JB HI-FI

Letter of Transmittal To Mr. David Robinson, CFO of JB HI-FICaulfield Campus, Monash University.900 Dandenong RoadCaulfield East, VIC 3145, Australia

October, 6th, 2014

Dear Mr. Robinson:Please find attached our corporate treasury analysis report. This report is based on JB Hi-Fis annual reports from 2010 to 2014 as well aspeer companies and industry reports.

In this report, we started byperforming the analysis of the companys cash flows, evaluating its capital structure and identifying recent changes in funding decisions over the last years as requested.Then, we identified its optimal capital structure and made some recommendations about improvements that could be implemented during the next two years to improve the firms cash flow, post-tax WACC,capital structure and funding strategy.We hope this report will be helpful for the JB Hi-Fis improvement in the next strategic planning horizon. We would be pleased to give you further clarification about any questions you may still haveabout this report.

Yours Sincerely,

Luigi CancielloYunqi ChenRu LiuArnaud Pornel

TABLE OF CONTENTEXECUTIVE SUMMARY30/ INTRODUCTION41/ JB HI-FIS PROFILE41.2) Du-Pont Analysis of JB HI-FI52/ FREE CASH FLOW ANALYSIS62.1)Free Cash Flow62.2)ForecastedCash Flows forthe future 3years73/ CAPITAL STRUCTURE93.1) Debt and Equity instruments of JB Hi-fi93.2) Capital Structure Ratio Analysis103.3) Comparison with its industry peers103.3) Factors impacting the capital structure113.4) Current post-tax WACC including dividend imputation124/ OPTIMAL CAPITAL STRUCTURE& FUNDING STRATEGY154.1) The companys optimal capital structure.154.2) Sensitivity analysis of the optimal capital structure174.3) Funding strategy204.4) Impacts from changes in the capital structure205/ RECOMMENDATIONS AND CONCLUSION21APPENDICES22Appendix 1.1: Geographical segments22Appendix 1.1.2: Category segments22Appendix 1.2: Du Pont analysis22Appendix 2.1.1: Free cash flow to operation23Appendix 2.1.2: Working capital23Appendix 2.1.3: Capital expenditure24Appendix 2.2.1: Net working capital based on data of the balance sheet24Appendix 2.2.2:Adjusted net working capital25Appendix 3.2:Capital Structure Ratio Analysis25Appendix 3.3: Comparison withits industry peers26Appendix 3.4: WACC input analysis26Cost of equity26Cost of debt32Capital structure34Dividend imputation35Appendix 4.1: Optimal capital structure36Appendix 4.4: Interest after tax38REFERENCE LIST39

EXECUTIVE SUMMARY

JB Hi-Fi Limited is a discount retailer of consumer electronics, electrical goods and softwares including music, games and movies in Australia and New Zealand. The group follows a low cost strategy, which enables it to market various electronic devices and home entertainment goods at the best value. This explains why the group has a lower profit margin than its competitors. However, it earns a higher return on equity (44%) than them thanks to its higher financial leverage and asset turnover.

Regarding its funding, JB Hi-Fi uses mainly a bank loan and its shareholders funds to finance its operations. It achieved to lower substantially its leverage over the last 3 years to reach a more sustainable D/E ratio nowadays, remaining yet higher than its main competitors one.Nevertheless, the groups D/EV ratio with market values indicates that it remains quite small (11,2%). We found out that its leverage should increase to 30% in order to reach the lowest possible post-tax WACC and hence maximize its enterprise value. We also highlighted that the optimal capital structure is not so sensitive to changes in the factors of the post-tax WACC but more to changes in the factors of the FCF.

To reach this new optimal structure, we would recommend the group to increase its leverage by taking more short-term debt and by issuing a long-term corporate bond. The former will allow it to undertake regularly share buy-backs while the latter will finance its expansion plan(opening of new stores, conversion into JB HI-FI HOME stores, online sales).Finally, we would let the dividend payout ratio unchanged at 65%.

To sum up, by increasing its current leverage, JB Hi-Fi would be able to maximize its enterprise value and optimise its financial structure in order to sustain its future growth.

0/ INTRODUCTION

In this report, we have performed the business analysis of JB Hi-Fi. We started by identifying its current capital structure, discussing the changes in its funding instruments over the last years and computing the firms post-tax WACC and cash flows. After having forecasted the financial statements for the next three years based on some internal and external factors, we then identified its optimal capital structure and funding strategy. We eventually came up with some recommendations about improvements that could be implemented during the next two years to improve JB Hi-Fis cash flows, post-tax WACC ,capital structure and funding strategy.1/ JB HI-FIS PROFILE

1.1) Background of JB HI- FIJB Hi-Fi Limited (JBH)listing on the Australian stock exchange since October 2003is a discount retailer of consumer electronics, electrical goods and softwares including music, games and movies in both Australia and New Zealand. The groups strategy follows a low cost model, which enables it to market various electronic devices and home entertainment goods at the best value.JB Hi-Fis performance is greater in Australia than in New Zealand, notably on return on sales (earns more profit for every dollar of sales) and return on assets (spends less on assets to generate each dollar of profit). In addition, Australia is a much bigger market for electronic devices than New Zealand. This is why Australia remains by far the main market for JB Hi-Fi with 97.78% of its total profit, while New Zealand accounts only for the remaining 2.22% (Annual Report 2014, see also Appendix 1.1).

According to the industry report, JB Hi-Fi is a major player in three segments: video game and music (44.9% of market share), domestic appliances (10.7% of market share) and computer and software (13.7%of market share). As the video game and music industry is mature and competitive and the groups market share already high, it would be hard to improve its profitability in this segment. However, in the domestic appliances and computer and software industries, JB Hi-Fis market share represents less than15% of the total market, and these two industries are characterised by a large number of small retailers (50.8% in domestic appliances industry and 70.4% in computer and software industry). Therefore we estimate that it is possible for the group to take market shares from those non-major players in the future and hence increase its profitability through operational rationalizations and economies of scale (Ibis world, 2014).

JB HI-FI sets out its strategy from both its supply chains and its customers perspective. From the supplys perspective, its cost leadership combined with its high market share allows the group to adopt a low-price strategy. Furthermore, JB HI-FI stores are located in high foot traffic precincts, and JBHI-FI HOME represents a significant growth strategy for this company, as the consumers embrace the connected home experience and as appliances become fashion within the home. From the customers perspective, JB HI-FI stores are able to provide a complete range of high-level customer services. The group continues to invest in its online sales and content platform, which allows it to evolve with its customers buying habits. This explains why JB Hi-Fi can rely on a high level of customer loyalty and trust.

1.2) Du-Pont Analysis of JB HI-FIDu-Pont analysis breaks return on equity into three parts: financial leverage, operating efficiency and profitability (detailed calculations are shown in Appendix 1.2).

The profitability measured by the profit margin is able to indicate how well the firm controls its cost. The profit margin of JB is 3.69%, which is lower than the rate of Harvey Norman (9.06%) and close to the rate of Dick Smith (3.43%). Since JB and DSH have a cost leadership and low price strategy, it is reasonable for them to have a lower profit margin.

Operating efficiency is measured by asset turnover, which shows how efficiently JB Hi-Fi uses its assets to generate profit. JB Hi-Fis asset turnover is 4.05, which indicates that for each dollar of asset JB can generate about $4 revenues. JB is more efficient than its competitors in using assets, because its stores have relatively high sales per square meter.

Financial leverage is measured by the equity multiplier, which is calculated as total asset divided by the equity based on book value. Leverage allows company to earn the same revenue with less equity invested in, so a higher leverage level of JB (2.9) comparing to Dick smith (2.7) and Harvey Norman (1.7) will result in a higher return on equity.

JB has a higher return on equity (44%) compared to its competitors (25% for Dick Smith and 8.9% for Harvey Norman), resulting from a higher financial leverage and asset turnover, but a lower profit margin. The return for shareholders is higher than it of its main competitors.

2/ FREE CASH FLOW ANALYSIS2.1)Free Cash FlowAll the data are taken from JB Hi-Fis 2014 financial report. However, only those expenses, revenues, assets and liabilities related to the normal business operations will be used in the calculation of the free cash flow to firm. Details on data selection are provided in the Appendix 2.1.1 for operating cash flow, Appendix 2.1.2 for net working capital and Appendix 2.1.3 for capital expenditures.

2.2)Forecasted Cash Flows for the future 3years

Cash Flow from Operations

According to 2014 annual report, the target sales amount is about 3.6 billion in 2015 financial year (FY), which implies a 3.34% of growth on sales. This target might be caused by a weak new product output and price deflation across the electronics industry. However, both the historic data and a significant growth opportunity represented by JB HI-FI HOME suggest a higher growth rate. By the end of FY15, JB plans to have 52 HOME stores, which would double in amount compared to FY14. If the plan is successful, we believe that JB can generate a 5.3% of sales growth in future 3 years.Cost of sales is really stable from FY10 within the range of 78%-79% of sales and shows a decreasing trend from 2012. In future 3 years, this ratio has a high probability to remain in this range and slightly decrease to 78.1%.Marketing expenses and occupancy expenses in term of sales are keeping increasing from 2010, but the scope is small around 0.1% or 0.2 %. Therefore, marketing expenses accounting for 10.4% of sales and occupancy expenses for 4.5% of sales seem to be fair predictions. On contrary, administration cost has a decreasing trend, so 0.77% of sales might be an accurate level for the future tendency.Overall, after deducting the tax expenses, the free cash flow from operation in future 3 years will be approximately 2.36% of sales.

Depreciation and impairment expenses

Those charges depend on the holding value of assets and equipment. According to the figures from 2010 to 2014, the ratio of PPE/Sales continuously decreases which may indicate that the efficiency of using non-current assets increases. Plant and equipment expenditures of 5% of sales are fair. On the other side, the depreciation rate slightly increases. Following the trend, depreciation and impairment cost will account for approximately 20% of the book value of plant and equipment.

Capital expenditures

This term is highly related to the amount of sales and the rates will decrease when the efficiency of using assets improves. It is more likely that those ratios will remain steady. Therefore, the average percentage of previous years from 2011 to 2014 (1.14%) is used as the rate for the future 3 years.

Increase in working capital

According to the historical data, the net working capital in terms of sales is highly volatile (Appendix 2.2.1), especially for the year 2012 and 2013. This is due to higher amount of trade payables, as the last day (30th of June) fell on a weekend. The impact of time difference is $82million in 2012 and $94million in 2013.According to our recalculated ratios (Appendix 2.2.2), the average of net working capital for previous 5 years account for 4.57% of sales. Since JB Hi-Fi is more likely to continue to increase the inventory turnover by reducing the inventory holding level and the following 3 financial years end are falling on weekdays, the working capital level should remain normal and might decline slightly to 4.5%.

3/ CAPITAL STRUCTURE3.1) Debt and Equity instruments of JB Hi-fiJB Hi-Fi operates very limited sorts of financial debt and equity instruments. On 30th June 2014, its equity amounted to $294.6 million and consisted of 98,947,309common shares. The company finances also its operations through a bank loan of $180 million and finance leases of $28,75 million (JB Hi-Fi, 2014).In addition, the company is also entitled to bank overdraft facilities of $80M and NZ$10M in case of emergency and it has even additional seasonal overdraft facilities of $50M. The Group uses its surplus funds to keep ample liquidity reserves and to undertake occasionally shares buy-backs in order to neutralise the effects of issuing new shares(like the company did in May/June and in September2014 for example).

CategoryAmounts in thousands of dollars

Bank Loan179,653

Lease Liabilities28,749

Total Equity294,633

3.2) Capital Structure Ratio AnalysisTable 1 capital structure ratios and the relevant description are shown in Appendix 3.2. The substantial changes in the capital structure over the last years pushed us to extend our analysis to 5 years instead of 2. This graph highlights indeed that JB Hi-Fis capital structure has changed significantly over that period. After a sharp increase of its debt from 2010 to 2011 mainly to finance a$173 million shares buyback (Annual Report 2011), the company achieved to lower back progressively its leverage over the last 3 years. Today with a gross gearing ratio (=debt/equity) of 61%, it has recovered a more sustainable level of leverage.

3.3) Comparison with its industry peersCapital Structure comparison with peer companies

Gross Gearing (D/E) Financial Leverage

2013201420132014

JB Hi-Fi Limited51%61%346%292%

Harvey Norman35%28%172%170%

Dick Smith23%7%263%270%

These two graphs indicate that JB Hi-Fi is currently more leveraged than its two main competitors: Harvey Norman and Dick Smith. As explained before, JB Hi-Fis Gross Gearing ratio has changed tremendously over the last five years whereas Harvey Normans D/E ratio has remained particularly low and steady over that period, varying only between 23 and 35%.Even though JB Hi-Fi seems to adopt a more aggressive capital structure than its competitors, it remains in a healthy position in 2014, with an interest coverage ratio of 22.6.

3.3) Factors impacting the capital structureJB Hi-Fi renewed its bank term debt and working capital facilities in June 2013. The term debt facility amounts to $200 million, is unsecured and is valid until June 2016. At the end of FY14, the group was using $180 million of its debt facility, up from $125 million in 2013.

From FY13 to FY14, its net debt increased from $57 to $136 million. This important increase of debt is mainly attributable to two factors. Firstly, the timing of year end creditor payments in 2013: the last day of FY13 falling on a weekend, the end year payments were hence actually processed during the following fiscal year, thereby resulting in a lower net debt in FY13. Secondly, the group undertook an on-market buy-back of 1,438,091 ordinary shares (approximately 1.4% of the total issued share capital) at a cost of $25.8 million at the end of FY14. The purpose was to offset the dilutionary effect of the shares issues to employees under the Companys share option plan during FY14 (Preliminary Final Report 2014).

Regarding the equity, the effect of the issuance of 1.4 million of new shares in FY 14 resulting from the exercise of employee share options was offset by the share buy-back described above. However, the equity rose sharply from FY13 to FY14 due to a30% increase of retained earnings. Concerning the dividend policy, the Board has increased the dividend payout ratio from 60% to 65% in 2014 (2014 Full Year Results).

This increase in both debt and equity should allow JB Hi-Fi to pursue its development strategy. The Group expects indeed to open a total of eight new stores in Australia in FY15.In addition, the company is convinced that with a total home appliances market estimated at around $4.6 billion for 2015, the HOME concept represents a significant growth opportunity for the Group (2014 Preliminary Final Report). Therefore the company will continue its strategy launched in 2013 by converting 26 extra stores into JB Hi-Fi HOME stores in FY15.

In conclusion, even though JB Hi-Fi is more leveraged than its competitors, it still has a quite conservative funding structure. It uses indeed only long term funding (equity and LT debt) and it can rely on strong and persistent earnings. Highly levered in FY11, the group has now reached a more sustainable capital structure, which gives it financial flexibility for the future.3.4) Current post-tax WACC including dividend imputationThe post-tax WACC including dividend imputation can be computed as follows:

But we need first to estimate the following parameters:

Cost of equity (re)

The most common way to estimate the cost of equity is through the CAPM. The model states that the cost of equity (re) is equal to the risk free rate plus an equity risk premium that depends on the risk of the firm, measured by the beta ( market that is the difference between the expected return of the market ( and the risk free rate (rf)

The results are reported in the following table:

rf3.57%(10 years Australian treasury bond)

E[RMkt]5.90%(Survey risk premium)

1.01(5 years, monthly returns)

re9.55%

Cost of debt (rd)

Since the company has never issued bonds, the cost of debt can be obtained adding a default spread to the risk free rate. The size of the spread will depend on the default risk of the firm. Because the firm is not rated by a credit rating agency, the first thing we have done was to estimate a synthetic rating. After adding the corresponding default spread to the risk free rate, we have finally obtained the cost of debt. The results are reported in the following table:

rf3.57%(10 years Australian treasury bond)

Credit rateBaa/BBBSynthetic rating

Credit spread2.03%Credit spread (RBA)

rd5.60%

Capital Structure [D/EV; E/EV]

In order to compute the capital structure we need to compute the market value of equity and the market value of debt.Obtaining the market capitalisation is simple: we need only to multiply the number of shares by the market price. Yet, the market price changes minute by minute. We have decided to approximate the market price by using the Volume Weighted Average Price for the last thirty days (August 26th-September 26th).

Obtaining the market value of debt is more complex. Since we dont have clear information about the debt and since part of its value fluctuation is mitigated by the use of derivatives[footnoteRef:1], we have decided to use the book value of debt as a proxyforitsmarket value. [1: JB Hi Fi is currently engaged into a swap contract (see page 101 of the 2014 Annual Report)]

Capital structure

EV (mln AUD)1858.79

E/EV88.79%

D/EV11.21%

Dividend imputation Two conditions are needed for the imputation of dividends: it only applies to dividends paid from companys profits whose taxes have beenpaid in Australia; credits are restricted to resident individuals for dividends paid by resident firms.

Indeed gamma depends on: proportion of dividends that have been franked utilization of franking credits

Given our estimates of 100% for the first factor and 87% for the second factor; our estimate of gamma is therefore 0.87.

Marginal corporate tax rate ()

The company operates only in Australia and New Zealand. Since most of the stores are in Australia (169 stores against 13 in New Zealand), we used the Australian corporate tax rate (30%)in our calculations.

JB Hi-Fis WACC is therefore:

re9.55%

rd5.60%

D/EV11.21%

E/EV88.79%

T30%

87%

WACC12.25%

For all the assumptions and calculations, please refer to Appendix 3.44/ OPTIMAL CAPITAL STRUCTURE& FUNDING STRATEGY

4.1) The companys optimal capital structure.

In order to compute the capital structure, we have at first calculated the cost of equity and cost of debt for all the possible capital structures. The results are shown in the following graph:

We can now estimate the WACC and the Enterprise Value of the firm for different level of debt. Note that the minimum point of the WACC curve is the point in which the value of the firm is maximized.

The optimal capital structure is therefore the one associated with a debt to enterprise value ratio of 30%.

RESULTS FROM ANALYSIS

CurrentOptimalChange

D/(D+E) Ratio =11.21%30.00%18.79%

Beta for the Stock =1.011.210.20

Cost of Equity =9.53%10.69%1.16%

Rating on DebtBBB

After-tax cost of Debt =3.92%4.57%0.65%

WACC12.04%11.59%-0.45%

Forecasted EBITDA 265,226,410

Growth rate2.00%

Enterprise value (Perpetual growth)$1,858,794.800 $1,945,902,375 $87,107,575

Value/share (Perpetual Growth) =$16.68 $17.56 $0.88

For all the calculations and assumptions please refer to Appendix 4.1.

4.2) Sensitivity analysis of the optimal capital structure

Regarding the factors affecting the free cash flow to the firm that could have an impact on the optimal capital structure we have chosen to examine the EBITDA (because it is directly linked to the credit rating), the Profit Margin and the forecasted percentage of change in the level of sales.The following figure shows the impact of changes in the EBITDA and Profit Margin on the capital structure.

The optimal D/EV is represented on the vertical axis while the horizontal axismeasures the magnitude of the change of the variable.We can see that both factors affect the capital structure. This is not surprising: when the EBITDA and the Profit margin increase, the rating of the firm becomes better and so the firm can borrow more money from the banks and increase the leverage.The same result happens when we project the capital structure for different percentage change in the forecasted level of sales, even if we need a wider change to perceive the effect on the capital structure.

Regarding the factors affecting the cost of capital that could have an impact on the optimal capital structure we have chosen to examine all of them (risk free rate, Equity Risk Premium, Beta and Gamma).Despite the fact that the cost of capital changed for any change in each of these factors, we surprisingly found that the capital structure was not much influenced by changes in these factors. We report for example below the case in which beta changes.

As we can see in the figure, although the WACC changes for each level of beta, the beta should double or go to zero to have an effect on the capital structure!

We conclude our analysis by proceeding a scenario analysis where we have changed simultaneously factors impacting the FCF (the EBITDA) and factors impacting the cost of capital (the credit spread and the risk free rate).

Scenario Summary

GFCbase caseEconomic boom

Changing Cells:

Crisisyesnono

EBITDA200.000265.226300.000

rf5.00%3.57%2.00%

Result Cells:

D/EV20.00%30.00%40.00%

In order to simulate a crisis we have changed the credit spread asymmetrically, in order to simulate the so-called phenomenon of the flight to quality/safety. So, when the indicator crisis is set on yes, the following spreads are added to the normal spread.

RATINGSurplus Credit spreadEstimated rd in crisis period

AAA0.10%4.37%

AA0.20%4.62%

A+0.30%4.87%

A0.80%5.67%

A-1.50%7.07%

BBB1.80%9.37%

BB2.10%11.17%

B+2.40%12.47%

B2.70%13.52%

B-3.00%15.32%

CCC3.30%16.37%

CC3.60%17.67%

C3,90%19,47%

The scenario analysis confirms the widespread idea stating that in period of crisis the firm has a lower level of debt (not only by choice) while in period of economic boom a higher leverage is advisable since it can boost the profits.4.3) Funding strategy

According to the calculation in 4.1, 30% of leverage ratio (D/(D+E)) is the optimal capital structure and can maximise the firm value. At the end of FY14, D/EV ratio of JBH was 11.2%, which is much lower than the desired capital structure. Therefore, the ratio should be increased through increasing debt or/and decreasing the equity. According to some experts, JB Hi-Fi might be seen as a possible takeover target for companies such as Woolworths or Wesfarmers Ltd[footnoteRef:2]. To prevent any takeover, JBH may be willing to borrow more debt from bank to buy back its own shares. Simultaneously, it would add value to JBH by lowering the total cost of capital. To do so, we would recommend to use short-term debt as long as the amount can be covered by the next years operating cash flow. [2: - http://www.morningstar.com.au/stocks/article/company-takeovers/4979?q=printme - http://www.fool.com.au/2014/04/14/jb-hi-fi-limited-the-next-takeover-target/]

Also, JBH has good expansion projects in the future such as the opening of new stores, the conversion into JB HI-FI HOME stores and the development of its online platform. Hence, JBH can borrow debt from bank to fund the project and approach to its optimal structure. But we would rather advise JBH to issue along-term corporate bond to finance its expansion.Overall, taking debt to buy back shares and to fund its new projects are both favourable options for JB Hi-Fi to optimize its capital structure.4.4) Impacts from changes in the capital structure

When the ratio of D/(D+E) reaches the most optimist point of 30%, the free cash flow to the firm will not change because it is only related to the business operations and excludes the impact of interests. Keeping the equity value unchanged, the optimal debt value should be about $558million. After-tax interest expenses are shown in Appendix 4.4. Therefore, net borrowing rises significantly and results in greater cash flow to equity. If the group undertakes share buy back at the same time, the optimal level of debt to match the optimal capital structure will be lower, but the free cash flow to equity will still increase.5/ RECOMMENDATIONS AND CONCLUSION

JB Hi-Fi should be suggested to increase its leverage ratio. Even though the leverage ratio with book values shows that the leverage of JB Hi-Fi is higher than its competitors ( section 3.3), the one with market values indicates that it remains quite small (D/EV = 11,2%). Also, it should increase its leverage to 30% in order to reach the lowest possible post-tax WACC and hence maximize the enterprise value ( section4.1).

We also highlighted that the optimal capital structure is not so sensitive to changes in the factors of the post-tax WACC but more to changes in the factors of the FCF ( section 4.2). As we expect the FCF to be stable in the near future ( section 2), we can reasonably assume that the 30% D/EV ratio remains optimal for a wide range of likely scenarios.

So how can the Group achieve this optimal capital structure?

First, the group can and should continue to undertake regularly share buy-backs over the next two years. It will contribute to deter potential hostile takeovers and offset the effect of the issuance of new shares resulting from the exercise of stock options. It could finance them by using short-term debt through its bank debt facility given that it implies many transactions whose the amount and timing are neither regular, nor known in advance.

Second, we would advise the group to issue a long-term corporate bond to finance its expansion plan (opening of new stores, conversion into JB Hi-Fi HOME, online sales) in addition to its retained earnings. We would indeed let the dividend payout ratio at 65% as it has already been raised by 5% this year and that we think the group will need to keep a certain level of its net income as retained earnings to finance its development strategy ( sections 1 and 3.3).

To sum up, by increasing slightly its current leverage, JB Hi-Fi would be able to maximize its enterprise value and optimise its financial structure in order to sustain its future growth.

APPENDICES

Appendix 1.1: Geographical segments

Appendix 1.1.2: Category segments

Appendix 1.2: Du Pont analysisThe Du-Pont model is an expression which breaks return on equity into three parts.Return on equity ratio is net profit to equity that measures how much profit JB HI-FI makes from shareholders funds. From the income statement and balance sheet, we computed that: Its profit margin is 3.69%, which shows how much profit is generated from the sales. The profit margin is the net profit divided by the total sales of the group. Its financial leverage is 2.918, which is calculated as the total assets divided by the equity and shows how much the company is financed by equity. Its asset turnover is 4.05, which is sales to total assets that measures sales of JB HI-FI earned per dollar of assets and hence represents its operating efficiency.

Appendix 2.1.1: Free cash flow to operation

According to FY14 annual report of JB Hi-Fi Limited (JBH), following items are listed in the statement of profit and loss. However, only those related to the business operations will be used when calculating the different cash flows.DetailInclude or Exclude

RevenueSale of goods and services

Include

Cost of salesDirect cost related to sale of goods and services

Include

Other incomeInterest received from bank not related to the operationOther income no detail provided, we assume that it is not related to operationExclude

Sales and marketing expensesOverhead costInclude

Occupancy expensesOverhead costInclude

Administration expensesOverhead costInclude

Other expensesNo details provided, we assume that it is not related to operation.Exclude

Finance costsNot operating costExclude

Income tax expenseAs the revenue and expense terms are adjusted, so the tax related is also changed. Since most stores are set in Australia (169 stores) and New Zealand only has 13 stores, actual tax rate is nearly 30%. Australian corporate tax rate is used when calculation.Adjust

Appendix 2.1.2: Working capital

Working capital is used to support daily business operation, so only terms of current assets and current liabilities related to business activities will be included in the calculation.Current AssetsDetailInclude or Exclude

Cash and cash equivalentsCash at bank and in hand no evidence shows that those cash and cash equivalents are related to operation. Exclude

Trade and other receivablesUsual term in working capitalInclude

InventoriesFinished goods - Usual term in working capitalInclude

Other current assets Prepayments and Deposits they could be the rent prepayments, lease bonds. Therefore, we assume they are related to business.Include

Current Liabilities

Trade and other payables Usual term in working capitalInclude

Other financial liabilitiesInterest rate swap related to financial activitiesExclude

Current tax liabilitiesAccounting difference between actual tax and accounting taxExclude

Provisions Employee benefits annual leave annual leave accrued, which is administration expenditure accruedLease provision related occupancy expensesInclude

Other current liabilitiesLease accrual and Lease incentive related to occupancy expensesInclude

Appendix 2.1.3: Capital expenditureIn the balance sheet, there are 4 types of non-current assets. Only those contributing to business operation will be included.DetailInclude or Exclude

Other financial assetsEquity securitiesfinancial activitiesExclude

Plant and equipmentSupport the businessInclude

Deferred tax assetsDifference between actual tax and accounting taxExclude

Intangible assetsBrand names, location premiums and rights to profit share usually generate from acquisitionInclude

Appendix 2.2.1: Net working capital based on data of the balance sheet

Appendix 2.2.2: Adjusted net working capital

Appendix 3.2: Capital Structure Ratio Analysis

Capital Structure Ratios

JB Hi-Fi Limited20102011201220132014

Financial Leverage244%504%440%346%292%

Gross Gearing (D/E) 24%153%81%51%61%

Net Gearing 6%135%60%23%46%

Net Interest Cover31.7948.6012.3418.3222.64

Source: FinAnalysis and JB Hi-Fis Annual Reports

This graph highlights that JB Hi-Fis capital structure has changed significantly over the last five years. In 2011, the group refinanced its debt facility for a further 3 years and increased its Net Debt from $17,9M to $205,3M. This sharp increase in debt was required to undertake a $173M shares buy-back and to align the groups dividend payments to the Groups half-year earnings split (Annual Report 2011).These are the reasons why its financial leverage doubled from 2010 to 2011 while its gross and net gearing ratios increased by more than 6 times. As a consequence, the net interest cover ratio plummeted from 2011 to 2012 as the interests increased with the amount of debt. One can also notice that the financial leverage and the gross gearing have followed approximately the same trend over the last five years. Today with a gross gearing ratio (=debt/equity) of 61%, JB Hi-Fi has recovered a more sustainable level of leverage.

Appendix 3.3: Comparison with its industry peersAfter having done researches to find out JB Hifis closest competitors in terms of products and services and geographical areas of sales, we came up with 3 different companies: Harvey Norman MUIR Electrical Company Pty Dick SmithHowever, MUIR is an owned proprietary company that does not publish public financial statements and Dick Smith is only publicly traded since 2013, which limits its track record regarding its financial structure and its performance. Luckily, Harvey Norman is by far the closest competitor of JB Hi-Fi and we will therefore focus on it.Capital Structure comparison with peer companies

Gross Gearing (D/E) Financial Leverage

2013201420132014

JB Hi-Fi Limited51%61%346%292%

Harvey Norman35%28%172%170%

Dick Smith23%7%263%270%

Appendix 3.4: WACC input analysis

COST OF EQUITYThe most common way to estimate the cost of a firms equity is through the CAPM. The model states that the cost of equity (re) is equal to the risk free rate plus an equity risk premium that depends on the risk of the firm, measured by the beta ( market that is the difference between the expected return of the market ( and the risk free rate (rf)

Risk free rateThe risk free rate is the return on a riskless asset. Since risk is the probability that actual return differs from the expected one, a riskless asset can be seen as an asset whose actual return is always equal to the expectation or, in other words, an asset whose return is certain.A worldwide used proxy for the risk free rate is the yield on Treasury instruments.One key decision concerns the maturity of the instrument to be used. Practitioners tend to use a 10-year bond or a 30-year bond.First, since firms are assumed to have infinite lives, we could think that a risk free rate derived by a 30-year bond is more appropriate to discount all the future cash flows of the firm. However, given that the 10-year bonds are more liquid (and so their price can be manipulated less easily) and the difference between the 10 year and 30 year rate is usually quite small we prefer to use this bond.The following figure, downloaded from Bloomberg website, shows the Australian Government Bond yield curve.

The risk free rate used is therefore 3.57%.Before concluding this section, we examined if these instruments are really risk-free.They offer a nominal return; in this return there is an inbuilt allowance for the expected inflation. Since the return is fixed by the contract, an unexpected change in the inflation will change the real return.Another aspect to consider is that Treasury bonds (especially the long term ones) are exposed to price risk and to reinvestment risk.

So why do we assume they are risk-free? We use Government instrument as proxy for the risk free rate because they dont have default risk[footnoteRef:3] since they are issued by the Government that can print money at any time to repay its debt. [3: We are assuming that the Goverment can control the monetary policy and that the instruments are issued in the currency controlled by the Governement.So if we consider the Argentinian bond denominated in USD they are not risk free because Argentina cant print USD.]

BetaThe beta measures the sensitivity of the stocks return to the return of the market portfolio.When estimating the beta some choices have to be made: time horizon and return interval: there is a trade-off between reliability and truthfulness of the estimates. If we use a too short time horizon we will have few observations. If we use a wider time horizon our data could be too old and not reflecting the actual and future market conditions. If we use a short return interval, short-term factors could influence our estimate and so we will have an unreliable estimate. Another problem could be that the stock may not be traded in that period. However, if we use a wider interval we will not have such problems but we will need to go backward for more years in order to collect a sufficient number of observations.

Practitioners tend to use two years of weekly return data or five years of monthly return data.

We have chosen to use monthly return for a period of five years in order to reduce to the minimum possible distortions.

Market proxy: there are no indices that contain all assets available in the market. A widely used proxy is to refer to the index of the country in which the company is listed or to an international index.We have decided to use the country index, the ASX 200, also because it has a desirable feature: it is a value-weighted index.

Post regression adjustment: some practitioners use an adjusted beta instead of the raw beta obtained by the regression. The adjusted beta can be computed as following:Adjusted beta= Regression Beta x 0.67 + 1 x 0,33The rationale is that in the long term beta should move towards one.We have decided to use a simple regression beta because this rationale doesnt convince us.

Given the assumptions above, we now report the calculations needed to compute the beta.

We start reporting the observations used :

No.DateASX 200 Adj CloseASX ReturnJB Hi Fi Adj closeJBH Return

101/09/145629.80.00069322216.880.000592768

201/08/145625.9-0.00124269916.87-0.138406537

301/07/145632.90.04396093219.580.088382435

402/06/145395.7-0.01762403317.990.00897364

501/05/145492.50.00061940917.83-0.060094887

601/04/145489.10.01747979518.970.029300054

703/03/145394.8-0.00185020718.430.019922524

803/02/145404.80.04138728318.070.051804424

902/01/145190-0.03030529517.18-0.162768031

1002/12/135352.20.00603372120.520.053929122

..

5501/03/104875.50.05127541716.330.042118698

5601/02/104637.70.01490283615.67-0.017554859

5704/01/104569.6-0.06179936815.95-0.107442641

5801/12/094870.60.0359892817.87-0.025627045

5902/11/094701.40.01253445918.340.115571776

6001/10/094643.2-0.0211653616.440.047133758

Note that the returns have been computed using Yahoo Finance closing adjusted price for stock splits and dividends.

We can now graph them to have an idea of the correlation between the stock and the market returns:

Finally, we can compute the beta:

Market Risk Premium

There are three approaches commonly used to estimate the market risk premium E[Rm]-Rf. 1) The first one is the historical approach, based unsurprisingly- on past data. 2) Another approach is based on the investors survey; since the market risk premium is what investors demand for investing in risky assets, the most logical way is to ask them their required/expected return. 3) The last one is to consider the implied market risk premium; this can be obtained by identifying the discount rate that is consistent with the actual level of the index. For example, using a constant growth model, the expected market return is equal to Div1/P0 + g [footnoteRef:4] where Div1/P0 is the expected dividend yield and g is its expected growth. [4: In a constant growth model we can write that P= Div1/(r-g); solving this equation per r we obtain the required rate]

Subtracting the risk free rate from the computed market return, we finally get the market risk premium.Before deciding which approach to use, we have summarized the pro and cons of each method.

MethodProConsEstimates

Historical Risk Premium- It is simple to compute- It is backward looking6,1 % for1883-2010 and 1958-20105,8% for 1980-2010

- Arithmetic or Geometric Average ?

- Large standard errors of the estimates.

- Changes according to the risk free rate used (e.g. 1 or 10 year bond; bond or bill)

Survey Risk Premium- It is the one required by the investors- Can be volatile.5,9% on average

- Change according to the market condition (inflation, interest rates)

Implied risk Premium- It is forward looking- Changes according to the risk free rate used (e.g. 1 or 10 year bond; bond or bill).

Damodarans estimates[footnoteRef:5]: [5: Note that the estimates of the implied risk premium are downloaded by Damodarans website and are computed using US market data. In order to have the Australian estimates we should add a country risk premium (that is actually around 30 basis points) if we use the American risk free rate too.]

4,96% at 01/01/20145,28% at 01/09/2014

- Changes according to the market conditions (inflation, interest rates)- Can be volatile.

The three methods analysed have different assumptions, advantages and disadvantages. However the estimates dont differ much: they range from the 4.96% of Damodarans MRP at the beginning of this year to the 6.1% obtained using the historical approach.We have decided to use the estimate derived by the surveys because, according to us, it best reflects the investors demanded/expected excess return for investing in risky assets.

Cost of debt

Since JB Hi-Fi has not issued bonds, the cost of debt can be obtained adding a default spread to the risk free rate. The size of the spread will depend on the default risk of the firm. Because the firm is not rated by a credit rating agency, the first thing to do is to estimate synthetic rating.

Given the Moodys Financial Metrics Key Ratios, weve selected some ratios and we have assigned a score for each of the rating (e.g. Aaa=1; Aa=2; A=3; and so on until C=7). After computing the average score, we assigned the company its score (Baa).

RatioValueRatingOur rates

EBITA/Average Assets22%Aaa1

Operating Margin5%B/C6.5

Debt/EBITDA105%Aaa/Aa1.5

Debt/Book Cap61%Ba/B4.5

FFO/Debt23%Ba5

CAPEX/Depreciation101%B6

EBIT/Interest Expenses 21,62 Aaa1

Average3,642857143Baa

We can compute the cost of debt using two different approaches:

Cost of debt adding a default spread

In this case the cost of debt is equal to the risk free rate plus a default spread found on the RBA website.[footnoteRef:6] [6: http://www.rba.gov.au%2Fstatistics%2Ftables%2Fxls%2Ff03hist.xls&ei=ghQpVNmBFoTl8gWh54DgBQ&usg=AFQjCNHYKDh-]

rf3,57%

Credit rateBaa/BBB

Credit spread2.03%

rd5.60%

Cost of Debt using CAPM

Using the following table, we can estimate the cost of debt using the CAPM:

rf3.57%

MRP5.90%

Beta0.1

rd4.16%

Capital structure

In order to compute the capital structure we need to compute the market value of equity and the market value of debt.One issue is that the market price changes minute by minute. We have decided to approximate the market price by using the Volume Weighted Average Price for the last thirty days (August 26th- September 26th).

DateClose PriceVolume traded

26/09/1415.61020400

25/09/1415.491352000

24/09/1416.13610900

23/09/1416.51602100

29/08/1416.87404800

28/08/1416,89899400

27/08/1416,691003500

26/08/1417770200

Average Price16.67953231

Number of shares98947309

Equity1650.394837

Debt179.65

Capital structure

V1830.044837

E/EV90.18%

D/EV9.82%

Computing the market value of equity (E) is simple: we need only to multiply the number of shares for the average market price.Then we computed the value of debt. Since we didnt have clear information about the debt and part of its value fluctuation are mitigated by the use of derivatives[footnoteRef:7], we have decided to use the book value of debt as approximation of the market value. [7: JB Hi-Fi is engaged into a swap contract (see page 101 of the 2014 Annual Report)]

Finally, after computing the market value of equity and debt, we have computed the capital structure.

Dividend imputation

Gamma depends on two factors: Aggregate Franking credits received: in the last five years the dividends paid by JB Hi-Fi were fully franked. Assuming that his main business will remain in Australia, we can suppose that the company will continue to issue full franked dividends.

Ex DateAmountFranked %

10 Feb 20140.5500100

19 Aug 20130.2200100

15 Feb 20130.5000100

20 Aug 20120.1600100

17 Feb 20120.4900100

17 Aug 20110.2900100

11 Feb 20110.4800100

17 Aug 20100.3300100

11 Feb 20100.3300100

17 Aug 20090.2900100

13 Feb 20090.1500100

Utilisation of Franking credits: since the 74% of the shareholders are Australian funds or company (see following table from the 2014 Report), and assuming a 50% of utilisation for the remaining 26%, we can assume a total utilisation of 87%.

Appendix 4.1: Optimal capital structure

In order to compute the capital structure, we have at first calculated the cost of equity and cost of debt for all the possible capital structures.

No particular problems occurred for computing the cost of equity. After having unlevered the beta with Hamadas equation ( , we have relevered it for each capital structure inverting the same formula. Finally we have computed the cost of equity for different levels of equity. The following table shows the cost of equity for different capital structures:E/(D+E)D/(D+E)Tax RateUnlevered BetaLevered BetaRisk free rateEquity Risk PremiumCost of equity

100%0%30%0.9550.9553.57%5.90%9.20%

90%10%30%0.9550.9873.57%5.90%9.39%

80%20%30%0.9551.0263.57%5.90%9.63%

70%30%30%0.9551.0783.57%5.90%9.93%

60%40%30%0.9551.1463.57%5.90%10.33%

50%50%30%0.9551.2413.57%5.90%10.89%

40%60%30%0.9551.3853.57%5.90%11.74%

30%70%30%0.9551.6233.57%5.90%13.15%

20%80%30%0.9552.1013.57%5.90%15.96%

10%90%30%0.9553.5333.57%5.90%24.41%

0%100%30%0.955#DIV/0!3.57%5.90%#DIV/0!

For the cost of debt, we have used Damodarans spreadsheet but we have decided to change the ratio on which the spread was based on. Instead of using the interest coverage ratio (that gave us unrealistic results), we have decided to use the Debt/EBITDA ratio(that better approximated the rating). We had to change the WACC formula because it didnt take into account the dividend imputation too. These are the results obtained:D/(D+E)Obtained ratingTax RateRisk free rateDebt SpreadRd before taksRd after taks

0%AAA30%3.57%0.40%3.97%2.78%

10%AAA30%3.57%0.40%3.97%2.78%

20%AA30%3.57%0.70%4.27%2.99%

30%A30%3.57%1.00%4.57%3.20%

40%BB30%3.57%4.00%7.57%5.30%

50%BB30%3.57%4.00%7.57%5.30%

60%B30%3.57%6.50%10.07%7.05%

70%B30%3.57%6.50%10.07%7.05%

80%B-30%3.57%7.25%10.82%7.57%

90%C30%3.57%8.75%12.32%8.62%

100%C-30%3.57%12.00%15.57%10.90%

Combining the two tables, we see that the optimal capital structure is therefore the one associated with a debt to enterprise value ratio of 30%.D/(D+E)Cost of equityPre tax Cost of debtAfter tax Cost of debtWACC

09.05%3.97%0.0277912.42%

10%9.47%3.97%0.0277912.08%

20%10.00%4.27%0.0298911.81%

30%10.69%4.57%0.0319911.59%

40%11.60%7.57%0.0529912.47%

50%12.88%7.57%0.0529912.48%

60%14.79%10.07%0.0704913.93%

70%17.99%10.07%0.0704914.18%

80%24.38%10.82%0.0757415.01%

90%43.54%12.32%0.0862416.63%

100%#DIV/0!15.57%0.10899#DIV/0!

Appendix 4.4: Interest after tax

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