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The management of Biltek (a debt free electronics company) is pondering over the
following exhibit which shows the ROE for the firm in the recent years.
Recent instability in the economy, a sudden surge in new products launched by our firm
and the competitors, the labour unrest followed by a strike, the scarcity of raw materials
which resulted in an increase in COGS and our recent entry into the foreign market which
created transaction exposure, all contributed to the volatility in the ROE. Commented
Sudip Banerjee, CFO of Biltek. But I am sure that as the growth picks up in the coming
few months, all the investments made by us will start resulting in better returns. We may
not require any additional investments for the next few years. With a proper cost and
financial structure, we will be able to reward our share holders.
.
Alternative A Alternative B
Price 94 94
Var.Cost 70.5 47
Fixed Cost 940,000 2,820,000
Assets 9,400,000 9,400,000
Tax Rate 40% 40%
Situations Probability Units
Terrible 0.05 60,000
Poor 0.20 80,000
Normal 0.50 100,000
Good 0.20 160,000
Excellent 0.05 200,000
Projected ROE Alternative A
DEMAND PROB. UNITS SALES OP.Costs EBIT PAT ROE
Terrible 0.05 60,000 5,640,000 5,170,000 470,000 282,000 3.00%
Poor 0.20 80,000 7,520,000 6,580,000 940,000 564,000 6.00%
Normal 0.50 100,000 9,400,000 7,990,000 1,410,000 846,000 9.00%
Good 0.20 160,000 15,040,000 12,220,000 2,820,000 1,692,000 18.00%
Excellent 0.05 200,000 18,800,000 15,040,000 3,760,000 2,256,000 24.00%
Biltek is paying entire earnings as dividends this year. Dividend is expected to grow at a
constant rate of 3%. The current risk free rate is about 6% and the historical average risk
premium is about 4%. Biltek is currently at an unlevered beta of 1.5, although you are
almost sure that there will be a major upward change in beta with more leverage as the
investors expect a higher risk for the additional leverage.