(Question 4 is composed of two parts.) The DuPont formula defines the net return on shareholders’ equity as a function of the following components:
- Operating margin
- Asset turnover
- Interest burden
- Financial leverage
- Income tax rate
Using only the data in the table shown below:
- Calculate eachof the five components listed above for 2010 and 2014, and calculate the return on equity (ROE) for 2010 and 2014, using all of the five components. Show calculations.
- Briefly discuss the impact of the changes in asset turnover andfinancial leverage on the change in ROE from 2010 to 2014
INCOME STATEMENT DATA 2010 2014
Revenues $542 $979
Operating income 38 76
Depreciation and amortization 3 9
Interest expense 3 0
Pretax income 32 67
Income taxes 13 37
Net income after tax 19 30
BALANCE SHEET DATA 2010 2014
Fixed assets $41 $70
Total assets 245 291
Working capital 123 157
Total debt 16 0
Total shareholders’ equity 159 220
David Wright, CFA, an analyst with Blue River Investments, is considering buying a Montrose Cable Company corporate bond. He has collected the following balance sheet and income statement information for Montrose as shown in Exhibit 10.10. He has also calculated the three ratios shown in Exhibit 10.11, which indicate that the bond is currently rated “A” according to the firm’s internal bond-rating criteria shown in Exhibit 10.13. Wright has decided to consider some off-balance-sheet items in his credit analysis, as shown in Exhibit 10.12. Specifically, Wright wishes to evaluate the impact of each of the off-balance-sheet items on each of the ratios found in Exhibit 10.11.
- Calculate the combined effect of the threeoff-balance-sheet items in Exhibit 10.12on each of the following three financial ratios shown in Exhibit 10.11.
iii.Current assets/current liabilities
The bond is currently trading at a credit premium of 55 basis points. Using the internal bond-rating criteria in Exhibit 10.13, Wright wants to evaluate whether or not the credit yield premium incorporates the effect of the off-balance-sheet items.
b.State and justify whether or not the current credit yield premium compensates Wright for the credit risk of the bond based on the internal bond-rating criteria found in Exhibit 10.13.
EXHIBIT 10.10 MONTROSE CABLE COMPANY YEAR ENDED MARCH 31, 2011
Current assets $4,735
Fixed assets 43,225
Total assets $47,960
Current liabilities $4,500
Long-term debt 10,000
Total liabilities $14,500
Shareholders’ equity 33,460
Total liabilities & shareholders’ equity $47,960
Operating & administrative expenses 14,050
Operating income 4,450
Depreciation & amortization 1,675
Interest expense 942
Income before income taxes $1,833
Net income $1,192
EXHIBIT 10.11 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 U.S. Treasuries 55 basis points
EXHIBIT 10.12 MONTROSE OFF-BALANCE-SHEET ITEMS
- Montrose has guaranteed the long-term debt (principal only) of an unconsolidated affiliate. This obligation has a present value of $995,000.
- Montrose has sold $500,000 of accounts receivable with recourse at a yield of 8 percent.
- Montrose is a lessee in a new noncancelable 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.
EXHIBIT 10.13 BLUE RIVER INVESTMENTS: INTERNAL BOND-RATING CRITERIA AND CREDIT YIELD PREMIUM DATA
|Bond Rating||Interest Coverage (EBITDA/interest expense||Leverage (long-term debt/equity)||Current Ratio (current assets/current liabilities||Credit Yield Premium over US Treasuries (in basis points)|
|5.00 to 6.00
4.00 to 5.00
3.00 to 4.00
2.00 to 3.00
|0.25 to .30
0.30 to 0.40
0.40 to 0.50
0.50 to 0.60
|1.15 to 1.25
1.00 to 1.15
0.90 to 1.00
0.75 to 0.90
Over the long run, you expect dividends for BBC in Problem 4 to grow at 8 percent and you require 11 percent on the stock. Using the infinite period DDM, how much would you pay for this stock?
The Shamrock Dogfood Company (SDC) has consistently paid out 40 percent of its earnings in dividends. The company’s return on equity is 16 percent. What would you estimate as its dividend growth rate?
What P/E ratio would you apply if you learned that SDC had decided to increase its payout to 50 percent? (Hint: This change in payout has multiple effects.)