Profit and Shareholder Wealth - Assignment Example

TYCO & GE: Profit and Shareholder Wealth Comparison Divide each company’s market capitalization by that company’s shareholders’ equity. This market-to-book ratio provides one measure of shareholder wealth created by each company. Include your calculations in the assignment. Tycos market capitalization for 2007 was $19,092.52M; its stockholders equity was $15,624.00m The ratio of market capitalization relative to stockholders equity was 1.22 to 1. GEs market capitalization was $264,820M; its stockholders equity was 115,559M. The relevant ratio for GE was 2.29 to 1. 2) Based on these market-to-book ratios, which company’s strategy has provided greater shareholder wealth creation? GE provided greater shareholders wealth because the market value of its shares was 2.29 times that of book value. Tyco, on the other hand, had a much lower ratio of 1.22 to 1. This means that over the years investment in GE appreciated more than the investment in Tyco, and has potential for performing consistently well in the future. With an average beta of .64, as computed by Yahoo and Reuters, GE is also a lot more stable than Tyco, whose beta is .93. 3) Calculate the average net profit margin for each company for the five years worth of data obtained. Include your calculations in the assignment. The net profit margins of the two companies are as follows: Tyco 2007 2006 2005 2004 2003 Revenues 18,781.0 17,336.0 16,665.0 37,939.0 34,256.0 Net income (loss) (1,742.0) 3,590.0 3,094.0 2,822.0 980.0 Net profit margin ( .0927 ) 0.207 0.186 0.074 0.029 5-year average net profit margin .081 GE Revenues 169,719.0 149,689.0 134,907.0 133,227.0 112,819.0 Net income 22,208.0 20,742.0 16,720.0 17,160.0 15,561.0 Net profit margin 0.131 0.139 0.124 0.129 0.138 5-year average net profit margin 0.132 4) Did the company achieving the greatest profit maximization also achieve the greatest stockholder wealth maximization? If not, which strategy was more beneficial to the shareholders? The average net profit margin of GE was better than Tycos by a ratio of 1.63:1, and was also more stable. Tyco had a high net profit margin in 2006 of .207 but it experienced a loss of -0.927 the following year. The measurement for stockholder wealth maximization is the return on stockholders equity. The following are the relevant data obtained: 2007 2006 2005 2004 2003 TYCO Net income (1,742.0) 3,590.0 3,094.0 2,822.0 980.0 Total equity 15,624.0 35,387.0 32,619.0 30,292.0 26,369.0 Return on equity (.111) .101 .095 .093 .037 5-yr average return on equity .043 GE Net income 22,208.0 20,742.0 16,720.0 17,160.0 15,561.0 Total equity 115,559.0 111,509.0 109,351.0 110,908.0 79,631.0 Return on equity 0.192 0.186 0.153 0.155 0.195 5-yr ave. return on equity 0.176 GE provided greater wealth maximization to stockholders in the latest year as well as on the basis of the five-year average rate of return. The best strategy is for a company to improve its sales while holding its costs low. In the long run it can also benefit from investing in a good research and development program. On the financial side, it can improve profitability if it chooses its capital structure wisely, by minimizing risk when the returns from capital of new projects are not better than the cost of capital on long-term debt. The use of leverage is justified only when it does not impose a risk on the common stocks as when the cost of marginal debt exceeds the returns on marginal equity investments. Both the return on revenues/sales and the return on equity should have a direct relationship, that is to say, the net profit margin should be reasonably high consistent with the return on stockholders equity. However, the net profit margin may be low in relation to revenues, particularly when the industry is highly competitive and companies survive on thin profit margins and compensate by increasing sales volumes. The ultimate measure of profitability is the net return on the shareholders equity, and not the net profit margin whenever there is a doubt as to which of these are paramount. 5) Which company’s strategy has presented greater risk to the shareholders’ investment? The degree of risk which investors or shareholders are exposed to depend firstly on how management handles the marketing function, because that is where income is generated. When little sales are generated, income can shrink or even turn into a loss because of fixed costs incurred regardless of sales level. The cost structure must also be managed well because the high costs can erode the operating margins even if revenues are high. The second most important factor that can expose shareholders to significant risk is the amount of debt incurred by the company. The debt-to-equity ratio must be normal for the industry - neither too low so as to miss out on profitable investment opportunities which can be availed of by using debt, nor too high as to threaten the stockholders equity in case of project failure and debt default. In fact, the higher the debt ratio, the higher would the stockholders required return on their capital. An optimal capital structure must be maintained by company management which primarily takes into account how leverage can contribute to the net returns to stockholders. The debt ratios of the two companies are shown below: TYCO Total liabilities 17,191.0 27,624.0 29,846.0 33,375.0 36,628.0 Long-term debt 4,076.0 8,853.0 10,569.0 14,542.0 18,251.0 Total equity 15,624.0 35,387.0 32,619.0 30,292.0 26,369.0 Debt to equity ratio 1.10: 1 0.78: 1 0.91: 1 1.10: 1 1.39: 1 5-year ave. D/E ratio 1.06: 1 G E Total liabilities 679,778.0 585,174.0 563,970.0 639,709.0 568,197.0 Long-term debt 319,015.0 260,752.0 212,281.0 207,871.0 171,966.0 Total equity 115,559.0 111,509.0 109,351.0 110,908.0 79,631.0 Debt to equity ratio 5.88: 1 5.25: 1 5.16: 1 5.77: 1 7.14: 1 5-year ave. D/E ratio 5.84: 1 6. Have the investors assuming that greater risk been rewarded with greater investment returns? Despite high leverage on the part of GE, investors continued to support GE. Latest Price/Earnings ratio according to Reuters was 12.05. and price per share was holding at $26 to $28 per share. The risk the company takes is in the amount of leverage. In ordinary circumstances, investors would push the price down because high leverage can mean insolvency risk. However GE is a stable company with a very good record of earnings and dividends over many years, and its stability, shown by its low beta, is outstanding. Tyco experienced negative earnings in 2007; however, in the most recent quarter ending June 2008, it showed a net profit margin of 6.45%, according to data provided by Yahoo. Its price has also stabilized at around $40 per share for most of this current year. It is very likely that Tyco will recover and that its investors will be show better investment results by the end of this year. REFERENCES Brealey, C.P., Myers, S.C., Marcus, A.J. (1999) Fundamentals of Corporate Finance (2nd ed.). Boston:Irwin/ McGraw-Hill Jackson, S. & Sawyers, R. (2001). Managerial accounting: A focus on decision making. Orlando, FL:Harcourt, Inc. Stickney, C.P. (1990). Financial statement analysis: A strategic perspective (2nd ed.). Orlando, FL: Dryden Press. Websites visited and used: http://finance.yahoo.com/q/ks?s=TYC http://finance.yahoo.com/q/ks?s=GE http://www.tyco.com http://www.ge.com http://www.reuters.com/finance/stocks/overview?symbol=TYC.N http://www.reuters.com/finance/stocks/financialHighlights?symbol=GE.N http://www.reuters.com/finance/stocks/incomeStatement? stmtType=INC&perType=ANN&symbol=GE.N http://www.reuters.com/finance/stocks/performance?symbol=GE.N Read More