Analysis of Qatar Sports Equipment That Is Evaluating Its Capital Structure - Case Study Example

Executive summary The report presents an analysis of Qatar Sports Equipment that is evaluating its capital structure. The company is analyzing whether it should repurchase its shares and issue bonds instead of these shares. The report therefore analyzes the EBIT EPS analysis of different situations available to the company. Cost of capital at these situations is also calculated. The report analyzes the EBIT EPS if EBIT of the company is increased or decreased by 25%. At the end, the report provides conclusion and recommendations. Introduction Qatar Sports Equipment Ltd is the Qatar sports retailer. The company has been growing with the passage of time because of number of reasons. One of the main reasons is the Football World Cup to be held in Qatar in the year 2022. As the time is passing by, the popularity of Football in the country is growing and there is a greater anticipation of Football in the country. With this growing popularity of the game, Qatar Sports Equipment Ltd is also able to capitalize and grow. The company is currently analyzing the decision to pay0off its shareholders special dividends. Moreover, the Qatar Sports Equipment Ltd (QSE) Board is also not sure how to raise funds for the future to manage the long-term capital needs. The Qatar Sports Equipment Ltd Board wants to reduce the cost of capital and at the same time increase the returns for the shareholders. Inclusion of debt in the capital structure of the company is critical. Inclusion of debt increases the risk of the company. However, this inclusion also helps the company to maximize the earnings of the shareholders. Therefore it is important for the management to identify the right balance between the debt and equity so that it is able to maximize the earnings as well as manage the risk of the company. Debt also helps the company to take advantage from the leverage as it maximizes the earnings of the company by increasing the fixed cost. This report analyzes the situation of the company, Qatar Sports Equipment Ltd and how the company should raise additional debt. There are three scenarios discussed in this report and the impact of each scenario has been analyzed on the earnings of the company and its cost of capital. The three scenarios that the company has are: a. To use the same capital structure for long-term capital needs and financing b. To buy back shares worth $2,500,000 from a bond at an interest rate of 6% c. To buy back shares worth $3,500,000 from a bond at an interest rate of 6% Adding another bond would increase the debt of the company and it would allow the company to take advantage of leverage. However, the company already has bonds and bank loan in its capital structure and therefore it is critical that the company does not add too much of debt in its capital structure. Purpose and objectives Qatar Sports Equipment is looking to maximize its earnings of the shareholders and at the same time the management is planning to reduce its cost of capital. Therefore, the objective of this report is to identify which strategy is most suitable for the company; whether the company should use the same strategy and do not repurchase its shares by increase debt, or the company should raise additional debt in the form of bonds at 6% interest rate and use this bond is used to repurchase the outstanding shares. There are two options for the company in repurchasing shares; the company can either repurchase shares worth $2,500,000 or $3,500,000. The total number of outstanding shares would be reduced at the market price per share which is $3. The objective and purpose of this report is to recommend Qatar Sports Equipment which strategy would be most beneficial in reducing the cost of capital and in increasing the wealth of the shareholders equity. The risk factor of increasing the debt is analyzed and for this purpose, an analysis of EBIT to EPS has been made for the three scenarios. Analysis Analysis section has been divided into three parts. The first part of the analysis section analyzes the discussed scenarios. These scenarios are then compared using the EBIT and EPS analysis. After the EBIT/ EPS analysis, the second part of the analysis calculates and analyzes the cost of capital of each of these scenarios. The third part of the analysis estimates and analyzes the situation if EBIT is higher or lower than 25%. PART I: EBIT / EPS Analysis Scenario 1: if the company uses the same strategy If the company uses the same strategy and do not repurchase its shares for additional debt, then the Earnings per share of the company would be as presented in the table below: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total number of share 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 2,800,000 Total value of share capital 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 7,100,000.00 Value of share 2.54 2.54 2.54 2.54 2.54 2.54 2.54 2.54 2.54 2.54 EPS 0.02893 0.04163 0.05494 0.06890 0.08354 0.08572 0.08773 0.08953 0.09112 0.09247 Earnings per share of the company is showing an increasing trend. Forecasted income statement and balance sheet of the company with this strategy of not repurchasing its shares have been presented in the appendix section. Earnings before interest and taxes (EBIT) of the company using this strategy is presented in the table below: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 EBIT $ 360,000.00 $ 399,500.00 $ 440,925.00 $ 484,362.35 $ 529,903.20 $ 536,697.63 $ 542,923.79 $ 548,533.74 $ 553,476.88 $ 557,699.80 EBIT of the company is also showing an increasing trend. As EBIT does not include the interest expense therefore adding more debt would not influence the EBIT of the company. However the Net Profit and Earnings before tax and after interest would be influenced. Therefore, for the other two scenarios, EBIT would remain the same. Scenario 2: If the company repurchases shares worth $2,500,000 The other scenario is that the company pays the special dividend of $200,000 to its shareholders and repurchases shares worth $2,500,000 from bond at an interest rate of 6%. In this scenario, the expected EPS of the company would be as presented in the tables: Trading price of share $3 Outstanding shares 2,800,000 Buying back shares worth $2,500,000 Shares to be repurchased 833333 New shares 1,966,667 Earnings per share: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 EPS -0.031 -0.002 0.028 0.060 0.084 0.097 0.110 0.123 0.137 0.152 EPS of the company was negative in the year 1 and year 2. However with the passage of time, as the company was able to cover its additional fixed cost of interest for the new bonds of $2,500,000, the company has been able to grow its EPS. Projected income statement and balance sheet have been attached in the appendix section. Scenario 3: If the company repurchases shares worth $3,500,000 In the third scenario, the company plans to repurchase shares worth $3,500,000 and pay a special dividend of $200,000. EPS of the company if the management decides to repurchase shares worth $3,500,000 with additional debt would be: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 EPS -0.073 -0.039 -0.003 0.035 0.068 0.083 0.099 0.116 0.132 0.150 EPS of the company is negative for the first three years. From then on, EPS is showing an increasing trend. EPS of third scenario is negative for a higher period than the second scenario as additional debt of $3,500,000 has increased the interest payment significantly. Projected income statement and balance sheet are attached in the appendix for scenario 3. EBIT/ EPS analysis EBIT EPS analysis is helpful to identify at what point of EBIT, the management should raise additional capital. Therefore this analysis would be critical in identifying which situation or scenario would be better for Qatar Sports Equipment. EBIT EPS of the company for three scenarios is presented in the table below: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 EBIT $ 360,000.00 $ 416,000.00 $ 475,046.00 $ 537,283.34 $ 602,863.86 $ 631,001.16 $ 659,939.82 $ 689,701.45 $ 720,308.17 $ 751,782.67 Without additional Debt $ 0.029 $ 0.047 $ 0.066 $ 0.086 $ 0.107 $ 0.116 $ 0.125 $ 0.135 $ 0.145 $ 0.155 With additional debt of $2.5M $ (0.031) $ (0.002) $ 0.028 $ 0.060 $ 0.084 $ 0.097 $ 0.110 $ 0.123 $ 0.137 $ 0.152 With additional debt of $3.5M $ (0.073) $ (0.039) $ (0.003) $ 0.035 $ 0.068 $ 0.083 $ 0.099 $ 0.116 $ 0.132 $ 0.150 EBIT EPS of these three scenarios have also been presented graphically below: The above graph reveals that EBIT of the first scenario when the company does not repurchase shares and does not raise additional bonds is above significantly in comparison to the other two scenarios. This shows that at this point it is better for the company to not raise additional debt. However as the EBIT of the company increases, the gap between three scenarios reduces. With increase in EBIT, the company is in a better position to pay its additional debt and therefore the gap is reducing. Moreover, with higher income, the management would be able to achieve a higher EPS and therefore the EPS of these scenarios are also increasing with the increase in EBIT. The gap between these three situations gets very close to each other with increase in EBIT. Indifference point is the EBIT where the EPS of two or more situations become equal. So to have a better analysis and a closer look at the EBIT EPS of the company for these three scenarios, another graph has been prepared for the last two years. The following graph would help in magnifying the results for these three scenarios and it would help in making a better decision. This closer graph reveals that EPS of the company would be higher if the company does not raise any additional debt. So, even if the EBIT of the company increases by $751,782 still the company should not raise additional debt because it would increase the risk of the company and at the same time it would not help in increasing the wealth of the shareholders or EPS. So, from the above EBIT EPS analysis it can be concluded that the management should not raise additional debt as it would not help in increasing the EPS. PART 2: Cost of Capital Cost of capital is the average weighted cost of the funds raised by the company. It is also the minimum required rate of return that the investors would like to achieve from the investment. Cost of capital is calculated using the WACC formula which is as follows: Cost of capital for three scenarios would be different. Scenario 1: Cost of capital Value Rate Cost Bank loan $ 2,000,000.00 5.50% 0.18018018 0.99% Bond $ 2,000,000.00 8% 0.18018018 1.44% Equity $ 7,100,000.00 2.82% 0.63963964 1.80% Total $ 11,100,000.00 4.23% The cost of capital is 4.23% if the company does not raise any additional debt. Scenario 2: Cost of capital Value Rate Cost Bank loan $ 2,000,000.00 5.50% 0.18018018 0.00990991 Bond $ 2,000,000.00 8.00% 0.18018018 0.014414414 New Bonds $ 2,500,000 6% 0.225225225 0.013513514 Equity $ 4,600,000.00 4.35% 0.414414414 0.018018018 Total $ 11,100,000.00 5.59% So, the cost of capital would increase to 5.59% at this situation. Scenario 3: Cost of capital Value Rate Cost Bank loan 2,000,000.00 0.055 0.180 0.991% Bond 2,000,000.00 0.080 0.180 1.441% New Bonds 3500000 0.060 0.315 1.892% Equity 3600000 0.056 0.324 1.802% Total $ 11,100,000.00 6.126% The cost of capital for the third scenario would be 6.126% if the company raises bond of $3,500,000. As the cost of capital of the first scenario is lowest therefore the management should not raise additional debt and should not repurchase its shares. PART 3: EBIT higher and lower by 25% Increase and decrease in EBIT could influence the EPS of the company and therefore it could also influence the decision of the management of whether to raise additional bonds or not and whether to repurchase shares or not. Therefore, if the EBIT of the company in all three scenarios increases by 25% then its impact on the EBIT EPS analysis is compared. Similarly, the impact if EBIT is lowered by 25% then how much impact it would make to the EPS of the company. If EBIT is increased by 25%: EBIT higher by 25% 450,000 520,000 593,808 671,604 753,580 788,751 824,925 862,127 900,385 939,728 EPS without additional debt 0.058 0.080 0.104 0.129 0.155 0.167 0.178 0.190 0.203 0.215 EPS with $2,500,000 additional debt $ 0.014 $ 0.046 $ 0.080 $ 0.115 $ 0.153 $ 0.169 $ 0.185 $ 0.202 $ 0.220 $ 0.238 EPS with $3,500,000 additional debt $ (0.018) $ 0.022 $ 0.063 $ 0.106 $ 0.151 $ 0.170 $ 0.190 $ 0.211 $ 0.232 $ 0.253 If EBIT is increased by 25%, then EPS of the company will increase. The following graph shows the analysis graphically: Initially when the EBIT is low, the advantage is without raising additional debt. However in the mid, there is an indifference point approximately when EBIT is 753,580 where EPS of these scenarios is almost the same. As EBIT further increases from this point, advantage is with raising additional debt of $3,500,000. Therefore it shows that if the earnings increase then the company should raise additional debt as it would be beneficial for the shareholders in the long run. If EBIT is decreased by 25%: If EBIT is reduced by 25% then the following figures are expected for the three scenarios: EBIT lower by 25% $ 270,000.00 $ 312,000.00 $ 356,284.50 $ 402,962.51 $ 452,147.90 $ 473,250.87 $ 494,954.86 $ 517,276.08 $ 540,231.13 $ 563,837.00 EPS without additional debt 0.0 0.017 0.034 0.052 0.072 0.080 0.088 0.097 0.106 0.115 EPS with $2,500,000 additional debt $ (0.08) $ (0.05) $ (0.03) $ (0.01) $ 0.01 $ 0.03 $ 0.04 $ 0.05 $ 0.07 $ 0.08 EPS with $3,500,000 additional debt $ (0.13) $ (0.10) $ (0.08) $ (0.04) $ (0.02) $ (0.00) $ 0.01 $ 0.02 $ 0.03 $ 0.05 Analysis is presented graphically below: If EBIT is lowered by 25% then the company should not raise additional debt because it would not be beneficial and it would result in reducing the EPS of the company. Conclusion The report presents the analysis of whether Qatar Sports Equipment should raise additional debt or not and whether it should repurchase shares. The analysis reveals that the company should not repurchase its shares and should continue the same capital structure as it would not result in increasing EPS. Moreover, increasing debt would result in increasing the cost of capital, therefore it is recommended to not raise additional debt. However if EBIT increases by 25% then it is worthwhile to repurchase shares and issue bond of $3,500,000. Recommendations Increase in debt results in increasing the risk of the company. Although it maximizes the shareholders’ wealth however the current situation of the company does not allow Qatar Sports Equipment to raise additional debt because it would result in reducing the EPS. The company can only raise additional debt if EBIT of the company is increased by 25%. However at this current situation, increasing of debt would result in further increasing the risk. Therefore it is recommended to not raise additional debt. Read More