Tutorial 7

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.

Require rate of return

- Risk free rate, expected inflation, risk premium (how risky is the thing
you are investing in)

Question 3
a) Compute Cheap&Good’s return on assets (ROA) for 20x2

ROA = EBIT margin x Total asset turnover

ROA = 0.04 x 7.95 = 0.32

(20x2) or 32.2%

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?

Limitations to push debt funds to the maximum because:

i) As the debt/equity ratio rises beyond a certain point, the marginal cost
of new debt rises fast when lenders start to perceive that they are
shouldering a larger share of the risk attached to Cheap&Good. The
implication is that the spread (R-I) narrows as leverage rises.

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

iii) Difficulty maintaining ROA

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.

If new shares are issued at

- Higher than asset value per share, EPS improves.
- Asset value per share, EPS remains unchanged.
- Lower than asset value per share, EPS deteriorates.

c) State 2 key assumptions that you have made in arriving at your calculations in
a)

2 key assumptions are:

1) that ROA is maintained at the current level of 20%
2) that effective tax rate remains at 30%

Question 5

What are the two common reasons why investors tend to view share buybacks as
positive for the concerned company’s share prices?

The 2 reasons are

I) Reducing the number of shares through share buybacks will lead to
increases in the company's earnings per share. Assuming an unchanged
normal P/E, this should mean a higher share price for the company’s
shares.

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.

II) Signalling argument – share buybacks is believed to be management’s

way of telling the market that it doesn’t know of any better investment,
using the company’s surplus cash, than to buy back the company’s own
shares i.e. the suggestion is that the company’s share price is below its
intrinsic value.

However, criticism of share buy-back 

1. Share holders feel management can’t grow the business if they are
giving cash back to shareholders
2. Management use share back-back as an easy way to boost financial
numbers.