N300 | Financial Instruments of two Australian Banking Industry

The current paper would investigate the financial instruments of the two popular banks operating in the Australian banking industry. These two banks include AMP Limited and Commonwealth Bank (CBA). Firstly, it would intend to discuss the trend and evolution of the current stock price of the banks over the past five years. Secondly, the essay would focus on the ways through which the Royal Commission is inquiring into the activities of the Australian financial institutions and their effects on market and firm-specific risks. The second part of this essay would shed light on the capital budgeting techniques in the context of Henry Property Limited. For this organisation, the two chosen capital budgeting techniques include net present value (NPV) method and internal rate of return (IRR) method based on which recommendations would be provided.

Research (a literature survey):

Resiliency could be observed in the Australian financial system and this has assisted to deal with any adverse shocks. The capital levels of the financial institutions are quite above the existing regulatory minimums and the increasing profit levels have further boosted their capital (Reserve Bank of Australia 2018). Even though the trend of net interest margins is lower, they are broadening now with the improvement in funding conditions and the impact of current loan repricing is recognised. The rise in capital of the banks over the recent time has increased their resiliency with a lowering return on equity. However, the investors still expect equivalent returns to those obtained a decade back. Such tension could motivate the financial institutions to obtain greater returns by accepting additional risks. This is the primary reason that the regulators have raised their concentration on the risk culture of the financial institutions and the sector is undertaking moves so that their approach to various risks is strengthened.

As commented by Almazan, Chen and Titman (2017), capital budgeting could be defined as a procedure where an organisation ascertains and analyses potential big investments or expenses. Such investments and expenses might be projects like establishment of a new plant or investment in any long-term venture. Primarily, all organisations need to pursue all opportunities and projects, which increase shareholders’ wealth. However, due to the limited availability of funds for new projects, it is crucial to use capital budgeting methods for ascertaining the most profitable projects. Some of the significant capital budgeting methods include net present value, internal rate of return, payback period, accounting rate of return, profitability index and others.

Analysis:

Part A: AMP and CBA share price

Figure 1: Share price of AMP Limited for the past five years

(Source: Au.finance.yahoo.com 2018)

According to the above figure, the current stock price of the bank is $3.44 and it is evident that the price has made significant fluctuations over the five-year period. The main reason that the stock price has fallen is due to the minimisation in firm valuation. Moreover, downfall in the financial health of the bank has been another reason contributing to its falling stock price. Even though stock price has increased considerably between 2014 and 2015, decline has been inherent after March 2015. This could be validated by the fact that the stock price of the bank has declined from $6.50 in 2015 to $3.44 in 2018 (Amp.com.au 2018). Due to such declining trend, the shareholders are unwilling to buy or retain stocks of the bank; instead, they are motivated to sell the same. In this context, it needs to be mentioned that the share charts are used by the investors to understand the existing business trend and accordingly, they assess whether they could generate adequate returns from investment (Viney and Phillips 2015).

Figure 2: Share price of CBA for the past five years

(Source: Au.finance.yahoo.com 2018)

From the above figure, it is clearly inherent that volatility is present in the stock price of CBA and hence, it has restricted to identify any particular trend from analysis. The stock price of the bank has a support line within the price range between $70 and $71.50. This is because the pricing structure has increased the stock price of the bank over the past five years. In 2014, the stock price of the bank has increased massively from $72 to $98 and this was possible because of superior financial health of CBA. However, after reaching this high price of $98, massive decline could be observed in 2015, as it has been $72. Such fall in stock price signifies the fall in the financial condition of the bank (Commbank.com.au 2018).

In 2016, the trading value of the stocks has been between $71 and $88, as the bank has encountered certain issues in maintaining its stable financial position in the market. At present, the stock price of CBA has been $74.79, in which it is no possible to ascertain the existing stock trend. However, after the five-year support line is broken, there would be initiation of the declining trend, in which the share price structure is likely to downgrade because of the falling financial condition of CBA. In this regard, Scholes (2015) mentioned that with the help of technical analysis, the investors could gain insight regarding the investment opportunities apparent within the stocks and such information assists in maximising their earning levels from investments.

The regulators of Australia have appointed the Royal Commission, which have direct effect on the existing operations of the Australian financial institutions. The reason behind the appointment of this commission is to assess the misconduct in superannuation, banking and financial services sectors functioning in the nation. Thus, this commission would detect the deficiencies evident in the existing operations of the financial companies. This has direct impact on systematic risk as well as unsystematic risk of these organisations, since the investors are worried about the illicit practices apparent in the same. Hence, the investment-related systematic risk and unsystematic risk is increased and this might lead to lower returns on investment for the investors. Moreover, different unethical measures of the management increase both systematic and unsystematic risks (Bikker and Spierdijk 2017).

There is increase in market risk due to the uncertainty within the investors. The Royal Commission is involved in assessing the four big banks in Australia that increase the investors’ concern along with highlighting the unethical practices adopted by the management of each bank. Moreover, increase in firm-specific risk is evident as well and adverse impact is deemed to be observed on the livelihoods of the citizens. The Governor General of Commonwealth has developed the Royal Commission so that the malpractices of the financial services sector could be revealed, as they have negative impact on the lives of the citizens. When the malpractices of the organisations operating in the above-stated sector are revealed, it would lead to rise in both systematic risk and unsystematic risk (Williams 2017).

After the appointment of Royal Commission, there is decline in stock prices of both AMP and CBA, since pertinent news about the manipulation of the financial organisations are revealed on the part of the commission. The Royal Commission has unfolded the scandal associated with AMP’s operations, in which the bank was charging more fees for its super accounts. This has highlighted the deficiencies of the bank management, in which AMP has to incur $5 million to 50,000 fund members of superannuation as compensation. This has negatively affected the stock price of the bank due to the identification of fraudulent activities. This signifies the fall in the stock price of AMP starting from February 2018 after the Royal Commission has revealed the news (Asx.com.au 2018).

Moreover, the commission has revealed the criminal offences that happened in CBA. The bank has conducted various unethical measures, which was disclosed by the Royal Commission. Moreover, the commission would disclose future reports regarding the bank necessary for revealing the unscrupulous practices of CBA.

Part B: Capital budgeting:

This sections deals with evaluating the two project proposals for Henry Property Limited, in which the difference between required rate of return and internal rate has been evaluated. Various differences are inherent between internal rate of return and required rate of return based on their usage level, which an organisation uses in obtaining the financial importance of any project or investment. As laid out by Andor, Mohanty and Toth (2015), IRR is deemed to be one of the significant elements of the capital budgeting methods, which the organisations use for evaluating the future earnings of their projects. The key differences between the two concepts could be listed down under:

• The basic difference between these two concepts is related to usage, which is necessary for an organisation to analyse for obtaining the accurate income. IRR is calculated to ascertain the minimum return level to be provided by the project in its economic life. On the contrary, required rate of return is the minimum return level necessary for carrying out any particular project (De Andrés, De Fuente and San Martín 2015).
• Another difference between the two concepts is observed in terms of ascertaining the financial feasibility of a project. The calculation of net present value needs consideration of required rate of return for signifying the financial performance associated with the project. Moreover, consideration of time value of money is made in required rate of return and thus, it plays a crucial role in ascertaining the present value of future cash flows. However, a project could only be accepted, if IRR exceeds the required rate of return (Johnson, Pfeiffer and Schneider 2017).

For evaluating the feasibility of the two proposed projects, X and Y, the NPV technique is used and its detailed evaluation for Project X is provided as follows:

It is apparent from the above table that the NPV of Project X is obtained as $77,250.04 by taking into consideration the cost of capital as 12%. This has assisted in ascertaining the level of returns, which could be sought from undertaking the project (Johnson and Pfeiffer 2016). As the NPV is found to be positive, the project could be considered favourable for the organisation. However, before undertaking any decision, it is necessary to evaluate the NPV of Project Y, which is presented as follows:

As per the above table, the NPV of Project Y is obtained as $357,825.17 and the useful life of the project is six years. Moreover, stability could be observed in cash flows as well, which would assist in generation of adequate income level (Rossi 2015). Therefore, after considering the NPVs for both Project X and Project Y, the financial viability of the latter seems to be more favourable for the organisation due to the fact that its earnings level would increase significantly. As pointed out by Rossi (2014), NPV assists the organisations in segregation of projects and accordingly, the appropriate investment opportunity would be chosen that would improve the value of the organisation in future.

In terms of IRR, the two projects are evaluated as well and their detailed calculations are provided as follows:

Based on the above tables, it could be stated that the IRR for Project X is obtained as 22.56%, while the same for Project Y is obtained as 48.32%. In the words of Daunfeldt and Hartwig (2014), with the help of IRR, the managers could identify the projects that would provide maximum return on investment. In this case, both the projects are providing better returns in contrast to the cost of capital of the organisation.

If the discount rate is changed to 10%, the following changes would occur in NPV for both the projects, which are demonstrated briefly as follows:

From the above tables, it is inherent that the NPV for Project X is obtained as $95,382.83, which is more than the NPV of the project having the discount rate of 12%. The similar situation could be observed in case of Project Y as well, as the NPV of the project has increased. Therefore, it is prominent that the fall in cost of capital increases the NPV of the project and vice-versa (Schönbohm and Zahn 2016). However, the trend is same and hence, no impact on the decision would be made, as both the projects seem to be profitable from the viewpoint of Henry Property Limited.

However, it is to be borne in mind that there might be circumstances, in which NPV and IRR would provide different recommendations and they need to be analysed carefully. Any change made in the cost of capital of the project might have favourable or unfavourable impact on the value of NPV, while the IRR value would tend to remain unchanged. This clearly signifies that the project recommendations for NPV would change with no modification in the value of IRR (Mukherjee, Al Rahahleh and Lane 2016). Another situation where NPV and IRR would not offer the same recommendation is related to the timing of the cash outflows. In such scenario, no change could be observed in NPV, while IRR might have negative or multiple values. This implies that in case of timing variation in cash outflows, the IRR value would tend to vary. The third situation, in which the NPV and IRR recommendations do not resemble each other, is associated with the economic life of the project (Roy, Rudra and Prasad 2017).  In this case, the change in project life would lead to change in NPV, while the accurate IRR values for the project would be obtained. Hence, there would be difference in recommendations between the two measures, as NPV focuses on discounting the project cash flows. Conversely, IRR computes the percentage of return expected to be made from a project. Therefore, under these three situations, the recommendations provided by NPV and IRR would not resemble each other.

Recommendations:

It has already been identified that both AMP and CBA have conducted certain ethical measures, which have deemed to violate the regulations and standards prevailing in Australia, due to which they have experienced massive downfalls in their stock prices. Therefore, both the organisations are suggested to appoint an independent committee that would look after the ethical issues towards the investors of the organisation and they would be independent of the organisation. For Henry Property Limited, both Project X and Project Y are deemed to be viable for the organisation due to positive NPVs and higher IRRs in contrast to its cost of capital. However, if it is assumed that the organisation has scarcity of funds, it is recommended to choose Project Y, as it would help in greater maximisation of its return on investment.

Conclusion:

It is prominent from the above discussion that after the appointment of Royal Commission, there is decline in stock prices of both AMP and CBA, since pertinent news about the manipulation of the financial organisations are revealed on the part of the commission. This is because both banks are involved in fraudulent practices that have declined their stock prices in the market. Therefore, they are suggested to form a committee independent of the boards of directors in order to avoid such situations in future. Moreover, for Henry Property Limited, both Project X and Project Y are deemed to be favourable in maximising its overall return on investment.

References:

Almazan, A., Chen, Z. and Titman, S., 2017. Firm Investment and Stakeholder Choices: A Top?Down Theory of Capital Budgeting. The Journal of Finance, 72(5), pp.2179-2228.

Amp.com.au., 2018. AMP Personal Banking - Accounts, Super, Home Loans & Insurance | AMP. [online] Available at: https://www.amp.com.au/ [Accessed 19 Sep. 2018].

Andor, G., Mohanty, S.K. and Toth, T., 2015. Capital budgeting practices: A survey of Central and Eastern European firms. Emerging Markets Review, 23, pp.148-172.

Asx.com.au., 2018. Home - Australian Securities Exchange - ASX. [online] Available at: https://www.asx.com.au/ [Accessed 19 Sep. 2018].

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Bikker, J.A. and Spierdijk, L. eds., 2017. Handbook of Competition in Banking and Finance. Edward Elgar Publishing.

Commbank.com.au., 2018. Personal banking including accounts, credit cards and home loans - CommBank. [online] Available at: https://www.commbank.com.au/ [Accessed 19 Sep. 2018].

Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.

De Andrés, P., De Fuente, G. and San Martín, P., 2015. Capital budgeting practices in Spain. BRQ Business Research Quarterly, 18(1), pp.37-56.

Johnson, N.B. and Pfeiffer, T., 2016. Capital budgeting and divisional performance measurement. Foundations and Trends® in Accounting, 10(1), pp.1-100.

Johnson, N.B., Pfeiffer, T. and Schneider, G., 2017. Two-stage capital budgeting, capital charge rates, and resource constraints. Review of Accounting Studies, 22(2), pp.933-963.

Mukherjee, T., Al Rahahleh, N. and Lane, W., 2016. The capital budgeting process of healthcare organizations: a review of surveys. Journal of Healthcare Management, 61(1), pp.58-76.

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Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

Roy, D., Rudra, D. and Prasad, P., 2017. Capital Structure and Capital Budgeting: An Empirical and Analytical Study of the Relationship. Research Bulletin, 42(4), pp.50-60.

Scholes, M.S., 2015. Taxes and business strategy. Prentice Hall.

Schönbohm, A. and Zahn, A., 2016. Reflective and cognitive perspectives on international capital budgeting. critical perspectives on international business, 12(2), pp.167-188.

Viney, C. and Phillips, P., 2015. Financial Institutions, Instruments and Markets, 8th edition. McGraw Hill.

Williams, B., 2017. Erratum to “The impact of non-interest income on bank risk in Australia”[Journal of Banking and Finance 73C (2016) 16–37]. Journal of banking and finance, 79(6), p.173.