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You cannot keep using debt forever, because the more debt you use, the higher
your interest rate will be.
If the interest rates keep going up until it’s interest rate exceeds it’s ROA, then it
will signal a sign to the bankers and shareholders that the company is risky. This
will cause the bankers to further increase their interest rate.
Question 3
a) Compute Cheap&Good’s return on assets (ROA) for 20x2
b) Based on your answer in (a), should Cheap&Good make use of more debt
financing or equity financing? Why?
Since ROA of 32.2% is higher than effective interest rate of 6% (interest expense
of $120,000 divided by long-term debt of $2,000,000), Cheap-and-Good
Supermarket should make use of more debt financing.
Using more financial leverage will improve earnings and returns to shareholders.
However, this view assumes that ROA can be maintained to be above its
borrowing rate of interest and the additional debt taken is not above prudential
limits.
c) Given your answer in (b), why shouldn’t Cheap&Good push the mix of total
funds acquired to the maximum limit of debt funds and minimize the financing
from equity sources?
ii) The added leverage also indirectly cause the cost of equity capital to
rise. Leverage increases the volatility of the firm’s earnings profile, and
risk of bankruptcy is higher. The increase in risk causes the P/E ratio to
fall. This translation
Unable to complete 3c. Anyone who have the complete answer, pls send me. TY!
Refer to lecture page 15. (The 3 points)
d) Management is thinking of increasing financial leverage, but not by taking on
more borrowings. Instead, it intends to buy back (and cancel) 100,000 shares at
its current (end 20x2) share price of $6.00. How are analysts likely to react to
this event?
20x2
$5,030,0
00
Assets value per Net total assets 2,000,00
share = No. of shares 0 = $2.52
Buy-back
shares @
$6.00
Old asset base $5,030,000
Cost of share buy-back ($600,000)
New asset base $4,430,000
ROA 32.2%
New EBIT $1,426,759
Interest ($120,000)
New pretax profit $1,306,759
Tax (20%) ($261,352)
New net profit $1,045,408
EPS = New profit/No. of
shares $0.55
[$1,045,408 / (2,000,000 -
100,000)]
EPS (before share buy-
back) $0.60
[$1,200,000 / 2,000,000]
As buying back shares at $6.00 (i.e. above its assets value per share of $2.52)
will lead to a lower EPS, analysts are likely to react negatively to this event.
Question 4
*Note: Notice the Assets is 150m, the same as the Equity. This means that there
is no liability, therefore no interest!
a) Calculate the possible impact on Coolunder’s EAT (earnings after-tax) and EPS
(earnings per share) if it issues new shares at $20, $15 or $10 per share to
finance the new factory. Show all your workings.
Issue of new shares
@ per share $20 $15 $10
Number of new shares to
issue (m) 1.5 2 3
Old number of shares (m) 10 10 10
New number of shares (m) 11.5 12 13
Old asset bsae ($m) 150 150 150
Proceeds from new shares
($m) 30 30 30
New asset base ($m) 180 180 180
ROA 0.2 0.2 0.2
New EBIT = EBT ($m) 36 36 36
(10. (10. (10.
Tax rate (30%) 8) 8) 8)
Earnings After Tax (EAT) 25.2 25.2 25.2
$2.1 $2.1 $1.9
EPS 9 0 4
b) From your calculations in a), state the relationship between the issue price of
new shares, asset value per share and EPS.
c) State 2 key assumptions that you have made in arriving at your calculations in
a)
Question 5
What are the two common reasons why investors tend to view share buybacks as
positive for the concerned company’s share prices?
Share buybacks decrease the proportion of cash in the total asset base of
a company. As cash earns a low rate of return, share buybacks shold
increase the ROA and ROE of the company after the buyback. Higher ROEs
usually lead to higher PEs and thus share price, shareholders will benefit.