Problem Set on Growth for Financial Analysis PDF

Problem Set #3 1/ The following are the earnings per share of Thermo Electron, a company that designs cogeneration and resource recovery plants, from 1987 to 1992: Year EPS 1987 0.67 1988 0.77 1989 0.90 1990 1.10 1991 1.31 1992 1.51 A. Estimate the...

Problem Set #3 1/ The following are the earnings per share of Thermo Electron, a company that designs cogeneration and resource recovery plants, from 1987 to 1992: Year EPS 1987 0.67 1988 0.77 1989 0.90 1990 1.10 1991 1.31 1992 1.51 A. Estimate the arithmetic average growth rate in earnings per share from 1987 to 1992. B. Estimate the geometric average growth rate in earnings per share from 1987 to 1992. C. Why are the growth rates diIerent? Year EPS Growth rate 1987 $0.67 1988 $0.77 14.93% 1989 $0.90 16.88% 1990 $1.10 22.22% 1991 $1.31 19.09% 1992 $1.51 15.27% A. Arithmetic 17.68% Average = B. Geometric 17.65% Average = C. The geometric average considers the compounded eIects of growth. The arithmetic average does not. 2/ Johnson and Johnson, a leading manufacturer of healthcare products, had a return on equity in 1992 of 31.4%, and paid out 36% of its earnings as dividends. It earned a net income of $1,625 million on a book value of equity of $5,171 million. As a consequence of healthcare reform, it is expected that the return on equity will drop to 25% in 1993 and that the dividend payout ratio will remain unchanged. A. Estimate the growth rate in earnings based upon 1992 numbers. B. Estimate the growth rate in 1993, when the ROE drops from 31.4% to 25%. C. Estimate the growth rate after 1993, assuming that 1993 numbers can be sustained. A. Retention Ratio = 64% Return on Equity = 1625/5171 = 31.4% Expected Growth Rate = 0.64 * 31.4% = 20.10% B. Growth Rate in 1993 = ( $5,171 * (.25 -.314)/ $1,625) + 0.64 * 0.25 = -4.37% C. Growth Rate After 1993 = 0.64 * 0.25 = 16% 3/ Eastman Kodak was, in the view of many observers, in serious need of restructuring in 1994. In 1993, the firm reported the following: Net Income = $1,080 million Interest Expense = $ 550 million The firm also had the following estimates of debt and equity in the balance sheet: Equity (Book Value) = $6,000 million Debt (Book Value) = $6,880 million The firm also paid out total dividends of $660 million in 1993. The stock was trading at $63, and there were 330 million shares outstanding. (It faced a corporate tax rate of 40%.) Eastman Kodak had a beta of 1.10. Analysts believe that Kodak could take the following restructuring actions to improve its financial strength: It could sell its chemical division, which has a total book value of assets of $2,500 million and has only $100 million in earnings before interest and taxes.  It could use the cash to pay down debt and improve its bond rating (leading to a decline in the interest rate to 7%). It could reduce the dividend payout ratio to 50% and reinvest more back into the business. A. What is the expected growth rate in earnings, assuming that 1993 numbers remain unchanged? B. What is the expected growth rate in earnings, if the restructuring plan described above is put into eIect? C. What will the beta of the stock be, if the restructuring plan is put into eIect? A. Retention Ratio = 1 - $660/$1080 = 0.3889 Return on Assets = ($1080 + $550 * (1 - 0.4))/($6000 + $6880) = 10.95% Debt/Equity Ratio = (6880/6000) = 1.14 Expected Growth Rate: = 0.3889 (10.95% + 1.14 (10.95% - (550/6880) * (1 - 0.4)) = 7.00% B. Retention Ratio = 50% Total Assets = $6000 + $6880 - $2500 = $10.380. New Return on Assets = (1020 + 550 * (1 - 0.4))/10380 = 13.01% (The earnings before interest and taxes goes down by $100. The earnings after taxes will drop by $60. Note that interest expenses will be lower after debt is paid oI, but the net income will go up by an equivalent amount.) New Debt Equity Ratio = (4380/6000) = 0.73 New Expected Growth Rate = 0.50 (13.01% + 0.73 (13.01% - 7%*(1 - 0.4))) = 9.72% (The growth rate next year will be much higher as a result of the shift in the return on equity, but the long term growth rate will now be 9.72%) C. Beta Before Change = 1.10 Unlevered Beta = 1.10/(1 + (6880/(330 * $63)) * (1 - 0.4)) = 0.9178 (Use market value of equity for this calculation) Beta After Change = 0.9178 * (1 + (4380/(330 * $63)) * (1 - 0.4)) = 1.04 4/ Computer Associates makes software that enables computers to run more eIiciently. It is still in its high-growth phase and has the following financial characteristics: Return on Assets = 25% Dividend Payout Ratio = 7% Debt/Equity Ratio = 10% Interest rate on Debt = 8.5% Corporate tax rate = 40% It is expected to become a stable firm in ten years. A. What is the expected growth rate for the high-growth phase? B. Would you expect the financial characteristics of the firm to change once it reaches a steady state? What form do you expect the change to take? C. Assume now that the industry averages for larger, more stable firms in the industry are as follows: Industry Average Return on Assets = 14% Industry Average Debt/Equity Ratio = 40% Industry Average Interest Rate on Debt = 7% Industry Average Dividend Payout ratio = 50% D. What would you expect the growth rate in the stable growth phase to be? A. Expected Growth Rate = 0.93 (25% + 0.10 (25% - 8.50% * (1 - 0.4)) = 25.10% B. The following would be the expected changes : (1) ROC will decline as the firm gets larger and the marginal projects are no longer as lucrative. (2) Dividend payout ratio will increase. (3) Debt/Equity ratio will increase as the firm gets larger and safer. (4) The interest rate on debt will decline for the same reasons. C. Expected Growth Rate = 0.5 (0.14 + 0.4 (0.14 - 0.07 * (1 - 0.4)) = 8.96%