Corporate Finance: EBIT and EPS - Essay Example

RUNNING HEAD: Corporate Finance Corporate Finance of 11 November 2009 Part Introduction This first part of the paper seeks to do the following: (I) to explain the columns in the given table with the related scenario as stated in the case study, and from the data , this paper will establish the amount of debt, the number of shares, the amount of share and the EPS for each gearing level; to determine the EPS for each level of gearing under a bad year or good year; to construct a graph where EBIT and EPS are the axes and , using the EBIT-EPS data that will be developed, plot the data on the graph and discuss the possible ranges where lower or higher gearing may be preferred; and to determine the major problem with the use EBIT and EPS approach. This will further estimate the market value of a share for each of the capital structures using the no growth share valuation model being considered and to comment on findings; to consider which capital structure is preferred under the approach; and to contrast and explain the assumptions and theoretical approaches to capital structure taken earlier. Discussion 1. (i) Explain the columns in the above tale given the scenario stated above. From the data, establish the amount of debt, the number of shares, the amount of tax and the EPS for each gearing level show workings The first column on capital structure displays the different debt to equity ratios and each capital structure has a corresponding level of debt interest rate in the second column which increases as the debt structure becomes more highly leveraged. That the direct relationship is obvious between the debt to equity ratio and the interest rate since higher debt would mean higher risk for the debtor as few creditors would be willing to lend at rate lower than contracted earlier by the debtor. This would also mean that higher level of debt in relation to capital would require the company to pay higher interest expenses to creditors in absolute amount and would also mean higher tax shield for the borrower since interest expense is tax deductible for income tax purposes. Table 1-A Computation for amount of debt, the number of shares, and amount of tax The same direct relationship is also expected on EPS which increases directly as the debt to equity ratio is increased. Further the same inference could be made with the required return on shares. This means that the investors or stockholders would require higher return for higher level of risk because of increase in debt to equity ratio or higher financial leverage. This higher required return on investment would be the same as the cost of capital that would be used in evaluating the acceptability of projects. Those falling under the required return would be rejected and those that are at least higher than the required return would be accepted for investment and expansion purposes (Ross et. al, 1996; Weston and Brigham, 1993). The amount of debt, the number of shares, the amount of tax and EPS for each gearing level can be derived by working back and using the data provided including the total asset which was provided at $1M and the book value per share of $25 per share. From these two given data, the total stockholders’ equity could now be extracted from each gearing level. Since the total stockholders equity could be assumed to be consisting of the capital stock or common stock, the amount generated per gearing level was divided by the book value per share of $25 to get the average outstanding common share. With the computed outstanding per share, it is now possible to get earnings per share dividing net income by the outstanding common shares. However, since it was the EPS per gearing level that was given, the net income after tax would be derived figure for each gearing level. See Table 1-A. 1. (ii) If the EBIT of the company was different to the EBIT in answer (a) above and the company reported a bad year of £150,000 EBIT or a good year of £250,000 EBIT, then determine the EPS for each level of gearing under a bad year or good year. The EPS for each gearing level under a bad year or a good year will definitely vary as shown below: Table 1-B. Computation of EPS per gearing level for good year and bad year. It would appear that the EPS during good year is definitely better than during bad year. In both cases however, there is still increasing EPS in direct relation with the increasing capital structure. 1.(iii). Construct a graph where EBIT and EPS are the axes, using the EBIT-EPS data developed in part (b). Discuss the possible ranges where lower to higher gearing may be preferred. Which structure maximizes EPS? What is the major problem with the use of this approach? The graph where EBIT and EPS are the axes, using the EBIT-EPS data developed in part (ii) will appear as follows: Figure 1- A- Graph for EPS, EBIT and Capital structure The possible ranges where lower to higher gearing may be preferred would have to be based on what will maximize the EPS. Since the relationship of the capital structure is direct with EPS – that is, increasing the capital structure increases the EPS, it would appear that what would maximized the EPS is when there is no equity and every assets must be owned must be match with debt in the balance sheet of the borrower. This must be so since higher interest expense would mean higher tax savings and therefore there would more net income that would be shared by common stockholders. The major problem of the use of this approach is that it is assumed that as capital structure becomes highly leveraged the EPS increases continuous and it would mean that that the structure that would maximize EPS is when there is no equity, which would sound illogical since no can go into business without owner’s equity. 1. (IV). Using the no growth valuation model, estimate the market value of a share for each of the capital structure being considered and comment on findings. Consider which capital structure is preferred here. To use no growth model, there is the need to modify Gordon constant growth model where the expected dividend per share one year from now will be divided by the difference between required rate of return and expected growth. The simple formula therefore in getting the market value per share is just to divide the expected dividend per share one year from now divided by the required rate of return. As computed below, the market value per share for each of the capital structure was made possible using the no growth model. Table I – C- Maximizing market value It could be observed that this time the market value of the share is not necessarily and continuously directly related with high leverage structure. Among the market values, there is now the maximum market value per share which should indicate the preferred capital structure. In both bad year and good year, it was found that market value would be maximized if the debt to equity ratio is 15% for the company’s capital structure. It must be noted that dividend was not included in the case facts thus it was that the EPS would be the same as the dividend one year from now to apply the no growth model. 1.(iv). Contrast and explain the assumptions and theoretical approaches to capital structure in (iii) and (iv) above. The capital structure approach in (iii) assumes that as the company increases the debt in relation to equity, the EPS is increased indefinitely or continuous so that hence the preferred capital structure appears to come with continuously increasing debt in relation to equity while the approach. In the second approach (iv above), a maximum market value is attained and hence the preferred capital structure is not necessarily the one with the highest leverage or debt in relation to equity. The corporate structure theories are conceptualized with the view that there is such a thing as optimal capital structure. One theory argues that the source of financing (i.e. debt or equity) is not important or irrelevant relative to shareholder value as according to the Modigliani-Miller theory while another view holds that it is relevant (Brigham and Houston, 2002). The second theory argues for the need to make a financial strategy because management is assumed to have the capacity to influence shareholder value. Under this second view is the trade-off theory where there is trade-off between benefits and cost of financing by debt and equity (Brealey and Myers, 2000; Albarran, et. al, 2006). The pecking order theory is also under this second view and the theory assumes that internal sources should prioritized first over that of external sources. Internal financing argues for the use of reinvested profits over that of new equity financing from stockholders. Between debt and equity however, debt financing should be prioritized first (Peirson, 2008). As applied to (iii) and (iv) above, it can be argued that the first is for pecking order theory since debt is preferred equity financing and this would be assumed to maximize shareholder value. This was supported in (iii) because it was found that increasing the capital structure’s debt to equity ratio brings higher EPS and therefore favourable to the company. No. (iv) above would fall under trade-off theory because there is advantage and disadvantage for each gearing level. It cannot be under this theory that the financing be done first by debt always if it would result to higher risk for the business since this would require higher cost of capital. Part 2 – Answers to Questions 2.1. The approach used by the company is seriously flawed from the capital budgeting or investment appraisal perspective because it disregards the time value of money. The time value of money assumes that a $100 today is not the same as $100 in the future. This means that earlier earnings or cash flows are better than latter cash flows. To bring future values to their present value requires the use of a discount factor. The use of cost of capital in net present value analysis would only work if values to be discounted are in terms of cash flows. The cash flow could either be cash inflows or cash outflows. The first would represent the expected benefits of a certain proposal or project while the latter would refer to the costs and other cash outlays that are needed to run the project like the requirement for additional working capital. The concept of cash flows and discounting the same gives important to time value of money and to equalize therefore the values of cash which may get involved in the inflow or outflow of cash resources about a certain proposal or project, the same values are brought to their present values by discounting the same using a cost of capital as discount factor (Brigham and Houston, 2002). By not applying the time value of money the management for Alpha project may have assumed that future value is the same as present value and this makes therefore the analysis distorted. Necessarily the basis for rejection may not be correctly established. The DCF approach would be served better any companys and shareholders interest from a financial perspective because the approach considers the time value of money. To see its advantage, this paper applies this to Alpha project using net present value analysis. The discount factor of 20% would be used to get the net present value so as to compare the cost of the project as represented by the initial investment and present values of expected cash flows of the project or proposal. If the resulting net present value (NPV) is at least higher that the initial investment, it can be inferred that the project or proposal is acceptable (Atkinson, Anthony, et al, 2005; Droms, 1990; Helfert, 1994). The result would be termed as having a net positive present value. It would mean that the project or proposal is deemed to produce an effect of net advantage of accepting as against not. If the two values are equal, it would mean that there would be no difference in making or the investment with the cost of capital which could represent the opportunity cost of money to another alternative (Carroll, Thomas,1983; Samuelson and Nordhaus, 1992; Dornbusch and Fischer, 1990). Therefore if the net present value would turn out negative, it would indicate the pursuing the proposal or project would be a losing proposition or a waste of money and resources. 2.2. After reformulating the financial information provided, using the DCF approach, it was determined that Project Alphas should have been rejected still at the time by previous management. This can be seen from the discounted projected cash flow where the net present value was still a negative as shown below. Table II-A. NPV computation The use DCF requires the use of cost of capital as discount rate and this was applied in the case of Project Alpha at 20% as the same cost of capital applied for similar projects. I can be seen above that the depreciation expense was computed by dividing the cost of equipment by four years and no salvage value. Said depreciation was added to profit after tax and the case flows are discounted using Microsoft Excel for NPV computations. 2.3. Ignoring inflation necessarily affected the analysis made by not restating the data in their real values. It could not therefore be assumed safely that the increases in revenues and expenses were real ones since they were not adjusted (Ross et. al, 1996; Weston and Brigham, 1993). If sales revenues were to be inflated at 4% per annum over the next four years; materials 2% p.a. over the four years; labour and overheads 3% over the next four years, the data should be accordingly brought to their real values before discounting them. In addition to assume that the nominal required rate on capital for the new owner company will increase incrementally by 1% p.a. for each of the following four years to reflect general higher inflation on the assumption that the UK company would be moving out of recession into slow growth, would mean there is need also to adjust first the values to their real values before discounting them to present values using the discount rate of 20%. Inflation bloated the values so they must be adjusted (Van Horne, 1992; Slaving, 1996). Since the initial finding was rejection after applying DCF analysis, bring first the cash flows to their real values would further lower the values to be discounted and therefore the net present value in negative amounts would still go up and which would make the result to have more evident basis for rejection. Since the revenues are inflated higher than expenses it could be uniformly assumed that the 4% inflation could be added to the cost of capital of 20% or make the new discount factor to be 24% (Bernstein, 1993; Brigham, and Houston, 2002). If such is applied the new net present value would be negative $323.72. See Table II-A. Hence the project proposal Alpha is still not acceptable. If inflated sales are brought to real values, the yearly figures can be divided b y 1.04 Material cost will be divided by 1.02 while direct labour and overhead will be divided by 1.03. The resulting NPV after recalculation is computed at negative $340.90, which is almost very close to earlier estimate as shown in Table II-B below. Note that the 1% additional increase per year was added to the discount factor thus the net present values became lower further. Table II-B – NPV computation by including inflation It can be concluded that although the recommendation is still rejection when DCF method is used, the answer is more reliable than using the non-DCF method. To err in the use of latter method would be serious because one may not know exactly whether one is earning or not and this would be very dangerous. References: Albarran, et. al (2006). Handbook of media management and economics. Routledge Atkinson, Anthony, et al (2005). Management Accounting. New Jersey: Person Custom Publishing Bernstein, J. (1993). Financial Statement Analysis, Sydney: IRWIN Brealey and Myers (2000). Principles of corporate finance. The Irwin/McGraw-Hill Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, London: Thomson South-Western Carroll, Thomas (1983). Microeconomic Theory Concepts and Applications. New York: St. Martin Press Dornbusch, R. and Fischer, S. (1990). Macroeconomics. New York: McGraw-Hill Publishing Co, Droms (1990). 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