FINANCIAL PERFORMANCE OF A BUSINESS:
Financial performance refers to a subjective measure as to how well a firm can use its assets to generate returns or revenues. It can also be termed as a general measure of financial health of a firm over a given period of time and therefore the measures like profitability and liquidity provides an important tool to stakeholders to analyze and evaluate the past financial performance of a firm and also its current position.
COST OF CAPITAL:
Market value of the share of the firm depends on the return of the firm. Cost of capital is that measure which the firm must earn minimum return equal to the cost of capital. The cost of capital is a benchmark to compare the financial data of the firm with the financial data of any other firm. The cost of capital is considered as the opportunity cost for the firm. (Singhal D K, 2015)
Opportunity cost refers to the returns which the firm can earn with the use of the same funds and risk by using other resource. Cost of Capital consists of cost of debt and cost of capital. The investing and financing decisions of a firm are taken considering the cost of capital of the firm. (Singhal D K, 2015)
COST OF DEBT:
Cost of Debt refers to the interest at a fixed rate of interest paid by the firm on its debt. It basically provides an idea that how much a firm is required to pay as interest for using the debt. Debt includes loans, bonds, term loans, etc. This is used by the investors to evaluate the risk associated with the firm in comparison to other firm in the industry. In the case of debts, which we generally classify as bonds, debentures, the rate of interest is fixed and known in general cases to the investors.(Investopedia, n.d.)
COST OF EQUITY:
The cost of equity refers to the return on the investment which is made by the stakeholders in the firm. However, the return on investment is not fixed as there is no fixed rate of interest, but the firm is required to pay the return on the investment to the stakeholders as they expect some return on their investment. The cost of equity is calculated by using various methods like dividend price approach, earning price approach, realized yield approach and capital asset pricing model. (Investopedia,n.d.)
ANALYSIS OF EFFECT OF COST OF CAPTAL ON FINANCIAL PERFORMANCE OF A BUSINESS:
The cost of capital of a firm consists of cost of equity and cost of debt. Higher the firm’s cost of equity and debt, lower will be the firm’s profitability. Lower the firm’s cost of equity and debt, higher will be the firm’s profitability. Lower cost of debt of the firm is considered better as it provides the protection to the trade creditors of the firm. The lower debt portion in capital structure implies Firm is not depending on the external funds for growth. If there is a higher debt portion in the capital structure of the firm, Cost of equity will rise because higher risk, means higher return and consequently, it will attract investors to invest in the firm. Therefore, cost of capital significantly affects the financial performance of a business.
FACTORS WHICH ARE IMPORTANT IN DETERMINING THE COST OF CAPITAL OF A FIRM:
The three most important factors which make cost of capital of a firm high or low are as follows:
The prevailing market conditions for the business of the firm plays an important and significant role in determining the cost of capital. If the business of the firm is quite riskier then the cost of capital comes to be high as lenders demand higher rates to compensate their risk on the funds provided by them. Contrary to it, if the prevailing market conditions for the business of the firm are such that it will generate high and secured returns for the business then the risk associated with the business will be lower and consequently the cost of capital will become less.
Basically, the unsystematic risk constitutes of two types of risks: business risk and financial risk. Business risks depend upon the investment decisions of the firm and financial risks depend upon the financing decision of the firm. They both, taken together, affect the overall cost of capital of the firm as these are associated with the firm’s promise to pay interest and dividend to its investors.
VOLUME OF FINANCING:
The cost of capital also gets affected by the volume of financing. It gets increased if the high amount of capital is involved in the business due to issue related costs and greater risks involved. High volume of capital increases the liquidity risk and therefore gives increased cost of capital but if lower volume of capital is involved then the providers of funds are assured of their funds and cost of capital reduces.
INTRODUCTION OF HARVEY NORMAN HOLDINGS LTD.
Harvey Norman holdings ltd. Operates through generally four segments i.e. franchising operations, Retail Businesses, Property, Other Businesses. There are Harvey Norman stores in Australia, New Zealand, Slovenia, Ireland, Singapore and Malaysia. Harvey Norman Holdings Ltd receives revenue from each franchisee through lease payments and a percentage of sales.
The firm reported turnover of $1,617.51 Million in 2015. Firm reported Net profit after tax and non-controlling Interest $261.84Millions. The firm’s last year Earnings per share go up by 24.5%.
ANALYSIS OF CAPITAL STRUCTURE OF HARVEY NORMAN HOLDINGS LTD.
With the help of Weighted Average Cost of Capital (WACC) or the overall cost of capital i.e. cost of debt + cost of equity the minimum required rate of return of the stakeholders is maintained. So with the help of WACC the Firm can measure its finance cost.
Analysis of Cost of Debt of Harvey Norman Holdings Ltd.:
Harvey Norman Holdings Ltd. has total debt of $694.11 Million from various sources of finance i.e. Bank Overdraft $32.62 million, Borrowings $561.81 Million, Other Loans $89.93 Million, Bills Payable $9.75 Million. We have taken floating average Interest rate as given under Interest rate risk management to calculate cost of debt.
Here, firm’s weighted average cost of debt is 2.30% approx calculated by using weights of particular debt out of total debt. Here, if we see weights in total capital of the firm debt proportion is relatively 21.35% as compare to equity proportion 78.65% which is relatively good for the firm in longer period.(Investopedia, n.d.)
If we see from another side, Firm’s debt equity ratio is 27.08% in 2015 slightly decreased from 28.17% but good for the firm. Here, we have used Book value of weights in calculation of weighted average cost of capital as in our calculation market weights are equal to book value weights. So, in our point of view firm’s financial position is sound. Investors can invest in the firm. (Investopedia, n.d.)
Analysis of Cost of Equity of Harvey Norman Holdings Ltd.:
The Firm paid the dividend during the year 2015 was 0.20 which is more than last year dividend i.e. 0.14 in the year 2014. Similarly the market price of the shares of the firm is in the year 2015 was 4.51 while in the year 2014 was 3.06. The cost of equity during the year 2015 was 4.43 while in the year 2014 was 4.58 which indicate that the return on the investment during the year 2015 is not showing the growth of the firm. (Investopedia, n.d.)
But if we see from another side, total equity has a proportion of around 78.65% which shows relatively low dependency on external funds.(Investopedia, n.d.)
Analysis of Weighted average cost of capital (WACC)/ Overall Cost of Capital of Harvey Norman Holdings Ltd.:
We have calculated the WACC by using book value weights which is convenient but not sounder when we compare to weights of market value. Here book value of debt is equal to market value. So I considered weights of book value.
The firm having the equity of 2556.86 million $ is more in comparison to the total debt from the outsiders at the fixed rate of interest i.e. 694.11 Millions $. The proportion of the weight of the equity is more in comparison to the weight of the debt. The weight of equity is 78.65 while the weight of the debt is only 21.35 out of total capital of the firm.
This shows the weight of the equity is more in comparison to the debt of the firm. Also the cost of capital on the equity is 4.43% while on the other hand the cost of the debt is 2.31% which is better as per the investor’s point of view. When we see the weighted average capital on the equity is 3.48 and the weighted average on the debt is 0.49 in the year 2015. This shows firm is paying the more return on investment in comparison to the interest payment on the debts which are raised from the financial institutions.(Wilkinson J, 2013)
We can conclude that the financial performance of a business gets significantly affected by the cost of capital. The business performs financially good if the cost of capital is lower and attracts investors to invest in the business. But if cost of capital is higher, it reduces the financial performance of the business.
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