Factors Affecting Financial Statement by wwm18296

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									Chapter 11: Debt and Equity.

========================================================================
 INTRODUCTION
==================

 The basic background data and key decision variables for this topic are summarized in
 Screens 3 through 5. Screen #3 contains the initial income statement and balance
 sheet, as well as the relevant industry financial ratios that provide industry standards.
 Screen #4 presents the initial values of the key decision variables involved in financing
 decisions. These data are used to analyze the key factors affecting financial
 decisions, as summarized in Screen #5. These are four risk factors: (1) financial
 structure; (2) fixed charge coverage ratio; (3) cash flow coverage data; and (4) the
 level of beta. The other key measures for evaluating alternative forms of financing
 consist of two measures of relative costs: (1) effects on the cost of capital; and (2)
 effects on market value per share of common stock.



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=====================================================================
 QUESTIONS
==================
1) Given the initial values of the decision variables, we analyze the effects on the six valuation
   factors (the four measures of risk and the two measures of cost). This will be done in five
   subsections of each question.

    a) How does the firm compare with the industry standards under the debt versus equity
       financing alternative?

    b) How does the firm perform in relation to the industry standard with regard to the
       coverage ratio under the two financing alternatives?

    c) Evaluate the performance of the firm in relation to the industry standard for cash flow
       coverage under the two financing alternatives.

    d) How is the level of beta affected by the two alternative forms of financing?

    e) Under what financing alternative is the firm's weighted cost of capital lower? Market
       price per share higher?

2) Suppose the cost of debt is .10 and the cost of equity is .15 under both financing
   alternatives. Go to Screen #5 (Summary of Key Quantitative Factors) and determine
   whether the effects on financial risk are consistent with the indicated effects on costs. To
   see how summary measures of risk and cost are calculated, see Screen #6.

3) Suppose the tax rate is 30% rather than 40%, answer subquestions a through e in
   Question 1.

4) You can now vary the amounts of capital to be raised and your assumptions about how the
   choice of debt vs. equity financing will affect the respective costs of debt and equity to see
   the effects on the cost of capital and the value of common per share.



=====================================================================




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=======================================================================
 BALANCE SHEET ($ MILLION)
===============================
 ASSETS                          LIABILITIES
Total current assets   $1,000   Notes payable                      $300
Net fixed assets         $800   Other current liabilities          $400
                                                             ——————
                                  Total current liabilities        $700
                                Long-term debt (*)                 $300
                                                             ——————
                                  Total debt                     $1,000

                                           Common stock, par value $1                $100
                                           Paid-in capital                           $300
                                           Retained earnings                         $400
                       ——————                                                  ——————
Total assets               $1,800           Total claims on assets                 $1,800
                       ==========                                              ==========

                                          $20
(*) Current annual sinking fund payments are million

=======================================================================
  INCOME STATEMENT ($ MILLION)
=========================================

                          Total revenues                                 $3,000
                          Depreciation expense                             $200
                          Other costs                                    $2,484
                                                                      ——————
                          Net operating income                             $316
                          Interest expense                                  $60
                                                                      ——————
                            Net income before taxes                        $256
                          Income taxes @ 40%                               $102
                                                                      ——————
                            Net income                                     $154

=======================================================================
INDUSTRY FINANCIAL RATIOS
===========================

           Current ratio:                                    2.0     times
           Sales to total assets:                            1.6     times
           Current debt to total assets:                     30%
           Long-term debt to net worth:                      40%
           Total debt to total assets:                       50%
           Coverage of fixed charges:                          7     times
           Cash flow coverage:                                 3     times
           Net income to sales:                               5%
           Return on total assets:                            9%
           Net income to net worth:                          13%

=======================================================================



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==================================================================
DECISION VARIABLES
=====================                 Funds raised  Funds raised
                           Current      with debt    with equity

Cost of debt                                   10%                    12%                     10%
Cost of equity                                 14%                    16%                     12%

-----------------------------------------------------------------------------------------------------------------
Price of new equity                                                           $9 per share
Outstanding shares of stock                                                 100 million
Tax rate                                                                    40%
Dividend payout rate                                                        30%

Amount of capital needed                                                  $200     million
Increased net operating income due to expansion                            $44     million
Increased depreciation expenses due to expansion                           $20     million
Increase in sinking fund due to debt increase                              $20     million

Risk-free rate of return                     6%
Expected market return                      11%
==================================================================




                                                                        bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls
===========================================================================
 SUMMARY OF KEY QUANTITATIVE FACTORS
=========================================
                                                   PRO FORMA

A. RISK FACTORS                                              Debt     Equity
1. Financial Structure                            Present Financing Financing Industry

      Current debt/net worth ratio                  39%         35%       35%      30%
      Total debt/net worth ratio                    56%         60%       50%      50%

2. Fixed charge coverage ratio                      5.27        4.00     6.00      7.00
3. Cash flow coverage ratio                         4.69        3.05     5.27      3.00
4. Level of beta                                    1.60        2.00     1.20

B. RELATIVE COSTS

1. Effects on cost of capital                       11.2%     12.1%     10.3%
2. Effects on market value per share of common stock#####     #####     #####

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                                                           bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls
==========================================================================
A.1. FINANCIAL STRUCTURE
==============================
                                              Pro forma             Industry
                     Present           Debt              Equity     Standard
                 Amount   Percent Amount Percent     Amount Percent  Percent

Current debt         $700     39%      $700     35%         $700     35%        30%
Long-term debt       $300     17%      $500     25%         $300     15%        20%
                  ————      ————    ————      ————       ————      ————       ————
 Total debt        $1,000     56%    $1,200     60%       $1,000     50%        50%

Equity               $800     44%      $800     40%       $1,000     50%
                  ————      ————    ————      ————       ————      ————       ————
 Total assets      $1,800    100%    $2,000    100%       $2,000    100%

Long-term debt
to net worth                  38%               63%                    30%        40%




==========================================================================
A.2. FIXED CHARGE COVERAGE
==============================
                                             Pro forma     Industry
                                 Present   Debt     Equity Standard



 Net operating income                 $316     $360         $360

 Interest expenses
 (From "Calculation of                 $60      $90          $60
  Debt Interest")

 Coverage ratio                        5.27     4.00        6.00       7.00




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==========================================================================
A.3. CASH FLOW COVERAGE
==============================
                                             Pro forma     Industry
                                 Present   Debt     Equity Standard

 Net operating income                        $316     $360       $360
 Depreciation expense                        $200     $220       $220
                                            ————     ————       ————
   Cash inflow                               $516     $580       $580

 Interest expense                              $60      $90        $60
 Sinking fund payments                         $20      $40        $20
 Before-tax sinking fund payments              $50    $100         $50
                                            ————     ————       ————
 Cash outflow requirements                   $110     $190       $110
 Cash flow coverage ratio                     4.69     3.05       5.27        3.00




==========================================================================
A.4. LEVEL OF BETA
===============================

         k s = RF + ( RM - RF ) Beta

Present level of Beta

      0.14 =            0.06   + ( 0.11 –     0.06 ) * Beta   ==>            Beta    =   1.60

New Beta with debt financing

      0.16 =            0.06   + ( 0.11 –     0.06 ) * Beta   ==>            Beta    =   2.00

New Beta with equity financing

      0.12 =            0.06   + ( 0.11 –     0.06 ) * Beta   ==>            Beta    =   1.20

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===========================================================================
B.1. EFFECTS ON COST OF CAPITAL
====================================

A. Total Market Value                     No             Expansion         Expansion
                                       Expansion          with debt        with equity

 Market value of equity                 $1,097             $1,013            $1,500
 Amount of debt                           $600               $800              $600
                                       ————               ————              ————
   Value of the firm                    $1,697             $1,813            $2,100


B. Leverage Ratios                        No             Expansion         Expansion
                                       Expansion          with debt        with equity

 Total debt                               $600               $800              $600
 Market value of the firm               $1,697             $1,813            $2,100
 Debt to value ratio                       0.35               0.44              0.29


C. Weighted Average Cost of Capital

        (    kb        )(   1-T   )(     B/V       )+(       kS       )(      S/V        )

   No expansion

        (   0.10       )(   0.6   )(     0.35      )+(      0.14      )(      0.65       ) =   11.2%

   Expansion with debt

        (   0.12       )(   0.6   )(     0.44      )+(      0.16      )(      0.56       ) =   12.1%

   Expansion with equity

        (   0.10       )(   0.6   )(     0.29      )+(      0.12      )(      0.71       ) =   10.3%
===========================================================================
B.2. EFFECTS ON MARKET VALUE PER SHARE OF COMMON STOCK
=======================================================

A. Calculation of Debt Interest
                                                    Expansion       Expansion
                                  No expansion       with debt      with equity
                                  Amount Rate      Amount Rate     Amount Rate
 $300 million
  short term notes payable          $30     ####    $36     ####     $30     ####

 $300 million
  existing long-term debt           $30     ####    $30     ####     $30     ####

 $200 million
  new long-term debt                                $24 ####
                                  ————             ————      ————
  Total interest expense           $60              $90       $60


B. Income Statement

                                                   Expansion       Expansion
                                  No expansion     with debt       with equity

  Net operating income             $316             $360            $360
  Interest expense                  $60              $90             $60
                                  ————             ————            ————
  Net income before taxes          $256             $270            $300
  Income taxes                     $102             $108            $120
                                  ————             ————            ————
  Net income                       $154             $162            $180


C. Market Value of Equity

                                                   Expansion       Expansion
                                  No expansion     with debt       with equity

  Net income                         $154            $162            $180
  Cost of equity                      14%             16%             12%
  Value of equity                  $1,097          $1,013          $1,500
  Number of shares                    100             100           122.2
  Price per share                  $10.97          $10.13          $12.27

===========================================================================
                   MARKET VALUE PER SHARE OF COMMON STOCK




$14.00


                                                                                 $12.27
$12.00
         $10.97

                                      $10.13
$10.00




 $8.00




 $6.00




 $4.00




 $2.00




 $0.00
         Present                     Financing                                 Financing




                                                            bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls
                                        FINANCIAL STRUCTURE RATIOS

100%


90%


80%


70%

                                                                                    60%
60%
                                                                          56%

                                                                                                 50%           50%
50%


       39%
40%
                35%          35%
                                            30%
30%


20%


10%


 0%
             Current debt/net worth ratio                                         Total debt/net worth ratio

                                             Present   Debt   Equity   Industry




                                                                                       bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls
                                                       COVERAGE RATIOS
         10.00


          9.00


          8.00

                                                      7.00
          7.00

                                         6.00
          6.00
                 5.27                                                                                       5.27
Ratios




          5.00                                                                     4.69

                             4.00
          4.00

                                                                                                3.05                    3.00
          3.00


          2.00


          1.00


          0.00
                        Fixed charge coverage ratio                                          Cash flow coverage ratio

                                                        Present   Debt   Equity   Industry




                                                                                                   bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls
                  COST OF CAPITAL

16.0%



14.0%


                         12.1%
12.0%
        11.2%

                                                         10.3%
10.0%



8.0%



6.0%



4.0%



2.0%



0.0%
        Present         Financing                      Financing




                                    bc2f1e84-78ff-413e-9a30-2894d8dbf2b4.xls

								
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