CHARTERED INSTITUTE OF STOCKBROKERS September 2018 Specialised Certification Examination Paper 2.5 Equities Dealing 2
Question 2 - Equity Valuation and Analysis 2a) An analyst gathered the following data: An earnings retention rate of 40%. An ROE of 12%. The stock's beta is 1.2. The nominal risk free rate is 6%. The expected market return is 11%. Assuming next year's earnings will be 4 per share, what is the intrinsic value of the stock? 2b) List and discuss two reasons why the P/E ratios of two companies operating in the same industry may differ. 2c) A negative Economic Value Added (EVA) for the year implies that the firm has not earned enough during the year to cover its cost of capital, and the value of the firm has declined. Do you agree with this statement? Briefly justify. 2d) The price/earnings ratio, or multiplier approach, may be used for stock valuation. Explain this process and describe the variant of the "multiplier" that would give the best result. (Total 12 marks) Solution to 2a) Dividend payout ratio = 1 earnings retention rate = 1 0.4 = 0.6 K E = R f + β(r M R f ) = 0.06 + 1.2(0.11 0.06) = 0.12 g = (retention rate)(roe) = (0.4)(0.12) = 0.048 D 1 = E 1 payout ratio = 4.00 0.60 = 2.40 Price = D 1 /(k g) = 2.40/(0.12 0.048) = 33.32 (Total2a: 3 marks) Solution to 2b) P/E ratios may differ for a number of reasons: i) Payout ratio In the P/E ratio calculation formula the payout ratio is in the numerator. As the payout ratio increases, the P/E ratio increases. ii) Risk The higher the risk associated with a stock, everything else being equal, the greater the required return, K E. The required return is in the denominator of the P/E ratio. Therefore, the higher the required rate of return, the lower the P/E ratio. [Note that being in the same industry does not necessarily mean the same risk as there could be differences in operating leverage (affecting asset beta) and financial leverage (affecting equity beta)]. iii) Growth rate Expected growth rate in earnings affects the denominator in the P/E. The higher the growth rate in earnings, the smaller the denominator ( ) (and the larger the numerator for P o /PI calculation), and therefore, the higher the P/E ratio. (1½ for any 2points mentioned) 3
Solution to 2c) Economic value added (EVA) is an internal management performance measure that compares net operating profit to the total cost of capital. The formula for EVA is: EVA = Net Operating Profit After Tax - (Capital Invested x WACC) EVA implies that businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating net income. Economic value added asserts that businesses should create returns at a rate above their cost of capital. Example: A Company has the following components to use in the EVA formula: Net operating profit after tax, NOPAT = N2,500,000 Capital Investment = N30,000,000 WACC = 10% EVA = N2,500,000 - (N30,000,000 x 0.10) = -N500,000 A negative number as above, indicates that the project did not make enough profit to cover the cost of doing business. (Total marks 2c: 3 marks) Solution to 2d) The P/E ratio is sometimes referred to as the multiple. In using the P/E ratio approach to value stock the following approach is taken: i) The earnings per share of the company to be valued is determined. ii) The P/E ratio of a company considered similar to it (or it s peers) is determined. Lets assume similar companies have a P/E ratio of 10 iii) The company s value is determined by multiplying the EPS by the P/E ratio i.e. P/E X EPS The price earnings ratio used for stock valuation should be the predicted price/earnings ratio. That is, the ratio of the current price of the stock divided by the expected earnings per share for the coming year. Thus, the ratio is the stock price as a percentage of expected earnings. All valuation models should be based on what the investor is expecting to receive in the coming period, not upon what past investors have received. Such a forecasted price/earnings ratio is published in Value Line. Question 3 - Corporate Finance A capital investment project has the following estimated cash flows and present values: Year Cash flow Discount factor Present value @ 12% 0 Initial investment (200,000) 1.0 (200,000) 1-5 Contribution per annum 108,000 3.605 389,340 1 5 Fixed costs per annum (30,000) 3.605 (108,150) 5 Residual value 30,000 0.567 17,010 Required: Calculate the sensitivity of the investment decision to a change in the annual contribution. 4
Solution to Question 3 Sensitivity to a change in annual contribution = NPV/PV of contribution NPV = -200,000 + 389,340 108,150 + 17,010 = 98,200 Sensitivity = 98,200/ 389,340 = 25.22% This means that the annual total contribution can drop by a maximum of 25.22% if the project is to remain viable. (Total 3: 2 marks) Question 4 - Financial Accounting and Financial Statement Analysis 4a) When Schemers Limited started facing problems it was, among other things, recording revenue in advance of the sale of the goods. How does such an accounting practice affect the following? 4a1) Reported earnings. (1½ marks) 4a2) Reported cash flows. (1½ marks) 4b) Explain how each of the items below would affect the statutory published earnings per share figure for a manufacturing company: Item The impairment of an intangible asset. A new issue of bonus shares to shareholders. Profit on the sale of a property. Impact (1½ marks) 4c) The Conceptual Framework for Financial Reporting identifies faithful representation as a fundamental qualitative characteristic of useful financial information. Distinguish between fundamental and enhancing qualitative characteristics and explain why faithful representation is important. (1½ marks) (Total 6 marks) Solution to Question 4 4a) 4a1) The practice of recording revenue ahead of sale of goods would impact on the reported earnings of the firm. It would result in an inflation of reported earnings. (1½ marks) 4a1) The practice would have no impact on reported cash flows of the firm. (1 ½ marks) 4b) Item The impairment of an intangible asset. A new issue of bonus shares to shareholders. Impact When an intangible asset is impaired, its carrying amount is reduced, and the impaired amount is written off to the operating statement. This reduces the amount of earnings, and hence the EPS, all else being equal. A new issue of bonus shares results in an increase in total number of shares outstanding. All else being equal, this results in a reduction in published EPS. 5
Profit on the sale of a property. Profit on the disposal of property results in increase in total earnings, which in turn results in an increase in EPS, all other things being equal. Solution to Question 4c: The Conceptual Framework for Financial Reporting implies that the two fundamental qualitative characteristics (relevance and faithful representation) are vital as, without them, financial statements would not be useful, in fact they may be misleading. As the name suggests, the four enhancing qualitative characteristics (comparability, verifiability, timeliness and understandability) improve the usefulness of the financial information. Thus financial information which is not relevant or does not give a faithful representation is not useful (and worse, it may possibly be misleading); however, financial information which does not possess the enhancing characteristics can still be useful, but not as useful as if it did possess them. In order for financial statements to be useful to users (such as investors or loan providers), they must present financial information faithfully, i.e. financial information must faithfully represent the economic phenomena which it purports to represent (e.g. in some cases it may be necessary to treat a sale and repurchase agreement as an insubstance (secured) loan rather than as a sale and subsequent repurchase). Faithfully represented information should be complete, neutral and free from error. Substance is not identified as a separate characteristic because the IASB says it is implied in faithful representation such that faithful representation is only possible if transactions and economic phenomena are accounted for according to their substance and economic reality. (1½ marks) (Total: 3 marks) Question 5 - Equity Valuation and Analysis 5a) Mr. T and Miss K are securities analysts who are evaluating TK plc, a company in the pharmaceuticals industry with 25 million shares. TK is currently in its first year of operations and has just reported a profit after tax of 1,500 million in July 2018. The company has a debt to equity ratio of 10% at present. The book value of the company s debt is 600 million and the average interest rate on its debt is 5%. The company is expected to have a high growth period for the first 5 years of its operations. From the sixth year onwards, i.e. from August 2022, the firm is expected to attain an annual stable dividend growth rate of 6% and an expected ROA (return on assets) of 14%. The company has a long term target debt to equity ratio of 40%. Ignore taxes. 5a1) What is the expected growth rate in earnings during the initial period of high growth (5 years) if the retention rate during this is expected to be 80%. 5a2) What is the expected dividend payout ratio after the period of high growth, if the average interest rate on debt remains unchanged? (4 marks) 5a3) If the company s cost of equity is 12%, the WACC is 10%, and the retention rate is 80%, what is its current expected price? Note: If you did not answer (a) above, assume an initial growth rate of 20%. (4 marks) 6
5a4) Discuss two (2) key weaknesses of dividend valuation model in valuing equity shares. Solution to 5a) 5a1) Using the formula: g = ROE b, where: ROE = return on equity b = retention rate = 80% We know that: Hence g = (25)(0.8) = 20% 5a2) Using the formula: g = ROE b (Total 5a: 3 marks) = 14 + (14-5) 0.4 = 17.60% 6 = (17.60)(b) b = 34% = retention rate Payout ratio = 100% - 34% = 66% (Total 5a2: 4 marks) 5a3) Current (July 2018) EPS o = 1,500/25 = 60 Current (July 2018) div = D o = 60 20% = 12 PV of dividends: First 4 years when g = 20% Using growing annuity: Years 5 infinity when g = 6% D 5 = 12(1.20) 4 (1.06) = 26.38 Total VPS = 57.21 + 279.42 = 336.63 (Total 5a3: 4 marks) Notes 1. Alternative methods of calculation are available with full credit 7
2. The growth rate of 20% is for the first five years of the company s operations and the result of the first year are already available. We therefore have 4 years to go. 3. The information given on WACC is irrelevant as the dividend valuation model uses cost of equity. 5a4) The Gordon growth model suffers from the following weaknesses: The model is not useful for valuing non-dividend paying companies. The model is also not useful for directly valuing dividend paying firms if the dividends are not growing at a stable rate. The estimated stock values are very sensitive to assumed required rate of return and the growth rate. Even a small variation in the assumed required rate of return or growth rate leads to a relatively large variation in the estimated stock value. (1 mark each for any two points mentioned) (Total Question 5a: 16 marks) 5b) Yaro Soundhead, an analyst, is assigned the responsibility of placing value on Model Furniture Ltd (MFL). MFL specializes in producing bespoke office and home furniture for the high and mighty throughout the country and along the ECOWAS sub-region. Your investment firm has been offered 60% stake in the company hence the need for valuation. You have collected the following financial data of MFL for the most recent two years. Table 1 Model furniture Ltd Summary Statement of Income Year ended 31 December ( 000 except for share data) 2013 2012 Revenues 194,850 171,930 - Depreciation - 8,425-7,945 - Other Operating costs -124,500-119,270 EBIT 61,925 44,715 - Interest expense - 2,425-715 Income before taxes 59,500 44,000 - Taxes at 30% -17,850-13200 Profit after tax (PAT) 41,650 30,800 Table 2 Model Furniture Ltd Statement of Financial Position ( 000) Assets 2013 2012 Non Current assets 32,500 20,231 Receivables 9,750 11,645 Inventory 15,476 13,940 Cash and bank 11,775 9,920 69,501 55,736 Liabilities and Equity Short term loan (payable within 12 months) 1,500 2,000 Accounts payable 2,040 4,250 Non-Current Loan 4,511 9,745 Total Liabilities 8,051 15,995 Equity 61,450 39,741 69,501 55,736 EPS 4.17 3.08 DPS 1.50 1.50 8
The number of shares has remained constant over the last five years and dividend per share has also remained constant at 1.50 over the period. 5b1) Determine whether using the Gordon dividend growth model to value MFL s equity is appropriate or inappropriate. Justify your response on the assumptions of the Gordon growth model and other relevant information in the scenario. (2marks) 5b2a) Managing director of the investment firm is of the view that Yaro should make use of the free cash flow to the firm (FCFF) model, based on a single-stage annual growth rate of cash flow. He recommends the following formula to value MFL s equity: (V o ) as of 31 December 2013: FCFF o x (1+g) V o = - BVD o r - g FCFF o = free cash flow to the firm in 2013 g = constant annual growth rate of cash flow r = required rate of return for equity BVD o = book value of debt as at December 2013 Indicate whether Yaro s use of each of the following two variables in the above formula for V o is appropriate or inappropriate: B (i) r ii) BVD o 5b2b) State, for any inappropriate variable, the variable that Yaro should use in his formula for Vo 5b2c) It is finally decided that Yaro should make use of the free cash flow to equity (FCFE) model: 5b2d) Calculate MFL s free cash flow to equity (FCFE) for 2013 show all workings (4marks) 5b2a) You have now collected the following additional information relevant for the valuation: Risk free rate 4% Market risk premium 8% Target debt-to-asset ratio D 0.2 E + D Appropriate asset beta 0.64 Effective tax rate 30% Beta of debt 0 d)(i) Using the target debt-to-asset ratio, compute the appropriate rate of return needed for the valuation of MFL (Round your answer to nearest 1%). Show your workings d) (ii) Assuming the FCFE in December 2013 is 20 million. The FCFE will grow at 15% for the following 4 years (i.e. 2014, 2015, 2016 and 2017) and 2.50% p.a. for the indefinite future. What is the total value of MFL s equity using the FCFE valuation approach? Note: if you could not calculate the appropriate rate of return in (e)(i) above, assume a rate of 10% 9
Solution to 5b Solution 5 a) Using the Gordon growth model would be inappropriate to value MFL s equity for the following reasons: 1. The Gordon growth model assumes a set of relationship about the growth rate in dividends, earnings, and stock values. Specifically, it assumes that dividends, earnings, and stock values will grow at the same constant rate. In the case of MFL, the Gordon growth model is not appropriate because management s dividends/policy has held dividends constant in Naira value although earning have grown, does reducing the payout ratio. This policy is inconsistent with the Gordon growth model assumption of a constant payout ratio. 2. it could also be argued that using the Gordon growth model given MFL s dividend policy violates one of the general conditions for suitability of use, namely that a company s dividend policy bears an understandable and consistent relationship to the company s profitability. 3. The investment company (i.e. the prospective investor) is taking a control perspective (60% in this case). The investor may change the company dividend policy substantially, for example it may set a level approximating MFL s capacity to pay dividend. The Gordon growth model assumes non-control perspective. 5b1) r - Inappropriate. Since the company is geared, weighted average cost of capital should be used to discount FCFF BVD o - Inappropriate. The market value of debt should be used i) Computation of FCFE NWC = Inventory + accounts receivable accounts payable 000 2013 : 15,476+9,750-2,040 = 23,186 2012 : 13,940+11,645-4,250 = 21,335 Increase in working capital 1,851 Purchase of non-current assets 000 Closing net book value 32,500 Add: depreciation for the year 8,425 Less: opening net book value -20,231 Non-current asset purchased 20,694 Loan repayment 000 000 Opening short-term loan 2,000 Opening non-current loan 9,745 11,745 Closing short-term loan 1,500 Closing non-current loan 4,511 6,011 Loan repayment 5,734 (¼ mark each for the highlighted) FCFE = PAT + Depr - WC + Debt (¼ mark) = 41,650 + 8,425 20,694 1,851 +(-5,734) = 21,796( 000) 5b2) (i) First, we need to determine the equity beta using : β E = β A + (β A β D ) D / E (1-t) 0.2 0.2 D / E = = = 0.25 1-0.2 0.8 (Note that Debt/Asset i.e. D / E+D is given) 10
β E = 0.64 + (0.64-0)(0.25)(1-0.3) = 0.752 Using CAPM: Cost of equity is 4% + (0.752 x 8%) = 10% (ii) First, we determine the terminal value at the end of year 4 (TV 4 ) FCFE 5 20(1.15) 4 (1.025) TV 4 = = = 478.06 million r - g 0.10 0.0 Next, we compute V o, the total current market value of equity: m FCFE 1 20(1.15) 1 Yr1 = = = 20.91 (1+r) 1 1.10 FCFE 2 20(1.15) 2 Yr2 = = = 21.86 (1+r) 2 (1.10) 2 FCFE 3 20(1.15) 3 Yr3 = = = 22.85 (1+r) 3 (1.10) 3 Yr4 = FCFE 1 + TV 4 (1+r) 4 20(1.15) 4 + 478.06 = = 350.41 (1.10) 4 Total Value = V o = 416.03m Note to correctors: The above approach is not necessarily prescriptive, candidates can use several methods leading to the same acceptable result. For example, the following alternative method can be used: First 4 years, when g = 15% We can use growing annuity: FCFE 0 (1+g) 1 + g 4 PV = 1- r g 1 + r 4 20 (1.15) 1.15 PV = 1- = 89.51 0.10-0.15 1.10 Years 5 to infinity, when g = 2.5% FCFE 5 PV = r - g (1 + r) -4 20(1.15) 4 (1.025) PV = x (1.10) -4 = 326.52 0.10 0.025 Total PV = V o = 89.51 + 326.52 = 416.03 million 11
5c) An investor considers investing in one of two risk free investment options. Option A gives the Investor 2% return every six months for the next 5 years, when he would get back his principal. Every semester the investor can reinvest the return in the same scheme. Option B guarantees a return of 21% to the investor after 5 years. 5c1) The investor wants to opt for option B. Is it the right option? Calculate the holding period returns for each option and justify your answers. 5c2) Calculate the annual average arithmetic, geometric and continuously compounded returns for the two options. Does the decision change based on the calculations of annual average returns? (5 marks) Required (36 marks) Question 6 - Corporate Finance The following financial information is available for PH Plc. 2014 2015 2016 2017 Earnings attributed to ordinary shareholder 200m 225m 205m 230m Number of ordinary shares 2,000m 2,100m 2,100m 1,900m Price per share (kobo) 220 305 290 260 Dividend per share (kobo) 5 7 8 8 Assume that share prices are as at the last day of each year. Required: Calculate PH plc s earnings per share, dividend yield and price/earnings ratio. Explain the meaning of each of these terms and why investors use them, and what limitations they may have. (6 marks) Solution to Question 6a 6a) Data: 2014 2015 2016 2017 1 Equity earnings ( m) 200 225 205 230 2 Number of shares (m) 2,000 2,100 2,100 1,900 3 Price per share (kobo) 220 305 290 260 4 Dividend per share (kobo) 5 7 8 8 5 Earnings per share (= 1 2)(kobo) 10 10.7 9.8 12.1 Dividend yield (= 4 3) 2.3% 2.30% 2.80% 3.1% Price/earnings ratio (= 3 5) 22.0 28.5 29.6 21.5 times (½ mark each) Earnings per share Earnings per share (EPS) shows the amount of profit after tax attributable to each ordinary share. Although a high EPS generally indicates success, care must be taken in interpreting the trend in EPS when there have been share issues, especially rights issues at heavily discounted prices or bonus issues, both of which result in a fall in EPS. Similar problems are encountered when warrants or convertible loan notes are issued. 12
Dividend yield The dividend yield shows the ordinary dividend as a rate of return on the share value. The figure is of limited use because it shows only part of the return to the equity investor. Price/earnings ratio The price/earnings ratio (P/E ratio) shows how many times bigger the share price is than the EPS. In general, the bigger the EPS, the more the share is in demand, though care must be taken when making comparisons because whereas EPS is a historical result, the share price is based on future expectations and is affected by both risk and growth factors. Consequently, abnormal results can often arise from a crude use of P/E ratios. (Total 6: 6 marks) Question 7 - Financial Accounting and Financial Statement Analysis 7a) In order to gain market share, Wazobia Limited has offered longer credit terms to customers in 2017. Comparative figures for 2016 and 2017 are shown below: Ratio 2017 2016 Sales for the year. 60,000,000 50,000,000 Operating profit for the year. 5,600,000 4,000,000 Closing balance of trade receivables. 9,000,000 5,000,000 7a1) Calculate the receivables collection period for 2016 and 2017. Solution Computation of receivables collection period Receivables collection period = Trade receivables x 365 days Sales 2016 N5,000,000 X 365 days = 36.5 days N50,000,000 2017 N9,000,000 X 365 days = 54.75 days N60,000,000 7a2) Has this policy had any impact on the company s performance? Solution to 7a2) Apparently, the policy appears to have benefited the company. Sales grew by 20% from N50m in 2010 to N60m in 2011, while profit equally grew by 40% from N4m to N5.6m. A possible explanation for this is that by relaxing credit policy, customers had an incentive to buy from Wazobia Limited rather than from its competitors. The company may have gained a higher market share in the process, especially if the company s competitors did not follow suit by relaxing their own credit policy. 7b) You have been hired as an analyst for Manifold Investment and your team is working on an independent assessment of Reward Plc, a firm that specializes in the production of freshly imported farm products from France. Your assistant has provided you with the following data for Reward Plc and their industry. 13
Ratio 2017 2016 2015 2017 Industry Average Long-term debt 0.45 0.40 0.35 0.35 Inventory Turnover 62.65 42.42 32.25 53.25 Depreciation/Total Assets 0.25 0.014 0.018 0.015 Days sales in receivables 113 98 94 130.25 Debt to Equity 0.75 0.85 0.90 0.88 Profit Margin 0.082 0.07 0.06 0.075 Total Asset Turnover 0.54 0.65 0.70 0.40 Quick Ratio 1.028 1.03 1.029 1.031 Current Ratio 1.33 1.21 1.15 1.25 Times Interest Earned 0.9 4.375 4.45 4.65 Equity Multiplier 1.75 1.85 1.90 1.88 7b1) In the annual report to the shareholders, the CEO of Reward Plc wrote, 2017 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current assets (cash, account receivables and short-term marketable securities). Is the CEO correct? Explain and use only relevant information in your analysis. Solution to Question 7b1) Note: The answer should be focused on using the current and quick ratios. While the current ratio has steadily increased, it is to be noted that the liquidity has not resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio one could note that the increase in liquidity is caused by an increase in inventories. For a fresh food firm one could argue that inventories are relatively liquid when compared to other industries. Also, given the information, the industry-benchmark can be used to derive that the firm's quick ratio is very similar to the industry level and that the current ratio is indeed slightly higher - again, this seems to come from inventories. 7b2) What can you say about the firm's asset management? Be as complete as possible given the above information, but do not use any irrelevant information. Solution to Question 7b2) Note: Inventory turnover, days sales in receivables, and the total asset turnover ratio are to be mentioned here. (½ march each) Inventory turnover has increased over time and is now above the industry average. This is good - especially given the fresh food nature of the firm's industry. In 1999 it means for example that every 365/62.65 = 5.9 days the firm is able to sell its inventories as opposed to the industry average of 6.9 days. Days' sale in receivables has gone down over time, but is still better than the industry average. So, while they are able to turn inventories around quickly, they seem to have more trouble collecting on these sales, although they are doing better than the industry. Finally, total asset turnover went down over time, but it is still higher than the industry average. It does tell us something about a potential problem in the firm's long term investments, but again, they are still doing better than the industry. (1½ marks) (Total 7b2: 3 marks) 7b3) You are asked to provide the shareholders with an assessment of the firm's gearing/leverage. Be as complete as possible given the above information, but do not use any irrelevant information. Solution to Question 7b3) Solvency and leverage is captured by an analysis of the capital structure of the firm and the firm's ability to pay interest. 14
Capital structure: Both the equity multiplier and the debt-to-equity ratio tell us that the firm has become less leveraged. To get a better idea about the proportion of debt in the firm, we can turn the D/E ratio into the D/V ratio: 1999: 43%, 1998: 46%, 1997:47%, and the industry-average is 47%. So based on this, we would like to know why this is happening and whether this is good or bad. From the numbers it is hard to give a qualitative judgement beyond observing the drop in leverage. In terms of the firm's ability to pay interest, 2014 looks pretty bad. However, remember that times interest earned uses EBIT as a proxy for the ability to pay for interest, while we know that we should probably consider cash flow instead of earnings. Based on a relatively large amount of depreciation in 2017 (see info), it seems that the firm is doing just fine. 7c) On 1 January 2017, company A had an authorized share capital of 4 million shares and an issued share capital of 2 million shares. The nominal value of each share is 25k. During 2017, the company undertook the transactions below: January 8 share. March 30 A successful rights issue of 1 new share for 5 at N2.12 per A bonus issue of 1 share for every 2 held. How many authorized and issued shares will the company have at the end of its 2017 financial year? Ignoring transaction costs, how much money has company A raised? Solution to Question 7c) 7c) The issued share capital is the key number here. Jan 2nd 400,000 new shares (2.4 million total) and raising N848,000. March 3rd 1,200, 000 new shares (3.6 million total). No money raised. (i) Dividend share capital = N3.6million and N848,000 raised (ii) Authorised capital stays the same. (Total 7c: 2 marks) 7d) A director of a manufacturing company was heard to say, Non-current asset turnover attracts too much analyst attention margin improvement has to be our key objective. Briefly state why improving non-current asset turnover may be important for such a company. Solution to Question 7d) 7d) Manufacturing assets are expensive and mean a great deal of capital is tied up and a return needs to be made on this investment. The return can only be achieved in two ways - charging a mark-up on cost or by getting more sales out of the assets. Asset turnover measures the latter of the two. 7e) Reservator Limited recently approached the bank in which you work seeking further finance. Your manager has asked you to review the loan application. While researching the company you found a recent newspaper article in which Reservator was described as a company with gearing ratio of 51.8. 7e1) Explain what is meant by high gearing. 7e2) Discuss the implications of a high gearing ratio on the loan application submitted 15
Solution to Question 7e) 7e1) The term gearing is used to describe the capital structure of a company which is usually made up of a combination of debt and equity. Equity refers to the monies owners (shareholders) have invested in the business and debt refers to the funds which have been borrowed. A company that is highly geared has a lot of debt relative to equity and a company that does not have a lot of debt relative to equity is said to have low gearing. The gearing ratio of a company is calculated as follows: Non-current liabilities x 100 Share capital + reserves +non-current liabilities 1 Elwood s gearing ratio is 52%* which means that for every N invested in the business 52 kobo of it came from borrowed funds, that is more than half the funds invested came from debt. While this is not a negligible level of debt it is not at a critically high level unless of course the company was unable to service this debt. Some of the disadvantages of a highly geared company are as follows: 1. Companies with high levels of gearing normally find it more difficult to borrow than companies with low gearing. 2. Interest on debt must be paid every year regardless of profits whereas there is no such obligation to pay dividends on ordinary shares. 3. Higher levels of debt results in higher interest charges and less funds available for the ordinary shareholders. (½ marks for any two mentioned) However there are some advantages to having higher gearing levels: 1. Interest is tax deductible whereas dividends are not. 2. When debt is used to finance the business instead of equity the ownership of the business is less diluted that businesses with low levels of gearing. (½ marks for any two mentioned) 7e2) While Reservator Limited has a relatively high level of gearing it may be generating sufficient profits to service the debt and still has profits available to make a dividend distribution to shareholders. Therefore I may not consider the current gearing levels to be too high and would like to review profit forecasts to determine whether the company can continue to service current and possibly higher debt levels. (Total Question 7: 18 marks) 16