Time Value of Money

The time value of money (TVM) is a concept that measures the value of money’s worth in the future at the present time (Investopedia, 2018). As the core principle of finance is that money would earn interest and the amount of money would worth more in the nearer future. However, investors would made decisions on investments base on the series of future cash flow that investors would receive in the future, thus, the present value calculation is employed to examine the worth of the project. Present value represented the current worth of the stream of future cash flow with a specific rate of interest.

In the case of Home depot, the revenue reported in the 2015 is $ 83,176 million, with 5.5% growth from 2014, thus the future cash flow of revenue is calculated based on the 2014 revenue with 6% growth rate for the first four years and 6.1% in the last year (Home Depot, 2015).  With 8% interest rate, the total present value of the Home Depot calculated based on revenue from 2015- 2019 is $ 391,533.93 million.

The future cash flow streams were discounted with certain interest rate in order to calculate the present value, thus, the lower interest rate the higher present value of the future cash flows. The interest rate is usually determined by external economic environment such as the LIBOR rate, where most of corporation would borrow money from banking institutions at LIBOR rate plus premiums (Bauer & Hammerschmidt, 2005). Thus, if some internal events has impact the future cash flow, it would likely impact the revenue stream of Home depots. Thus, in order to examine how much the present value of the company would be, the future revenue stream of the company is calculated with an estimation of 3% growth each year from the second to the fifth year, this estimation represented the company growth at a smaller rate in comparison the 2013 and 2014 fiscal year. In this case, the present value of Home Depot is $ 370,338.66 million.

The valuation of the cooperation of the company would be determined by the value of free cash flow, and the final value would measure the profitability of the company (La Port et al, 2002). Base on the current information, the price range for the Home Depot is set around from $ 370,338.66 to 391,533.93 million.

Implication of Risk

The Home Depot recognizes risks of market exposure primarily from the fluctuations in interest rates, in order to mitigate such risks, Home Depot has invested in interest rate swap agreements. Also, Home Depot expose to the risks from currency rate fluctuation, inflation, and changing prices, these risks had minor impact to the company where Home Depot has small international sales and inflations does not impact commodity prices significantly.

From 10K report, Home Depot claimed it would experience 1% of interest rate influences on its current debt, and exposure to market risks would have limited impact on its business, thus, Home Depot could consider a investment portfolio that is more conservative but liquid. However, the interest rate risk is unavoidable, an interest rate increase would impact the present value of the Home Depot. Assuming the Home Depot is forced to payout a large sum of money because of an unexpected events in business operation, such as recall of product, data breach and public relation crisis. Those events would disrupt cash flow of the company and shake investors’ confidence on Home Depot. With these situations, Home Depot would have to make higher interest offer to attract investors, while the present value would drop as the same time.

Future Value Investment

Home Depot had made investments in highly liquid financial assets, hold shares in other business organizations, with available cash flow, Home Depot could invest in logistic and supply chain company in order to lower the cost that incurred by connectivity between stores and distribution. Also, with the fact that Home Depot has already expanded to Canada and Mexico, the impact from currency fluctuation may expanded in the nearer future, thus, Home Depot should also consider the invest in currency swaps as well. In order to mitigate risks, Home Depot could also buy treasury bills and high rating bonds that would guarantee fix amount of returns.

At the same time, Home Depot has high ROIC rate, it implies the company has confidence over its own growth in the future, hence the company continuing to invest in capitals. This assures investors that Home Depot has intrinsic believes and is able to continuously offer high returns to its investors.

Stock Valuation

The dividend yield ratio can be calculated using the dollar number of dividends paid out divided by the per stock dollar value (Ehrhardt et al, 2017). From Home Depot’s 10-K SEC report for fiscal year ended in Feb. 1, 2015, it stated that the assumed dividend yield is 2.3%. Therefore, as the yield stated in the 10 K report page 40, the number for 2014 was 2.2%, 2013 was 2.3%, the amount of cash dividend paid out from Home Depot from 2012 till 2014 were listed on Home Depot 10K page 35, while the information about dividend yield presented on page 40.

The amount paid out each share was $1.16 for 2012, $1.56 for 2013, and $1.88 for 2014, $2 for 2015, thus, the stock prices for Home Depots were $86.96 in 2015, $85.45 in 2014 and $ 67.83 in 2013. An high dividend yield may stated that the stock of the company were under valued or the company might have difficult financial situation, therefore, it is also important for Home Depot to keep their dividend yield of company at the rate they could offer to investors while make the stock appealing at the same time.

Under scenario one, the dividend per share was decided to get an increase of $ 1.75, thus the dividend pay out per share would be $3.31 for 2013, $3.63 for 2014 and $3.75 for 2015. The amount of dividend per share increases has doubled the amount the Home Depot paid out had doubled the amount paid out in 2013, almost double the amount paid in 2014 and 2015. Thus, the dividend yield will rise to 4.88% for 2013, 4.25% for 2014 and 4.31% for 2015. This rise on dividend yield would attract more investors to purchase Home Depot’s stock, higher dividend yield would attract more investors to purchase the stock. However, it would be more beneficial for the Home Depot to retain the more cash flow and reinvest in the company, and it could generate more value in the long run.

Under the second scenario, a stock split will be issued to the Home Stock, outstanding shares will issued for 25,044 in 2013, and 18,644 in 2014. With stock split, the cash dividend and dividend yield will decrease into half of the previous number. Stock splits will dilute the number of the shares in the market, and the price of the share will drop as well, under theoretical model the price of the stock will be half of what it used to be, therefore, investors could seen the stock as more affordable and attract more investors without changing the value of the company  (He et al, 2016).

With the number provided, for 2015 the return on equity would be 3.72% opposed to 1.97% and for 2014, the rate would be is 3.78% opposed to 2.03%, with increases the per share dividend by $1.75. The return on equity is important measure for investors to idealized what would be the return for the money they plan to invests, the higher return, the more likely investors would make the decision to invest.

According to Home Depot’s 10K report, the company started to pay dividend since 1987. And the company claimed  “future dividend payments will depend on the Company’s earnings, capital requirements, financial conditions, and other factors considered relevant by the Board of Directors.” (Home Depot, 2015)  This policy enabled Home Depot gain the autonomy on the usage of revenue streams. For Home Depot, small amount of dividend has been paid to investors while the company reinvested in itself, as Home Depot values investments in company capital, productivity, and efficiency. With continuous investment, the operation of the company could get more improvements on its operation, it also allow Home Depot “build shareholder value through the concepts of higher returns on invested capital and by the value returned through dividends” (Home Depot, 2015).

Bond Issuance

Home Depot can also raise money from its investors through issuing senior notes and it also known as bonds. Bonds have a fixed face value and date of maturity, also the interest rate and coupon payment were also pre-determined on the day of issuance (Ehrhardt et al, 2017). Bond issuance could be more beneficial to Home Depot with a lower coupon rate that bank loan interests and there are fewer restrictions for Home Depot in comparison to bank loan.

If the market interest rate is increased by 5%, the present value of the bond to increase from $9,433.58 to $24,634.04, an increase of $15,200.47 will be applied to the cost of financing. With the differences, Home Depot may need to find alternative solution to financing. Higher interest rate force Home Depot to make higher coupon payment, thus increase the cost of borrowing. If the market interest rate dropped by 5%, the present value of the bond to decrease from $9,433.58 to $3,528.3 resulted in lose of $5,905.26 on the value of bonds to investors. With lower market interest, the cost of borrowing will decrease and the future coupon payment would be really low, thus if the interest rate decrease, it would be a good time to borrow.

Therefore, Home Depot should raise money when interest rate were low, if the interest rate raises, Home Depot should not issue more bond unless the company need money in desperation. However, the Home Depot has issued bonds previously, for example, Home Depot issued bonds at 5.875% and rates had risen 5% since then, Home Depot should start to buy back bonds at the discount rate, as investors would be looking for better rate with same amount of investment elsewhere.

Bond issuance is considered as an efficient way to raise capital without changing the percentage of shareholders equity. At the same time, bond issuance can provide longer term that not available to business from bank loans, with a fixed rates. For Home Depot, there were polices that should be followed, including bond issuance, redeemed, or called, the bonds issued by Home Depot can be recalled at any time, if the company pay the redemption price plus any accrued interest up to date to investors, with the rights to recall bonds, Home Depot can issue bonds when the interest rate is lower and take advantage on favorable interest rates. If Home Depot buys back bonds, the amount of long-term debt would decrease and reduce the amount of future cash flow by eliminating interest payment, thus the profit of the company could be higher. Therefore, Home Depot should recall bonds and accelerated share repurchase program in order to take advantages of the interest rate dip.

Capital Budgeting

The initial investment of the project that Home Depot currently evaluation is $65,000,000 and weighted average cost of capital for Home depot is 8%.

Net Present Value

With information on initial investment and future cash flow of the project that Home Depot is evaluating, the net present value of the project is $9,785,570.71. By calculating the net present value, Home Depot would be able to determine if they should reject or accept the specific project. Under Net Present Value method, all future cash flow will be discounted to present value with a interest rate adjusted with risk factors (Ehrhardt et al, 2017). Home Depot should accept the project if it has positive NPV, thus, Home Depot should accept the current project they are evaluating (Investopideia, 2018).

Internal Rate of Return

The internal rate of return is calculated by set the net present value equal to zero, from information given, the project that Home Depot is evaluating has an IRR equal to 50%. As the WACC of Home Depot estimated as 8%, the IRR of the project is greater the WACC, therefore, the project would generate a return larger than cost of financing the project. Under internal rate of return method, project should be accepted if IRR is greater than WACC, thus, Home Depot should accept this project (Investopideia, 2018).

Implications

From calculation, Home Depot should accept the project. If the project is independent and positive cash flow has been generated through out the project life cycle, the calculation of NPV and IRR would come to the same decision (Ehrhardt et al, 2017). At the same time, the actual payback period is calculated as less than 2 years, for the initial investment to be recovered from project generated cash flow.

The net present value estimated the actual return from the project in terms of the present value, as it is calculated as discounting all future cash flow towards present value and minus the initial cost, while assuming stable discount and reinvestment rate. IRR assuming the return from the project just recover the initial investment, and the project would be accepted if IRR were greater than the discount rate. Therefore, if only IRR has been calculated, there could be risks as the cost of capital could change along with external market condition.

Therefore, it is better for Home Depot to calculate both NPV and IRR to capture the rate of return and the future cash flow of the project, from both calculating, Home Depot would able to gain a better understanding of potential profitability towards the project.

Difference Between NPV and IRR

The Net present value focused on future cash flow that one project can contribute to the business organization, while IRR focused on the return on investment of single project. The perspectives of evaluation have different focus under the two methods, however they would provide same answers to the project with the decision on accepting or rejecting of the project. However, when evaluation a single project, it would be best to use both method as a way to minimize risks, as project could provide less than estimated returns. NPV helps business understand the amount of cash it can generate while IRR provides guidelines on the targeted cost of capital when financing the projects.

Macroeconomic Changes

Macroeconomic indicators have included many different aspects in everyday life, changes in the macroeconomic environment would not only impact consumers behaviors but also business activities. Macroeconomic indicators include GDP, inflation, unemployment and other issues (Bailly, 2009).

Changes in Interest rate

The Interest rate were set by U.S. Federal Reserve and the adjustment would be announced by Federal Reserve Open Market Committee, changes in interest rate will have impact on Home Depot’s cost of financing. The weighted average cost of capital of Home Depot would also change with the changes in Interest rate, as some of the loans using a floating interest rate, and the actual interest rate is calculated as LIBOR or Federal Reserve rate plus premium, thus, interest payment for debt would also increase. Moreover, the increased interest rate would impact borrowing from bond issuance, as calculated in the previous section, if the market interest rate is increased by 5%, the present value of the bond to increase from $9,433.58 to $24,634.04, an increase of $15,200.47 will be applied to the cost of financing.

If the market interest rate dropped by 5%, the present value of the bond to decrease from $9,433.58 to $3,528.3 resulted in lose of $5,905.26 on the value of bonds to investors. At the same time, the project that Home Depot is currently evaluating using a weighted average cost of capital of 8%, therefore, the net present value of the project would also change with interest rate fluctuation. Assuming the weighted average cost of capital raise to 15% as a result of interest rate hike, the project that Home Depot currently considering would have a lower net present value at $58,232,882.01. Even through it is still an acceptable project with positive net present value, however, the profitability of this project has decreased. With lower market interest rate, the cost of borrowing will decrease and the return on investment would also increase. With the differences, Home Depot should invest during the low interest rate period.

Stock Market

Stock market served as an indicator towards general economy, as a strong stock market as it shows as a bull market predicts economic growth and higher GDP (Bailly, 2009). Strong stock market also attract more investors as well, as previous strong stock market in U.S. history provided over 15% return in one single year (Ritter et el, 2002). While strong stock market offer greater return and increase confidence among investors, a weak stock market would deliver a contrary message. When stock market is weak, it is called bear market, it normally parallel with weak economic environment. In 2008 financial crisis, the stock market also tanked, with low confidence among investors, the liquidity in the financial market also dropped drastically. Among those conditions, individual business would also get severe impact as well, because consumers would also consider the general economic condition in their spending plans. Moreover, Home Depot’s business focused on home upgrades and decors, the business correlated with consumer’s willingness to spend and economic condition.

External Factor

Other influencing external factors included inflation, unemployment rate and many other factors. However, unemployment rate would be a more reflective indicator towards the general economic environment, as unemployment rate would increase along with weaker economic condition. High unemployment rate also predicts weaker consumption power form consumers, this would also impact overall profitability of individual business. As for Home Depot, its business revenue total depending on the willingness of consumer to spend on home upgrades and other related items. Therefore, it is important for Home Depot to monitor general economic condition and adjust operation plans accordingly.

Conclusion

Home Depot offers unique business and aiming at a special customer group, which are do-it-yourself home upgrader. The financial position of Home Depot has been analyzed through information provided in Home Depot’s 10 K SEC report. From the analysis it showed that Home Depot should be consciously aware of general economic condition, as it would strongly influence the well being of Home Depot’s business.