Financial Accounting & Statement Analysis Workshop II Philippe Giraudon

Transcription

1 Financial Accounting & Statement Analysis Workshop II Philippe Giraudon

2 Below are the 2012 forecasts of companies A and B which operate in the same sector: P&L Statement ( m) Alpha Beta Revenues Operating Income (EBIT) Interests 21 3 Profit Before Tax (BPT) Tax Net result ROE (%) 8.0% 8.0% Earning per share (USD) Dividend per share (USD) Number of shares (million) Balance Sheet Alpha Beta Current assets Other assets Property, Plant and Equipment Total assets Short term debt Long term debt Shareholders equity Total liabilities ) Compare Alpha and Beta ROE, ROCE and leverage effects (in two ways), based on accounting values 2

3 1) Compare Alpha and Beta ROE, ROCE and leverage effects (in two ways), based on accounting values ( m) Alpha Beta EBIT EBITx(1-IS) 62x(1-40%) = x(1-40%)=45 Capital Employed: WCR+Assets ( )+( )=730 ( )+( )=600 Invested Capital: Net fin debt+shs eq = =600 ROCE: EBITx(1-IS)/CE 37.2/730 = 5.10% 45/600 = 7.50% Leverage effect: ROE - ROCE 8% % = 2.90% 8% % = 0.50% Leverage effect: After tax cost of debt (21/420)x(1-40%) = 3% (3/60)x(1-40%) = 3% gearing: debt/shs eq. 420/310 = 1.35x 60/540 = 0.11x (ROCE - cost of debt after tax) x gearing (5.10%-3%)x1.35 = 2.90% (7.50%-3%)x0.11 = 0.5% Financial leverage Significant Very low 3

4 2) Compare Alpha and Beta break-even, assuming that variable costs account for c. 35% of sales for both companies (as they operate in the same sector) Break-even analysis is a measure of the margin sensitivity to a change in sales We can say that break-even sales level is such that margin on variable costs = fixed costs Fixed charges: - Alpha: Fixed charges = sales EBIT variable costs = 1, % x 1,230 = Beta: Fixed charges = sales EBIT variable costs = 1, % x 1,170 = Break-even sales: - Alpha: 737,5 / (1-35%) = 1,135 Higher operating leverage - Beta: / (1-35%) = 1,055 Check: EBIT = sales variable costs fixed charges - Alpha: 1,135 35% x 1, = 0 - Beta: 1,055 35% x 1, = 0 4

5 3) A Financial Analyst considers that that Alpha performance is to fluctuate more in the future. Considering they have similar ROE, EPS and DPS, do you share his opinion? Yes indeed, the following reasons can be given: - figures show that property, plant and equipment account for a larger % for Alpha the lower margin as a % of sales is Alpha s (5.04% vs. 6.41% for Beta) = Alpha has a higher operating leverage Alpha will thus have higher depreciation and other fixed costs, and, should its sales change, will have wider fluctuations in its operating profit - the balance sheets show that Alpha also has a higher % of long-term debt Alpha thus has larger interest payments and any change in its operating profit will result in wider fluctuations in its EPS = Alpha has a higher financial leverage cf. degree of financial leverage: EBIT/Pretax income (inverse of the interest burden) 1.51 for Alpha vs for Beta 5

6 4) The Financial Analyst concludes that Alpha theoretical share price will be lower taking into account the higher volatility of its results. Justify this assessment on the basis of Gordon-Shapiro Constant Growth Dividend Model According to the constant growth dividend discount model: Theoretical share price = Dividends per share. Required rate of return sustainable growth rate Also, sustainable growth rate = ROE x (1 payout ratio) Forecasts say that Alpha and Beta will have the same dividends per share, and the same ROE and payout ratios in the future However, Alpha has a higher operating leverage and financial leverage, so its beta and its required rate of return will be higher and its theoretical share price therefore lower 6

7 5) Beta management have set up a project aiming at increasing the company sustainable growth rate (= ROE x retention ratio) by reducing its pay-out ratio a) By using Gordon-Shapiro model, calculate Beta theoretical share price as of 01/01/12, assuming a required rate of return (cost of equity) of 10% According to the constant growth dividend discount model: Theoretical share price = Dividends per share. Required rate of return sustainable growth rate Beta sustainable growth rate = ROE x (1 payout ratio) = 8% x (1 6/10) = 3.2% Beta theoretical share price = 6 / (10% - 3.2%) = b) What would be Beta theoretical share price if the dividend par share was 5 instead of 6, all other things being equal? Beta sustainable growth rate = ROE x (1 payout ratio) = 8% x (1 5/10) = 4.0% Beta theoretical share price = 6 / (10% - 4.0%) =

8 5) Beta management have set up a project aiming at increasing the company sustainable growth rate (= ROE x retention ratio) by reducing its pay-out ratio c) Comment the economic reason explaining the change in Beta theoretical share price as calculated in the 2 previous questions A lower dividend means a higher retention rate. As Beta ROE is 8.0%, which is lower than the required rate of return of 10%, this means that Beta has a negative net present value (NPV) on its investment (Beta is destroying value ) Even though Beta sustainable growth rate will be higher, if Beta increases its retention rate and uses the increase in retention for re-investment in its operations, Beta theoretical share price will decline as such an investment will bring a negative PV 8

9 6) Alpha projects a 100 million bond issue to buy its own shares, with a purchase price of 100 per share (current share price). Bond interest rate amounts to 5% a) Calculate Alpha ROE (Return on Equity) after the share buyback After the bond issuance, Alpha will have a higher interest burden of 5m ( 100m x5%) Alpha P&L Statement ( m) Before bond issue Revenues Operating Income (EBIT) Interests Profit Before Tax (BPT) Tax Net result Alpha will thus have a decreasing net income of 22m Alpha shareholders equity will decrease from 310m to 210m After bond issue Alpha ROE will thus increase to 22 / 210 = 10.5% (or even 22 / (210 3) = 10.6%) 9

10 6) Alpha projects a 100 million bond issue to buy its own shares b) Another financial analyst asserts that this share buyback will increase Beta shareholders wealth as Beta EPS (Earning per Share) will necessarily increase Provide 3 arguments supporting and contradicting this statement EPS will indeed increase with a decrease of 1 million shares (100 m/100) : from 10 to 21 / (2. -1) = 14: this is a pure accounting effect due to the positive leverage However, we have to look at the market effect of the stock repurchase: - in a Modigliani & Miller world with taxes, a higher leverage will benefit shareholders due to the interest tax shield; - however, ABC has already a high debt ratio: D/EV = 700/( x 100) = 73.68%; assuming no market effect, after the stock repurchase, D/EV = ( )/950 = 84.21% Levels probably beyond the optimal debt level and the stock repurchase will probably induce a decrease in the shareholders' wealth due to bankruptcy & agency costs; - investors may interpret this repurchase as a sign that the company did not have any promising investment opportunities, & this would have a negative impact on the share prices 10

11 7) Omega, which benefits from a high growth potential, considers the opportunity to acquire Alpha (with its own shares). Both companies operate in the same sector but are not competitors and the potential merger is not expected to bring substantial synergies Omega key financial figures are provided below: - Forecast net result: 30m - Share price: Number of shares: 3m Based on the market data provided, the newly merged entity EPS will amount to An analyst following Omega considers that if the share exchange ratio is based on market prices, the merger will increase Omega shareholders wealth, even without any synergies. He estimates that the newly merged entity s EPS will increase after the merger, probably leading to a share price increase. What do you think of this estimates? Explain The analyst is right: EPS will indeed increase as it appears in the answer of question 3b), - but this is a purely technical effect that occurs all the time when the acquiring firm has a higher P/E ratio than the acquired company (bootstrap effect) - he is wrong as regards the impact on price which should remain constant : the newly Omega merged firm has a lower potential growth than the former one Therefore, the P/E ratio should decrease 11

12 8) The financial analyst following Omega actually realises that he not only has to calculate its basic EPS but also its diluted EPS, considering that the company also has: - 10% treasury shares - 3 million convertible bond (with a face value of 1,000 and a 5% interest rate), which are convertible with a ratio of 1 convertible bonds for 7 shares Assume that Omega tax rate is 30% Calculate Omega Basic and Diluted EPS Basic EPS = Net result = 30 = 30 = 11.1 per share number of shares (excluding treasury shares) 3-3 * Diluted EPS = Net result taking into account all potential dilution effects = Net result excluding convertible bond interest. number of share (excl. treas. sh.) including converted convertible bonds 12

13 8) The financial analyst following Omega actually realises that he not only has to calculate its basic EPS but also its diluted EPS, considering that the company also has: - 10% treasury shares - 3 million convertible bond (with a face value of 1,000 and a 5% interest rate), which are convertible with a ratio of 1 convertible bonds for 7 shares Assume that Omega tax rate is 30% Net result excluding convertible bond interests = % x (1 30%) x 3 = Number of shares including converted convertible bonds (and excl. treasury shares) = 3 + (3/1,000 x 7) - 3 * 0.1 = Diluted EPS = / = per share 13

14 Appendix: relevant formulae 14

15 Questions pgiraudon<a>gmx.net 15