Corporate Finance Queries

deepakkrkanodia
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Joined: Thu Aug 09, 2012 4:45 pm

Corporate Finance Queries

Postby deepakkrkanodia » Mon Oct 29, 2012 6:15 pm

Q1. Acme corp has reported the following financial ratios for the past 2 years:

net profit margin year 2010 - 14%

financial leverage 2010 - 1.3

total asset turnover 2010 - 1.1

net profit margin year 2011 - 13%

financial leverage 2011 - 1.8

total asset turnover 2011 - 0.9

Based only on these results, an analyst would most correctly conclude that the results in year 2011 compared to those in year 2010 indicate that Acme's ROE has:

A. declined in part due to lower profitability
B. increased because the company has used more debt financing
C. increased because of the improvement in asset utilization

Query: please tell how ROE is calculated in this case and how the correct answer is B.



Q2. A firm has after-tax cost of debt of 5%, a cost of equity of 9%, and earns 1% on its surplus cash. A share repurchase will increase the company's earnings per share when the repurchase is funded with:

A. debt, and the earnings yield is less than 5%
B. debt, and the company's price/earnings ratio is greater than 5%
C. surplus cash, and the repurchase price is greater than company's book value per share

Query: I assumed it will be B because if price/earnings ratio is greater than 5%, then its earnings yield (inverse of p/e) will be greater than debt.
but the correct answer is C. plz tell how company's eps will increase when repurchase price is greater than book value per share. plz give any example of it to illustrate.

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content.pristine
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Joined: Wed Apr 11, 2012 11:26 am

Re: Corporate Finance Queries

Postby content.pristine » Wed Oct 31, 2012 7:58 pm

Hi Deepak,

The ROE is calculated by the du-pont formula:
You just need to multiply the three numbers given:
NPM FL Asset TO ROE
14% 1.3 1.1 0.2002
13% 1.8 0.9 0.2106

The ROE in the second case is higher.
If you compare both row, you can see this is due to the higher financial leverage.
Hence, B is your answer.

About your second question, what is the source?
Option B is almost ALWAYS true... generally you might see P/Es around 10 or so depending on county, sector etc etc.. its not a question of 5%.
Looks wrong to me too..
What is the source of this question?

8-)

deepakkrkanodia
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Posts: 49
Joined: Thu Aug 09, 2012 4:45 pm

Re: Corporate Finance Queries

Postby deepakkrkanodia » Thu Nov 01, 2012 10:00 am

Regarding Q2 the source is kaplan schweser eoc question.

here the answer is C and the explanation for answer is given as follows:

"using the company cash to repurchase shares will increase EPS because it reduces the no of shares outstanding and the yield on surplus cash is less than firm cost of capital. whereas as repurchase funded by debt will increase EPS only if the cost of debt is less than company earnings yield (EPS/share price).



according to my understanding for above given explanation, EPS will increase in both cases whether funded by debt or surplus cash as outstanding shares gets reduce. "now plz explain the statement " repurchase shares through cash will increase EPS when yield on surplus cash is less than cost of capital and repurchase shares through debt will increase EPS when cost of debt is less than earnings yield"

content.pristine
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Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

Re: Corporate Finance Queries

Postby content.pristine » Thu Nov 01, 2012 1:34 pm

Check out LOS 39d and 39e (2012).
They have some very good examples for the same..

Let me know if there is anything more you would like me to clarify.

8-)

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shreyas
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Re: Corporate Finance Queries

Postby shreyas » Sat Nov 03, 2012 5:43 pm

The EPS will increase as we are using internal funds to repurchase the shares. The internal funds earns a return on equity which is greater than surplus cash yield, which ultimately increases EPS.


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