Assignment 3: Ratio Analysis By Tuesday, November 22, 2016 solve the problem below, calculate the ratios, interpret the results against the industry average, and fill in the table on the worksheet. Then, provide an analysis of how those results can be used by the business to improve its performance. Turn in your completed work to the M1: Assignment 3 Dropbox by Tuesday, November 22, 2016. Balance Sheet as of December 31, 2010 Gary and Company Cash $45 Accounts payables $45 Receivables 66 Notes payables 45 Inventory 159 Other current liabilities 21 Marketable securities 33 Total current liabilities $111 Total current assets $303 Net fixed assets 147 Long Term Liabilities Total Assets $450 Long-term debt 24 Total Liabilities $135 Owner’s Equity Common stock $114 Retained earnings 201 Total stockholders’ equity 315 Total liabilities and equity $450 Income Statement Year 2010 Net sales $795 Cost of goods sold 660 Gross profit 135 Selling expenses 73.5 Depreciation 12 EBIT 49.5 Interest expense 4.5 EBT 45 Taxes (40%) 18 Net income 27 1. Calculate the following ratios AND interpret the result against the industry average: Ratio Your Answer Industry Average Your Interpretation (Good-Fair-Low-Poor) Profit margin on sales 3% Return on assets 9% Receivable turnover 16X Inventory turnover 10X Fixed asset turnover 2X Total asset turnover 3X Current ratio 2X Quick ratio 1.5X Times interest earned 7X 2. Analysis: Give your interpretation of what the ratios calculations show and how the business can use this information to improve its performance. Justify all answers. Assignment 3 Grading Criteria Maximum Points Has correctly calculated the ratios. 40 Has correctly analyzed and interpreted the significance of the resulting ratios and suggested actions for improvement. 40 Wrote in a clear, concise, and organized manner; demonstrated ethical scholarship in accurate representation and attribution of sources; displayed accurate spelling, grammar, and punctuation 20 Total: 100
Ratio Analysis – Gary and Company The table below presents the ratios and their comparison against the industry average: Ratio Your Answer Industry Average Your Interpretation (Good-Fair-Low-Poor) Profit Margin on Sales 3.40% 3% Good Return on Assets 6.00% 9% Poor Receivable Turnover 12.05 times 16X Fair Inventory Turnover 4.15 times 10X Poor Fixed Asset Turnover 5.41 times 2X Good Total Asset Turnover 1.77 times 3X Poor Current Ratio 2.73 times 2X Fair Quick Ratio 1.30 times 1.5X Fair Times Interest Earned 11.00 times 7X Good (Please refer the attached excel for workings) Workings: 1. Profit Margin on Sales Net profit $27.00 Net Sales $795.00 Therefore, Profit Margin on Sales (Net profit / Sales) 3.40% 2. Return on Assets Net profit $27.00 Total Assets $450.00 Therefore, Return on Assets (Net profit / Total Assets) 6.00% 3. Receivable Turnover Net Sales Revenue $795.00 Avg Accounts Receivable $66.00 Therefore, Receivables Turnover 12.05 4. Inventory Turnover Cost of Goods Sold $660.00 Avg. Inventory $159.00 Therefore, Inventory Turnover 4.15 5. Fixed Asset Turnover Net Sales Revenue $795.00 Net Fixed Assets $147.00 Therefore, Fixed Assets Turnover 5.41 6. Total Asset Turnover Net Sales Revenue $795.00 Total Assets $450.00 Therefore, Total Assets Turnover 1.77 7. Current Ratio Total Current Assets $303.00 Total Current Liabilities $111.00 Therefore, Current Ratio 2.73 8. Quick Ratio Current Assets - Inventory $144.00 Total Current Liabilities $111.00 Therefore, Quick Ratio 1.30 9. Times Interest Earned EBIT $49.50 Interest Expenses $4.50 Therefore, Times Interest Earned 11.00 Interpretation: 1. The profit margin of the company is calculated as 3.40% which is more than the industry average of 3%, it indicates that the company has better profit margins against that majority of the competitors in the industry. The company should focus its marketing efforts to sell more of the goods at least at this margin to generate higher overall profits for the company. 2. The company’s return on Assets is at 6.00% which is lower than the industry average of 9.00%. This implies that the company is not using its assets effectively and they should target their efforts in reducing the asset cost, reducing the expenses and increasing their revenue. Though the company has higher profit margin than the average, the lower return on assets shows that it has scope to further improve the margins and ROA by targeting more sales and reducing expenses. 3. The receivables turnover of the company is at 12.05 times which indicates that the company is able to receive the credit sales from its debtors 12.05 times in a year. This is lower than the industry average of 16 times. The company should make more stringent policies for its debtors so that they pay off in time. The company can also consider reducing the credit to its customers at an optimal level so that the sales doesn’t decline and the credit sales are reduced. 4. The inventory turnover ratio of the company is calculated at 4.15 times against an industry average of 10 times. This is very poor as compared to the industry average and a gap of almost 6 times clearly shows that the company has not been able to utilize the inventory efficiently. The company should increase its sales and try and reduce the level of inventory it maintains to reduce the inventory turnover. The company’s inventory is held up in stores and not getting sold. The company should focus its marketing efforts to sell inventories at a higher pace. 5. The Fixed Asset turnover of the company is at 5.41 times which is much higher than the industry’s average of 2 times. This essentially proves that the company has been able to effectively use all of its fixed assets to generate revenues. This is a good sign! 6. The total assets turnover at 1.77 times is lower than the industry average of 3 times which proves that the company has not been able to effectively use the current assets of the company. I quote current assets as in point 5 above we have seen that the company has used its fixed assets effectively, so if the total assets turnover are lower, it implies that the current assets were not used effectively. This is further established by lower inventory turnover in point 4 above. The company should consider reducing its investment in inventory. 7. The current ratio of the company at 2.73 times is better than the industry average of 2 times. This implies that the company has enough current assets to pay off its liabilities in time and meet its current debt obligation. It is better equipped to meet the debt obligation than its competitors. 8. The quick ratio of the company at 1.30 times is lower than the industry average of 3 times. Inspite of having better current ratio the company is lagging in the quick ratio which is mainly due to the inventory holding of the company. The company can improve the ratio by reducing the investment of the inventory. 9. The times interest earned is at 11 times which is better than the industry average of 7 times. The company is generating enough revenue to pay off the interest on the debts. It is a welcoming news for the money lenders as the company will be able to pay off their interest in time. The company can consider expanding business as it will be able to raise fund easily from the market. In a nutshell, the company’s inventory is a major cause of problem and the company should direct its efforts to sell off its inventory faster, collect the receivables sooner and sell more of its products to generate higher revenues and improve other ratios.
Assignment 2: The Weighted Average Cost of Capital (You do not have to do power point, excel spreadsheets, like you have with my managerial accounting from last month, they were GREAT) Thank you, sir). By Wednesday, December 7, 2016, complete the following assignment: Coogly Company is attempting to identify its weighted average cost of capital for the coming year and has hired you to answer some questions they have about the process. They have asked you to present this information in a PowerPoint presentation to the company’s management team. The company would like for you to keep your presentation to approximately 10 slides and use the notes section in PowerPoint to clarify your point. Your presentation should address the following questions and offer a final recommendation to Coogly. Make sure you support your answers and clearly explain the advantages and disadvantages of utilizing the weighted average cost of capital methodology. Include at least one graph or chart in your presentation. Company Information The capital structure for the firm will be maintained and is now 10% preferred stock, 30% debt, and 60% new common stock. No retained earnings are available. The marginal tax rate for the firm is 40%. A. Coogly has outstanding preferred stock That pays a dividend of $4 per share and sells for $82 per share, with a floatation cost of $6 per share. What is the component cost for Coogly's preferred stock? What are the advantages and disadvantages of using preferred stock in the capital structure? B. If the company issues new common stock, it will sell for $50 per share with a floatation cost of $9 per share. The last dividend paid was $3.80 and this dividend is expected to grow at a rate of 7% for the foreseeable future. What is the cost of new equity to the firm? What are the advantages and disadvantages of issuing new equity in the capital structure? C. The company will use new bonds for any capital project, according to the capital structure. These bonds will have a market and par value of $1000, with a coupon rate of 6% and a floatation cost of 7%. The bonds will mature in 20 years and no other debt will be used for any new investments. What is the cost of new debt? What are the advantages and disadvantages of issuing new debt in the capital structure? D. Given the component costs identified above and the capital structure for the firm, what is the weighted average cost of capital for Coogly? What are the advantages and disadvantages of using this method in the capital budgeting process? Assignment 2 Grading Criteria Maximum Points Correctly calculated the cost of issuing preferred stock and explained the advantages and disadvantages of using preferred stock in the capital structure. 20 Correctly calculated the cost of issuing new equity and explained the advantages and disadvantages of issuing new equity in the capital structure. 20 Correctly calculated the cost of new debt and explained the advantages and disadvantages of issuing new debt in the capital structure. 20 Correctly calculated the weighted average cost of capital for the firm and explained the advantages and disadvantages of the using this method in the capital budgeting process. 20 Prepared an informative and accurate PowerPoint presentation which summarized the relevant and important aspects of the findings. At least one chart or graph was included and the notes section was used to clarify the talking points. 10 Written in a clear, concise, and organized manner; demonstrated ethical scholarship in accurate representation and attribution of sources; displayed accurate spelling, grammar, and punctuation. 10 Total: 100
Assignment 2: The Weighted Average Cost of Capital Answer to Question 1: We have the following information from the question: 1. Dividend per share of preferred stock = $4 2. Selling price per stock = $82 3. Floatation cost = $6 The cost of the preferred stock (Kp)can be calculated as below: The component cost for Preferred stock is 5.26%. The advantages of using preferred stock in the capital structure of the company are: • The stockholders receive fixed divided so the fixed pay-out is known. • They offer a reduced amount of risk • The preferred stock holders are not allowed to vote on company policies The disadvantages of using preferred stock in the capital structure of the company are: • The stock price does not rise in line with company’s achievements. • The interest dividends paid out by preferred stocks are not tax deductible Answer to Question 2: We have the following information from the question: 1. Last Dividend (D0) = $3.80 2. Selling price per stock = $50 3. Floatation cost = $9 4. Growth rate (g) = 7% The dividend for year 1 can be calculated as: D1= D0 +g = $3.80 +7% = $4.07 The cost of the new equity for the firm (Ke)can be calculated as below: The component cost for the equity stock is 16.92%. The advantages of using equity stock in the capital structure of the company are: • The financing through equity has no fixed payment requirements • The financing through equity do not require any collateral for raising funds. • The focus is on future earnings and increasing the value of a business rather than immediate return. The disadvantages of using equity stock in the capital structure of the company are: • For the investors, neither profits nor business growth nor dividends are guaranteed. • There are a lot of legal restrictions governing the issue and use of equity funds • Each investor has a right to the cash flow generated after all other claims are paid. Answer to Question 3: We have the following information from the question: 1. Par Value = $1,000 2. Coupon rate = 6% 3. Floatation cost = 7% 4. Years to Maturity = 20 years 5. Tax rate of the company = 40% For calculating the after-tax-cost-of-debt we will first need to calculate the yield to maturity of the bond, for which we will use the following: 1. Market Value of Debt = Par Value – Flotation Cost = $1,000 – 7% * $1,000 = $9,30 2. Par Value of Debt = $1,000 The YTM (Y’) can be calculated as below: The cost of the new debt for the firm (Kd)can be calculated as below The component cost for the debt is 3.98%. The advantages of using debt in the capital structure of the company are: • Debt financing allows us to pay the debt in instalments over a period of time. • Using debt does not relinquish any ownership or the control of the business. The disadvantages of using debt in the capital structure of the company are: • We need to repay the loan plus the interest • It is a borrowing against the future earnings of the company. Answer to Question 4: The capital structure of the company is 10% preferred stock, 30% debt, and 60% new common stock and costs of each identified component is as below: • Cost of Preferred Stock – 5.26% • Cost of Equity – 16.92% • Cost of Debt – 3.98% The weighted average cost of capital can be calculated as below: The WACC for the company is 11.87%. The advantages of using WACC for capital budgeting decisions are: • It is very simple and easy • It helps in making prompt decisions as it can be compared with the rate of return available. The disadvantages of using WACC for capital budgeting decisions are: • The assumptions of ‘No Change in Capital Structure’ is impractical • Other forms of financing including convertible or callable preference shares, debt, or stock market-linked bonds, or puttable or extendable bonds, warrants, etc are not considered, for simplicity we take only debt, equity and preference shares into consideration.
Assignment 1: LASA # 2—Capital Budgeting Techniques As a financial consultant, you have contracted with Wheel Industries to evaluate their procedures involving the evaluation of long term investment opportunities. You have agreed to provide a detailed report illustrating the use of several techniques for evaluating capital projects including the weighted average cost of capital to the firm, the anticipated cash flows for the projects, and the methods used for project selection. In addition, you have been asked to evaluate two projects, incorporating risk into the calculations. You have also agreed to provide information, with detailed explanation of your methodology, findings, and recommendations. Company Information Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%. Required: A. Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm? B. The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm? C. The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process. D. Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations. E. If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not? F. Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not? Wheel has two other possible investment opportunities, which are mutually exclusive, and independent of Investment A above. Both investments will cost $120,000 and have a life of 6 years. The after tax cash flows are expected to be the same over the six year life for both projects, and the probabilities for each year's after tax cash flow is given in the table below. Investment B Investment C Probability After Tax Cash Flow Probability After Tax Cash Flow 0.25 $20,000 0.30 $22,000 0.50 32,000 0.50 40,000 0.25 40,000 0.20 50,000 G. What is the expected value of each project’s annual after tax cash flow? Justify your answers and identify any conflicts between the IRR and the NPV and explain why these conflicts may occur. H. Assuming that the appropriate discount rate for projects of this risk level is 8%, what is the risk-adjusted NPV for each project? Which project, if either, should be selected? Justify your conclusions.
Explanation A Ke = Cost of New Equity =? D0 = Dividend = $2.50 PO =Selling Price of the Stock Today = $50 F = Floatation Percentage = 10% g = Constant Growth Rate = 6% Ke = [D1 / (PO(1 – F))] + g Ke = [$2.50*106%/($50(1-.1))] + 6% Ke = [$2.65/($50(.9))] + 6% Ke = [$2.65/$45] + 6% Ke = .058889 + 6% Ke = 5.89% + 6% = 11.89% Advantages of using common stock in the capital structure are as follows: • No fixed yearly costs associated with issuing common stock – The issuing company is not supposed to make any payment to the equity stockholders. The company may not declare dividends even if the company is in profits and declaration of dividend is the prerogative of the board of directors. The company avoids any fixed obligation and hence has better financial leverage • No operational covenants on issuance of stocks – Issuance of stocks is not subject to any covenants such as maintaining a decided working capital ratio or leverage ratio etc. This helps the management in freely conducting its operations. • No liability to repay the common stock – The company is not supposed to repay the stockholders till the winding up of the company or if the board of directors decide to buy-back the shares. Hence, the company is not under the stress of repayment of the common stock Dis-advantages of using common stock in the capital structure are as follows: • Diluting the ownership of the company – Issuing stock would mean diluting the ownership of the company. This may lead to hostile takeovers of the company. Further, if the new owners have significant stake, they may interfere in the working of the company. Issuing new shares to new shareholders would mean diluting the voting rights of existing shareholders. • Expensive source of financing – Common stockholders demand more rate of return than bond holders due to inherent security risk. If a company fails to generate the desired return, then the share price of the company may fall in the stock market leading to erossion of shareholders wealth. • Dividends paid on common stock are not tax deductible. The impact of this factor is reflected in the relatively higher cost of equity capital as compared with debt capital Explanation B Market rate of interest on debt = 5% Tax rate = 35% After tax cost of the debt = Market rate of interest on debt * (100%-Tax rate) After tax cost of the debt = 5% * (100%-35%) = 3.25% Advantages of using debt in the capital structure are as follows: • No dilution of ownership – There is no dilution of ownership upon issuance of debt as debt holders do not have voting rights. This gives a lot of security to the promoters or the management, that the company will not be subjected to hostile takeovers or if someone will interfere in the smooth functioning of the company • Interest paid are tax deductible – Debt issuance is cheaper as the interest paid are tax deductible. Further, due to inherent nature of this financing, the cost of financing is cheaper as compared to stock financing Dis-advantages of using debt in the capital structure are as follows: • Fixed yearly payments in the form of interest – Bonds carry a rate of interest which needs to be paid whether or not the company is making profits. This can lead to huge strain on the financials of the company even leading to insolvency of some companies. Management would ideally want lower financial leverage so that the company does not suffer during period of poor business performance. • Restrictive covenants on business operations – Issuance of bonds generally require pledging of collaterals and restrictions on maintaining certain business ratios such as working capital ratio, times interest earned ratio etc. If the business is not able to maintain the desired ratio, the bondholders may ask for early repayment of debt which may lead to bankruptcy of the company. Explanation C WACC = Weight of equity * Cost of equity + Weight of debt * cost of debt WACC = 70%*11.89% + 30%*3.25% = 9.30% Weighted average cost of capital is the minimum rate of return which the project should earn to justify any new investment. If the expected return from a prospective project is less than the weighted average rate of return, then that project should not be accepted and vice versa. Weighted average cost of capital is used to discount the future cash flows to its present value which is then used to calculate the Net Present Value. Investments with positive Net Present Value should be accepted and those with negative Net Present Value should be rejected. Explanation D, E, F, G, H Refer attached spreadsheet. Years Particulars 0 1 2 3 Initial investment -1500000 Additional revenues 1200000 1200000 1200000 Less - additional annual costs 600000 600000 600000 Less - depreciation 500000 500000 500000 Earnings before tax 100000 100000 100000 Less - taxes @ 35% 35000 35000 35000 Earnings after tax 65000 65000 65000 Add - depreciation being a non cash item 500000 500000 500000 Net cash flows -1500000 565000 565000 565000 Notes Initial investment is a cash outflow and hence is shown as a negative amount Additional costs and depreciation has been deducted from additional revenues to arrive at earnings before tax Taxes has been deducted Then depreciation has been added back on account of it being a non-cash item The method used to calculate the after tax flow is basically called Discounted Cash Flow method. Years Particulars 0 1 2 3 Initial investment -1500000 Additional revenues 1200000 1200000 1200000 Less - additional annual costs 600000 600000 600000 Less - depreciation 500000 500000 500000 Earnings before tax 100000 100000 100000 Less - taxes @ 35% 35000 35000 35000 Earnings after tax 65000 65000 65000 Add - depreciation being a non cash item 500000 500000 500000 Net cash flows -1500000 565000 565000 565000 Net Present Value 10,252 This project is economically acceptable project to undertake as the company is earning more than 6% which is the required discount rate for this project. This means that the company is earning more than the shareholders's expectations and hence will add value to shareholders wealth Particulars 0 1 2 3 Initial investment -1500000 Additional revenues 1200000 1200000 1200000 Less - additional annual costs 600000 600000 600000 Less - depreciation 500000 500000 500000 Earnings before tax 100000 100000 100000 Less - taxes @ 35% 35000 35000 35000 Earnings after tax 65000 65000 65000 Add - depreciation being a non cash item 500000 500000 500000 Net cash flows -1500000 565000 565000 565000 Internal rate of return 6.37% The project should be accepted as the company is earning actual rate of return of 6.37% which is higher than the desired discount rate of 6% When compared to the WACC of 9.30%, this project should not be accepted as the project is generating 6.37% return as compared to desired return of 9.30%