Qatar Sports Equipment Limited Assessment - Case Study Example

Running Head: QATAR SPORTS EQUIPMENT LIMITED Name Course Lecturer Date Executive summary A firm may be able to use equity capital or debt capital to finance its operations and make investments. Equally, a firm can use the combination of both equity and debt to finance its operations. Actually, finance experts’ supports for the use of both equity and debt at a given ratio. Equity provides stability while debt is cheaper. A firm that uses more debt than equity is considered more geared or levered. Capital budgeting experts promote for a ratio of 70:30 equity to debt respectively. Debt is good because the interest on the debt is not taxable while the dividends to equity holders are taxable making debt to be cheaper. This report provides analysis of equity and debt for Qatar Sports Equipment Limited Company. Table of Content 1.0 Introduction 4 2.0 Purpose and Objectives 4 3.0 Option A 5 4.0 Option B 6 5.0 Option C 7 6.0 Recommendations 8 7.0 Conclusion 9 8.0 References 10 1.0 Introduction Qatar Sports Equipment Ltd (QSE) is a sports retailer company based in Qatar. QSE is a public company and it is listed in the Qatar stock exchange. It provides a wide range of sports equipments and facilities in Qatar. QSE has been experiencing rapid growth and it is anticipating even more growth with Qatar hosting the 2022 football world cup. The company is assessing and considering the benefits of paying one off special dividends to its shareholders. As such, it is considering the cheapest source of capital and the possibility of gearing up its balance sheet. This report provides analysis of the company's balance sheet the ten-year financial projection by the management in order to provide recommendations on which option to implement. 2.0 Purpose and Objectives The purpose of this report is to consider, provide and recommend the best option to the management of Qatar Sports Equipment Company. The report also purposes to provide insights in long-term financing and cost of capital for this company and hence advice the board accordingly. The objectives of the management form the objective of the report so that the researcher can provide the management with what they need. The objectives of the management are to: To continuously increase and sustain the growth of the company To increase the gearing level of the company To pay maximum dividends to the shareholders To use the cheapest source of capital Utilize the available resources efficiently to generate revenue 3.0 Option A There is no payment of dividends or repurchase of shares. Under this option, the company will not issue any dividends and therefore the earnings before interest and tax will not change. The earnings will remain the same and the earnings will be included with the retained earnings (Denis & McKeon, 2012). This will increase the equity of the company. It will reduce the gearing level of the firm as equity will increase and the company will have extra funds to use for making investments and financing its operations. As such, it will avoid borrowing funds, hence; reduce the gearing level of the firm. The company will also not incur any costs on capital. The retained earnings are internal funds generated by the company and they are the cheapest source of capital to a firm because retained earnings do not have any costs. The company will save financial resources of borrowing or raising funds. On the other side, the shareholders of the company will foregoer dividends for the period under consideration. The expense of the shareholders foregoing the dividends is the growth of the company. The company is anticipating greater rates of growth as the 2022 football world cup, which Qatar will host, is approaching. The period will coincide very well with the tournament and the company will have made good investment in both equity and supply of sports equipments to the preparation of the world cup. This will guarantee the shareholders more returns after the company establishes itself and attains high growth rate (Campello, 2006). However, the objective of Qatar Sports Equipment Ltd management is to “gear up” its balance sheet. It is considering paying special dividends and buys back some or all of its shares. As such, this option may not be the best to the management of QSE. this is because there will be no effect on the balance sheet if the company does not pay the one off special dividends and does not buy back its shares from the shareholders. This option will not “gear up” the balance sheet therefore going against the objectives of the management. As such, the option of no dividend or share repurchase is not recommendable. 4.0 Option B This option involves paying one off special dividends and repurchase of shares. The share repurchase involves buy back of 2,500,000 shares from the shareholders. Currently, the company has $2,800,000 shares trading in the market. $2,500,000 represents 833,333 shares basing it on the current price of the shares in the market. This therefore means that, if the company repurchases $2,500,000 shares, it will remain with 2,800,000 – 833,333 = 1,966,667shares only. This option will increase the gearing position of the company and therefore conform to the management’s objective to “gear up” the balance sheet. The management will buy back 30% of its shares. This is a considerable margin and it will change the equity of the company. The company will replace the share repurchase by issuing new perpetual bond at an interest rate of 6%. The six percent is the cost of the perpetual bond. The bond will be equal to the amount of share repurchase. Since the shares of the company are trading at $3 in the market, this is assumes intrinsic value of the shares and therefore the company will spend $2,500,000 on the share repurchase. The company will issue new perpetual bonds of $2,500,000 at six percent rate. The cost of this perpetual bond with therefore be 6% x $2,500,000 = $150,000 every year. If the company maintains the shares, it would spend at least 40% of its earnings as dividends to the shareholders. The 40 percent is the recommended dividends payout ratio. According to the earnings before interest and tax projections for the ten-year period, the cost of the perpetual bond is less expensive than maintaining the current proportion of equity. The remaining shareholders will enjoy an increase in the dividends payout as the earnings available after the costs of cost of the perpetual bond will increase because of the reduction in the number of shares. As such, the company will increase the payment of dividends to the shareholders. However, although the dividends will increase to the remaining shareholders, the cost of the perpetual bond is lower than the cost of equity or the amount of dividends that the shareholders will be receiving if there is no share repurchases. This issue of special dividends and repurchase of $2,500,000 shares presents the management with an option that meets its objectives. This option does not only gear up the balance sheet but it also increases the EBIT and earnings per share. It is therefore important for the management to consider this option. 5.0 Option C This option involves paying dividends and repurchase of $3,500,000 share. The $3,500,000 represents 1,166,667 shares. Therefore, if the management undertakes this option, it will buy back 1,166,667 shares from the shareholders. This represents 42% of all shares of the company. This option will increase the company leverage and the gearing position. The company will use more debt than equity to finance its operations. The company will issue a perpetual bond worth equal share repurchase amount of $3,500,000. Considering that, the company has other borrowed funds it is servicing it will use more debt. The balance sheet of the company will “gear up” and hence be in line with the objective of the company. However, it is very important to note that the debt needs to be refinancing and it has costs. These costs on the debt are mandatory and therefore the company has to pay it whether it makes profit or loss. This is unlike the equity whereby it is not mandatory for the shareholders to receive dividends when the company makes losses (Niemann & Sureth, 2005). The use of debt is more risky than the use of equity. The company must generate enough earnings to repay the debt and the costs of debt. This will be enhanced by the growth prospects that the company is anticipating especially the biggest football tournament that Qatar will host. This option is good and it meets the objectives of the management. The difference between this option and option B is that this option provides more gearing than option B. 6.0 Recommendations One of the most important objectives of Qatar Sports Equipment Ltd is to “gear up” the balance sheet. The management is considering one of the three options analyzed above to increase the gearing level of the company. All the options are good but they offer different degrees of gearing while option A does not increase gearing. The essence of gearing is to reduce the use of equity to finance the company operations and use borrowed funds to finance the operations. Among the options, the best option to implement is the third option (option C). This option increases the gearing of the balance sheet according to objectives of the management. Moreover, option C has the highest earnings per share (Bierman & Smidt, 2012). This option provides the management with the highest EPS meaning that if the management implements this option, the shareholders will get the highest returns on their investment. This option provides the cheapest capital as well. This will provide a good balance on the payment of dividends and interest expense on the borrowed funds. This will enable the company to plan its long tern future by investing in the huge investments. This option will ensure that the management has enough funds at their disposal to undertake huge projects. I recommend option C to the management (Bierman & Smidt, 2012). 7.0 Conclusion The inclusion of equity and debt in a company's balance sheet is paramount in determining the returns. Maintaining the right balance between debt and equity plays an essential part in the gearing position of a firm. This report has explored three options of increasing the gearing position of Qatar Sports Equipment Ltd. While equity capital provides stability, debt capital is cheap than equity. This is probably the reason for the QSE management to increase the gearing level of the company. The objective of the management is to “gear up” the balance sheet. After consideration of all the options provided, the researcher recommends paying one off dividends and repurchase of $3,500,000 shares to the management as the best option according to its objective of gearing up the balance sheet. This option will provide the company with the cheapest source of capital and the highest EPS and EBIT. 8.0 References Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge. Campello, M. (2006). Debt financing: Does it boost or hurt firm performance in product markets?. Journal of Financial Economics, 82(1), 135-172. Denis, D. J., & McKeon, S. B. (2012). Debt financing and financial flexibility evidence from proactive leverage increases. Review of Financial Studies, 25(6), 1897-1929. Niemann, R., & Sureth, C. (2005). Capital Budgeting with Taxes under Uncertainty and Irrevesibility. Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), 225(1), 77-95. Read More