Current Royal Commission Into Australian Banking System And Capital Budgeting: Case Studies

Identifying Areas of Concern in the Australian Banking System

• Market Capitalization = Number of share X Share Price

2009: (39 X 1554 shares)

               = 60606

           2010

          =$48.64 X 1664 shares = 79964.16.

• PV of future Cash flow= (Current CF + Growth rate)/ Discounting factor for year 1

 =(3445*1.06)/(1/1.14)

= 4162.94

• Return = Dividends + Capital gains

Dividends (DOLLARS)                                 = 2.9

Increase in price per share (48.64 – 39) = 9.64  

Total benefits                       (9.64+2.9)    = 12.54

Base price                                                    = $ 39

Return                             (12.54/39)*100 = 32.15%

• Percentage change in cash remuneration

=(3128875-3253551)/3253551

= (3.83)%

Percentage change in incentive remuneration

=(6415735-1936546)/1936546

= 231.30 %

• Cash remuneration alone would not be lucrative enough to align the interest of the CEO with that of the firm’s interest. There must be additional forms of remuneration to induce the CEO to devote more efforts for enhancing the company’s performance. Like in this case, giving of stock options is only beneficial for the CEO if the company performs well and its share price rises(Kim, et al., 2017). Only then he can derive gains out of those stock options. Other perquisites and incentives gives the push to the CEO to go the extra mile in achieving the objectives of the entity.

• Other types of incentives that can align the interest of the CEO with that of those of the shareholders:

1. They can be given high end technology devices which they will be entitled to use for personal as well as business use. This will not only add as a perk but will also bring in more technology in the work environment.
2. The CEO’s could be given creative paid time offs. During this period, they will not be required to be physically present in office. They can be at a leave or holiday and think, plan or strategies about the company’s operations and roll it out once they are back. This will act a breather for them as well as be beneficial for the company from a long term perspective(Trieu, 2017).
3. They can be given a sabbatical leave to pursue academic courses of leadership or entrepreneurship courses from top-rated universities which would be sponsored by the company. This will not only create personal value for the individual and enable him to grow as a business leader but the knowledge achieved by him could also be channelized to fulfill the objectives of the company.

Case Study 2:

• Since we know the price of the of the share we can find out the discount rate or Re using the formula for Walter’s Model which is

Price = Dividend per share + (Earnings per share – Dividend per share) Return on Investment/Re

                                                                        Re

So, this equation we can write it as

48.64 = 2.9 + (3.955 – 2.9) 0.187/Re

                                  Re

Upon solving the equation, we will get the Re which will come to 10.01 %. We can say that the discount rate is reasonable because since the risk-free rate is 4.5%, the market return would obviously be a few notches higher than that. Together when both put under the CAPM model after considering the Beta of the stock would come somewhere around our calculated figure.

• New DPS = 2.9*1.025= $ 2.9725

Current year Share price = $ 48.64

Growth rate = 2.5%

Considering Re to be ‘x’ we can solve the equation as

Re = Next year dividend  +Growth rate

         Current year price

which be written as,

Re = 2.9725 + 0.025

         48.64

This comes to 0.086 or 8.6 %.

The number seems less realistic than the answer computed in (1) above. As the growth rate is in line with the inflation, no value is being created (Werner, 2017). The growth is getting offset by the the inflationary rate. In such scenario, the required rate of return will significantly rise. Consequently, the discount rate would also be on a higher side.

• The formula for growth rate is given by ‘b X r” which is the retention rate multiplied by the Return on Investment. Retention is the undistributed amount of earnings that is not given to the shareholders upfront but is retained by the company and further re-invested to fuel growth.

‘b’ is calculated as Earnings per share – Dividends per share  X 100

                                               Earnings per share

So, in the given question we have 3.056 – 2.28 X 100

                                                               3.056

Therefore ‘b’ = 0.2539 or 25.39%.

We have Return on Investment as 0.158 or 15.8%

Hence Growth = 0.2539 X 0.158 = 0.0401 or 4.01%.

Actual growth rate in dividends between 2009 and 2010 = 2.90 – 2.28 X 100  X  0.187

                                                                                                             2.28

= 0.0508 or 5.08% . So the actual growth rate in dividends is more than the the forecasted rate by 5.08 – 4.01 = 1.07%.

Forecasted growth rate = 4.01.

Re= 2.9*1.0401 + 0.0401

            48.64

= 0.1021 or 10.21 %.

Yes, it is realistic.

• Growth rate for 2010

‘b’ X ‘r’

Addressing Concerns Raised by the Royal Commission

‘b’ = 3.955-2.90

             2.90

=0.2668 or 26.68%

‘r’ = 0.187 or 18.7 %

G = ‘b’ X ‘r’ = 0.2688 X 0.187 = 4.99%

Using this rate, EPS for 2011 would be 3.955 X 1.0499 = $ 4.152.

Assuming that the price of the share will grow proportionately, the new price would be

$48.64 X 1.0499 = $ 51.07

PE ratio for 2011 = Market price per share/ Earnings per share

= 51.07/4.152 = 12.30.

PE ratio for 2009 = 39/3.056 = 12.76.

Prospective PE ratio may have changes because of the following:

1. Due to the change in Return on Equity
2. Due to the Change in growth rate.
3. Due to the change in dividend payout and retention ratio of the earnings.

Case study on Capital Budgeting (Pg-117):

• Capital budgeting can be defined as a method for the evaluation of expenses and incomes relating to an upcoming project which are significantly large amounts. It measure the cash flows generated by the projects in its present value terms. The tool can be helpful in taking business decisions when a company has to choose between more than one mutually exclusive projects.

It is important because:

1. It can estimate future cash flows in present value terms.
2. It helps in the monitoring and control of expenditures
3. It helps in taking timely decisions. If a project is going bad or likely to go bad, we can shut it down to avoid further losses(Sithole, et al., 2017).
4. It provides the firm with a long term planning option which in turn contributes to wealth maximization for the shareholders.

• Payback period is the time taken for a project to recover its initial investment cost in the form of regular income. A faster payback period is generally considered favorable for a business as it boosts the liquidity conditions for the entity(Kim, et al., 2017).

For Project A

The Payback period is 4 years as the initial investment outlay of $ 300,000 is recovered in the form of cash flows from year 1 to year 4.

For Project B

The Payback period is 2 years as the initial investment outlay of $ 300,000 is recovered in the form of cash flows from year 1 to year 2.

• The time taken for the project’s sum of cash flows earned (discounted at its present value) to be equal to the initial outlay of funds is termed as a discounted payback period.

For Project A

Year	Cash Flow	PV factor	Discounted CF	Cumulative Discounted CF
0	-300,000	1	-300,000	-300,000
1	50,000	0.9091	45,455	-254,545
2	50,000	0.8264	41,322	-213,223
3	50,000	0.7513	37,566	-175,657
4	150,000	0.6830	102,452	-73,205
5	430,000	0.6209	266,996	193,791

Discounted payback period

= Last year with negative Cumulative Discounted CF + (Cumulative Value of Disc CF in the last negative year / Discounted Cash flow for the year for the year after negative cumulative CF )

4 + 193,791

      266,996

= 4.73 years 

For project B   

Year	Cash Flow	PV factor	Discounted CF	Cumulative Discounted CF
0	-300,000	1	-300,000	-300,000
1	200,000	0.9091	181,818	-118,182
2	100,000	0.8264	82,645	-35,537
3	100,000	0.7513	75,132	39,595
4	100,000	0.6830	68,301	107,896
5	100,000	0.6209	62,092	169,988

2 + 35,537/75132 = 2.47 years

• The weaknesses of payback period are as follows:

1. This approach does not factor in the time value of money as a result of which a true picture is not presented.
2. The method does not consider profitability of a project. A project with a faster payback period does not necessarily mean that it is more profitable(Belton, 2017).
3. The payback approach does not consider a hurdle rate. Investors of some companies might require a projects rate of return to cross a hurdle rate (generally WACC) , otherwise they don’t seem the project to be viable.

Yes the payback period method has some usage:-

1. When a company has liquidity constraints and turnaround of funds is a crucial aspect, in such scenarios this method will be of good use.
2. For project involving investments that are not very significantly large, payback method can be used instead of using other sophisticated methods of calculation(Arnott, et al., 2017).       

• NPV can be defined as the difference between the future cash flows of project over its life discounted to its present value and the initial investment made to set up the project.

For Project A:  

Year	Cash Flow	PV factor	Discounted CF
1	50,000	0.9091	45,455
2	50,000	0.8264	41,322
3	50,000	0.7513	37,566
4	150,000	0.6830	102,452
5	430,000	0.6209	266,996
Total discounted cash inflows	493,791
Less: Initial Investment	300,000
NPV	193,791

For Project B:       

Year	Cash Flow	PV factor	Discounted CF
1	200,000	0.9091	181,818
2	100,000	0.8264	82,645
3	100,000	0.7513	75,132
4	100,000	0.6830	68,301
5	100,000	0.6209	62,092
Sum of discounted cash flows	469,988
Less: Initial Investment	300,000
NPV	169,988

             Base on the NPV project A should be accepted as its NPV is higher than that of B.

• Internal rate of return is the discounting factor at which all the cash inflows of the project are equal to the cash outflows which means it is the rate at which the NPV of a project is zero.     

In terms of IRR, project B should be accepted as it has a higher IRR. The greater the difference between the IRR and the cost of capital, the bigger would be cash flows for the project.

Case study on Valuing Securities (Pg220-221)

Number of periods	RIO	STW
1	74.89	45.59
2	68	42.8
3	70.5	43.65
4	78.4	46.25
5	72.1	45.51
6	67.14	42.18
7	66.66	40.4
8	70.61	42.12
9	70.09	41.65
10	76.77	43.58
11	82.69	44.25
12	82.21	43.81
13	85.47	44.6
Simple Average	74.27	43.57
Standard Deviation	6.08	1.64
2)
Number of periods RIO STW     1 74.89 45.59     2 68 42.8   Covariance 3 70.5 43.65   6.092041 4 78.4 46.25     5 72.1 45.51     6 67.14 42.18     7 66.66 40.4     8 70.61 42.12     9 70.09 41.65     10 76.77 43.58     11 82.69 44.25     12 82.21 43.81     13 85.47 44.6

							Weighted Portfolio Average Returns
	Simple Average	74.27		43.57
a)			0.1		0.9		46.64
b)			0.25		0.75		51.24
c)			0.5		0.5		58.92
d)			0.75		0.25		66.60
e)			0.9		0.1		71.20
			Weightage for Rio		Weightage for STW		Weighted Portfolio Standard Deviation
	Standard Deviation	6.08		1.64
a)			0.1		0.9		2.08
b)			0.25		0.75		2.75
c)			0.5		0.5		3.86
d)			0.75		0.25		4.97
e)			0.9		0.1		5.64

Two areas of concern identified by the current Royal Commission into the Australian banking system:

1. The conduct of the major banks are not matching the community standards and ethics. There has been forging of client documents as well as bribery particularly when it comes to the retirement corpus of the members.
2. To add to the woes further, the banks have been found lacking in having effective grivenace redressal mechanisms for its clients who have suffered as a result of the malpractices and misconduct(Alexander, 2016).

Ways to address these concerns are as follows:

1. As strong internal control framework is required to counter unethical framework. There should be an element of surprise in the way monitoring of the processes are being carried out. Care should be taken to protect the interest of the whistleblowers in such scenarios.
2. Classify the kinds of grievance queries received by the bank into different categories and layout specific time bound redressal for each category of grievance.
3. For grievances related to fraud, forgery, cheating or other similar instances, reach out to the clients in the early stages so as to maximize the evidence gathering capabilities.
4. The miminum variance portfolio of the stocks would be the one that helps in mitigating the risks to the lowest levels possible.

1. The capital market line equation would be :

E(Rc) = RF + SDc	E(RM) – RF
SDM

Beta of the stocks can be calculated by dividing the co-variance with the variance of the stock and this can be stated has = 6.092041/3.04 = 2.009.

References

Alexander, F., 2016. The Changing Face of Accountability. The Journal of Higher Education, 71(4), pp. 411-431.

Arnott, D., Lizama, F. & Song, Y., 2017. Patterns of business intelligence systems use in organizations. Decision Support Systems, Volume 97, pp. 58-68.

Belton, P., 2017. Competitive Strategy: Creating and Sustaining Superior Performance. London: Macat International ltd.

Kim, M., Schmidgall, R. & Damitio, J., 2017. Key Managerial Accounting Skills for Lodging Industry Managers: The Third Phase of a Repeated Cross-Sectional Study. International Journal of Hospitality & Tourism Administration, , 18(1), pp. 23-40.

Sithole, S., Chandler, P., Abeysekera, I. & Paas, F., 2017. Benefits of guided self-management of attention on learning accounting. Journal of Educational Psychology, 109(2), p. 220.

Trieu, V., 2017. Getting value from Business Intelligence systems: A review and research agenda. Decision Support Systems, Volume 93, pp. 111-124.

Werner, M., 2017. Financial process mining – Accounting data structure dependent control flow inference. International Journal of Accounting Information Systems, Volume 25, pp. 57-80.