Corporate Finance Strategy - Assignment Example

ASSIGNMENT COVERS SHEET Office use only INDICATIVE MARK All marks are to ratification at the appropriate Examining Board. I.D: Surname: First Name: Module Code: Module Name : Programme: Submission Date : Assignment Title: STUDENT SIGNATURE: DATE: PLEASE FILL IN YOUR DETAILS ON THE TEAR OFF RECEIPT BELOW (Tear-off Slip) RECEIPT OF ASSIGNMENT SUBMISSION: Student I.D : Surname: First Name: Module Code: Module Name : Programme Submission Date : Signed on behalf of (For office use only) TUTOR COMMENTS: ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… ………………….……………………………………………………………… ……………………………………………………………………………….… ………………………………………………………………………………… ……………………………………..……………………………………………………………...………………….………………………………………………………………………………….………………………………………………………………………………………………………...………………….………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………..………………………………………..…………………….………………………………………………………………………………..…………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………..…………………………………………..………………………………………………………………………………………………………………………………………………………………………………………………………………………………..……………………………………………………… Problem 1 1. Calculate the combined effect of the three off-balance-sheet items in Exhibit 3 on each of the following three financial ratios shown in Exhibit 2. Following is the given information of the ratios in the Exhibit 2. Exhibit 2 - Selected Ratios and Credit Yield Premium Data for Montrose EBITDA / interest expense 4.72 Long-term debt / equity 0.30 Current assets / Current liabilities 1.05 Credit yield premium over US Treasuries 55bps Following is the given information of the off balance sheet items in the Exhibit 3. Exhibit 3 – Hudson Chemical off-balance sheet items 1 Hudson Chemical has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000. 2 Hudson Chemical has sold $500,000 of accounts receivable with recourse at a yield of 8 percent. 3 Hudson Chemical is a lessee in a new non-cancellable operating leasing agreement to finance transmission equipment. The discounted present value of the lease payments is $6,144,000 using an interest rate of 10 percent. The annual payment will be $1,000,000. When we calculate the combined effect of the three off balance sheet items on the three ratios the following changes will take place. EBITDA / Interest Expense a. The guarantee of long term debt will not affect operating (EBITDA) or the interest expense. This ratio therefore remains the unchanged i.e. 4.72. b. The account receivable should be treated as if they had not been sold, but rather a loan for $500,000 had been taken out of 8% rate of interest. This means that the interest expense would be $40,000 higher ($500,000 x 8%) and EBITDA would also be increased by $40,000. This is under the assumption that the proceeds of the loan would be invested and would provide interest income. It is assumed that it could be invested and would provide interest income. It is assumed that it could be invested at 8% thus the adjusted numbers would be $4,490K for EBITDA and $982K for interest expense. Now the ratio will be calculated as follows: New EBITDA = 4,450K + 40K 4,490 New Interest Expense = 940K + 40K 982K EBITDA / Interest Expense 4,490/982 = 4.57 c. The operating lease should be treated as a capital lease. The interest expense for the first year will be increased by the interest expense of $614K ($6,144Kx 10%). EBITDA includes the rental expense of $1,000,000. If the lease is capitalized then a portion of this represents the interest expense (614K) and EBITDA should be increased by the 614K. Long-Term Debt / Equity a. The guarantee of long-term debt should be taken into account. The long-term debt will increase by $995,000 but the equity will be unaffected. New Long-Term Debt = 10,000K + 995K 10,995K New Equity = 33,460K + 0K (no changes) 33,460K Long-Term Debt / Equity 10,995/33,460 = 0.33 b. The sale of the receivables should be taken into account. However, the adjusting entries would be to increase account receivables by $500K and increase short-term by the same amount. Neither of these adjustments will affect the long-term debt/equity ratio. Therefore the ratio will be unchanged i.e. 0.30. c. The operating leases restated as if they were capitalized leases. This means that the asset would be increased by $6144K and the liabilities would be increased by this amount too. However, some of the liabilities will be classified as short-term –the amount that is due to be repaid next year. This equals next year lease payment ($1M) less the interest payment (10% x $6.144M) = $385,600. Therefore, the long term liability is $6,144K - $385.6K = $ 5,758K. The equity remains unchanged. New Long-Term Debt = 10,000K + 5,758K 15,758K New Equity = 33,460K + 0K (No changes) 33,460K Long-Term Debt / Equity 15,758/33,460 = 0.47 Current Assets / Current Liabilities a. The guarantee of long-term debt would not affect current liabilities or current ratio and therefore the debt would remain the same i.e. 1.05. b. The sale of the receivables should be taken into account. The adjusting entry would be to increase account receivables by $500K and increase short-term debt by the same amount. New Current Assets = 4,735K + 500K 5,235K New Current Liabilities = 4,500K + 500K 5,000K Current Assets / Current Assets 5,235/5,000 = 1.047 c. The operating leases restated as if they were capitalized leases. This means that the assets would be increased by $6,144K. However, the assets would be considered fixed assets and current assets would remain unchanged. Liabilities would be increased by $6,144K. However, only some of the liabilities will be classified as short term – the amount that is due to be repaid next year. This equals next year’s lease payment ($1M) less the interest payment (10% x $6.144M) = $385,600. New Current Assets = 4,735K + 0K (No changes) 4,735K New Current Liabilities = 4,500K + 385.6K 4,885.6K Current Assets / Current Assets 4,735/4,885.6 = 0.97 2. State and justify whether or not the current credit yield premium compensates Jones for the credit risk of the bond based on the internal bond-rating criteria found in Exhibit 4. The internal bond rating criteria in Exhibit 4 is quite fine and when we see the analysis of the Hudson Chemical we see that overall condition of the firm is secure for investment point of view. If Jones buys Hudson Chemical’s bond he will get compensated for his investment as credit risk is not high only in one situation where the current ratio falls to 0.97. Overall the financial health of the firm is good and offers opportunities for the investors. Problem 2 1. Evaluate the Net Profit Margin, the Total Asset Turnover and the Financial Leverage Multiplier of the company. Then, calculate the Return on Equity of the company by applying the DuPont System (Please make use of the Exhibit 1 and 2). The Net Profit Margin is given below in the table: 2007 2006 2005 2004 2003 Net Income 1965.2 1839.2 2240.3 2075.9 1933.8 Sales 15717.1 15035.7 14934.2 14146.7 13566.4 Net Profit Margin 12.50 12.23 15.00 14.67 14.25 The total asset turnover is calculated below: 2007 2006 2005 2004 2003 Sales 15717.1 15035.7 14934.2 14146.7 13566.4 Total Assets 16377.2 16555 16173.4 14689.5 14119.5 Total asset turnover 95.97% 90.82% 92.34% 96.30% 96.08% The Financial Leverage Multiplier is calculated below 2007 2006 2005 2004 2003 Total Assets 16377.2 16555 16173.4 14689.5 14119.5 Shareholder Equity 3938.7 3343.3 2668.1 2711.7 3052.3 Financial Leverage Multiplier 4.1580 4.9517 6.0618 5.4171 4.6259 The calculation of the Return on Equity of the company by applying the DuPont System is given below: ROE DuPont Method: (Net Profit Margin) x (Total Asset Turnover) x (Financial Leverage Multiplier) 2007 2006 2005 2004 2003 Net Profit Margin 12.50% 12.23% 15.00% 14.67% 14.25% Total Asset Turnover 95.97% 90.82% 92.34% 96.30% 96.08% Financial Leverage Multiplier 4.1580 4.9517 6.0618 5.4171 4.6259 ROE DuPont Method 49.89% 55.01% 83.97% 76.55% 63.36% 2. Based on the information as it appears on Exhibit 4, calculate the Return on Equity for the company’s main competitors using the same methodology as above. Give a comparative analysis of your findings. International Spirits Asia Pacific Beverages European Brands South African Distilleries Net Margin 12.5 3.1 10.24 11.63 Asset Turnover 0.96 1.14 0.94 0.46 financial leverage 4.16 4.16 4.16 4.16 ROE 49.90% 14.69% 40.02% 22.24% We have calculated the return on equity of International spirits and its competitors by using the methodology of DuPont three-step formula. We have made an assumption and have used the value of financial leverage of International Spirits in the calculation of ROE of Peer’s group as the given data was not sufficient to calculate the value of financial leverage of peer’s group. The results show that the profitability situation of our company is far better than any other company of Peer’s group. International Spirit is generating more income from its invested shareholder money. But having a look on the past on the company we see that the performance of the company has declined the major reason for that decline is that the company is now leveraging its assets more with equity whereas it was previously using more debt than equity. This shows that the cost of equity is higher as compared to the cost of the debt. The trend of asset turnover has remained almost the same with very little variations. The only company that can compete International Spirits is European Brands and has a better profitability status. The company has the best net margin ratio as the net income generated by the sales of the firm is comparatively high. The financial condition of Asia Pacific Beverages and South African Distilleries are weak as there ROE is low as compared to their competitors. 3. Using Exhibit 3, calculate the Cash Flow Coverage Ratio and the Cash Flow Long Term Debt Ratio of International Spirits Inc. and give an analysis of the cash flow situation of the company. Cash Flow Coverage Ratio Cash Flow Coverage Ratio = Operating Cash Flows / Total Debt Ratios 2007 2006 2005 2004 2003 Operating Cash Flows 2709.4 2727.8 2940.3 2970.9 2765.2 Total Debt 7872.4 8173.9 8483.3 7486.5 6935.8 Cash Flow Coverage Ratio 34.42% 33.37% 34.66% 39.68% 39.87% It is the measure of a company’s ability to make payments of interest and principals they become due. A cash flow coverage ratio with result of less than one indicates that company is going to be bankrupt soon. Investors losses trust on the firm and pull backs their investment. The condition of the company is not in a good state and needs to be attention otherwise the company will become bankrupt. Cash Flow Long Term Debt Ratio Cash Flow Long-Term Debt Ratio = Operating Cash Flows / Total long-Term Debt Ratios 2007 2006 2005 2004 2003 Operating Cash Flows 2709.4 2727.8 2940.3 2970.9 2765.2 Total Long-Term Debt 7653.5 7972.1 8278.6 7285.4 6603.2 Cash Flow Long Term Debt Ratio 35.40% 34.22% 35.52% 40.78% 41.88% The condition of the company in this regard is almost the same as in the cash flow coverage ratio. The company has taken huge amount of long term debt as compared to its cash flows in operations. The value is less than one which is a threat for the future of the firm. 4. Based on the information, as it appears on Exhibit 2 and 5, calculate each companys potential growth rate and compare with clear explanation the potential growth rate of the peers-group. Ratios Formula International Spirits Asia Pacific Beverages European Brands South African Distilleries Dividend Payout 44.35% 19.22% 24.28% 36.11% Retention Ratio = 1 - Dividend Payout 55.65% 80.78% 75.72% 63.89% ROE 49.90% 14.69% 40.02% 22.24% Growth = RR*ROE 27.77% 11.87% 30.31% 14.21% The potential growth of International Spirits and its competitors are calculated above by using dividend payout, retention ratio and the return on equity ratios. The results of potential rate show that Europeans brands have the most potential for future with International Spirits not far behind. Since the retention ratio of International Spirits is the lowest amongst competitors by which its growth rate has suffered a bit. If retention ratio or ROE is improved the potential growth of the firm will become substantial and more investors will be attracted towards the firm. But still the firm on the whole has performed well compared to its Peer’s Group competitors. Read More