Vortelinos, 2016).
Harvey Norman is selected for calculating WACC and as of now its weighted average cost of capital is 4.20%. Calculation of WACC involves some components which are discussed as below.
As the capital consists of debt and equity both, so weight of each is necessary to determine in order to perform the calculation of WACC. In this value of company’s equity and debt are taken and then their weights are determined. The equity of Harvey Norman is $2790 million and it debt is $715 million. This makes a proportion of 80% and 20%. The weight of equity is 0.80 and of debt is 0.20. As a result of which, the total capital of the company is $3505 million (Fernandez, 2017).
The weight of Equity = E/ (E+D)
The weight of debt = D/ (E+D)
It is basically a return a company pay to its shareholders for the risk undertaken by them. It is also known as required rate of return. It is calculated by using Capital Asset Pricing Model. It the most appropriate technique used for calculating cost of equity. This method takes into account the risk free rate, beta value and the risk premium which a difference between the risk free rate and market return (Penman, Reggiani, Richardson &Tuna 2018).
According to CAPM, it is calculated by applying following formula:
E(R) = RF + β*(Rm – RF)
RF = risk free rate
Β = Beta
Rm = market return
The above formula is applied to calculate the cost of equity of Harvey Norman. It is determined as 4.23%.
It is basically an interest paid by an organization on its borrowings. It is usually calculated as after tax cost of debt because the interest is deductible from income taxes. Harvey Norman pay an interest at rate of 5.78% on its long term borrowings. The corporate tax rate of the company in year 2017 was 29.20%. After applying a proper formula, the after tax cost of debt is derived at 4.09% (García, 2017).
It shows the portion of company’s operations funded through debt and those that are funded by equity. A high ratio is not considered to be good for company’s financial health (Vogel, 2014). Harvey Norman’s Debt equity ratio is calculated as:
|
Debt-equity |
|
|
2017 |
|
|
Debt (A) |
715 |
|
Equity (B) |
2790 |
|
D/E (A/B) |
26% |
The D/E ratio of the company is 26% which is reasonable and not so high. This is because of the low debt financing of the company. This implies that Harvey has less financial risk.
It identifies the number of times a company pay its interest out of its earnings before interest and tax. A high ICR is favourable as it reflects that the company has made sufficient earnings to make its interest payments.
|
Interest coverage ratio |
|
|
EBIT (A) |
256 |
|
Interest expense (B) |
20 |
|
ICR (A/B) |
12.8 |
The ICR of Harvey is 12.8 times which means it has enough EBIT to pay interest expense of $20 million.
It measures the extent of company’s financial leverage. It shows the proportion of company’s total debt to total assets.
|
Debt ratio |
|
|
Total Liabilities (A) |
1399 |
|
Total Assets (B) |
4190 |
|
DR (A/B) |
33% |
Harvey has only 33% of debt ratio in 2017. This is because its total assets are way more than its total liabilities. It means company is financially strong and can pay off all its liabilities with its total assets.
As such no difficulties were there at time of calculation, but sometimes ascertaining the amount of total debt become a difficult task. As company operates on a large scale and is engaged in raising funds from its borrowings at variable interest rate. As a result, sudden increase in payments may create a problem while calculating the value of total debt.
Capital structure theory is a systematic approach used to decide financial business activities of an organization by a mixture of equities and liabilities. The combination between equity, debt and market can be defined with the help of capital structure theories. According to the traditional approach, accompany must minimize its WACC and should maximise the value of its assets. As per this approach, organizations must use debt financing to a certain limit and excessive use may lead to the devaluation of company’s financial position (Fischer, Heinkel&Zechner, 2014).
It is said that financing decisions directly impact the WACC of a company. Therefore, a lower WACC results in high market value of the company. According to the above calculations, the WAC of Harvey Norman is 4.20% which is already low and as result of that the market value of the company increases. So it can be said Harvey Norman has an optimal capital structure with less debt portion and more equity financing. Also the management of the company is focused on keeping up the same (Zeitun&Tian, 2017).
Also the ideal debt to equity ratio of the company is 2:1 which the 2/3rd funds of the company are financed through the debt component and 1/3rd through equity. The calculations one above shows the debt equity ratio of Harvey as 0.26 which is below the standard benchmark. Therefore, company needs to improve on this by financing the activities using the debt component more than the equity.
The capital structure of a firm is a mixture of debt and equity component. The current capital structure of Harvey Norman comprises of 80% equity and 20% debt. The company can make an optimal capital structure by increasing its debt component. However, it should be done in a limit otherwise the same can prove to be unfavourable for the company and make it more risky. There are many benefits of raising debt for a company like Harvey Norman. Here are some pros and cons of increasing the debt in a company.
Apart from debt rising, equity financing is another option which gives ownership to the investors and venture capitalists. It has its own pros and cons which are as follows:
So it can be said that if company needs funds for short term, it must go for debt financing whereas on the other hand, if it wants to expand its business it must raise funds from its equity. Equity financing is very much beneficial for the company’s long term objectives. As per Harvey Norman capital structure the company has more equity than debt. So, it is recommended that it should increase its debt component to some extent, so that it can have ample short term funds (Campbell, Galpin& Johnson, 2016).
Conclusion
The above report concludes that Harvey Norman can improve its capital structure by increasing its debt component. As of now it has a WACC of 4.20% and its equity financing is 80% and debt financing is 20%. So in order to have funds for short term, it must increase the percentage of its debt. Furthermore, the company has a good debt equity ratio of 26% and a debt ratio of 33% which makes the company less risky for investment purposes. Overall, Harvey Norman has a good capital structure and the same can be improved in future.
References
Campbell T C, Galpin N & Johnson S A. (2016). Optimal inside debt compensation and the value of equity and debt. Journal of Financial Economics 336, 352.
Camilleri E, &Camilleri R. (2017). Accounting for Financial Instruments: A Guide to Valuation and Risk Management. Taylor & Francis.
Fernandez P. (2017). WACC: definition, misconceptions and errors. Springer.
Fischer E O, Heinkel R &Zechner J. (2014). Dynamic capital structure choice: Theory and tests. The Journal of Finance, 19, 40.
García, F J P. (2017). The WACC: In Financial Risk Management. Palgrave Macmillan.
Harris R S. (2017). A Comparison of the Weighted-Average Cost of Capital and Equity-Residual Approaches to Valuation, 4(3) Journal of Darden Business Publishing Cases 1, 5
Johrz S &Mondell T. (2015). An empirical study on the practical efficacy of ideal financial ratios 18(3). Journal of financial ratios 11, 21.
Lakshmi G, Khan M &Vortelinos D. (2016). Cost of capital of stakeholders’ WACC. Palgrave Macmillan.
Penman S H, Reggiani F, Richardson S A, & Tuna I, (2018) An accounting based model 12(3) A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-To-Price 112, 125.
Vogel H L. (2014). Entertainment industry economics: A guide for financial analysis. Cambridge University Press.
Zeitun R &Tian G. (2017). Capital structure and corporate performance: evidence from Jordan. Springer.
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